ISLAMIC FINANCE: PRINCIPLE AND OPERATION...Islamic finance is experiencing a “formalist deadlock” where the industry is more concerned with formal adherence to Islamic law instead

ISLAMICFINANCE:PRINCIPLEANDOPERATION

Zulkifli Hasan

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Contents

•  Introduc+on•  BetweenAspira+onandReality•  IslamicFinance:PrincipleandOpera+on•  Challenges•  ConcludingRemarks 2

•  GlobalIslamicbankingassetsreachUSD1.8trillion(17%averageannualgrowthandIslamicfinancewillbeabletoMpUSD6.5trillionbytheyear2020).

•  Islamicbankinggrowth:1.9MmeshigherthanconvenMonal2009-2013.

•  DespitethegrowthandtransformaMon,therearenumerouscriMcismsonthecurrentpracMceofIslamicfinance,whichhaveledtoseriesofquesMonsastothedisMncMvenessofIslamicfinancewithitsconvenMonalcounterpartsandthegrowingfrustraMonontheethicalissuesbeyondthelegalrealmofShari’ah-compliance.

•  Shari’ahcompliantfundsuffereddifficulMesin4yearsduetolackofinnovaMon(USD584bnin2015/USD2.4bnin2014).

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Introduction

Between Aspiration and Reality: 40 Years After Its Inception

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A study by Beloufi et al (2015) on 40 researchesbetween 1983-2013 found a significant divergencebetweenthetheoryandprac+ceofIslamicfinance.

AOer40Years?

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2015

MarketShare Customers TotalAssets

4Marketswith30%MarketShare

Lessthan100millioncustomers(2.5bnnobank’saccount,1bnyouthacrossOIC)

3trillion(GlobalfinancialassetUSD300trillion)

2021

20marketswith40-50%MarketShare

250millioncustomers

9trillion

IMFReport2017

•  Islamicbanking(IB)conMnuestogrowrapidly,insizeandcomplexity,posingachallengetosupervisoryauthoriMesandcentralbanks.

•  ProgresshasbeenslowindevelopingIB’sliquiditymanagementandmoneymarkets.

•  hybridfinancialproductsinIBhaveemergedthatreplicateaspectsofconvenMonalfinanceinanIBcontext,raisingfinancialstabilityconcerns.

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Islamic Bank Share of Total Assets & Deposits

Country Assets% Deposits%

SaudiArabia 48.9 N/A

Kuwait 44.6 47.3

Bahrain 27.7 47.8

Qatar 23.6 35.7

UAE 21.4 32.8Malaysia 20.7 29.4Pakistan 9.5 11.4Turkey 5.9 7.1

Indonesia 5.5 11.4

AssetandDeposit

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Bank Assets$billion

Deposits$billion

Overseasfocus

AlRajhi 74.6 61.6 Malaysia

KuwaitFinanceHouse

57.3 35.8 Turkey

MaybankIslamic 38.0 25.3 Indonesia,Singapore

DubaiIslamicBank 30.8 21.6 Pakistan

•  ThetotalnumberofShari’ahscholarsreached952covering652IFIsinmorethan46countries.

•  75%withinthetop10countries(MalaysiaBangladeshIndonesiaKuwaitSaudiArabiaBahrainSudanUAEPakistanOman)

•  41%intheGCCregion.•  26%SouthEastAsia•  16%inSouthAsia•  11%inMENAna+ons•  2%Europe

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PresentNumberofScholars

HighConcentra.ononFewScholars

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• 10Shari’ahscholarsserveinapproximately497IFIsrepresen+ng76%thetotalIFIswithShari’ahboards.• 3scholarswiththehighestnumberofboardmembershipsserveabout40%ofIFIsglobally.• Thenumberofins+tu+onsincreasesandtheamountofworkincreases.• Thereisdeficiencyofabout1700Shari’ahboardmembers,wherebyitisexpectedthattherequirementforShari’ahscholarswillriseto3000innext5yearsif5%growthisassumedinthenumberofIFIs.• SuccessionPlan–Seriousac+onrequired• PerformanceAssessment(Collec+ve&Individually)

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Shari’ahScholarsAroundtheWorld

Countries NumberMalaysia 203Bangladesh 173Indonesia 131Kuwait 70SaudiArabia 68Sudan 60Bahrain 60UAE 57Pakistan 43Oman 32Qatar 30

•  “Iwouldliketotellyou,inallfrankness,thatifIweretostartalloveragain, I would not choose the bank as a framework for theapplica+on of Islamic teachings in the field of economy andinvestment.Iwouldlookforanotherframework,whichisfullyinlinewiththeShari’ahprinciplesregula+nginvestment.Thisisduetothefactthatwehavenotbeensa+sfiedwithtakingonlythenameofthebank but also its basic concept, namely, that it is a financialintermediary. So, we have not been able to find for our financialins+tu+onsaconceptandapajern,whichgoesbeyondtheissueoffinancial intermediary. This has led to the fact that the preferredinvestmentpafernsof Islamicbankshavebecomeamixofa loanandaninvestment.Itisamix,whichhasmostofthecharacterisMcsofariba-basedloanandtheflawsoftheWesterncapitalistsystem.It fails tohighlightthefeaturesof Islamic investmentbasedonrisk-sharingandreal investment. Itdoesnotrecognizetheguaranteeofthecapitaloritsreturn.”

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SheikhSalehKamel

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Critiques on Islamic Finance

Themes CriMques

Objectives of Islamic law.

Islamic in Islamic finance should relate to the social and economic ends of financial transactions rather than the contract mechanics through which ends are achieved.

Excessive debt.

The disproportionate percentage of debt-based instruments as compared to equity-based.

Relying on legal fiction.

In developing a fiqh muamalat caution must therefore be exercised for it is all too easy, when creating and then relying on legal fiction, to fall into the pit of complacency and inadvertently developing a fiqh hiyal.

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Critiques on Islamic Finance Themes CriMquesLack of social dimension and poor record of corporate social responsibility.

Lack of commitment of Islamic finance industry to support developmental agenda and corporate social responsibility.

‘The doctrine of shareholders’ value, which is the bedrock of capitalistic market, has been shown to be the basis of Islamic finance practices’.

Identical to the conventional banking.

“The ‘applied business model’ of IBs is almost identical to the conventional interest-bearing one. It is neither a ‘two-tier mudharabah’ nor a wakalah (agency) based model but rather a specially ‘engineered’ debt model. The framework adopted in the development of Islamic financial instruments has been to design products in such a way that these are almost equivalent in economic and risk characteristics to conventional debt instruments”.

Lack of authenticity and operates within Neo-classical economics.

“Rather than being part of the Islamic political economy, Islamic finance has been pursuing policies away from the theoretical underpinnings and systemic understanding of Islamic economics and has located a surrogate financial framework in neo-classical economics”.

Themes CriMquesOver legalistic approach.

“From the legalistic perspective, it is argued that interest is haram for being unjust and exploitative. However these concerns are merely rhetorical, as the new institutions in question have become too cozy with their own exploitative environment about which they are mute. Islamic finance is delinked from the broader goals of development and poverty alleviation” (Farooq, 2007).

Islamic finance is experiencing a “formalist deadlock” where the industry is more concerned with formal adherence to Islamic law instead of promoting Islamic ethical values (Balz, 2008).

“The current trend reduces Islam and its Shari’ah to their legal dimension rather than seeing them within a greater civilizational framework” (Haneef, 2009).

“Shari’ah scholars approach the issue from a microeconomic perspective, and reflect on how an IB, as a financial firm, should conduct its transactions according to fiqh rules; they do not see it in a macroeconomic terms, with IB, as financial intermediaries, meeting the financing needs of society” (Siddiqi 2000).

•  Nega+vepercep+onbythegeneralpublic.•  MuslimConsumerAssocia+onofMalaysia(PPIM)reportedthattheyhavereceivedmorethan4000reportsfromconsumersbetween2003-2012oftheirdissa+sfac+onwithIFIs.ThePPIMclaimedthattheIFIshaveabusedtheword‘Islam’forthepurposeofprofitmaximiza+onwithouttakingintoconsidera+ontheethicalaspectsofdoingbusiness.

•  TherearemanycaseswherethecustomersneedtopaythewholeamountofsellingpricetoIFIseventheconstruc+onprojectwasclearlyabandoned.

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Nega+vePercep+on

IslamicFinance:PrincipleandOperaMon

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“EverythingthatlapsesoutfromjusMceintoinjusMce,andfrommercyintoitsopposite,andfrommaslahahtomafsadah,andfromwisdomintothefrivolous,doesnotbelongtoShari’ah,evenifitisinductedintoitbyinterpretaMon”(Ibnal-Qayyim).

•  STAGE1:FocusonhowtomigrateMuslimfromprac+cingriba.Thefocuswastofindhalalsolu+onbyreplica+ngcertainfeaturesofconven+onalproductwithsomehiyaltoquicklymigratetheprac+cefromriba.

•  STAGE2:FocusontobegenuinelybasedonShari’ahbyremovingexcessivehiyalintheirprac+ce.

•  STAGE3:ConcernwiththeTAYYIBdimensionofhavinga“goodandresponsiblefinance”.Thepermissibilityofatransac+onwillnotonlydependonthepillarsofavalidcontractbutalsoonthevalues,ethics,outcomeorconsequencesofthetransac+ons.

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StagesofIslamicFinance

IslamicFinanceisMorethanFinancialContract

Tenet-BoundFundamentalstenetsderivedfromShari’ah

Principles-BoundConceptisgroundedonethicsandvalues

Real-economyLinkedAsset-backedtransac+onswithinvestmentsinreal,durableassets

Society-ServiceServingcommuni+es,notmarkets

– Blameworthy:• Riba• Gharar• Maisir

+Praiseworthy• Risk• Ethics

TheBasisofFiqhMuamalat

RibainConven+onalBanking

•  Onthebothsidesoftheconven+onalbanksRibaexists:

•  OntheLiabili+esSide,throughborrowingfromdepositorsonfixedandguaranteedreturn

•  OntheAssetsside,throughlendingonInterestbasis.

•  Onthetreasuryside,throughlendingandborrowing.

TypesofUqud

Legality Purpose Reciprocity Validity Executability

ModernClassifica+on

•  PartnershipBased•  Exchange-Based•  Securitycontracts•  CharitableContracts•  AgencyContract•  Suppor+ngContracts

PartnershipBasedContracts

•  Mudharabah•  Musharakah

ExchangebasedContracts

•  Murabahah•  BayalIs+sna’•  BayalSalam•  BayalDayn•  BayalSarf-•  BayalInah•  BayalTawarruq•  Ijarah•  BayalIs+jrar

SecurityContracts

•  Kafalah(guarantee)•  Alrahn(mortgage)

CharitableContracts

•  Hibah•  Wadiah(Deposit)

Suppor+ngContracts

•  Muqasah•  Ibra•  Wa’d

1. Product Initiative

7. Periodic Shari’ah review

8. Annual Shari’ah review

6. Dissemination of Shari’ah rulings

5. Shari’ah ruling 4. Shari’ah review of the documents

3. Legal Documentation and Product Proposal

2. Preliminary Shari’ahAnalysis

ProductDevelopment

ProductDevelopmentStage1

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• Marketresearch•  Benefitanalysistobanksandclients

•  Productconcept&opera+on•  Balancingofrisk• Marke+ngchannel•  StandardOpera+ngmanual•  Feedbackfromstakeholders/commijee

•  Shariahstandardsandparameters

ProductConcept&Framework

Shari’ahParametersandGuidelines

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•  Forthepurposeofharmonisa+onandconsistency,thestandardsepngagenciesandregulatorshaveissuedseveralShari’ahparametersandguidelinestoIFIsasguidanceandreferencetopromoteharmoniza+onandstandardiza+onofIslamicfinanceprac+ces.

•  Thesestandardsincorporatevalue-orientedaspectsofIslamicfinanceprac+cesandputcertainrequirementstoensureeachfinancialtransac+onisgenuineandvalid.

ProductDevelopmentStage2

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•  Riskassessmentofproducton• Marketrisk•  StructuralRisk• Documenta+onrisk•  Peoplerisk•  Proposedmi+ga+onofrisk•  Endorsementoftheproduct•  Shari’ahcompliancerisk

Evalua+onofProductRisk

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“TheriskoflossresulMngfrominadequateorfailedinternal processes, people and systems or fromexternal events, which includes legal risk andShariahnon-complianceriskbutexcludesstrategicandreputaMonrisks”.“The risk that arises from the Bank’s failure tocomply with the Shariah rules and principlesdetermined by the relevant Shariah regulatorycouncils.”

Shari’ahComplianceRisk

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1STLINEOFDEFENSE

LineManagementandallstaff

3RDLINEOFDEFENSE

InternalAudit(IncludingShariahAudit)2NDLINEOFDEFENSE

Opera+onalRiskMgmtDept,Compliance,Shariah

ComplianceRiskManagementUnit,

Opera+onalRiskControlCommijee

RESPONSIBLEforongoingoversight of risk and control atdaytodayworklevel

ESTABLISHandmaintainORMandSCRM

Framework,assessingmonitoring,repor+ng

&controllingriskonabankwidelevel

PROVIDEINDEPENDENTASSURANCEtoBoardofDirectorsandSeniorManagementthatRisk

Managementprocessesandtoolsareeffec+vely

implemented.

ManagingSCRisa“collecMveresponsibility”“3linesofdefenses”concept

ProductDevelopmentStage3

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• ManagementRiskCommijee•  Shari’ahCommijee•  BoardRiskCommijee•  (Ministry’sapprovalwheremandateisexceeded)

•  BoardofDirector•  Regulator•  Launch

Approval

Post-Approval

•  Dissemina+onofShariahrulings•  ShariahReview•  ShariahAudit•  ReviewofShariahRulings•  ShariahNon-complianceRepor+ng.

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PenalMes

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FormofPenalMes PenalMes

AdministraMve theBNMmaymakeanorderinwriMngrequiringthepersoninbreachtocomplywithorgiveeffecttoortodoornottodoanyactinordertoensurecompliancewithsuchprovision

Monetary suchamountastheBankconsidersappropriate,notexceeding(RM5mil-bodycorporateorRM1mil-individual);

CriminalOffence

Upto10yearsimprisonmentor5-50millionringgitfineorboth

Challenges

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Themes RemarksCompeMMveness Equal the conven+onal product in

benefits.

Price Islamicfundingmaycostmore.Benchmarkagainstconven+onal.

Process Processandopera+onslightlylongerandrequireaddi+onaldocument.

Flexibility Interchangeability of Shari’ah conceptsto be at par with the conven+onalproducts.

Non-Compliance To simplify opera+on, some processmaybeomijed.E.gexecu+onofblankLejeroffer

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Profitability Some charges may not be avail to Islamicproducts e.g commitment fees, lowercompensa+onfee.

MarketDifferences

Differences in Shari’ah concepts in variousmarkets. E.g Bai Al Dayn not acceptable bymanymarketorevenbanksinM’sia.

ProductAwareness

PublicawarenessonIslamicfinanceiss+lllacking.Indifferenceaptude

PosiMveValues

Islamic principles advocates fairness and just.Ideally, genuine defaulters to be givenconcessions,butnotbeingdoneinsomeIFIs.

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ProductRisk Riskinsomeconceptsarehigherthantheconven+onalproduct.E.gMurabahah(riskofnonacceptanceofgoods by customer) Is+sna’ (non-comple+onofprojects).All possible risk to be iden+fied andproperlymi+gated.

LegaldocumentaMon

An extended version of conven+onaldocument. Too much influence on theprevious prac+ce. Market wants simpledocumenta+on

ModifiedConcepts

Investmentproductse.gpureMusharakahcannotbedonewithoutmodifica+on.

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Shari’ahRisk Product development and opera+on requiresShari’ahCommijee’s endorsement and requires indepth study. Conven+onal banking can transact onanything.Non-Shari’ah compliant may lead to “haram”income whichrequiresthebanktoforgotheprofitearned.

BalancingofBusinessandShari’ah

Some business areas are out of bound in Islamicfinance.

People Changesinincep+onofIslamicfinanceknowledgeandvaluesamongststaff.

TechnologicalAdvancement

EfficientdigitalbankingsystemthatcomplywiththeShari’ahprinciples

CaseStudies

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•  Insteadofintroducingandempoweringmudharabahtoportraythetruespiritofinvestment,IFIsontheotherhandarenowmigra+ngtotawarruq.

•  Inordertosupporttheini+a+vetopromoteequity-basedproducts,theMalaysiangovernmentbackedtheInvestmentAccountPlauormwithanini+alstart-upfundforRM150million.LembagaTabungHajialsoallocatedRM200millionfortheestablishmentoftheShari’ahcompliantRestrictedInvestmentAccount.

•  6IFIshavepar+cipatedinthisini+a+ve.TheseinvestmentaccountproductsarestructuredundertheprinciplesofMudharabahandwakalah.

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Risk Sharing Initiative

Concluding Remarks

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•  (1)DevelopmentofrobustenablingframeworkatnaMonallevel;

•  (2)Legal:regulatoryreformstocreatea“levelplaying-field”;

•  (3)PoliMcalsupport:industrybuildinginsMtuMonsarekeytobringingstandardizaMon;

•(4)Economics:towardsanindependentbankingsystem;and•  (5)TalentRecruitment.

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EnablingEnvironmentistheKeytotheOn-goingDevelopment

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