Chapter 22
The Impact of Islamic Finance
22.1 INTRODUCTION
Islamic finance is a system of banking activity that is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits the collection and payment of interest (commonly called riba) in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). In the late 20th century, a number of Islamic banks were created to cater for this particular banking market. Because of the very large number of individuals and corporations that wish to raise or invest capital according to Sharia principles, many of the world’s leading financial institutions such as HSBC, UBS and Citicorp, as well as institutions whose origins lie in Islamic countries, offer Sharia compliant products to their customers. Conservative estimates suggest that over USD 500 billion of assets are managed according to Islamic investment principles. Such principles form part of Sharia, which is often understood to be Islamic law, but it is actually broader than this in that it also encompasses the general body of spiritual and moral obligations and duties in Islam.
An investor who wishes to invest according to Sharia principles may not:
- Be a party to any transaction that, however indirectly, involves the payment or receipt of riba (interest)
- Be a party to any transaction whose nature is gharar (contractually ambiguous). Gharar is defined as “a situation where one party to a contract has information regarding some element of the contract which is withheld from the other party, and/or the subject of the contract is something which neither party has control”. Some Islamic scholars argue that most derivative contracts are, by their nature, gharar, and are therefore prohibited instruments.
- Invest in securities issued by any company whose business activities include activities that are haraam (forbidden). The following list of business activities has been deemed inconsistent with the principles of Sharia:
– Alcohol
– Pork-related products
– Conventional financial services (banking, insurance, etc.)
– Entertainment (hotels, gambling, cinema, pornography, music, etc.)
– Tobacco
– Weapons and defence.
- Invest in any company that finances itself mainly by the use of conventional debt instruments, or depends upon interest for a substantial proportion of its income
- Sell a stock short.
22.2 DELIVERING ISLAMIC FINANCIAL SERVICES
Islamic financial services are delivered not only by banks that have their origins in Islamic countries, but also by banks that have their origins in North America and Europe. These banks are delivering both wholesale and retail services both to international and domestic customers through Islamic windows – departments that only offer Sharia compliant products. Such an Islamic window must be supervised by a Sharia Supervisory Board – a group of Sharia scholars that also understand the financial services industry. It is this board that decides what products may be offered to customers, and also how those products are to be financed by the institution offering them, and what types of instruments (such as derivatives) may be used to hedge the firm’s positions.
22.3 SHARIA COMPLIANT INSTRUMENTS
As both borrowers and lenders are prohibited from investing in conventional debt instruments that pay interest, the market has evolved a wide range of products that have similar characteristics to conventional bonds, but do not involve the payment of interest per se. Many of these instruments are designed for the retail financial services sector, in particular for the residential mortgage market.
To avoid the issue of paying interest, Islamic mortgages usually involve the bank buying the property and then the buyer purchasing it from them over a length of time at a slightly increased price. Islamic mortgages also involve making other aspects of the mortgage Sharia compliant, for instance making sure that the money the banks use to buy the property comes from permissible sources.
Until July 2002 only one financial institution in the UK offered Islamic mortgages (the United Bank of Kuwait). The shortage of Islamic mortgages was due to a combination of technical and cultural problems. Stamp duty was one of the biggest problems. Stamp duty is a one-off tax that is charged on every property sold. But stamp duty was being charged twice on Islamic mortgages because in a Muslim mortgage the property is in theory bought twice (once by the bank and once by the buyer).
The law on stamp duty has been altered – double stamp duty was abolished on Islamic mortgages in April 2003 – and the government has been urging banks to work with Muslims. One of the first results came in July 2003 when HSBC, one of the biggest banks in the UK, brought out a range of Sharia compliant mortgages. By the end of 2005 there were five banks offering Islamic mortgages including Lloyds TSB and the Islamic Bank of Britain.
The main Sharia compliant instrument that this book is concerned with is the Sukuk, which is an alternative to interest bearing debt securities.
22.3.1 Sukuk instruments
Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of a bond. However, interest bearing bonds are not permissible in Islam, hence Sukuks are securities that comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest. The first Sukuk instrument was issued by the Jordan Islamic Bank in 1978, and many governments, banks and corporate entities have issued Sukuks since then. The steps involved in creating a Sukuk are as follows:
1. An asset, such as land, quoted investments or other property that belongs to the entity wishing to raise capital (the borrower), is identified. These assets are then sold (together with an agreement to buy them back at a predetermined price after a given period) to a corporate entity (the special purpose vehicle or SPV) specially created for the purpose of the Sukuk.
2. The SPV then sells certificates (the Sukuk) to investors representing their share of the assets acquired.
3. The SPV then leases the assets back to the borrower from whom it acquired them, in exchange for periodic lease payments. It passes these payments back to the holders of the Sukuk, less a small deduction for its administrative expenses.
4. During the life of the Sukkuk, the borrower makes the periodic payments in the same way that it would make coupon payments on a traditional bond. However, the difference between Sukuk periodic payments and coupon payments is that coupon payments have to be made irrespective of the economic performance of the assets that service them, but Sukuk payments are only made if there is sufficient income generated by the underlying assets. Most Sukuks can, like conventional bonds, be traded in the secondary markets.
5. At the end of the period agreed in Step 1, the SPV sells the assets back to the borrower at the price that was agreed in Step 1, and uses the proceeds to repay the investors in the Sukuk.
22.4 THE VALUATION AND RISK MANAGEMENT OF ISLAMIC FINANCING INSTRUMENTS
Because Sukuk cash flows are based on periodic predetermined lease payments, these cash flows may be accrued in the same way that bond interest is accrued, and used in yield to maturity calculations as if they were coupon payments.
However, firms that hold positions in Sukuks and other Islamic instruments must be aware of the following issues:
1. Sukuk investors also have to monitor the quality of the performance of the underlying assets. If they are not providing the income to make the periodic payments, then these payments cannot, under Sharia law, be made.
2. Under Sharia, no penalties such as additional interest payments can be imposed on borrowers or other trade parties for late payment; as such a penalty would be considered as riba which is haraam. Therefore, firms that take positions in Sukuks and similar instruments need to monitor and manage credit risk and market risk differently to the way that they monitor and manage these risks for conventional financial instruments.
3. Many of the commonly used tools (for example, certain types of derivatives which are used for hedging against currency, interest rates and other risks) are not acceptable to almost all Sharia scholars. In the past, this has made risk management more difficult for wholly Islamic firms as Sharia compliant substitutes have been slow to develop. However, new products and techniques are gradually emerging – for example, Sharia compliant, derivative-like products for managing foreign exchange and interest rate risk.
4. An issue that was highlighted by the UK FSA in a paper entitled “Islamic finance in the UK: regulation and challenges”, published in November 2007, is the fact that both wholly Islamic banks and also conventional banks that provide Islamic services are suffering from a scarcity of experienced professionals in the Islamic finance sector. Resources that are in short supply include not only operations and risk management professionals, but also Sharia scholars with relevant banking experience who are therefore qualified to join the Sharia Supervisory Board.
The Islamic Financial Services Board (IFSB) is an international standard-setting organisation that promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors.
Full membership of the IFSB is open to regulators, but investment firms may join as observers. The IFSB has developed credit risk and market risk management principles, shown in Tables 22.1 and 22.2 respectively.
Table 22.1 IFSB credit risk principles
| Principle 2.1 | Islamic financial institutions shall have in place a strategy for financing, using the various Islamic instruments in compliance with Sharia, whereby it recognises the potential credit exposures that may arise at different stages of the various financing agreements |
| Principle 2.2 | Islamic financial institutions shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument |
| Principle 2.3 | Islamic financial institutions shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument |
| Principle 2.4 | Islamic financial institutions shall have in place Sharia compliant credit risk mitigating techniques appropriate for each Islamic financing instrument |
Table 22.2 IFSB market risk principles
| Principle 4.1 | Islamic financial institutions shall have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market and/or are exposed to high price volatility |
22.5 THE IT IMPLICATIONS OF PROVIDING ISLAMIC INSTRUMENTS
In principle Sukuks can be valued as if they were straight bonds, as the periodic payments by the borrower can be accrued as if it were interest. However, firms that are offering these products need to be aware of the specific risks that they are incurring, which were described in section 22.4. As the market in Sharia compliant instruments is a young and emerging one, it is likely to be a source of application enhancement requests in the trade processing and risk management areas.