The Evolution of Islamic Funds in Sri Lanka

The first Islamic fund was introduced in January 2008. It was an equity fund, close-ended with a maturity period of five years, and offered a return to the investor of approximately 10 percent per year. The first open-ended equity fund was launched in October 2011, and two more open-ended equity funds were launched in the first quarter of 2013. The first open-ended mudaraba fund was launched in January 2013.³

There is tremendous room for the development of Islamic funds in Sri Lanka, and many of the funds—such as real estate investment trust funds, pension funds, and exchange traded funds—can be introduced in the field of Islamic asset management.

Asset management from an Islamic finance viewpoint mirrors the systemic issue of asset management in conventional finance. The asset management companies (mostly unit trusts) have the inherent issue of being more skeptically viewed by investors compared to the banking industry (its more established alternative). Investor confidence in unit trusts is quite low.

Although the policy makers have shed many tax and exchange control regulations for the unit trust industry, the growth and development is limited by investor sentiments.

Financial Reporting Standards

Regarding Islamic finance in Sri Lanka, no separate accounting standards are presently available; as such, businesses are required to follow the Sri Lankan financial reporting standards and the Sri Lankan accounting standards. Since these are an adaptation of the IFRS, the accounting is similar to what is widely used in countries such as the United Kingdom. However, for reporting purposes, the Central Bank of Sri Lanka has issued circulars on the introduction of products based on Islamic principles, which sets out that a bank should maintain separate account books for its Islamic banking operations.

The Institute of Chartered Accountants of Sri Lanka has a pivotal role to play in promulgating accounting standards that may be applied across the board in the Islamic finance industry of Sri Lanka. Concepts may be borrowed from the standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions for ease of understanding by any stakeholder and for international convergence.

Tax Legislation

A key facet in the development of Islamic finance in any jurisdiction is the development of a framework facilitating the taxation of Islamic finance instruments in a similar manner to their conventional counterparts.

Sri Lanka has a plethora of taxes; as such, there is a great need to amend the tax laws to sustain the growth of Islamic finance and create a level playing field for its instruments vis-à-vis its conventional counterparts.

Tax Neutrality

The government budget of 2011 contained a significant proposal for the elimination of tax barriers for Islamic finance in Sri Lanka. The following tax statutes were introduced with provisions pertaining to the taxation of Islamic finance instruments:

• Inland Revenue (Amendment) Act No. 22 of 2011
• Value Added Tax (Amendment) Act No. 9 of 2011
• Nation Building Tax (Amendment) Act No. 10 of 2011
• Economic Service Charge (Amendment) Act No. 11 of 2011

These statutes enacted legislative provisions for the Commissioner General of Inland Revenue to prescribe rules for taxation of Islamic financial instruments. With this change, many tax barriers that impeded the development of Islamic finance in Sri Lanka were removed. A salient feature of the change was the provision that provides for the tax office to look into the economic reality (substance) of the instrument over its legal form and extend the tax treatment currently applicable to the conventional product to its Islamic alternative.

Tax Incentives and Exemptions

There are no special tax incentives or exemptions conferred upon the Islamic finance industry. The current need is tax neutrality, and this has been achieved to a great extent by the tax statutes listed above.

Other Tax Issues

Another taxation issue is the need for the removal of dual stamp duty, which arises because of the nature of most Islamic finance products.

Conclusion

The tax regime has taken great strides in the area of Islamic finance by amending the tax statutes to provide for tax neutrality. Guidelines to be issued under the relevant laws have not yet been published, but timely publication will ensure tax certainty and uniform applicability of the laws across the board.

Products

The Islamic retail market currently offers the common products that are offered by the conventional financial institutions. Table 27.1 shows the products widely offered and used by most industry players and their relative size as of 2011.

• Murabahah. This is a Shari'ah-compliant financing product in which the bank agrees to buy a product required by the customer as opposed to extending credit for it. The pricing is at cost plus markup and is payable by the customer on deferred terms. The essence of this product is included in an amendment to the Banking Act in 2005 and is widely used in place of a bank loan.
• Mudaraba. This is a transaction derived from a partnership based on risk and profit sharing. A two-tier mudaraba involves the financier redepositing such funds in another Shari'ah-compliant institution or venture. The essence of this product structure is included in an amendment to the Banking Act. This is the most common Islamic finance instrument in the Sri Lankan market and has proved itself attractive to a wide range of investors.
• Musharaka. This is very similar to mudaraba except that the concept of partnership finance is applied. That is, the customer and the bank jointly invest funds and management skills in the project. The deposit base for musharaka in Sri Lanka as of 2011 was Rs3,216 million (US$29.2 million), and the total payables were Rs651 million (US$5.9 million).
• Diminishing musharaka. This is an arrangement in which the bank and the customer participate in the joint ownership of an asset capital with the understanding that the customer will purchase units of the asset at periodic intervals until the bank's share is depleted and the customer becomes the sole owner of the capital investment. In Sri Lanka, this product is commonly—around 60 percent—connected to the purchase of buildings, and the purchase of equipment and property accounts for the remaining 40 percent.
• Ijarah. This is broadly the Shari'ah-compliant version of leasing. A number of leasing companies in Sri Lanka have opened Islamic windows, and this field is attracting popularity because of its very nature and the concept of it as a compassionate form of leasing. As of 2011, a fair number of players were offering ijarah in Sri Lanka with an aggregate policy value of Rs1,881 million (US$17.1 million) and receivables of Rs2,776 million (US$25.2 million). These numbers have grown fast, and because of the limitations of the quantitative data, it is not possible to comment further on this.

The Demand for Microfinance

The people of Sri Lanka are at various wealth levels. Microfinance focuses on offering financial facilities to those who have no means to obtain them from a bank or a finance institution. In an attempt to reach out to those below the poverty line, microfinance services are offered in both conventional and Islamic finance.

The practice of Islamic microfinance is quite imminent in rural parts of the island and has been actively promoted by advocates for the poor, who have been educated in Shari'ah and in the basic concepts of credit (they are essentially entrepreneurial). The microfinanciers act as the investors. Islamic microfinance in Sri Lanka includes microleasing and micro-takaful.

Microfinance service providers have a large market in terms of customer numbers and excellent recovery rates. There is ample room for the growth of Islamic microfinance in Sri Lanka, which is home to many entrepreneurs who are below the poverty line with no access to funds.

Opportunities

The retail market has much room in which to grow in terms of product portfolios and market outreach.

The market calls for more and innovative products, and the industry needs to widen its portfolio to complement this demand. A classic example is credit cards. Credit cards are useful to customers because they enable them to meet their need for emergency liquidity or their personal cash-flow management. Islamic banking customers rightfully demand such a product from their Islamic banks. Conventional credit cards are one of the most profitable business lines for conventional banks; interchange fees from merchants are about 2 percent of the transaction value, and interest rates charged to the consumer can be as high as 30 percent a year.

Credit risk tends to be high for credit cards because it is unsecured, and transaction costs are also potentially high because of the high capital adequacy requirements for unsecured lending. Islamic banks cannot replicate the business model used by conventional banks for credit cards because of the reliance on interest; Islamic banks have therefore developed alternative structures for credit cards.

Such structures can be implemented in the Sri Lankan Islamic banking industry to cater the demand for Shari'ah-compliant payment and cards. In terms of market outreach, the Islamic industry must tap a wide customer base through a large network dedicated to Islamic banking services. Electronic media are also a key tool that the industry may utilize. This would help expand its asset base, which at present is still very small.

Issues

The main bottleneck faced by the local takaful industry is the shortage of Shari'ah-compliant investment opportunities. This impedes the growth of the industry. Stiff regulations imposed by the regulator also have a negative effect on growth. This tends to increase the product price, and sometimes the takaful operators have to compromise benefits to face the price war.

Another issue in the lack of technical expertise in the takaful industry. Since the industry is in a growing stage, there is a strong requirement to introduce new products to the market. There is a high demand for Shari'ah scholars to support the introduction of innovative and attractive products to the market without compromising the industry's underlying Shari'ah principles.

Conclusion

With more players entering this market, the takaful industry is set on a growth agenda. The industry both supports and depends on the Islamic banking industry to nurture its own growth.

Debt Capital and the Money Market

There is currently no framework for facilitating the proliferation of money market products and services, which Islamic finance requires. There are currently several institutions that are willing to invest in short-term products, but the inability of the regulators to keep up has led to the underutilization of Islamic finance funds. This has meant that the overall financial sector of the country is less liquid, resulting in Islamic finance institutions having higher costs and therefore making their products and services more expensive. Institutions have been prevented from achieving the scale required to compete directly with traditional financial institutions on profits.

The lack of an established regulatory framework for the Islamic money market in Sri Lanka has impeded the ability for players to explore this avenue.

The Stock Market

The equity capital market in Sri Lanka has faced a lot of challenges in the recent past. Stock exchange performance was volatile, and investor confidence was overall quite low in light of such volatility. The white-listed stocks are about 30 percent of the entire stock market. Even though this a significant percentage, foreign direct investment and local investment through Islamic finance products and services have been limited. The market as a whole has faced significant volatility and negative sentiment as a result of the following:

• The perception that a few individuals manipulate and control the market.
• Worries about rising overhead costs.
• The inability of local entrepreneurs to innovate and compete with world markets.
• The inability of the SEC chair to have a significantly long tenure on the job.

The above factors have definitely hindered investment in Shari'ah-compliant finance. Compared to the traditional market's ability to bring in investment, Islamic finance has failed, especially in foreign direct investment. The inability to bring in both foreign and local investment may be the result of the following factors:

• No central Shari'ah authority.
• A white list not stringent enough to attract the most religious foreign investors.
• Insufficient education of the general public about the benefits of the products and services.
• Higher administrative costs than for products that are not Shari'ah-compliant.
• Ineffective publicity for products and services to target the non-Muslim population.

Initial public offerings were quite well-known in the recent past, but they were mostly not Shari'ah-compliant.

The investors who have preserved their faith in the equity capital market actively utilize the white list. However, the innate inability of a Shari'ah-compliant investor to speculate in his or her trading portfolio coupled with the instability of the equity market in Sri Lanka as a whole has held people back from exploring this avenue of investment. Most investors prefer to invest in short-term investment products to play it safe and pay back any borrowed money that may have aided their financing in the equity shares.

As a result of the stated general market factors and sector-specific factors, the benefits of Islamic finance, which arise from the ability of the industry to tap into funds that traditional markets cannot access, have not been felt in the country.

Sri Lanka is only beginning to understand the levers of the Islamic banking industry. This lack of awareness is restricting market growth. However, the market leaders, together with the industry, are lobbying for the introduction of Shari'ah-compliant instruments at a national level. Discussions with the Central Bank and other bodies have improved this understanding, and there is encouragement to pursue these products. The Central Bank and other bodies are more accepting in the interest of national development policies. The potential benefits to the national growth plan may result in the introduction of these Shari'ah-compliant instruments in the near future.

Regulatory Improvements That Pave the Way for Islamic Banking in Sri Lanka

The Central Bank, which regulates Islamic finance, has developed the Islamic banking industry through amendments to the Schedules of the Banking Act No. 30 of 1988. The amendments, which were passed in 2005, permit licensed commercial banks and specialized banks to offer certain Islamic financial instruments. The amendments provide for the following:

1. The acceptance of a sum of money in any manner or form from any person for a fixed amount of time for investment in a business venture of the bank on the basis that profits or losses of the venture will be shared with the person from whom such money is accepted in a manner determined at the time the money is accepted.
2. The purchase of goods to be sold immediately upon purchase to a buyer on deferred payment terms provided that the goods and their suppliers are specified by such buyer and the price at which such goods are sold to the buyer and the deferred payment terms are determined at the time the bank agrees with the buyer to purchase the said goods for sale to the buyer.

Although the amendments do not refer to any product by name, the wording, in essence, captures the concepts of murabahah, musharaka, mudaraba, and ijarah. The language also leaves it open for an institution to innovate structured finance products within the framework as set out and is thus a very encouraging move.

The Central Bank has also issued guidelines entitled “Introduction of Products Based on Islamic Principles,” which set out a regulatory framework to ensure that Islamic banking operations are conducted in a prudent manner. These guidelines cover four key aspects:

• A call for Islamic banking operations to strictly adhere to the existing regulatory framework applicable to licensed banks.
• Maintenance of separate books of accounts for Islamic banking operations.
• Data on Islamic banking to be included in a separate column in the statutory returns submitted to the Central Bank to enable a clear demarcation between the accounts relating to conventional banking and those relating to Islamic banking.
• Regulations currently applicable to conventional banking operations to be applied equally to Islamic banking operations. Any deviations will result in the immediate cessation of the relevant operations.

In order to promote the local industry, further amendments may be required for several other statutes and regulations set by the exchange control, insurance, banking, and other financial institutions.

Shari'ah Supervisory Boards

Sri Lanka does not have a central Shari'ah authority, therefore institutions are governed and audited for compliance by their internal Shari'ah supervisory boards. The industry calls for independent external Shari'ah audits and/or a central board recognized by a regulatory body such as the Central Bank or the SEC. Shari'ah standardization is an important tenet that the industry anticipates.

Standardization of Products

Standardization of products is vital to ensure that the entire industry is speaking the same language in terms of its product offerings. The banking sector has a dedicated committee that is working toward product standardization as a top priority.