ISLAMIC FINANCE COULD HAVE SAVED THE WORLD

(Article was extracted from International Financial Law Review - author : Simon Crompton)

Lawyers in Islamic finance firmly believe that if company financing had been done entirely along shariah lines, this financial crisis would not have happened.

A session at the Middle East Financial Law Congress in Doha, Qatar on 17 - 18 February 2009 saw passionate disagreement on the subject.

Panelists from western banks argued that there was nothing wrong with the due diligence that went into local companies when they issued conventional debt. Islamic debt would not have fared any better.

The argument for shariah was put by one speaker particularly strongly, who said: "Islamic finance has been mixed and matched with conventional debt in companies’ financing, with the result that none of them are really Islamic. Even the Islamic parts of their debt have been watered down and adapted to conventional structures."

When asked whether he really thought that the world would not have had a financial collapse under Islamic financial law, he replied: "Yes, absolutely. Islamic debt is about investment; conventional debt is about trading money for its own sake. Islamic law would have prevented the kind of leverage ratios we saw in Dubai."

Dubai real estate company Nakheel became the focus for the discussion, as it had both Islamic and conventional funding and has seen its spreads widen dramatically as investors refuse to buy the debt for fear of it going bust.

A speaker from a western bank disagreed with the Islamic lawyers. "Let’s get this straight," he said. "Everyone that invested in Nakheel knew they were exposed to big real estate risk. They knew the projects that Nakheel had lined up. They knew how it was plowing the profits of one project into another; it was all over the papers.

"There was big real estate risk in a market obviously driven by expectations. But they did their due diligence and took the gamble. They weren’t stupid." He carried on the point out that given the growth predictions for Nakheel at the time it issued most of its debt, the leverage ratio was no higher than any other real estate company anywhere else in the world.

No one disagreed that Islamic finance has become disconnected from its foundations. Rather than being involved from the very start of a deal, it is sometimes brought in at the last minute for a rubber stamp. One straightforward Islamic structure is not picked at the beginning – instead the company’s needs are shoehorned into a tweaked or adjusted structure.

One speaker referred to it as Islamic beer. "You go to the imam and get ask him whether it is compliant with shariah to tie a rope to a door handle. Then you ask him whether it is compliant to lie on the floor. Then to tie a beer bottle to the rope. When someone walks in, the bottle tips over and you happen to be lying there with your mouth open. That is Islamic beer."

He continued: "We must give Islamic finance a chance. We must keep it pure and start over again with companies, making sure all financing is compliant. The rest of the world has a lot to learn from shariah, but only if it remains consistent."

A speaker from the floor agreed. He argued that local investors in the Gulf had just become capitalistic, picking whichever type of financing happened to give greater returns. There was no concern over shariah compliance.

With the number of companies in trouble in the Gulf, particularly in Dubai, this could be the perfect opportunity for Islamic lawyers to get their way and restructure corporate debt along entirely Islamic lines.

My comment :

Islamic finance despite having its origins 1,400 years ago, was only commercially practiced in the last 3-4 decades ago. Yes, we must give it a chance - to purify and start again, while ensuring its compliance to shariah rom the very beginning and safeguarding it against manipulation and intervention from its conventional counterparts. This time around, there should be control and standardization - after all, Islam is one religion and there should only be one shariah guide (that should be obtained by consensus by all jurists) for the interest of the ummah.

GOLD DINAR

The idea of using Islamic gold dinar was first mooted in 2001 by Malaysia's ex-premier (Tun Dr Mahathir Mohammed). He proposed a new currency that would be used initially for international trade between Muslim nations, i.e., the islamic gold dinar and it was defined as 4.25 grams of 24 carat (100%) gold. He promoted the concept on the basis of its economic merits as a stable unit of account and also as a political symbol to create greater unity between Islamic nations. The purported purpose of this move would be to reduce dependence on the United States dollar as a reserve currency, and to establish a non-debt-backed currency in accord with Islamic law against the charging of interest.

The return to the gold standard is supported by many followers of the Austrian School of Economics, Objectivists and libertarians largely because they object to the role of the government in issuing fiat currency through central banks.

Few lawmakers today advocate a return to the gold standard, other than adherents of the Austrian school and some supply-siders. However, many prominent economists have expressed sympathy with a hard currency basis, and have argued against fiat money, including former US Federal Reserve Chairman Alan Greenspan (himself a former Objectivist). Greenspan famously argued the case for returning to a gold standard in his 1966 paper "Gold and Economic Freedom", in which he described supporters of fiat currencies as "welfare statists" hell-bent on using monetary printing presses to finance deficit spending. He has argued that the fiat money system of today has retained the favorable properties of the gold standard because central bankers have pursued monetary policy as if a gold standard were still in place.
The current global monetary system relies on the US dollar as a reserve currency by which major transactions, such as the price of gold itself, are measured. Currency instabilities, inconvertibility and credit access restriction are a few reasons why the current system has been criticized.

Taking the 1997 Malaysian economic and financial crisis as an example, it shows that the fundamental cause of business cycles, unemployment and inflation is rooted in some of the features of the present day financial system, namely fiat money, fractional reserve requirements and interests rates. It then shows how these features also indirectly bring about many social problems to such an extent that they threaten the culture and sovereignty of nations. Even Islamic banks cannot truly operate on Islamic principles in the present system.

Most Islamic financial products are tied to the market interest rate - the very thing they are supposed to avoid. A return to a gold payment system - like the Islamic dinar - could solve many of the woes of today's economic system. The return is not only desirable from the economic, political, social and religious perspectives, but also urgent in the present era of globalization and existing world recession, besides providing a conducive environment for Islamic economics, banking and finance to flourish.


The following articles are important to strengthen our understanding on the issues at hand :

1) Seriousness of Gold Dinar

2) Gold, Paper..Or Is There A Better Money?

STORY - AL ZUBAYR IBN AL-AWWAM

Remember my earlier post on the issue of Wadiah versus Qard? Well, my lecturer did provide a case study to substantiate the issue, which I have reproduced here :

Al-Zubayr Ibn Al-Awwam was a Companion of the Prophet Muhammad s.a.w., and one of the ten who were promised paradise. People always wanted to deposit their money with him (wadiah) for his honesty. If he took it as wadiah, his liability would be fault-based had the money been lost while in his custody - which means, that with no negligence or wongful doing on his part, the owner could not sue him for the loss. Neither could the owner sue him for loss due to factors beyond human ability to guard against natural hazards or disasters.

However, he could not utilize the wadiah for his own purposes as a trustee because wadiah is only for safekeeping.

What he did was asking the people to deposit the money with him as qard/loan instead of as wadiah. Now, his shariah legal position has changed to that of a borrower. As a borrower, he assumed the duty to repay the owner in whatever circumstances. He also assumed ownership over the money and risk of loss was transferred to him. As such, it was legitimate for him to utilize the fund for his own purposes.

It was reported that he managed to make nearly 3 million dinars in the venture : this was halal return based on risk for return principle.

Point to note :
Benefit to Al Zubayr (as borrower)
a) He can use the money any way he likes

Benefit to the lender (the depositors)
a) Full guarantee of payment by borrower (in whatever circumstances)

The Qard principle, if used in the Islamic banking system for savings and current accounts, proves to be a win-win situation for all parties.

**The ten people promised paradise (Arabic: Al-Asharatu Mubashshirun or Al-Mobashareen Bel-Jannah) are : The Rightly Guided Caliphs or The Righteous Caliphs ( transliteration: ) is a term used in both Sunni and Shia Islam to refer to the rightly guided Caliphs prophesised in the famous tradition, Hold firmly to my example (sunnah) and that of the Rightly Guided Caliphs (Ibn Majah, Abu Dawood). ...

1. Abu Bakr As-Siddiq (51 B.H - 13 A.H; 573 - 634 C.E)
2. Umar bin Al-Khattab (40 B.H - 23 A.H; 584 - 644 C.E)
3. Uthman ibn Affan (47 B.H- 35 A.H; 577-656 C.E)
4. Ali ibn Abi Talib (23 B.H - 40 A.H; 600 - 661 C.E)
5. Talha ibn Ubayd-Allah (28 B.H - 36 A.H; 596 - 656 C.E)
6. Zubayr ibn al-Awwam (28 B.H - 36 A.H; 596 - 656 C.E)
7. Abd al-Rahman ibn Awf (d. 31 A.H; 654 C.E)
8. Sa'ad ibn Abi Waqqas (23 B.H - 55 A.H; 600 - 675 C.E)
9. Abu-Ubaida ibn al-Jarrah (40 B.H-18 A.H; 584-640 C.E)
10. Said ibn Zayd (d. 51 A.H; 671 C.E)

ISLAMIC FINANCE BODY RULES ON CAPITAL, INVESTMENTS

(Extracted from Reuters on February 20, 2009)

The Kuala Lumpur-based Islamic Financial Services Board (IFSB), an umbrella group for Islamic financial regulators, said it had adopted guidelines to promote transparency for investors of collective investment schemes.

It also released rules on capital requirements for Islamic institutions involved in Islamic bond issuance and real estate investments.

IFSB's regulations are not binding on the sector and compliance is voluntary, as is the case with those issued by other Islamic finance industry bodies.

As at January 2009, IFSB had 178 members including the International Monetary Fund, World Bank, Bank for International Settlements and Islamic Development Bank.

The full guidelines are available at IFSB's website at www.ifsb.org

MAIN FINANCIAL PRODUCTS AVAILABLE IN MALAYSIA

I extracted the information from BNM (hope, it is beneficial to strengthen our understanding )

Bai Al Inah (sell and buy back) is a contract which involves selling and buying of an asset where a seller will sell the asset to a buyer on a cash basis and subsequently will buy the same asset on a deferred payment basis at mark up price. It can also be applied when a seller sells the asset to a buyer on a deferred basis and will later buy back the same asset on a cash basis with a price which is lower than the deferred price. This product is not accepted in the Middle East countries.

Ijarah (leasing) refers to a contract under which the lessor leases equipment, building or other facilities to a client at an agreed rental rate and pre-determined lease period upon the aqad (contract). The ownership of the leased equipment remains in the hand of a lessor.

Mudharabah (profit-sharing) is a contract which is made between two parties to finance a business venture. The parties are a capital provider or an investor who solely provides the capital and an entrepreneur who solely manages the project. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. In the event of business loss, the loss shall be borne solely by a provider of the capital.

Murabaha (cost plus) refers to a contract of a sale and purchase transaction of an asset whereby the cost and profit margin (mark-up) are made known and agreed by all parties involved. The settlement for the purchase can be settled either on a deferred lump sum or installments basis, will be specified in the agreement.

Qardhul Hassan (benevolent loan) is a contract of loan between two parties on the basis of social welfare or to fulfill a short-term financial need of the borrower. The amount of repayment must be equivalent to the amount borrowed. It is however the borrower may choose to pay more than the amount borrowed as long as it is not stated or agreed at the point of contract.

Rahnu (collateralised borrowing) is equivalent to the conventional colleteralised borrowing. It refers to an arrangement whereby a valuable asset is placed as collateral to raise funding. The amount borrowed must be equal with the collateral rendered. The collateral may be transferred to lender in the event of default. To get the principal back the lender will sells the collateral and take the principal amount. Any excessive amount must be returned to the borrower.

Wadiah (savings with guarantee) is a trust concept which refers to the deposits or valuable goods that have been kept with a depository agent. The depository agent will safeguard and provide guarantee to the principle of the deposits or valuable goods. With permission from the depositors, depository agent may invest the deposit to earn some returns. However, the depositors are not entitled to any share of the returns but the depository agent may give a gift (hibah) to the depositors as a token of appreciation.

SOME POINTS TO PONDER - WADIAH VERSUS QARD

When I was studying for my Masters Degree a few years back, I took up a course in Islamic Banking and Finance. My lecturer is a prominent academician and an industry expert in Islamic banking (having served in the Islamic Banking Division of a local bank for nearly 2 decades). Being a person with minimal knowledge in Islamic banking and for my further understanding of the concept of Wadiah, I raised a question on the concept of Wadiah on savings accounts – since Wadiah means safekeeping and the Bank acts as a Trustee for the deposits, they should not invest the depositors’ monies as ownership of the deposits still lies with each individual depositors.

My lecturer gave me an explanation that was not very satisfactory and so I did some research on this very concept and for knowledge purposes, I reproduced a comprehensive (but short) write up on wadiah (courtesy of http://wadiah.com) :

Wadiah or safekeeping is an instrument that allows a person to keep the wealth or assets belonging to oneself with another person for safekeeping purposes. In the legal sense, it signifies a thing entrusted to the care of another. The proprietor of the thing is known as mudi’ (depositor), the person entrusted with it is known as wadi’ or mustawda’ (custodian) and the deposited asset is wadiah. The concept of wadiah is not specifically mentioned in the Holy Quran. However, as far as safekeeping which is closely related to trust is concerned, there are some indications on this concept, which can be observed in the following verses:

· “Those who are faithfully true to their trusts (amanah) and to their covenants” 23:8

· “Verily, Allah commands that you should render back the trusts to those, to whom they are due” 4:58

In the Sunnah, Al-Bayhaqi narrated that ‘A’ishah said on the occasion of the Prophet’s (pbuh) migration to Medina (Hijrah), “The Messenger of Allah asked ‘Ali to take his place in Makkah in order to deliver the deposited things to their owners.” Moreover, the Prophet (pbuh) is reported to have said: “Return the trust to those who entrusted you, and do not betray those who betrayed you.” (Abu Dawood and Tirmidhi).

Therefore, premised on the above, all Muslim jurists unanimously agree on the permissibility of Wadiah.

There are 2 types of wadiah :

· Wadiah Wadiah based on custodianship (wadiah yad al-amanah)

The actual nature of wadiah as started earlier is amanah (custodianship) where it is charitable and divinely rewarded. The custodian shall keep the deposit as if he is keeping and taking care of his own property. As an amanah contract, this type of wadiah does not impose any liability on the custodian in normal cases of loss or damage except in the case of negligence or wrongful doings (fault-based).

· Wadiah with Guarantee (wadiah yad al-Dhamanah)

It is a combination of two contracts which are safekeeping (wadiah) and the guarantee (Damman) contract. Dhamanah contract when attached to the wadiah contract, converts the concept of wadiah to guaranteed safe custody. The custodian is entitled to use the deposited item for trading or other purposes, irrespective of the consent of the depositor as he is guaranteeing the return of the deposit and is liable for any damage or loss. The custodian has a right to any income derived from the utilization of the deposited asset. Since the custodian owns the profit, he may dispose it as he wishes and may give some portions of the profit as a gift (hibah) to the depositor.

The same issue cropped up when I attended my Islamic law of contract class this morning – my lecturer raised the issue that if the Bank wants to invest the deposits made by the depositors, they should use a contract of qard (loan) instead of wadiah. After all, in qard, ownership and risk of loss and returns are transferred to the borrower (in this case, the Bank) and at the same time, the lender (the depositors) are ensured of the return of the deposits. The borrower (i.e., the Bank) has a legal duty to repay to the lender the money that they borrow (the actual deposit), and therefore, the interest of the depositors are safeguarded at all times.

This makes me think that if Islam has made it easy for the Bank to use the contract of qard (for money lending) why do we need another concept of Wadiah yad al-Dhamanah for our savings or even current accounts???

My next question is – is Malaysia the only country that opts to use of Wadiah yad al-Dhamanah concept for our savings and current account?

What if a depositor does not wish his savings to be used for investment purposes? Will he not be entertained by the Bank? As it is right now, when a person opens an account with a Bank, we are to sign opening of account agreement(s) that is/are unilateral in nature – is this just? Or is it only beneficial to one party? What happens to mutual consent of terms and conditions in the agreement?

Hhhhmmmm, too many unanswered questions here – I leave you to ponder ……

ISLAMIC FINANCE MART NEEDS MORE HYBRID PRODUCTS

(Extracted from Business Times, February 20, 2009)

The Islamic finance market is in need of more hybrid products to meet the increasingly sophisticated needs of corporate clients, said Zain Ibrahim & Co (ZICO) chairman Datuk Dr Nik Norzrul Thani.

Local players must grab the opportunity to become more product innovative, taking advantage of the strong Islamic finance framework already provided by the authorities.

"Japan and Hong Kong are now keen (to venture) into this market and if we could become more innovative, we could easily export our expertise," Nik Norzrul told Business Times in an interview.

Nik Norzrul, a former dean at the International Islamic University Malaysia, said the presence of foreign Islamic banks in Malaysia has been positive.

"The competition has brought about more product innovation among the local players, although there is still a lot of room for improvement," he said.

Nik Norzrul advises clients on a wide range of legal matters incorporating Islamic finance, banking, offshore finance, debt restructuring, international, corporate and commercial law.

A director of Al Rajhi Banking and Investment Corporation (Malaysia) Bhd, he has also written several articles on corporate and financial issues, particularly on Islamic banking.

ZICO is the country's largest legal firm and is active in Islamic finance locally and regionally. It has presence in Indonesia, Singapore and Thailand.

It is the first law firm in Malaysia to establish a shariah advisory firm called ZI Shariah and will soon open an office in Dubai.

ZI Shariah, which is licensed by the Securities Commission to advise on sukuk, has advised clients from the Middle East who came to Malaysia on syariah framework.

The advisory services include not only for the Islamic banking legal matters, but also on personal Islamic financing and syariah-compliant wealth management.

"We have done this quite successfully with the Middle East clients and we are now contemplating to open an office in the region, maybe in Dubai," Nik Norzrul said.

Realising the growing importance of Islamic finance globally, especially among those from the Middle East who are flushed with cash, ZI Shariah has hired Arab-speaking lawyers as well as Arabic classes are being provided for its lawyers and staff.

Nik Norzrul said apart from language, legal advisers must be well equipped in understanding the syariah field, especially in the area of Islamic financing.

There is still lack of experts in this area, he said, when compared with the huge demand for Islamic financial products.

"In Malaysia, for example, why is that Muslims are still generally hesitant to engage an expert in Islamic financial management? Why is there still this assumption that Muslims cannot have wills?" he asked.

Nik Norzrul said this is an area that posed great potential and shariah lawyers should be well equipped with Islamic financial management skill.

"Muslim lawyers can play the role of family counsellors and advise Muslims to plan their finances properly before their death," he added.

My comment :

This is a good example that Malaysians can go far with their knowledge in Islamic finance, even establish their own firm in the GCC and not restrict their presence in the South East Asia region only. After all, there are nearly I billion Muslims worldwide - one must also remember that Islamic finance is not only restricted to Muslims but can attract a lot of non-Muslims as well.

RISK MANAGEMENT IN ISLAMIC FINANCE

Risk management for Islamic banking financial products and services is one of the greatest challenges that many westernized, as well as Islamic Banks, are facing today.

As a result of this market growth in Islamic financial products there is a high demand to understand how to assess and manage the risks arising from applying these products and services. Credit, operational, market and liquidity risks together with the risk of non-compliance with the Shariah law are becoming very hot issues for financial institutions. This book presents a common framework of how to efficiently manage the risks faced and minimise the overall degree of Islamic financial risks.

Below is the view of Dr Shamshad Akhtar (Governor, State Bank of Pakistan published in The Banker on September 1, 2008)

Islamic finance has grown substantively in the past few years and with it there has been a growing interest and debate on the appreciation of its risk architecture and profile. It is now well recognised that, by and large, Islamic banks are prone to the same risks as conventional banks. Concurrently, however, Islamic banks face additional risks that emanate from the unique characteristics of Islamic finance transactions, along with risks associated with the real or perceived non-compliance of Shariah principles that may erode customer/investor confidence.

To understand the complexities of an appropriate risk and reward-sharing mechanism embedded in Islamic finance transactions, a better understanding of the management and mitigation of the risks associated with certain Islamic products is necessary. This requires a change of mindset for both the Islamic banking industry and the regulators, whose primary focus has been debt-based financial intermediation.

At the same time, it requires the development of a financial, legal and regulatory infrastructure to help manage principal agent-entrepreneur relationships in profit and loss-sharing transactions, where commercial banks are exposed directly to equity exposures of partners in business while catering for investment account holders’ concerns.

Most importantly, Islamic banks are generally exposed to substantial liquidity risk owing to the lack of access to standardised sharia-compliant investment portfolios and liquidity management instruments. This has affected their ability to successfully manage the maturity profile of both assets and liabilities, and has curtailed diversification.

Lack of instruments
Risk management in Islamic finance is further complicated by the lack of adequate risk hedging instruments and techniques. Shariah prohibition of riba and gharar means many techniques based on conventional tools, such as options, futures, and forwards, are not yet available to Islamic banks and this lack has increased banks’ vulnerability to foreign exchange, interest rate, commodity and equity price risks.

In order to address liquidity risks, the Islamic financial industry must develop appropriate liquidity management instruments. Moreover, the compound risks faced by Islamic banks have necessitated the development of a shariah-compliant derivatives market. Besides providing hedging, such derivative instruments are expected to improve transactional efficiency. However, further progress in this area would require substantial research and employment of financial engineering and innovation.
Further, the disclosure regime in Islamic banking needs to improve to ensure proper market discipline, removal of information asymmetries, better risk-return profile, building trust in shariah-compliance and improvement in internal governance. Better disclosure would also contribute towards the development of equity-based financing such as mudaraba and musharaka.

Consistent with the best practices of the corporate governance framework, Islamic banks also need to conform to its well-accepted and time-tested principles, in recognition of the fact that shariah offers a stakeholder-oriented model of corporate governance implicit in Islamic property and contract provisions. Also, the model of governance is affected by the role of investors as depositors, in addition to the oversight of Islamic banks by shariah advisory boards, and is critical for ensuring credibility and sanctity.

Regulatory framework
Work also needs to be accelerated to develop proper understanding of prudential regulations and shariah inspection and supervision of Islamic banks. Guidance on a prudential regulatory framework should incorporate appropriate amendment and refinements to the Basel II framework or other best practices, with the objective of providing effective treatment of risks associated with Islamic products and balance sheets.

There has been considerable movement in recent times in the development and promulgation of international best practices in Islamic risk management principles. In this regard, the work done by international bodies such as the Islamic Financial Services Board guides the industry and regulators. Notwithstanding, as the risk architecture for Islamic finance continues to evolve, a fuller appreciation of its risks will emerge as more empirical evidence comes forth with the growth in the size of the industry.

My comment :

I somehow agree with the above view. There is already a framework in terms of reporting (even though, they are non-conclusive as yet, but efforts are being made towards that direction) for Islamic financial institutions developed by AAOIFI, however, it is sad to note that only a few countries/organizations have made it compulsory to adopt it (e.g., Bahrain, Jordan and Dubai International Financial Centre). What about the other member countries or OIC? With the standardization, comparability can be made and the framework can cover the unique and peculiar characteristics that are only available in Islamic financial institutions.

Islamic finance also lacks financial instrument – what we have now, is just a direct replication of the conventional instruments, with the deletion of the word interest etc. But the substance remains the same. Therefore, efforts must be made, especially by the learned Islamic finance scholars and with the necessary support by the Central Banks and Governments to promote development of innovative and full-fledge shariah-compliant financial instruments that are accepted worldwide – we do not want a product, e.g. Bai Bithaman Ajil that is accepted in Malaysia but rejected everywhere else in the world.

TASK FORCE FOR ISLAMIC FINANCE AND GLOBAL FINANCIAL STABILITY

The Task Force was proposed during the Forum held by the Islamic Development Bank on 25th October 2008, in response to the Global Financial Crisis, and was endorsed by the Council of the Islamic Financial Services Board (IFSB) at its meeting held on 29th October 2008. It is mandated to assess the performance of the Islamic financial system in the current financial crisis and areas in which Islamic finance could contribute to promote financial stability.

The Task Force has set up three working groups to examine the following areas:
• Promote greater understanding and appreciation of the universal values inherent in Islamic finance.
• Lessons learned from the current financial crisis and how Islamic finance needs to be developed to enhance the resilience of the Islamic financial system.
• Further strengthening of the international Islamic financial architecture.

A preliminary report will be discussed at the next meeting of the Task Force on 28th March 2009.

My comment :
I sincerely hope that the findings could be made public and could help to somehow give insights on how to overcome the financial crisis.

MALAYSIA SERVICES EXHIBITION 2009 IN DUBAI UAE

Malaysia Services Exhibition 2009 (MSE 2009) in Dubai, UAE
Event Date: 17 Mar 09 - 19 Mar 09

MIFC will participate in the Malaysia Services Exhibition 2009 (MSE 2009) at Dubai Airport Expo Exhibition Centre, Dubai from 17 to 19 March 2009.