The Islamic finance industry has expanded rapidly in the last decade, growing at around 10-12 percent annually, according to the World Bank. We examine the underlying Shariah principles and how this could inform banking and financial services within the Muslim world and more widely.
Shariah-compliant financial assets are estimated at around $2 trillion globally, says the World Bank. This includes bank and non-bank financial institutions, capital markets, money markets and insurance (takaful). However, with roughly 1.6 billion Muslims worldwide and increasing interest from non-Muslim countries and consumers, there is significant growth potential – writes Joyrene Thomas, Payments, Cards and Mobile (PCM).
At the same time, the underlying principles of Islamic finance help make the sector more resilient to economic downturns. Socially responsible investing has also seen a massive uptick over the last decade, particularly among millennials. Influencers such as Klaus Schwab, the founder of the World Economic Forum, are on record as saying that capitalism in its current form no longer fits the world around us. So, is Islamic finance a viable way of addressing economic and societal imbalances? And what are the implications for the development of financial products?
There is a considerable body of scholarship informing Islamic or Shariah law. Scholars do not always agree, nor do all Muslims. However, the main financial principles are a ban on interest and contractural uncertainty, an adherence to risk- and profit-sharing, and asset-backed, ethical investment.
Quranic verses prohibit riba, interest or usury. Interest is felt to give the lender an unfair advantage over the borrower as the latter becomes doubly burdened. He has to repay the debt and the finance charge regardless of his financial circumstances in the future. This may increase his financial hardship and cause him to be overloaded with debt. Interest is felt to be a lost opportunity to act generously.
Attitudes to money and risk or uncertainty (gharar) underpin much of Islamic financial thinking. Muslims believe that money cannot generate money. Thus trading money for money is not permitted; transactions must have an underlying asset. Islamic scholars are generally uncomfortable about any investment based on a contract as the underlying asset.
‘Attitudes to money and risk or uncertainty underpin much of Islamic financial thinking.’
Whilst there is no prohibition on making money or the pursuit of wealth in Islam, hoarding money is frowned upon. Savers are not paid interest for putting their money away in a savings account. This goes to views on risk and reward, and the social dimension to money and wealth. There is a strong commitment to risk- and profit-sharing in Islam. There is no such thing as money for nothing. If the saver is not taking a risk, they cannot expect to be rewarded.
‘The principles of Islamic finance go beyond a prohibition on interest’
Almsgiving or charity (zakat) is one of the five pillars of Islam, which reflects the community dimension to wealth among Muslims. The tithing of a percentage of one’s wealth each year is a commitment to social justice and for the care and protection of others. If everything ultimately belongs to God, returning to God a portion of the bounty he has conferred for re-distribution within the community is felt to be appropriate
Islamic financial dealings are characterised by fairness, equality and transparency. This extends to where and how Muslims may invest, and how business transactions are conducted. Forbidden investment areas include alcohol, gambling, pork products, pornography, tobacco, weapons and heavily indebted companies. As to business dealings, these should be transparent and eliminate contractural uncertainty, doubt, and ambiguity.
SQUARE PEG, ROUND HOLE?
“In terms of needs, Shariah-conscious consumers are not massively different to anybody else,” says Hamza Abu-Musa, founder of SharedEq, an online portal for financial literacy and halal(permitted) products. “There is a need to store money somewhere, purchase a house or finance a business.”
Developing Shariah-compliant products within the conventional financial system is challenging. “It’s like trying to fit a square peg into a round hole,” says Abu-Musa. “Even the term ‘Islamic bank’ is almost an oxymoron. You have an equity mode of finance and you are trying to fit that into something deeply ingrained that revolves around debt.”
The global, interconnected nature of financial markets amplifies the problem. Islamic banks act in accordance with Shariah principles, yet central banks act for the most part in accordance with conventional financial principles. Islamic and non-Islamic banks are subject to the same regulatory, legal and tax arrangements.
This sometimes explains why Islamic banks create overly-engineered, synthetic products, which mimic the functions of conventional products. It helps them to comply with Basel III and other prudential regulation. However at the same time, Shariah scholars and end-customers are left feeling uncomfortable about products that may adhere to the letter but not necessarily the spirit of the law.
Elsewhere there are tax implications, for example capital gains tax in home finance agreements.
Such agreements work on a principle of diminishing musharaka, where the bank and customer go into partnership over a jointly-owned asset. The property is seen as a series of units. The customer’s payments are partly rent for the right to live in the property, and partly unit acquisition. The bank’s share diminishes over time as the customer makes payments, before ownership transfers to the customer at term.
“You’ve got to buy the house and then sell it to the customer, so there are two transactions. The bank buys first and then sells later, in which case they would pay capital gains tax in countries where there is such a tax. In conventional financing, there is only one owner. It is debt-based or loan-based and the customer just pays the loan,” explains Ezamshah Ismail, dean at the International Centre for Education in Islamic Finance (INCEIF).
CHICKEN AND EGG
Uptake of Shariah-compliant institutional and retail products remains a chicken-and-egg scenario. Uptake of any product in the capital markets is driven by the large pension funds, insurance companies and asset managers. However, this is difficult in emerging markets where people do not have a pension safety net or savings, and the market for insurance is small. The institutional structures are not always there at a macro-economic level. Meanwhile at the retail level, there is no take-up without products, and no products without take-up.
When governments and regulators get behind Shariah-compliant finance, it can move the market. The Malaysian government has issued a number of fixed-income Sukuk bonds. The Malaysian equity markets and pension funds are increasingly allocating money to be managed in a Shariah-compliant way. Bank Negara (the central bank of Malaysia) is also promoting Islamic banks to tap into risk-sharing pools. It was also far-sighted in addressing the skills shortage of Islamic finance professionals when it set up the International Centre for Education in Islamic Finance (INCEIF) in 2005. This was the first international post-graduate university specialising in Islamic finance.
There are some things that only government can do, reasons Omar Shaikh, executive board member, Islamic Finance Council UK. “One of the core elements in all pension funds is government-backed, fixed-income notes — sovereign bonds of debt. There is no GBP government-backed Sukuk that is accessible,” Shaikh explains. When Britain became the first western country to issue a Sukuk bond in June 2014, it was over-subscribed by ten times. The £200 million sale attracted orders of more than £2 billion, however it remains the only UK government Sukuk. “How can you construct a pension fund for public sector workers and others, who wish have their pensions managed in line with their faith-inspired, ethical principles without such notes? That is something that government needs to do because the private sector cannot issue government bonds.”
So, what are the factors that need to come together to break the chicken-and-egg scenario and help Shariah-compliant finance take off more widely? “It is the culmination of political will, enabling regulatory frameworks, education and awareness and effective delivery channels at the retail level,” says Shaikh.
CONSUMERS AND COMMERCIALS
For Islamic finance to take off, there also needs to be greater awareness at the individual level. “You need greater awareness so that people have a change of mindset,” says Ezamshah Ismail, dean, INCEIF. The barriers are twofold: increasing financial literacy and overcoming financial apathy. “Many of us have taken a form of financing, but do you really look through and find out how things work? If you own an insurance policy, have you read your policy, even with conventional finance?” he asks.
Abu-Musa of SharedEq hears two common complaints from consumers: products are not Shariah-compliant and they are too expensive. “There have been trust issues over the past 15-20 years, where certain products have been fixed-income, Sukuk-type products, and it turned out later that they were not Shariah-compliant at all. They were just replicating conventional bonds,” he says. Shariah-compliant products typically also cost more than conventional products. Either the consumer is paying more for a current account or home financing, or they are earning a lower rate of return.
Irfan Khan, CEO and co-founder of Yielders, a Shariah-compliant, equity-based crowdfunding platform explains: “The reason why traditional Islamic finance has found it challenging is because of the commercial viability. They are doing the same processes and practices as traditional banking, but have additional overheads due to the compromises they have to make. Their operating costs are significantly higher as well, yet their transaction volumes and customer bases are lower.” The higher costs are passed on to the consumer, who pays a premium for a Shariah-compliant product.
“It’s really about ethical and Shariah-compliant products being on par with traditional products. From a commercial and consumer perspective, they should be no difference. I think that we are at that point now where FinTech can eliminate a lot of back- and middle-office costs and provide a level playing field,” says Khan.
TIME TO GET REAL
If technology is the great leveller, principles and values become the great differentiator. Subject to having the budget, any organisation can buy and use technology. What sets organisations apart is developing ideas around how to make technology meaningful, authentic and real for customers and staff. This is where the principled and values-based approach of Islamic finance gives it an edge.
Islamic financial principles go beyond a prohibition on interest to encompass the social and commercial framework around the transaction. As a result, the appeal of ethical and Islamic finance goes beyond Muslims. Socially responsible investing has seen a massive uptick, particularly among millennials. Sustainable investments totalled around $21.1 trillion globally in 2014, up 61 percent from 2012, according to the Global Sustainable Investment Alliance. The appetite for ethical finance as a viable alternative to conventional finance exists.
People are turning to ethical finance as an alternative to the excesses of capitalism. The pursuit of profit maximisation at any cost. Wealth transference over wealth creation. Short-term gains over long-term sustainable growth. Increasing social and economic inequalities. It is time for an alternative. It is time to get real. Real in the sense of real-economy transactions that build something physical, create jobs and generate revenue for people, as opposed to paper speculation. And real in the sense of moral values that are ethical, honest, simple, un-spun, sustainable, rooted and human.
“Looking at the crisis of conventional banking, the FinTech headwinds described as the ‘Uberisation’ of the banking sector, I am seeing genuine signs that there are opportunities to influence and change the way the broader banking system or intermediation role works,” says Shaikh. “The way retail consumers in the digital world are engaging with their banks has changed. The appetite, openness and willingness of millennials to invest in products with social along with financial returns is considerably more than in previous generations,” he concludes.
Looking to Islamic finance to rehabilitate broken business models, market structures and consumer trust is a big ask. Timing is everything in life as in business. Is it time for Islamic finance to go mainstream? Now is as good as any time in the past.
Innovation is hard, yet the addressable market for ethical and Islamic finance is huge. In innovation, as in Islamic financial dealings, risk and reward are balanced. There is no such thing as money for nothing.
Glossary of Terms
Gharar — can be translated as uncertainty, hazard, chance or risk. In the context of Islamic finance, it usually means uncertainty in a contract.
Ijara — a lease contract, which may be combined with one or more other contracts to form a more complex transaction.
Maisir — gambling or betting, which is prohibited in Islam.
Mudaraba — an investment partnership or trustee financing. Investors place money with a manager, who invests or manages this to produce a return. Profits are split between the investors and the manager according to a pre-determined ratio. Losses are borne in relation to the amount invested by each individual.
Murabaha — a trade with cost plus mark-up, usually used as a method of financing goods. Typically the asset is purchased on behalf of a client and resold at a pre-determined price. Repayment can be made in a lump sum or in instalments. The asset remains with the financier until repaid in full.
Musharaka — an investment partnership, similar to modern venture capital. Similar to the concept of mudaraba, except there is no one individual managing the investment. Profits are split between the investors according to a pre-determined ratio. Losses are borne in relation to the amount invested by each individual.
Riba — usually translated as interest or usury.
Sukuk — financial certificates or certificates of ownership. A fixed income investment product, similar to a conventional bond. The returns on the certificates are directly linked to the returns generated by the underlying assets.
Takaful — can be translated as solidarity or mutual guarantee. This is Shariah-compliant insurance organised along mutual or co-operative lines.
Zakat — can be translated as purification. Almsgiving or charity and one of the five pillars of Islam. Generally, this consists of Muslims giving 2.5 percent of their wealth each year, although calculations can vary.