Demystifying Islamic Finance

Interest in Islamic finance is growing worldwide. The Washington- based International Monetary Fund (IMF), which is always headed by a nominee of the European Union, helped set up a global Islamic finance regulator, the Islamic Financial Services Board, in Malaysia and has published a number of research papers and reports since the 1990s and also set up an external advisory group to identify policy issues and enhance coordination in a fragmented market.

In a 2015 report, the IMF gives three reasons why Islamic finance should get the attention it deserves worldwide and not just in Muslim-dominated soci- eties. Firstly, Islamic finance has the potential to foster greater financial inclusion, especially of large underserved Muslim populations. Secondly, the emphasis on asset-backed financing and risk-sharing can support both SMEs and large public infrastructure projects. Thirdly, Islamic finance poses fewer risks to financial systems because of its risk-sharing features and prohibition of speculation.

A few people understand the concept of Islamic finance (Sharia-compliant finance), with many arguing that it is the same as conventional banking, but using different names. The main difference between Islamic banks and conventional banks is that the former operates in accordance with the rules of Sharia, the legal code of Islam. However, in its early years, Islamic scholars were rejected by Muslims themselves when they spoke of Islamic finance as people thought they would take  their money in the name of religion and never return. A little known fact is that Islamic finance has little to do Islam, but most principles are based on simple morality and common sense applicable beyond the Islamic world.

Islamic Finance faces several chal- lenges around the world, the biggest one being realizing its potential in global markets dominated by interest rates. Islamic banking does not pay or charge interest, which is considered undesirable or Haram according to Sharia law. According to scholars, the prohibition of Riba (the Arabic term synonymous with interest/usury) is in line with teachings of most religions of the world. The Bible says “Do not charge your brother interest, whether on money or food or anything else that may earn interest” (Deuteronomy 23:19), while the Quran says “But Allah has permitted trade and has forbidden interest”.

Almost all other religions also teach people not to exploit others and to fulfill promises on time. Conventional banks operate by charging interest on loans and giving returns to depositors also in the form of interest, albeit at a lower rate, with the cost difference being their profit to meet the bank’s operating costs. However, Islamic banking stakeholders are supposed to share profits and losses. Hence, Riba is prohibited. Islamic banks conduct transactions in the form of mark-up pricing, leasing or partnerships.

Therefore, despite the absence of interest rates, Islamic banks may still be influenced by variations in interest/market rates, with allegations that some such institutions may even be benchmarking with conventional players when deciding on the mark-up. Owing to this, there are those, includ- ing Muslims themselves, who hold that Islamic banks simply mimic conven- tional banks, particularly in countries where interest-based banks and Islamic banks coexist.

“Financial returns may be competitive, but Islamic finance provides some ethical standards; for example, we steer clear of socially undesirable areas like gambling and alcohol, and highly speculative markets,” says Muath Mubarak, Chief Executive and Senior Lecturer of First Global Academy (FGA), a pioneering institute in Sri Lanka that promotes training and career development in Islamic banking, finance and Takaful. The concept of profit or loss sharing, ownership and risk bearing are vital elements of Islamic finance that differentiate it from conventional bank- ing. Higher risk areas more often yield a better return, while low risk areas, as anywhere, yield lower profits. However, Islamic banks take stringent measures to minimize risks, as would any finan- cial institution. “Our system of evaluating customers is more stringent than in conventional banking as we can’t afford to have defaulters, because they will have a direct impact on the depositors,” explains Hisham Ally, Head of Islamic Banking at HNB.

Another challenge is on the regulatory front. Regulators in many jurisdictions don’t accommodate the unique features of Islamic finance in their regulations, which prevents Islamic finance from realizing its potential. This also poses another challenge: complex Islamic financial products and cross-border transaction modes have developed without any supervision or regulation.

Sri Lanka’s Banking Act of 1985 was amended in 2005 to accommodate the profit and loss sharing model, pav- ing the way for Islamic Finance in Sri Lanka. Although authorized, all Islamic financial institutes in Sri Lanka are not directly regulated by the Central bank, unlike Malaysia, which has a National Sharia Board that promotes Islamic banking in the country. Each financial institute in Sri Lanka is governed by their own Sharia Supervisory Board (SSB) to ensure that they are Sharia- compliant. The board provides guid- ance on processes, monitors funding and advises on conflicting matters in their capacity to give rulings.

Globally, although Islamic banks are well capitalized, there are prob- lems in complying with the Basel III accord dealing mainly with capital risk mitigation. New capital and liquidity requirements for the banking sector were introduced by the Central Bank in March 2015 in keeping with Basel III, requiring banks to fall in line with Basel III liquidity coverage ratios and assign capital coverage for different segments of lending, with high-risk lending requiring more capital. Islamic financial institutions were exception- ally exempted from this ruling. “Some of the Central Bank regulations do apply to Islamic financial institutions, but the regulator has allowed some technical report flexibility given the differences between Islamic banking and conventional banking under strict monitoring. Standalone Islamic banks will have to comply with the minimum capital requirement of Rs10 billion by 2018,” Mubarak says.

Islamic finance is not based on a creditor-debtor relationship like con- ventional banks, so assigning capital risks and raising capital are challeng- ing in an environment dominated by conventional banks, where monetary policy is also interest rate-based. “Op- erating in an environment dominated by interest rates is a challenge. In some countries, the International Islamic Benchmark Rate (IIBR) is used as an alternative and is loosely a derivate of the London Inter Bank Offered Rates (LIBOR), but we cannot use this system in Sri Lanka because IIBR/ LIBOR is not a major indicator for the market here. So this is another techni- cal challenge we have. We can develop financial markets and instruments that would give Islamic banks a level play- ing field to compete with conventional banks, but the regulatory environment must be right.” Mubarak adds.

Globally, Islamic banking is prevalent in many non-Muslim countries. According to Mubarak, the UK’s Muslim population is just four per cent and they have six fully fledged Islamic banks and more than 80 Islamic finance education providers. Since 2005, the UK budget has included various provisions for Islamic banking. In Thailand, the Muslim population is less than seven per cent, but the government started the Islamic Bank of Thailand.

Sri Lanka’s experience with Islamic finance so far suggests that banks are merely trying to attract the highly- productive Muslim population, many of whom have stayed clear of conventional banks because of religious beliefs. But the industry wants to unleash the full potential of Islamic finance here. There are compelling reasons why Islamic banking should be taken more seriously.

Most Muslim businesses are family- oriented SMEs that may not want to quote in stock markets or go public. In rural Muslim communities, a signifi- cant number (about 75%) do not even use or are reluctant to use conventional banking products due to high interest charges or non-compliance with their beliefs and principles. Ally explains that these people can bring their money into the system through Islamic banking and thereby contribute to the country’s economic growth.

“Interest in Islamic finance is growing partly because the market is liquid and global investors are looking for opportunities outside the Middle East.”
Muath Mubarak

He claims that Sri Lanka’s Muslim population of around 10% controls approximately 30% of businesses in the country. “Although many banks and financial institutions are in existence, my personal guesstimate is that they haven’t even touched 20% of the total market. There is still 80% left, so the pie is pretty big.”

Feroza Ameen, Chief Manager of Islamic Banking at Commercial Bank, comments, “There’s a lot of potential in Colombo and outstation, and while Muslims would be the initial focus, certain attractive features like ethical financing will appeal even to the non-Muslim segment.”

However, to date, policymakers have not comprehended the role Islamic finance could play in developing the country. Mubarak believes a vibrant Islamic finance industry will benefit the economy. Public infrastructure projects are largely funded by foreign loans at high interest rates. Sri Lanka’s sovereign debt is also 300 basis points higher than LIBOR. Interest payments alone eat up most of the country’s tax revenues each year. “We won’t need loans for large infrastructure projects anymore if we can attract funds with Islamic finance’s profit and loss sharing mechanism,” he adds.

“Interest in Islamic finance is grow- ing partly because the market is liquid and global investors are looking for opportunities outside the Middle East,” says Mubarak.

However, attracting investors for capital is also challenging given the need to compete with the conventional banking sector and regulations. Islamic banking is a small market here and returns are low compared with other Islamic finance markets in the region, so it is difficult to attract global Islamic finance investors as well.

Following the failures of conventional financing, perhaps it may be time to consider Islamic finance seriously, although it is unlikely to replace the conventional banking system.

In spite of all the risks taken by the Islamic banks, at the end of the day, even these institutions need to be profitable. Islamic finance institutions make money through three primary means.

The first is profit and loss sharing. This is at the centre of any Islamic financial product, primarily Muda- rabah (profit and loss sharing part- nership). Mudarabah occurs when a customer deposits money, entering into a partnership with the bank. The bank uses this money to invest or partake in a particular business, which gains a profit or makes a loss. If the business makes a profit, the bank shares in this profit with the customer (capital pro- vider). The profit made by the seller/ lender is not regarded as interest, but a profit on his investment. Essentially, the return depends on the outcome of the business. In the case of a loss, theoretically, the capital provider loses his money, while the bank loses the time and effort put into the business; both parties will lose equally in a joint venture agreement. “However, certain countries, as is the case in Sri Lanka, say that the capital has to be protected in the least,” explains Mubarak.

The second way the bank makes money is by charging service fees. Is- lamic banks believe that every transaction has two partners. As one partner, the bank spends its time and effort on a particular business, for which it charges a service fee. This is a primary source of income for the bank, and is the only fixed rate on Islamic financial products.

The third method is rental-based income. This relates primarily to a bank’s leasing or installment-related businesses. This markup, as mentioned previously, may be a fixed or floating rate, depending on the product (lease/loan) and scheme requested by the customer. In this instance, as the trade partner, the bank is entitled to a rental-based income as in any business partnership.The mark-up charged on Islamic banking products puts the in- dustry under further scrutiny. Today, Is- lamic financial institutions are required to meet the same needs of the busi- ness world as are conventional banks. Thereby, Islamic financial Institutions are compelled to offer competitive pric- es for their services. Therefore, charges are almost equal in both methods of banking. However, Mubarak explains that while the products and charges may look similar (in terms of numbers), the main difference is the transaction process. He explains that in the same way two similar chicken dishes may be Halal or Haram, the difference is not in the outward appearance of the product, but the manner in which a transaction is conducted or processed.

Sharia law mandates fair play and prohibits interest (excessive) charges. However, profit charging in a business transaction is more of a business deci- sion than a Sharia principle. It is a sad situation that this has obligated Islamic banks to remain within the Sharia law, while not being true to its spirit.

From the bank’s point of view, the risks are high. As in conventional bank- ing, Islamic banks face the issue of loan defaulters on occasion. While conven- tional banks will invariably penalize the defaulter or guarantors, Islamic banks take a personal approach. “We will inquire the reason behind the default or delay in settlements. If it is a genuine problem such as an illness or unforeseen event, the bank will not strain its relationship with the customer and let the customer off the hook until he is able to recommence his payment,” Mubarak explains. He adds, “In some instances, if a customer has paid installments for a five-year loan for four and a half years and is struggling to make the final payments, the bank may decide to waive off the remaining amount as a gift to the customer.”

In the case of a willful defaulter, the bank takes a sterner approach. If the defaulter is delaying payment even after a grace period, the bank will charge a penalty fee. However, this does not become part of the bank’s profit. Rather, this additional amount goes to charity. The amount that can be charged in this instance is 2-3% in Sri Lanka. In the worst-case scenario, if the customer is unable to make his payment, the bank will take the asset to the market and sell it. However, unlike conventional banks, the Islamic bank will only take back its due amount and the remainder will be given to the customer, benefitting both parties.

Islamic finance faces several challenges around the world, the biggest one being realizing its potential in global markets dominated by interest rates.

The global Islamic finance industry began in 1963 with Mit Ghamr, a savings project based on the profit and loss sharing model for small- scale entrepreneurs and poor farmers in Egypt. Sri Lanka was not very far behind. Starting as mosque-based savings plans in small Muslim villages in the 1980s, Islamic finance was legally introduced to Sri Lanka by Amana Investments in 1997. Today, there are more than 40 Islamic banks/finance institutions and service support organisations. Amana Bank is the country’s only standalone Islamic Bank, but did not respond to repeated requests for an interview. There are also five Islamic finance education service providers, a few IT players developing software modules for Islamic banks, and two main publications (Islamic Finance To- day and Halal World) promoting Islam- ic banking. In addition to banks, there are several Takaful (insurance) players in the country – Amana Takaful, HNB and LOLC stand out among the rest. In regulating the Islamic finance industry, domestic banks and leasing companies that have established Islamic finance units are now required to submit financial statements separately to the Central Bank for supervision purposes, but are not made public.

Islamic finance is one of the fastest growing segments of the global finan- cial industry. Total assets of the Islamic finance industry were estimated at USD1.8 trillion at the end of 2013. The Middle East is the centre of Islamic finance, with contribution of approxi- mately 74%, while the remaining 26% is shared by the rest of the world. In countries like Sri Lanka, the Islamic finance industry has become too big to be ignored. While awareness has increased since 2005, the industry in Sri Lanka still faces several regulatory hurdles. Amendments to the Banking Act to allow banks to engage in other types of Islamic financial instruments, demystifying Islamic finance concepts among regulators and developing Islamic finance professionals are a few issues that need to be addressed for the progression of the industry.

While there is no doubt that, in theory, the Islamic banking system can add value to the global financial system, much work is still needed to demon- strate the purported viability of the Sharia-based system. More specifically, the main focus should be on narrowing the gap between theory and practices. Perhaps then we can answer the global question: Is the Islamic banking system a viable option?