Islamic finance: textbook manual 9786010422315

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AL-FARABI KAZAKH NATIONAL UNIVERSITY ______________________________________________________

Zh. Kazbekova, D. Kulibayeva

ISLAMIC FINANCE Textbook manual

Almaty «Qazaq university» 2017

UDC 005.915 (075.8) LBC 65.261я73 K 22 Recommended for publication by the Scientific Council of the High School of Economics and Finance and RISO of Al-Farabi Kazakh National University (protocol No.2 from 29 December, 2016 y.)

Reviewers: PhD, Associate professor A. Issakhova PhD, MBA, acting associate professor A. Nurgazina

Kazbekova Zh., Kulibayeva D. K 22 Islamic finance: textbook manual / Zh. Kazbekova, D. Kulibayeva. – Almaty: Qazaq university, 2017. – 98 p. ISBN 978-601-04-2231-5 The textbook manual on Islamic finance takes a detailed look into the Islamic Finance and its offering to the modern globalised economy. Today, no country in the world is unaffected from the financial crisis. Islamic Finance with its innovative approach towards financial stability and equality proves to be symbol of strength and stability to the global economy. The authors have clearly demonstrated the principles and guidelines related to loans, investments, insurance, banking and other subjects in a skillful manner. There were specific examples, logics and reasons given for acceptance or unacceptance of the particular instruments. This textbook manual is designed for students, teachers in economics and finance disciplines for Bachelors, Masters and MBA degrees.

UDC 005.915 (075.8) ISBN 978-601-04-2231-5

© Kazbekova Zh., Kulibayeva D., 2017 © Al-Farabi KazNU, 2017

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CONTENTS Background of Islam and Islamic Finance..............................................5 Islam – the Islamic Way of Life .......................................................5 Islamic Finance .................................................................................6 CHAPTER 1 ISLAMIC FINANCE – A GENERAL OVERVIEW .......8 1.1 Islamic Trade and Finance ................................................................8 Questions ..........................................................................................10 1.2 Sharia ................................................................................................10 Questions ..........................................................................................13 1.3 Money in Islam .................................................................................13 Questions ..........................................................................................15 1.4 Main concepts and terms of Islamic Finance ....................................15 1.4.1 Riba ..........................................................................................17 1.4.2 Gharar ......................................................................................19 1.4.3 Mudarabah ...............................................................................21 1.4.4 Musharakah ..............................................................................23 1.4.5 Murabaha .................................................................................25 1.4.6 Ijarah ........................................................................................26 1.4.7 Sukuk .......................................................................................27 1.4.8 Salam........................................................................................28 Questions ..........................................................................................30 1.5 Islamic Finance around the World ....................................................31 Questions ..........................................................................................34 1.6 Islamic Finance in Muslim nation ....................................................36 Questions ..........................................................................................38 1.7 Islamic Banking and Finance in Secular Nations .............................38 Questions ..........................................................................................40 1.8 Islamic Finance in Kazakhstan .........................................................41 1.9 Kazakhstan – A social, religious and historical perspective .............42 1.10 Developments in Islamic financial system in Kazakhstan in recent years ........................................................................................43 Questions ..........................................................................................45 1.11 Islamic Finance in Kazakhstan – Its Goals and Aims .....................45 Questions ..........................................................................................49 Part 2 – Foreword ...................................................................................50 CHAPTER 2 – ISLAMIC FINANCE AND FINANCIAL INSTRUMENTS ....................................................................................51 An International Perspective...................................................................51 Islamic Finance in 21st century – A detailed analysis ............................51 3

Sharia Advisory Boards ..........................................................................63 Sharia as an International I slamic financial law in 21st century ............65 Country Specific Islamic Finance and Financial Instruments.................71 Questions ................................................................................................77 Bibliography ...........................................................................................79 CHAPTER 3 – CHALLENGES TO THE DEVELOPMENT OF ISLAMIC FINANCE .......................................................................81 Challenges to Islamic Finance – Introduction ........................................81 Challenges highlighted by the International Monetary Fund ..................81 Analysis of the challenges by Islamic Finance News .............................88 Contemporary issues faced in the practice of Islamic Banking ..............90 Questions ................................................................................................93 Bibliography ...........................................................................................94 Conclusion ..............................................................................................95 Bibliography ...........................................................................................96

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Background of Islam and Islamic Finance Islam – the Islamic Way of Life

(Source: ancient-origins.net)

The great religion of Islam is the biggest religion in the world in terms of number of people that adhere to its tenets and follow the way of life prescribed by it. Over 1.6 billion people around the world practice Islam. It constitutes around 25% of the total population of the world1. Islam is not just a faith; it’s also a way of life for its adherents. Right from the birth till death, every aspect of the life of the faithful Muslims is guided by the principles of their holy faith. The holy Quran defines the virtues that Muslim needs to follow throughout their lives and also the vices that they must refrain from2. The Islamic way of life, that promotes wellbeing of everyone defines the guidelines that Muslims must follow in their financial and commercial dealings. The Islamic laws that are known as Sharia prescribe the duties that every Muslim must follow. 1 Qran (2014), Muslim Population in World Population Ranking. < http://www.qran.org/a/aworld.htm>. 2 M Hasan. (1987). HISTORY OF ISLAM. New Delhi: Adam Publishers.

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Islamic Finance

(Source: emergingequity.com)

The Islamic financial practices have their origins in Sharia and are guided by these laws that outline the financial practices that are acceptable and those that aren’t. The adherents of Islam have traded on a global level since the ancient times3. Throughout the history, Muslim merchants have travelled to the far corners of China, Europe, Africa and South Asia4. Since these times, Sharia was the guiding force behind their trade and commerce5. With the increase of globalisation and the integration of the economies of the world, Islamic finance is also fast emerging as a major financial model. It offers a more prudent and benign alternative to the western capitalistic economic system and have its practices firmly rooted in the teachings of Islam, Quran and Sharia. 3 Institute of Islamic Banking and Insurance (2016). Shari'ah Rulings and Finance. < http://www.islamic-banking.com/shariah-rulings-finance.aspx>. 4 Heilbrunn (2016). Trade between Arabia and the Empires of Rome and Asia. < http://www.metmuseum.org/toah/hd/ince/hd_ince.htm>. 5 M Ayub. (2009). Understanding Islamic Finance. West Sussex: John Wiley and Sons.

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The objective of Islamic Financial model is to ensure holistic growth and wellbeing of every section of the society with the benefits of trade and commerce being delivered even to the poorest. Islam propounds equality and supports the belief that every human being must be treated equal. It mandates Muslims to help the poor and needy in their times of need and therefore they must refrain from exploiting others. The Islamic finance supports this notion of equality and help for the needy. The principles and rules of Sharia mandate that any transactions done by Muslims should confirm to the rules and regulations of Sharia and tenets of Quran. This textbook manual is an endeavour in understanding the basic aspects of Islamic Finance and its relevance in the modern times. It includes a thorough analysis of the Islamic financial models in various countries including Muslim and Secular nations and its impact on the Muslim societies in these nations. An analysis of the Islamic financial instruments is also an important part of this research. The role of various Islamic agencies and certifications and standardisations are also analysed. The book also evaluates the impact of Islam over the financial institutes in Kazakhstan. An analysis of the Islamic financial guidelines and their influence in Kazakhstan are examined.

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Chapter 1 Islamic Finance – A General Overview

1.1 Islamic Trade and Finance

(Source: coachparkerworldhistory.weebly.com)

Islamic Financial system, in some form or the other has existed since the beginning of Islam in the 7th Century CE6. Over the last 14 centuries, Muslim traders have travelled across the world and have conducted financial transactions7. The ancient Silk route that connected China with Europe passed through the Muslim dominated regions, thereby enabling the traders and merchants from Arabia to travel to various places around the world. Traders from Arabia travelled in all directions – towards West to Europe, South to Africa, South East to the South of India, Sri Lanka, and further to Malaysia, Indonesia, and several other countries. 6 Heilbrunn (2016). Trade and Commercial Activity in the Byzantine and Early Islamic Middle East. . 7 M.G.S. Hodgson. (2009). The Venture of Islam, Volume 1: The Classical Age of Islam. Chicago: University of Chicago.

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Along with their trading activities, these merchants and traders are given credit for the organic spread of Islam to several of these nations. The Arabian merchants spent months and even years travelling to distinct places where people from their culture had never travelled before. Hence, trade and commerce were highly appreciated and acceptable aspects of the Islamic way of life in the Middle East. Stories such as the Arabian Nights and Sinbad talk about trade voyages and are highly popular in this part of the world. It proves the prominence that trade and business have gained in Muslim cultures. The importance of trade and finance in Islam is evident from the fact that Quran and Sharia prescribe the dos and don’ts of financial transactions. Sharia defines the guidelines for individuals as well as institutions while entering into financial dealings. It has been mandatory for them to ensure that the financial transactions they enter into are Sharia compliant. Sharia and Quran define how the life of a follower of Islam should be. These guidelines specify the dos and don’ts for the entire life as well as for the daily conduct of the people including their financial transactions. Since finance and commerce are integral aspects of human life since times immemorial, Islam gives these activities significant prominence. The importance to trade, commerce, and financial transactions accorded by Islam is evident in the manner in which Sharia guidelines and laws are framed to ensure that the human morality and ethics are not overlooked in financial transactions. At the core of Islam is the wellbeing of every individual and it mandates that all humans must refrain from indulging into acts that violate integrity and respect of other people. According to Islam, due respect needs to be given to big and small, young and old. Since money, if not managed properly can be the root of all the evils, Islam necessitates for all of its adherents to follow the tenets of Sharia in all financial dealings to ensure that money is utilised for the good of everyone and evil of none. The purpose of ensuring that the financial transactions should be compliant with the Islamic laws of Sharia is to ensure that no individual, in the course of the financial transactions is exploited. 9

It is therefore, essential that every individual and institution must adhere to Sharia laws while engaging in any form of financial behaviour. Even the status of money and the importance it is to be given is determined according to the principles of Sharia. Every Muslim must implement these principles to avoid misuse of money as a means of exploitation of the poor and needy. Based on the above discussion, it is evident that Sharia laws give a clear definition to the way wealth, money, and financial transactions must be treated so that they become potent tools of social welfare and wellbeing of the fellow humans. Questions 1. Since when the Islamic Financial System has existed? 2. The financial transactions done by Muslims should comply with which laws? 3. Which entities define the ideal life of a follower of Islam? 4. What is the main purpose of the Sharia laws?

1.2 Sharia

(Source: henrymakow.com)

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Sharia is the legal system of Islam. It is derived from Quran and defines the legal framework that needs to be followed by every Muslim. The tenets of Sharia are applicable to every Muslim irrespective of their social or economic status8. The principles of Sharia are derived from the Holy Quran and its interpretation by the Muslim clerics and scholars. Sharia states the guidelines that are to be followed by every Muslim around the world in all aspects of life9. It also includes financial dealings and Sharia is applicable to individuals as well as organisations run by Muslims such as banks, financial institutions, etc. Sharia and consequently Islamic Finance believe in social welfare over individual profiteering and therefore it is important that the followers of Islam stay away from any financial deals or practices that might result in loss of the other persons. Sharia laws consider money as an instrument that is to be used for other main purposes. According to the Islamic finance, money is not an end. It’s just a means to a more meaningful end and therefore it must be treated accordingly. Sharia defines money as an instrument and not a commodity. Hence, using money as the base product for earning more money is strictly prohibited under Sharia. It is considered to be exploitation and the erring persons or organisations are subject to severe penalty under the Sharia laws. The conventional or the classical theories of money also define it as a medium of exchange that can be paid for goods and services and in exchange of the work done by other person10. Money includes the physical coins and notes as well as other tenders and the financial instruments. The economic definition of money also considers it to be a storage of value11. It means that money is not just a means of an exchange, it is also a repository that holds the value of several other 8 BBC (2014). What is Sharia and how is it applied?< http://www.bbc.com/news/world27307249>. 9 Ibid. 10 Merriam-Webster Dictionary. . 11 Valentino Piana. (2002). Money. .

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elements that correspond to tangible and intangible assets12. The money represents the equivalent value of these assets in a unit of measurement that is represented by the specific currency. Here lies the major difference between the Islamic version of money and its interpretation by the conventional or classical economists. As per the classical theory, money represents value of specific assets. It is also possible to hold the same value in the form of real assets13. These assets are likely to appreciate over time in their value and equivalent measurement in money. For example, the price of a real estate property or land will appreciate in time. However, if the same value is held in the form of money, it will not appreciate, and in fact will depreciate due to inflation. The way the value of money can appreciate is by using the money, through investments or lending resulting in interests or other forms of income. It is exactly what the banks and other financial institutions do and the individuals invest in these institutes to let their money grow and appreciate. People make deposits in banks to earn interest income and the banks lend money to other people or companies and charge interest. However, this is contrary to the Islamic definition of money which considers it not as an asset but a means to an end. Therefore, Muslims and Islamic organisations are not allowed to generate money from money without the involvement of any other activity or conversion of the money to a tangible asset. Sharia laws are non-negotiable since they are based on Quran which contains the words of Allah and hence, no deviation is allowed in this regard. It is reason why Islam does not allow Muslims to invest in financial instruments that are interest bearing. Interest is considered an exploitation mechanism where the needy are exploited by the rich who lend them money and charge exorbitant interest rates to them which amounts to exploitation – an action that is condemned in Quran which mandates that every human being must be treated equally. 12 13

Ibid. Ibid.

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According to Sharia, no individual is allowed to profit from the grievances of others and the most important thing is supporting fellow Muslim over any kind of personal financial gains. Sharia is the state law in several Islamic nations. In other Muslim nations, if Sharia is not the primary law, then the local laws are derived from Sharia and its interpretations by the legal and religious scholars in these countries. Questions 1. Who should follow the legal framework of Sharia? 2. Who have interpreted the principles of Sharia? 3. In which aspects of life should Sharia guidelines be followed? 4. Should Sharia guidelines be followed only by the individuals? 5. Which types of financial deals is prohibited in Islam? 6. Are deviations allowed in Sharia laws? 7. Does Islam allow Muslims to invest in interest bearing instruments?

1.3 Money in Islam

(Source: Islamic-arts.org)

Money in Islam is not an asset, it’s just a means for procuring other assets14. Sharia doesn’t allow generation of more money from money, which means that interest earning is prohibited in Islam15. 14

Muslim Investor (2002). Wealth as a responsibility in Islam. < http://musliminvestor.com/mi/wealth-in-islam.phtml>.

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It is for this reason, that several Muslims prefer investments that do not generate interest income16. Although Islamic finance has existed for over 1400 years, the modern version of Islamic finance can be dated back to the 1960s and 1970s17. It was the time when the oil industry gained the impetus globally resulting in large inflow of money in the Islamic nations. The increase in the income of the Middle Eastern Muslim countries due to the boom in the oil industry led to the establishments of various banks and financial institutions. The need was felt to develop institutes of Islamic finance that believed in the guidelines of Sharia of mutual good and non-exploitation. The reason the need for Islamic banks and financial institutions has been felt in these countries is due to two main reasons. One, the booming oil industry has made this country rich and wealthy. The second reason is that it is felt, in the era of globalisation that even the ardent Muslims have to act within the framework of conventional banking systems. It becomes evident in the manner in which money is treated differently by Islam and classical theories, which has been discussed in the previous section. In Islam, as stated earlier, money is just a medium and not a tangible asset18. Unlike the western application of money, which allows investments and charging interests for making more money, Islam believes that every asset and resource is for the common good and using money in a manner that leads to its appreciation without procuring any tangible goods and service amounts to the exploitation of those who pay such interest on the money borrowed by them. Such practices are against the beliefs and tenets of Islam that states money should be used for welfare of everyone and not for their 15 Institute of Islamic Banking and Insurance (2016). Islamic Banking. < http://www.islamicbanking.com/islamic_banking.aspx>. 16 J Smithin. (2000). What is Money? London: Routledge. 17 The Economist (2014). Big interest, no interest. < http://www.economist.com/news/financeand-economics/21617014-market-islamic-financial-products-growing-fast-big-interest-nointerest>. 18 M.A. Choudhury. (1997). Money in Islam: A Study in Islamic Political Economy. London: Routledge.

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exploitation. Money should be used to help people in their crisis situations and not for taking advantage of their problems. Money, in Islam is not meant for hording. A Muslim can use the money to help someone or procure an asset, become its owner, share its risk and then appreciate their wealth. Appreciation of wealth by not sharing the risks or investing into a tangible asset surmounts to profiteering and corruption and also the exploitation of the poor. Hence, the tenets of Sharia and Islamic financial laws clearly define how the money be used or what are the prohibitions on its use. In the next section, key Islamic financial concepts are explained which will make the understanding of these key concepts as well as of money clear. Questions 1. Is money an asset in Islam? 2. Does Sharia permit using money for generating more money? 3. Since when did the period of modern Islamic finance began? 4. What are the two main reasons that led to the focus on Islamic finance in the recent times? 5. The growth of which industry in the modern times resulted in an increased focus on Islamic finance? 6. Does Islam support appreciation of money without the procurement of tangible goods or services? 7. Does Sharia allow hording of money?

1.4. Main concepts and terms of Islamic Finance There are various concepts that have great importance in Islamic finance. These terms are applicable to all the Islamic banking and financial institutions. Some of these are explained here. Main concepts of Islamic Finance The main concepts of Islamic finance are explained in the below sections. It is important to understand each of these concepts as they are interlinked and help interpret the financial guidelines of Islamic finance. 15

Each of the below mentioned concepts, individually as well as collectively play a crucial role in ensuring that Islamic finance and trade abide by the guidance of Quran, the Hadith and the Almighty Allah. These concepts are guidelines that specify how a Muslim individual or financial institution should practice trade and commerce.

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1.4.1. Riba

(Source: Knowingallah.com)

Riba in Islamic finance refers to usury. Islam considers that money is a measuring parameter for the value of an asset and not an asset per se. It is therefore restricted to generate more money from money19. Under Sharia, when a person lends money to another person, the lender is not allowed to charge any interest. The amount of money lent and refunded should be the same and there should not be any additional amount charged over what has been lent20. Hence, interest income, whether lent to another individual or through the deposits made in a bank is prohibited. An increment of the money over the original value through its lending to another is considered Riba or Usury, which is prohibited. The laws are applicable to the individuals as well as Islamic institutions such as banks or financial companies. Riba comprises not just the interest in the monetary form earned from lending the money but also any other returns that are of similar characteristics. 19

M.A. El-Gamal. (2006). Islamic Finance: Law, Economics, and Practice. Cambridge: Cambridge University Press. 20 Ahmad, Abdel-Rahman Yousri (2016). Riba, Its Economic Rationale and Implications. < http://www.islamic-banking.com/iarticles_8.aspx>.

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There is a prohibition on receiving additional money over and above the money that has been given as a loan. It is to avoid any kind of financial harassments of the poor at the hands of money lenders or money lending financial institutes. The concept of Riba aims at reducing the exploitation of the poor by the money lenders and therefore Muslims are not allowed to invest their money in any instrument that generates interest income. Investors can invest in instruments that makes them an owner of the underlying asset. Accordingly they have to share the profits or losses arising from the investments. They can take ownership in the underlying asset. Equity investment is one such investment as it gives the investor a stake in the company whose shares have been purchased. However, investors are not allowed to buy debentures or give a loan to the companies. Both of these are considered as interest bearing loans and are strictly prohibited under the rules of Sharia. It makes them more accountable towards the investment and discourages them from exploiting others for their personal gains. It results in avoidance of lending to the poor at exorbitant rates thereby enforcing Riba. Riba is a concept that encompasses the Sharia guidelines on money. It aims at ensuring that money is used in a righteous manner without any person or organisation resorting to unethical means that breach the principles of Islam. Money is just an instrument or a medium according to Islam and must be used accordingly. Its application must be just and ethical. Riba allows clearly differentiating between the financial instruments that are acceptable or unacceptable under the tenets of Sharia and help the Islamic financial scholars and institutions to develop instruments that are Sharia compliant.

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1.4.2. Gharar

(Source: i.ytimg.com)

Although Islamic finance permits investing in financial instruments that bestow the ownership of the assets to the investors, it mandates that the investment should not be in the assets that have uncertainties or undue risks. In comparison, there is no such restrictions in the conventional western financial structure where the investors can invest into speculative instruments such as derivatives, debentures and also insurance products. Gharar is the principle that prohibits investing in insurance. Insurance claims are uncertain as the death of the policy holder cannot be determined. Uncertainties of life and death prohibits investing in insurance or similar instruments21. Insurance, which is an instrument used to cover uncertainty related to the life of an individual deals with one of the many possible future circumstances. Even the timescale when such an instance may occur is uncertain. Due to such uncertainties, Gharar prohibits investments in insurance products. 21 I. Warde. (2000). Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press.

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A simple translation of Gharar in English is “Uncertainty”. In Quran, there is a term Al-Gharur, which means deception22. Hence, what is uncertain is not allowed under Islamic financial laws. A Muslim, according to Islamic Finance is not allowed to invest in instruments such as derivatives and hedge funds. These investment avenues derive their value from other underlying assets and therefore there is a high degree of uncertainty in the returns they earn as well as the principal amount invested. Any kind of investment that includes a large amount of uncertainty or is deceptive in nature is not allowed under Sharia. It also includes uncertainty in price of a particular contract. For example, if a contract of a product is X amount in one place and is Y amount in another place, there is a big degree of uncertainty and there can also be deceptive elements involved in it23. Investing in equity is allowed and not prohibited under Gharar. It is because the asset ownership is certain and there is a direct correlation between the investment and the profit and loss of the asset. Also, the ownership is direct and hence the returns on the investments are in the form of the appreciation of the value of the assets and not interest income. However, there are certain types of companies in which investments cannot be made. These include companies involved in the production of alcohol, weapons, pornographic material and gambling. It is also essential that the company where equity investments are being considered meet all the guidelines prescribed by Sharia. Islam defines what is Halal and Haram. Halal are the acceptable practices while Haram are prohibitions. In every aspect of life, Muslims must ensure conforming to Halal and strictly avoiding Haram. Gharar allows making similar distinction when it comes to investments and application of wealth or money.

22 23

Ismalic Finance (2010). What is Gharar? < http://www.islamic-finance.com/item160_f.htm>. Ibid.

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1.4.3. Mudarabah

(Source: www.financialislam.com)

Mudarabah is a form of contract where one of the parties invest in the form of money and the other party brings its knowledge, information and other resources. Both of these parties are assigned specific responsibilities and based on the assigned responsibilities they are required to perform their functions24. Mudarabah can be a person or a group of persons such as an institute, organisation or a company. These are referred to as joint Mudarabah. The joint Mudarabah can be for a specific time or continuous25. Mudarabah are the contracts for sharing profits and losses. It involves creating a pool of investors who abide by the Islamic laws and invest in assets where they are granted an ownership in proportion to their respective investments. 24 Citi Bank (2007). Mudarabah. < http://www.citibank.com/ciib/homepage/finance/mudaraba.htm>. 25 Ibid.

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If the asset or the company where they have invested earns profit, it is shared with the investors according to their investment proportion26. The persons in the group can continue to be in partnership or exit it by taking their share of profits. Based on the concept of Mudarabah, a specific type of mutual fund has been constituted. These mutual funds invest in equity of the companies that meet the Sharia guidelines. These companies are meticulously screened to ensure that they do not have large debt based investments or produce goods that are prohibited under Islam27. The process of the evaluation of the stocks includes a meticulous analysis of the balance sheets of the companies and their other financial statements. A company that has huge debts or has given loans of huge amount are not allowed for the investments. Investors can invest only if the company meets all the other criteria as prescribed under Sharia and is not involved in any activity that is considered as unlawful or anti-Islamic. These mutual funds are also traded on stocks exchanges and have their own indexes. FTSE Global Islamic Index and Dow Jones Islamic Market Index are the examples of these Sharia compliant stock exchange indexes.

26

Ross, Marc L. (2016). Working With Islamic Finance. < http://www.investopedia.com/articles/07/islamic_investing.asp>. 27 Ibid.

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1.4.4. Musharakah

(Source: FinancialIslam.com, Musharaka diminishing for bank and ownership increase for the eventual owner)

Islamic banks that strictly follow Sharia, follow Musharakah as an alternative to the conventional loans28. It can be in the form of partnership or a joint venture. In other terms, Musharakah refers to partnership or a joint ownership of the equity or stocks. This type of investment is Sharia compliant unless the asset in which the investor has the ownership is not prohibited by Islam. This type of ownership pattern is useful as an efficient substitute for home loans. Since home loans result in the interest income of the company that lends the money, it is not permissible under Sharia. Sharia and Islamic financial laws are as much applicable to institutions as they are to individuals. There is no distinction between an institute and a person when it comes to the applicability of Sharia and the Islamic laws. Hence, it is important that no Islamic financial institute should practice anything that is against the principles of Islam. Similarly, no individual should deal with any institution that is against the basic tenets of Islam and the guidelines of Sharia and Quran. 28 Institute of Islamic Banking and Insurance (2016). Musharakah on shari'ah Ruling. < http://www.islamic-banking.com/Musharakah_sruling.aspx>.

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As a substitute for home loan or any other loan that is borrowed to purchase an asset, the financial institution in the case of Musharakah acquires a joint ownership of the asset. The actual owner is either a co-owner, to the extent of his investment in the asset or a leases it from the institute that has invested in it29. In the first instance, the individual gradually increases his ownership in the asset by paying for it proportionately and when the entire amount is paid, the complete ownership is transferred to the individual. The bank or the institute that was the joint owner transfers the complete ownership to the individual investor30. In the process, the financial institution makes profits but it is not same as an interest income. Hence, it is Sharia compliant process as there is no exploitation of the individual investor by the way of charging him exorbitant interest. The process also involves clearly defining the amount that the individual investor pays for acquiring the complete ownership of the asset. In the second instance, the individual leases the asset, such as a home from the institution and in return pays a certain sum of money that gradually transfers the ownership to the individual. It involves prescribing a fixed term throughout which the investor pays to the institute a certain fixed amount of money in the form of lease and at the end of the term, he pays the balance amount to acquire the complete ownership of the asset. Leasing is also known as Ijarah under the Shaira laws and is acceptable under the Islamic financial guidelines.

29 30

Ibid. Ibid.

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1.4.5. Murabaha

(Source: Financialislam.com)

Just like Musharakah, Murabaha also involves gradual transfer of ownership between the financial institution and the individual. In this case, the asset is bought by an intermediating institution or an individual and is sold to the individual buyer31. For example, the bank may buy a machine on immediate payment and sell it to the customer on a deferred payment basis. The difference in the purchase and sale prices of the bank constitutes its profits. It involves cost plus financing of the asset. The buyer can either pay the lump sum or buy the asset in instalments. In either case, there is no lending or the interest charged to the individual buyer of the asset, thereby making Murabaha Sharia compliant32. 31 Institute of Islamic Banking and Insurance (2016).Murabaha on Shari'ah Ruling. < http://www.islamic-banking.com/murabaha_sruling.aspx>. 32 International Institute of Islamic Bankers (2016). Certification in Islamic Banking and Finance: Meezan Bank.

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1.4.6. Ijarah

(Source: Albaraka.com)

The concept of Ijarah or leasing is already explained. It mandates that the lessor should be the owner at the time of leasing the asset and continues to own it till the end of the duration of the lease33. It is a method where the owner of the asset (the leaser) leases the assets to the lessee for a specific time and a specific period. It benefits the lessee as the lessee might not have the funds to buy the asset and therefore can use it under Irarah. It is a suitable alternative to interest based loan or finance. At the term of the lease period, the ownership of the asset is transferred to the lessee34. A lessor may enter into a control with the lessee where the ownership is transferred to the lessee at the end of the lease duration in lieu of the payment of the balance amount. In such a contract, the lessor is bound to sell the asset if the lessee consents, but there is no similar obligation to the lessee to compulsorily buy it from the lessor. Ijarah is basically of two types. Financial and Operational. Financial lease results in the complete ownership of the lessee at the end of the lease period, whereas in operational lease, the full cost of the asset is not paid during the lease period and the asset might be returned to the original owner35. 33

B. Maali. Et. al. (2006). Social reporting by Islamic banks. John Wiley and Sons. Financial Islam (2016). Ijarah. < http://www.financialislam.com/ijarah.html>. 35 Ibid. 34

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1.4.7. Sukuk

(Source: Islamicfinance.com)

Sukuk have fast emerged as one of the most preferred Islamic financial instruments in the recent times. These are Sharia compliant Islamic Bonds36. Unlike the traditional debt based bonds where the investors are actually the creditors who earn interest income, Sukuk Bond holders are the actual owners of the bonds37. Once the investors acquire Sukuk Bonds by purchasing them, they can rent these bonds back the issuer, which is a financial institution. The issuer will then pay the rent to the bond owners. Hence, the earnings of the bond owners is rental income and not interest income. The rental rates could be regulated by linking them in to international benchmarking rates such as the LIBOR (London Interbank Operating Rate). The linked rental rates could be fixed or floating based on the guidelines of the issuer of the Sukuk Bonds. 36

R.H. Kanji. (2014). Kazakhstan IF Sukuk Conference 2014: Legislative Aspects of Sukuk. Financial Times (2012). Definition of sukuk (Islamic bonds). < http://lexicon.ft.com/Term?term=sukuk-(Islamic-bonds)>. 37

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1.4.8. Salam

(Source: Islamic-banking.com)

Although Salam is a term that is commonly heard in the domain of Islamic finance, it is an instrument that is not used very frequently. Salam is a type of instruments that is an exception to the principle of Gharar. Gharar does not permit investing in instruments that are risky or uncertain like insurance. Any instrument that consists of even a small quantum of risk or uncertainty is not permissible under Gharar. There is an exception to this rule in the form of Salam, which allows undertaking risks by making investments in assets that will turn profitable in the future. However, the risk is mitigated by ensuring that there is an underlying tangible asset which shall be delivered or its ownership transferred to the investor in the future. The tangibility of the asset and the assurance of its transferability at a future date, make the risk acceptable. 28

Under Salam, a buyer pays the price for the asset in advance and the asset is delivered in the future38. Salam is also known as Istisna, except there is a technical difference between the two and the use of the specific term depends upon the product it is used for financing. Salam is considered financing of agricultural products and Istisna is used for financing manufactured products39.In Istisna, the transaction is executed even before the actual asset is brought into existence40. Both Salam and Istisna allow the investors to take the risk and share it with the counterparty while still ensuring that the risk remains within the acceptable boundaries of Sharia. The acceptability of risk is also determined by the nature of the underlying asset and whether it is not something prohibited by Sharia. Salam is an agreement between the supplier and buyer of the goods. It is like a normal sale and purchase transaction, albeit the one in which the money is paid much in advance than the delivery of the goods. It is a form of forward contract where the supplier of the goods promises to deliver the goods at a future date. The bank or the financial intermediary coordinates the entire process. The risk is managed and mitigated through a formal process which ensures that none of the parties is hampered in the entire contract. The necessary precautions are taken for assuring the concerned parties, especially the buyer that there will not be any fraudulent or unscrupulous transactions which will take place in the process of the execution of the contract. Although the risk is not entirely eliminated, it is reduced to a significant extent, which makes such contracts entirely acceptable to the individuals and institutes that follow strict adherence to Sharia. Hence, despite being uncertain and fraught with risks, the quantum of the risk is already accounted for as these contracts are prepaid and the future ownership is guaranteed. Several oil rich Islamic nations use Istisna or Salam for developing their oil fields and exploring oil. It ensures that they retain the control of their oil and gas fields while also benefitting from the technical skills and 38

Financial Islam (2016). Salam. < http://www.financialislam.com/salam.html>. Blom Development Bank (2016). Islamic Finance. < https://www.blomdevelopment.com/development/subpage.aspx?pageid=10638>. 40 Ibid. 39

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knowledge of the private enterprises. Most of the oil and gas producing gulf nations are ardent followers of Islam and Sharia laws. According to Sharia, natural resources are owned by Allah and only the people of the nation can be given the control over them. Hence, it is prohibited to sell the rights of ownership of the natural resources, which necessitates that the state retain its control. However, since the countries do not have the necessary human resources and technical prowess to explore these natural resources, an effective way is to hire the services of the external experts, most of which are from the western countries at the managerial levels, and Asian countries at the workers and employee levels. Hence, Salam or Istisna is adopted to take the benefits of the skills and expertise of the external parties while also retaining the ownership of the natural resources with the state. According to the contract, the ownership of the oil and gas fields is not transferred, but the extracted oil or gas ownership is transferred at a later date when the terms and conditions of the contract are fulfilled. In this manner, the contract is executed within a structure of controlled risks. This is just one of the examples of the application of Salam and there are many instances where it is used to form deals that are potentially risky. Salam not only provides a framework to undertake such transactions while ensuring conformation to Sharia, but also provides the necessary mechanism to mitigate the risks. Questions 1. What is Riba? 2. Explain the concept of Gharar? 3. What do you understand by Mudarabah? 4. Define the term‘Musharakah’ in context of Islamic Finance? 5. When is the concept of Murabaha used? 6. Explain the situations when Ijarah should be used? 7. Define Sukuk? 8. What is Salam and when it is used?

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1.5. Islamic Finance around the World

(Source: KFH Research)

Islamic Finance is witnessing a growing interest around the world. The existence of Islamic indexes in the US stock markets (mentioned in the previous section) shows the pace of the growth of Islamic Financial Industry as an alternative to the western capitalist economic system. Around the world countries and financial experts are embracing Islamic Finance. Although Islamic financial principles have been around since the early days of Islam, Islamic finance as an established set of principles has seen extensive developments in the recent decades. The rate at which Islamic Finance has grown is stupendous. Islamic finance has gain prominence in several parts of the world which include not just the Islamic nations but also secular nations. In several of the Islamic nations, Islamic finance has become the primary form of financial management. It is considered more 31

important than the convention financial methods, which has changed not only the financial structure of these nations but also the way compliance is measured and implemented in these countries. The rise of Islamic finance as a force to reckon with is evident from the fact that even several secular nations now have Islamic finance as a part of their overall financial structure to some extent. Recently, India, which is a non-Muslim majority and secular country, but has one of the highest Muslim population in the world, has proposed an Islamic window as a part of its banking structure. The central bank of the country, Reserve Bank of India or the RBI has initiated this proposal, which when implemented will be one of its kind Islamic banking system where conventional banks will operate a separate window in their bank branches to offer Islamic banking services41. The Indian Centre for Islamic Finance has been working on presenting an alternative financial system for the Muslims of the country42. These facts prove the significance and prominence that Islamic finance and banking are gaining around the world. A glance at the Islamic financial assets and their growth trajectory within a span of five years – from 2009 to 2014 display the remarkable growth in this form of financial and banking system. In 2009, the global Islamic financial assets were around $1 trillion which grew to $2 trillion by 2014. It proves the exponential growth that Islamic banking and finance has witnessed. It also evidences the fact that Muslims and even several non-Muslims around the world are fast embracing Islamic financial system as an alternative to conventional, western financial system. The growth that Islamic financial assets have experienced since 2009, just after the global financial recessionary phase which started in 2007 displays the increasing inclination of people and institutes towards Islamic finance and away from conventional banking and financial 41

Zafar Sareshwala (2016) Islamic Banking: India has potential to become world leader in this system. < http://www.firstpost.com/world/islamic-banking-india-has-potential-to-becomeworld-leader-in-this-system-3127630.html>. 42 ICIF (2016) Welcome to ICIF. < http://www.icif.in/>.

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systems. It is because Islamic finance offers a holistic and ethical financial system that is free of the blemishes of the conventional system.

(Source: KFH Research)

It needs to be greatly emphasised here that the very fact that not only the Muslim nations but also secular countries are adopting Islamic Finance proves its inherent strength which is based on the Divine principles of Quran. Islamic Financial industry has evolved rapidly since the 1970s and currently assets worth US$2 Trillion are owned by this industry43 is symbolic of the rapid strides it is taking. Around 80 percent of the assets are in the form of bank deposits held by Islamic banks or Islamic units of other banks, 15 percent is in the form of Sukuk and 5 percent in other investment avenues. The spread of the assets is more inclined towards bank deposits at the moment, but the exponential growth of Islamic finance also means that other forms of assets will soon find a place of prominence. The various financial instruments discussed here are likely to gain further significance in the years to come. The growing financial 43 The World Bank (2015). Islamic Finance. < http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance>.

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uncertainties in the world and the likelihood of cyclic recessions every few years, as well as the global economic and political turmoil have help rendered conventional western financial system untrustworthy. The common perception that the western capitalist economic system has increased the disparity among the poor and the rich is also one the main reasons as to why people around the world are looking for an alternative system that is not just more efficient but also more moralistic. The alternative to them is available in the form of Islamic financial system which considers human values and ethics as the core of the financial system. It presents the perfect alternative to the western financial structure in the form of effectiveness as well as ethical principles. Unlike the conventional western system which is based on increasing profits as its sole aim, Islamic financial system has the wellbeing of the people at its core. It does not sanction unscrupulous profit mongering and even abhors it. The Sharia based financial system that derives its processes and tenets directly from the teachings of the Almighty and the Prophet (Peace Be Upon Him) as well as the Holy Quran, places the entire emphasis on the betterment of the people and using trade and commerce as a means to help improve their lives. Thus, the prominent difference between the conventional financial system and Islamic finance is that in the conventional system, wealth is an end in itself whereas in Islamic finance, wealth is only a means towards higher, altruistic end which is improving the lives of the people. It is this moral and ethical application of finance and financial instruments that seeks to avoid using them for exploitation of the needy and instead helping them ease their pain, which appeals to billions of people around the world. Not only Muslims, but even several non-Muslims see intrinsic value in the form and principles of Islamic finance and have begun considering it as a more viable and humane option as compared to the conventional financial system. As Islamic finance resonates the spiritual values of billions, it is fast becoming a financial system which offers a better solution than the western financial system. By eliminating risk bearing financial 34

instruments and exploitation in the form of high interest rates, Islamic finance aims at using financial instruments to uplift the downtrodden and to bring a sense of justice among the masses by restraining unethical use of money as a source of the exploitation of the poor. Questions 1. Which country’s stock market has an Islamic Index? 2. In which geographical regions does Islamic finance have a mainstream presence? 3. In which secular nations does Islamic Finance have a niche presence? 4. What is the growth trend on Islamic finance in terms of geographical regions and assets? Illustrate with a diagram.

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1.6. Islamic Finance in Muslim nation Below is the illustration of few of the Muslim countries around the globe that are adopting practices of Islamic Finance and Banking44. 1.6.1. Saudi Arabia Saudi Arabia owns around 31.70 percent of all the Islamic Banking assets. It has the largest asset base in the world in terms of Islamic banking and finance asset ownership. There are four banks in Saudi Arabia – Al-Rajhi Bank Saudi Arabia, Al Jazeera Bank, Al-Bilad Bank and Alnima Bank – that are considered as Islamic Banks45. These banks operate on the core financial model derived from Sharia laws that specify the acceptable and unacceptable practices. Hence, customers that are inclined towards banking with only Sharia compliant banks prefer these banks in the country. 1.6.2. Malaysia Malaysia is one of the oldest destinations to have embraced the modern version of Islamic banking in 1963. It ranks second after Saudi Arabia regarding percentage of Islamic banking assets held by the country. Malaysia has a share of 16.70 percent of the global Islamic banking assets46. Due to its legacy in the field of Islamic finance and banking system, Malaysia continues to be a dominant player as well as one of the leaders in this format of banking. 1.6.3. The United Arab Emirates The UAE ranks at third position with ownership of 14.60 percent of all the assets. Several Islamic banks operate in the UAE. These include Abu Dhabi Islamic Bank, Sharjah Islamic Bank, Rakbank 44

World Economic Forum (2016). These are the top 9 countries for Islamic finance. < http://www.weforum.org/agenda/2015/07/top-9-countries-islamic-finance>. 45 Ibid. 46 Ibid.

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and Emirates Islamic Bank47. These banks offer Islamic banking facilities to the customers who prefer banking with banks that are Sharia compliant. 1.6.4. Kuwait Kuwait holds 10.50 percent of the Islamic banking assets, making it the fourth ranked country48. The top Islamic banking and financial institutions in Kuwait are the Kuwait Finance House, Boubyan Bank, International Bank of Kuwait, Al Ahli United Bank and Al-Rajhi Bank49. 1.6.5. Qatar Qatar has a share of 7.70 percent of the global Islamic banking assets. Qatar Islamic Bank and Al Rayan Bank are the top Islamic Banks in the country50. 1.6.6. Other Muslim Nations Other Muslim nations also have a growing network of Islamic banking and financial institutions. In terms of ownership of the Islamic banking assets, Turkey, Indonesia, Bahrain and Pakistan are ranked sixth, seventh, eighth and ninth respectively. Turkey owns 5.80 percent assets, Indonesia 3.80 percent, Bahrain 1.70 percent and Pakistan 1.20 percent51. The growth of Islamic banking system is high in these countries. Also, since their current base is very small as compared to the overall banking business in these countries, there is a tremendous opportunity for the growth and development of Islamic banking in these nations. An efficient method to increase their acceptance among the masses is to increase the awareness among them. The second critical aspect is to reach out to the regions in these countries that currently do not have any kind of banking system. 47

Ibid. Ibid. 49 Kuwait Report (2012). Islamic Banks in Kuwait | Kuwait's Largest 5 Islamic Banks. < http://www.marcopolis.net/top-islamic-banks-in-kuwait.htm>. 50 See Above 32. 51 Ibid. 48

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OWNERSHIP OF ISLAMIC BANKING ASSETS Saudi Arabia

Malaysia

UAE

Kuwait

Turkey

Indonesia

Bahrain

Pakistan

21% % 4% 6% 8%

Qatar

38%

10% 14%

17%

Questions 1. Which four banks in Saudi Arabia are considered Islamic Banks? 2. When did Islamic banking begin in Malaysia? 3. Name two Islamic banks from the UAE. 4. Name Islamic banks from Qatar.

1.7. Islamic Banking and Finance in Secular Nations Islamic Financial and Banking sector is not just limited to the Muslim nations. It also has an increasingly strong presence in several secular nations. Not only Muslim but even non-Muslim countries have substantial investments in Islamic banks and other financial institutes. 1.7.1. The United States FTSE Global Islamic Index and Dow Jones Islamic Market Index are Islamic indices in the United States of America52. 52 Islam Can (2016). Interest Free Islamic Mortgages Halal Mortgages. < http://www.islamcan.com/islamic-articles/interest-free-islamic-mortgages-halalmortgages.shtml#.VsYQ5Pl97IV>.

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Ameen Housing Cooperative Among the institutes, Ameen Housing Cooperative offers services related to financing buying of new homes and mortgaging the existing loans. It has a housing finance model that is a Sharia based alternative to housing and mortgage loans in the United States. Lariba American Finance House Lariba American Finance House is another Sharia compliant housing finance institution in the United States. It offers services for finance and refinance of homes and cars. 1.7.2. The United Kingdom In the United Kingdom, there are five main banks that offer Islamic banking services53. Ahli United Bank Ahli United Bank offers Sharia compliant housing finance solutions for buying residential properties in the United Kingdom. The financing of homes through this institute can be availed by residents of the UK as well as foreigners who want to buy or invest in residential properties in the UK. United National Bank The banking products offered by the United National Bank are compliant with the tenets of Shaira and are suited for Muslim investors. Al Buraq Al Buraq is a UK Islamic bank held by ABC International Bank Plc., a subsidiary of the Arab Banking Corporation (ABC). It offers several Islamic financial services. Islamic Bank of Britain It is another bank in the country that offers buying and mortgaging of the properties. It practices Ijara as a method of leasing and reducing partnership that is known as Musharaka under Sharia laws. HSBC Amanah HSBC Amanah is another major bank in the UK that offers Islamic Banking products. 53

Ibid.

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1.7.3. Canada Canada has Islamic financial institutions such as Lariba Canada, Ansar Co-operative Housing Corporation LTD., ISNA Housing, Salam Financial and An Nur Cooperative. An Nur Cooperative offers financing for residential as well as commercial properties54. Questions 1. Which are the two Islamic indices in the USA? 2. Name two Islamic financial institutes in the USA. 3. Name the five main banks in the UK that offer Islamic banking services. 4. Name the two Islamic financial institutes from Canada.

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Ibid.

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1.8. Islamic Finance in Kazakhstan

(Source: National Bank of Kazakhstan)

The Republic of Kazakhstan is witnessing a tremendous support for Islamic banking from the general populace as well as the political echelon. The President of the country Nursultan Nazarbayev has shown great interest in the development of Islamic finance and Islamic financial institutions by inviting Islamic financial institutes from all parts of the world to partner and lead the progress of this model of finance and economy in the future55. The President has shown a great intent in redeveloping (symbolically) the ancient Silk Road, which is a symbol of prosperity. Kazakhstan has shown a keen interest in the development of Islamic finance56. 55 56

National Bank of Kazakhstan (2016). A New Frontier for Islamic Finance. Ibid.

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Although the country is not among the top nations to embrace Islamic financial system, efforts are underway to develop it further within the country. 1.9. Kazakhstan – A social, religious and historical perspective

(Source: www.aboutkazakhstan.com)

Kazakhstan has a long history that dates back to ancient times. In the 13th century under the Mongol rule, it became an important destination on the Silk Road. Since its independence from the former Soviet Union in December 1991, Kazakhstan became a sovereign nation57. The current population of the country is over 16 million and it constitutes people of several different ethnicities. People from diverse cultures and language groups live in the country. Around 70 percent population of the country constitutes of Muslims58. 57 BBC (2015). Kazakhstan country profile. < http://www.bbc.com/news/world-asia-pacific15263826>. 58 Ibid.

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Until recently, due to being a part of the Soviet Union, the financial system in the country was influenced by the western financial and economic principles. However, due to a large Muslim population and the global development in Islamic banking and financial industry, Kazakhstan is also witnessing an inclination towards Sharia compliant Islamic financial system59. 1.10. Developments in Islamic financial system in Kazakhstan in recent years

(Source: www.islamicfinance.de)

The very first law in the country on Islamic banking was passed in 2009. Al Hilal Bank of Abu Dhabi is the only Islamic bank in the country. The recent developments in Sharia compliant financial system in Kazakhstan include establishing Association of Islamic Finance Development (ADIF) in 2009, an Islamic Finance Training Centre and Astana International Financial Centre (AIFC)60. 59 60

See Above 40. Ibid.

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Establishing a non-governmental National Sharia Supervisory Committee (NSSC) is also under consideration. Additionally, the seventh World Islamic Economic Forum (WIEF) was hosted at Astana, the capital of Kazakhstan between 7th and 9th June, 2011. Similar developments are taking place in Islamic Finance Laws. It is proposed that the existing conventional banks are to be converted to Islamic banks in 2016. More support is proposed for Ijara and Takaful companies61.

(Source: www.ifsb.org) 61

Ibid.

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A conference of the Islamic Financial Services Board was organised in Almaty in May 2015. The event was hosted by the National Bank of Kazakhstan. There is a growing interest in Kazakhstan from all the sections of society who want to make Sharia and Islam as primary sources of all the financial practices and it is evident from the participation of all the members of the economy and country62. The country is planning to introduce its first Sukuk in 2016. New Islamic banks would get licences in 2016 and 2017.The banking laws are being changed gradually to make them more Sharia compliant. The latest amendments in the laws were made on 24th November 201563. Questions 1. When was the first law on Islamic banking passed in Kazakhstan? 2. Which is the only Islamic bank in the country? 3. What is the full form of ADIF? 4. What is AIFC? 5. What is NSSC? 6. Where and when was the 7th World Islamic Economic Forum held? 7. Where and when was the conference of the Islamic Financial Services Board organised?

1.11. Islamic Finance in Kazakhstan – Its Goals and Aims Islamic Finance in Kazakhstan has gained importance in several nations and its characteristics have been evaluated in detail in the previous sections. However, the pertinent questions still remains is to why the country wants to pursue Islamic Finance and what are its goals and aims. To understand these goals and aims, it is important to analyse the nature and situation of the Kazakh economy. Kazakhstan is one of the former USSR countries and since its inception as an independent nation, it has its own financial system and relations with other nations around the world. The country is a part of the global economy and consequently is affected by the global political and economic situations. The 62 63

Ibid. Ibid.

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financial crisis that began in 2007, engulfed the entire world and none of the economies could remain unaffected. Since no nation is isolated economically, the global financial crisis marred their respective economies. Kazakhstan was one of the nations that was severely affected by the global financial crisis. Within the Kazakh economy, the most affected industry was the banking sector. Banks in the country had borrowed large sums of money from the overseas financial institutions. The global financial crisis resulted in downgrading of the Kazakh economy and even the country to BBB by Fitch Ratings in 200964. It led to the devaluation of the currency of Kazakhstan, which further depended the crisis. The devaluation of the currency against dollar and other foreign currencies meant that the debt on the banks, which were borrowed in a foreign currency, increased further, resulting in weakening of the banking sector as well as the overall economy. It led to an increase in the unemployment as the country is dependent on its natural resources for economic development and lowering demands that began with the financial crisis of 200765. Kazakhstan managed to retain some of its economic growth momentum, but the financial crisis still loom large over the region as well as the country, albeit in different forms. Kazakhstan has done well since its inception. But the disparity in the growth of the income of the people, poverty, social and regional disparities still exist in the country and threaten its social and economic growth66. The country is also facing several challenges in the form of social and environmental issues. There is a growing difference between the rich and the poor and different regions in the country have witnessed differential growth rates67. 64 Valeriya Anichshenko. (2009). The Impact of the Financial Crisis on the Banking System of Kazakhstan. Central Asia Business Journal, Vol. 2. 65 Ibid. 66 European Parliament. (2013). Kazakhstan: Selected trade and economic issues.< http://www.europarl.europa.eu/RegData/etudes/briefing_note/join/2013/522303/EXPOINTA_SP(2013)522303_EN.pdf>. 67 Ibid.

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All these factors continue to exert tremendous pressure over the economy and the development of the nation. There is serious imbalance in the economic development and Kazakhstan has several vulnerabilities in its economic system68. The recovery from the crisis of the years 2007-2010 arguably is still not complete. The crisis was so severe that the effects of it are still felt. The banking and the insurance sectors in the country reel under the pressure of the crisis from bad loans, inability to pay huge borrowed money, and the liquidity crunch that these institutions are facing69. There is a very slow progress in the management of the low performing liabilities and the country lacks sufficient expertise in the management of crisis. There is insufficient preparedness for the management of financial issues and the framework to tackle the issues is untested70. All these issues continue to adversely affect the economy of the country for several years now and the recent drop in oil prices has only intensified the crisis significantly in the last couple of years. Oil exports constitute 70 per cent of the total exports from the country and the dip in oil prices has severely affected the exports and economy of the country71. The weakening oil prices and the economy of the country can lead to an increase in unemployment. There is a fear in the nation that around 120,000 people might lose their jobs due to the ongoing crisis72. Due to the financial cuts by the government, the social infrastructure in the country has been affected severely over the last few years. It would further intensify the crisis73. Ways in which an Islamic financial system can help Kazakhstan. 68 IMF. (2014). The Republic of Kazakhstan Financial System Stability Assessment. < https://www.imf.org/external/pubs/ft/scr/2014/cr14258.pdf>. 69 Ibid. 70 Ibid. 71 Bradley Jardine. (2015). Kazakhstan: Economic Crisis, State Companies, And The Nation’s Image. . 72 Ibid. 73 Ibid.

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The global financial crisis and the drop in the oil prices have been disastrous for several economies of the world. Kazakhstan has faced the brunt of these crisis. The main reason why all the nations of the world have been affected is due to the global financial integration, also known as globalisation and adherence to the conventional financial system. The way forward for Kazakhstan lies in its adoption of Islamic financial practices. It is already evaluated that Islamic financial laws, governed by the Sharia principles, emphasise on an equal development of everyone, prohibition on practices that can be termed as exploitation and ensuring that all the transactions are ethical and do not harm those in need. Adopting Islamic finance means Kazakhstan can implement these ethical and societal values in its financial system. Conventional financial system does not make any restrictions on profiteering in the form of exorbitant interests, which the banks in the country are facing and other forms of speculative dealings. Islamic finance does not allow such speculative practices and defines the ethical and moral standards for the individuals and the institutions. The country has over 13 million Muslims. It has already realised the benefits of Islamic financial system. Kazakhstan, since the global financial crisis has been on the path of adopting Islamic financial system. It intends to attract investment from other prominent Muslim nations such as the Arab nations and Malaysia. In 2010, the first branch of the Abu Dhabi based Al Hilal bank was opened in Kazakhstan. The nation is also contemplating issuance of Sukuk bonds that will help it receive investments from other Islamic nations and Muslim investors74. Islamic finance ensures mitigation of risks by prohibiting speculations. Financial instruments such as derivatives that are highly speculative in nature are not allowed in Islamic finance. These derivatives were the main reasons for the financial crisis that hit the world. Derivative investments in the housing sector affected the entire world when the housing crisis began in the west. 74

Robin Paxton. (2010). FEATURE-Kazakhstan pushes Islamic finance post-crisis. < http://in.reuters.com/article/kazakhstan-finance-islam-idINLDE67I09Q20100823>.

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Islamic finance maintains balance between risks and rewards. It holds the key for sustainable further development and achievement of the financial and economic objectives75. Islamic finance is not about profiteering or opportunism. It is the path for sustainable universal goals that allow equal development of the people of all the classes. For Kazakhstan, such sustainable economic development that also helps improve the social and financial structure of the society and all of its population groups and regions is essential. Adoption of Islamic financial practices will help the country achieve its economic and social goals and avert any further financial crisis. The global economy faces threats of cyclical recessions every few years. If Kazakhstan implements Islamic financial practices effectively, it will be able to sustain itself through the crisis. Islamic finance can lead to sustainable development of the economy and its further development. Questions 1. What was the Fitch Ratings of Kazakhstan in 2009? 2. Has the country recovered completely from the global financial crisis that began in 2007? 3. Which is the largest export commodity from Kazakhstan? 4. What is its percentage in the total exports of the country? 5. How many people in the country can lose their jobs due to weakening of the oil prices? 6. How the Islamic finance help the economy of the country? 7. Which Islamic bank opened its first branch in Kazakhstan and when?

75

Islamic Development Bank. (2015). The Role of Islamic Finance in Achieving Sustainable Development Goals. < http://www.isdb.org/irj/go/km/docs/documents/IDBDevelopments/Internet/English/IDB/CM/T opics/Role%20of%20IF%20in%20Achieving%20SDGs.pdf>.

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Islamic Financial Instruments and Impediments in the Development of Islamic Finance Part 2 – Foreword In the previous chapter, the nature, characteristics and concepts of Islamic finance were discussed. The first chapter of this part further dwells into the intricacies of Islamic Finance and financial instruments. Further, the chapter analyses the types of financial instruments that the different Islamic nations follow. The next chapter evaluates the various developments in the field of Islamic finance and the impediments that are restricting its progress. It is done through the analysis of the various researches, articles and interviews.

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Chapter 2 Islamic Finance and Financial Instruments An International Perspective Islamic Finance in 21st century – A detailed analysis

Islamic finance has developed considerably over the last fifty years. There have been numerous changes in the global financial system which has made a profound impact over the Islamic Finance. Despite this, Islamic financial system continuous to be guided by the principles and values such as equality, ethics, morality and fairness76. The reason why the core values of Islamic finance have not changed is because it is based on the truest principles known to humanity. Islamic finance is based on the guidelines of Sharia and Quran which makes them holy as well as sacrosanct. The scholars working in the field of Islamic finance ensure that they abide by the word of Allah and Quran and do not, at any cost, compromise with the spirit of Islam and Sharia. Therefore, despite the external influences, at its heart, Islamic financial principles remain pure and unblemished. 76 Hamza, Mohamed, (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd.

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These principles are inclined towards the betterment of humanity and the use of wealth and financial instruments as the means to help people live a dignified and prosperous life. These principles are unlike the western financial system where profit is the end objective. In Islamic finance, profit is just a way to make human life better. Islamic finance stresses on the point that money is not to be used as a tool of exploitation and should always be used in a manner that no human is harmed and all are benefitted. The Sharia based principles of Islamic finance are sacrosanct and pure, which protect them from getting diluted due to the vested interests of the wealthy people. These principles have their source directly in Quran and are interpreted as well as implemented by the highest level of clergy and Islamic preachers. These wise men are only concerned with the welfare of humanity and are not capitalists in any way. Hence, it ensures that only the most learned and scholarly Muslims that hold a high rank in the Muslim world interpret Sharia financial principles. Therefore, the quality of these tenets remains high and they remain unpolluted by the interests of few capitalists. In comparison, the western financial system does not restrict the type of people that can make changes to it. Any economist or capitalist can interpret this financial system and manipulate it to fulfil their interests and greed. There is little or no moral control. The capitalists often find a way to circumvent the legal requirements so that they can benefit from the manipulation of the financial system. The subprime crisis and the consequent global financial crisis are the evidences of how the capitalists, for their unscrupulous gains manipulated and circumvented the financial system which led to a domino effect thereby engulfing the entire global economy into a massive turbulence. Something like this is not possible in Islamic finance since it prohibits activities that led to the global financial crisis. The austerity, purity, and chastity of Islamic finance is the reason why it 52

has increased exponentially in the years following the global financial crisis. The realisation that the Islamic financial institutions remained unaffected during the crisis proves the efficiency of these institutions77. The resilience of the Islamic banks and financial institutions during the financial crisis has been highlighted by the International Monetary Fund or the IMF. According to the IMF, Islamic financial institutions contributed towards stabilising the global economy78. In 2009, when the global financial crisis was at its peak, the conventional banks lost their profitability to approximately 50 percent. In comparison, the loss of the Islamic banks was only 10 percent79. The credit growth of conventional banks was almost nil during this phase while that of the Islamic banks soured by 12 percent. Additionally, the asset growth of the conventional banks was at around 5 percent, whereas that of Islamic banks was at around 10 percent80. Below is the chart that presents the above data. As can be seen in the chart, the comparisons between the conventional banking system and Islamic banking system clearly differentiate how the Islamic system performed admirably even during the crisis and even helped to reduce the intensity of the crisis to a certain extent. Even the International Monetary Fund has acknowledged this contribution of the Islamic banking system, which in itself proves the growing reputation of the Islamic financial system in the world in the 21st Century. The growth in the assets of the Islamic financial institutions further provide testimony to the increasing acceptance this system of financial management is gaining. 77 Moazzam Farooq and Sajjad Zaheer (2015) Are Islamic Banks more resilient during financial panics? IMF Working Paper. 78 IMF (2016) IMF Survey: Islamic Banks: More Resilient to Crisis? < https://www.imf.org/en/News/Articles/2015/09/28/04/53/sores100410a> 79 Ibid. 80 Ibid.

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(Source: International Monetary Fund)

The contribution of Islamic bank is not just limited to the Islamic nations or the Muslims. As acknowledged by the IMF, it has made a great contribution towards the stabilisation of the global economy at the time when even 100 year old institutions such as Lehman Brothers collapsed and millions lost their jobs. Broadly, the banking system can be divided into two factions – Conventional Banks and Islamic Banks. The conventional banks constitute the entire banking system around the world that works on the capitalist model. Every bank except for the Islamic banks operate on a mode of accepting deposits from the customers and giving them interest in return, and lend the money to the borrowers in the form of 54

loan on which the bank collects the interests. The spread or the difference between the money given out as loan and the deposits accepted by the bank is the most important source of income for the bank. This system is based entirely upon interest income, which is prohibited under the Islamic financial system and Sharia laws. At such as time, Islamic financial instructions and banks positively contributed towards assuaging the crisis and mitigating the risks. Since Islamic financial system is much smaller than the conventional banking system, it could only make a limited positive impact. But, the contribution of the Islamic banks has not gone unnoticed. It can be seen in the way the Islamic financial assets have grown in the five years following the financial crisis. From being a fringe financial system, as it was for the last several centuries and even in the 20th century, slowly but steadily until 2009, Islamic finance gained prominence. After 2009, the growth has been stupendous and outstanding. The figures speak for themselves and the quantitative as well as qualitative analysis of the Islamic financial system in general and Islamic banks in particular prove their efficiency and effectiveness. Islamic financial system, financial instruments, and concepts have always helped to improve the lives of people around the world. This system continues to benefit not just the Muslims or Islamic nations but also people from other religions and other nations through its contribution towards the global financial system. Islamic finance is highly moralistic per se and it is also an inspiration for the conventional financial system and institutions. Islamic finance is the torchbearer of the ethical financial practices. The eight key pillars of Islamic finance are discussed further in this chapter. These are discussed in great detail and the analysis of how they have contributed towards making Islamic finance a more evolved and sophisticated financial system than any other financial system in the world. However, before the discussion on these eight pillars, there is a brief analysis of the sources of these pillars and Islamic finance. The efficacy of Islamic finance proves that its source is based in the 55

words of Almighty Allah and represented through Quran. Hence, its source deserves a rightful discussion in this book.

(Pillars of Islamic Finance – Key Terms and Concepts to explain Sharia Finance)

Islamic finance has its roots in Islamic law known as Sharia. Sharia principles have two important sources on the basis of which the Sharia laws are formed. The first source is Quran – the holy book of Islam. The words of Quran are considered literally since these are the words of the almighty. Quran does not need any introduction. It is the holiest book for Muslims and an account of the words of Allah himself. Every aspect of the life of a Muslim and the ideal way of living it is explained by 56

Quran. Hence, even for the financial matters and transactions, it is the Holy Quran that holds the supreme position. Hence, it is the first and the most important source of the tenets of the Islamic financial system. Quran describes the broader guidelines of how Muslims should live and conduct themselves. It teaches universal peace and humane treatment by Muslims to not just their fellow Muslims but also people of all religions. Allah through Quran has prescribed the duties of all Muslims towards their fellow human beings. It therefore, naturally entails that these principles must be given precedence over any other rule even in case of financial matters. No financial matter or regulation is above Quran which is the source of all the things Muslims must follow. Every aspect of the lives of Muslim persons or the institutions and businesses run by these persons must adhere to the words of Quran since these are the words of the Almighty and no one is above him. Quran prescribes the broader guidelines which are further described in detail by Sharia. Hence, it can be stated that Quran described the guidelines more generally and introduces them while the Sharia explains them specifically and in a great detail. So, the first source of guidelines for Islamic finance stems from the Holy Quran which teaches the most efficient way of life. A life where people trust and respect their brethren and help them in the times of troubles. Since in this material world wealth is an important means for achieving and giving happiness and for living a fulfilling life, the teachings of Quran imply that people must use their wealth not for their personal material gains, but rather for bringing happiness to others, especially the poor by sharing with them. Quran teaches that the haves must share their wealth with the have not. Even the Muslim festivals are developed in such a way where the rich share their possessions such as food and wealth with the poor. Everyone is equal in the eyes of Allah and so he mandates that people use their worldly possessions such as wealth for the betterment of all of his subjects irrespective of their social status and class. This philosophy of Islam that believes in true parity among people is the source of inspiration for the tenets of Islamic finance. The teachings of equality and brotherhood are at the core of the 57

teachings of Quran and these teachings also form the firm foundations of the Sharia laws and subsequently Islamic finance. Even before the development and establishment of the formal Islamic financial system, the Holy Quran taught sharing and benevolence. The universal truth taught by Quran is also found in nature, the biggest creation of the Almighty Allah, where nature shares its resources with everyone. Hence, it can be stated that when it comes to managing its own wealth, nature does not hold onto it, but rather distributes it. It not only helps those who need the resources of nature, but also the wealth and abundance of nature keeps growing. So, the way Allah has blessed its greatest creation – nature – with abundance and prosperity, he has also blessed several humans with great wealth, and he wants them to share their wealth with those that need their help. This virtue of using wealth as a means of helping others forms the crux of Islamic finance. It also means that amassing wealth by exploiting others is prohibited and is considered an act of displeasing Allah. It can therefore be succinctly stated that Quran considers wealth and prosperity as a means for a higher level of fulfilment and not just an end in itself. These virtues and ethical principles reflect in the form of Sharia laws that prescribe the regulations to be followed by the Muslims in every aspect of their lives and also in the manner in which they use their wealth and prosperity. Sharia says that wealth and prosperity is to be shared in a rightful manner and a hoarding of wealth at the expense of others or by exploiting others must be strictly avoided. Sharia is the way of life every Muslim must live and not just a bunch of laws. It is the guiding spirit of the Holy Quran and the words of Allah, and therefore, must be abided by all Muslims in all walk of their lives. Sharia laws specify every action that a Muslim must take or should avoid taking. It describes how Muslims need to act in their lives which include their personal lives as well as any institutes or businesses they run. Sharia is therefore, applicable to not just the people but also organisations operated by Muslims. Within the context of the Islamic financial system, Sharia regulations apply to the banking and financial institutions in the Muslim countries. It also specifies which types of financial transactions should Muslim individuals carry out in 58

their personal capacities and accordingly must choose the organisations that comply with Sharia regulations. This ideology is behind the establishment of Sharia compliant financial institutions in secular nations. Although most of the financial organisations in these countries operate according to the conventional financial system, to serve their customers better, they have instituted Islamic financial system as a part of their organisation. These institutes as well as those in the Islamic nations closely follow the words of the Almighty which are mentioned in Quran and which form the basis of Sharia.

(The Holy Quran – Source: Abuzahra.org)

The tenets for Sharia can be summarised in the form of a single phrase in Quran that says, “God has permitted trade but has forbidden interest”81. It can be found in the Verse 275 of the 2nd chapter. The Verse clearly states the will of Allah and also the intent which is universal good. Interest, according to Quran is the root of evil where the rich and wealthy use it as a tool to fulfil their greed and vested interests. Poor and needy borrow money for their 81

The Holy Quran.

59

requirements and the rich could charge them heavy interests, which is nothing but exploitation. Islam and Quran forbid exploitation. Hence, Quran says that trade is permissible but it should not be done in a way that money is used for generation of more money in the form of interest, which can then be used for the exploitation of the poor who have borrowed money so that they could meet the exigencies of their lives. So, to avoid exploitation of the poor at the hands of rich, interest is prohibited. The crux therefore is that for Muslims and businesses run by Muslims are forbidden to get involved in any trading activity that involves interest82. So, the first source of Islamic financial principles is Quran and Sharia, which is discussed above. The second source of Sharia is “Hadith”. Hadith is a record of the practices and the exemplary life of the Prophet Mohammed (Peace be upon him)83. Hadith explains or more aptly is an account of the Sunnah84 which are the daily practices followed by the Great Prophet. The Prophet preached the words of Allah through the Holy Quran as well as through his own life. He led an exemplary life which is still the ideal life even today. Rather, people now are more in need to learn to live their lives the way the Prophet did and Hadith is the way to know the virtues of his life who followed Allah and the path prescribed by him. Hadith demonstrates the Sunnah of the life of the Prophet and sets it as an example for the Muslims to learn so that they too can benefit from the practical teachings of the Prophet that he demonstrated through his own life. Hadith is an attempt to record the practices followed by the Prophet himself so that others can learn from him. If any human has followed the path of God exactly the way God wanted it, is Prophet Mohammed. So, Hadith is the second most important source for the development of the Islamic financial system after the Holy Quran and Sharia. Throughout his life, the Prophet not only preached but followed practices with his own wealth of sharing rather than amassing and accumulating. 82

Ibid. UGA (2003) Hadith and the Prophet Muhammad. < http://islam.uga.edu/hadith.html>. 84 See Sunnah < https://sunnah.com/>. 83

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He, at the great risks to his own life fought against the evils of the unscrupulous wealthy persons of his time and always defended the rights of the poor. He stated that charging interest is an evil which is nothing but the exploitation of the poor. According to him, charging interest is tantamount to committing a great sin since it leads to the widening of the economic and financial disparity among the people. It increases the chasm between the rich and the poor. Hence, the life and practices (Sunnah) followed by the Prophet Mohammed is the living personification and practical application of the teachings of Allah. Through his life the Prophet has proven that it is indeed possible to have a financial system that is social responsible and yet profitable. It is possible to generate honest profits without charging exorbitant interest and exploiting the needy and the poor. The Islamic financial system is based on these teachings of Hadith.

(Source: Deviantart.net)

Hadith is the second source apart from Quran and is the genesis of Sharia laws. Hadith describes the ideal way of life that a Muslim should live and the practices that the followers of Islam should follow. Therefore, by imitating the life of the Prophet, Muslims endeavour to live a peaceful and meaningful life by ensuring personal as well as social wellbeing. 61

These two sources - the Sharia laws and Hadith, which explains Sunnah of the Prophet, all aspects of the ideal and righteous lives of the Muslims are defined, which also include laws for trade and finance. These laws pertaining to the trade and finance specify how Muslim individuals and institutions must function85. It is essential for the Muslims and the financial institutes and organisations run by them to abide by these laws rather than relentless pursuit of profit. According to Sharia laws for finance, there are five main prohibitions:  Riba – which prohibits interest  Gharar – it means uncertainty of any kind in financial dealings  Maysir – it refers to gambling and speculation  Undue profit – Muslims must invest and become part of only those businesses where they share the risks. Profits without risk is prohibited.  Other forbidden businesses – Muslims must not invest in businesses that are prohibited by Sharia which include gambling, alcohol, weapons, pork and pornography. A very basic concept of Islamic finance is how it treats money. In Islam, money is not an object or a commodity per se. It is just a means to buy other commodities and is a unit of measurement. However, it is just a means to an end and not an end in itself. Therefore using money for generating more money is prohibited86. It is the reason why interest is prohibited in Islam. All the Islamic financial transactions, trades and instruments must adhere to this basic principles and other guidelines as per Sharia, Hadith and Quran. Even in the 21st century, despite the tremendous changes to the financial markets and economies around the world, these basic pillars of Islamic finance continue to be important and help create the framework for Islamic financial dealings around the Islamic world. Even several non-Muslim persons and institutes also follow the guidelines of Islamic finance. 85 86

Ibid. Ibid.

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Sharia Advisory Boards

(Source: IslamicBanking.info)

The spread of Islamic finance across the Muslim world has gained impetus in the last few decades. Islamic finance and banking system is fast emerging as a viable alternative to the western capitalist financial system. Despite the tenets of Sharia being the guiding force for Islamic finance, these principles and guidelines are subject to interpretation. It is therefore crucial that they are interpreted in the right manner to avoid any instances of misuse of these guidelines. With the growing volume of Islamic finance and banking in the 21st century, it has become even more critical to implement the right checks to ensure that the interpretations of these laws abide by the core values of Quran, Hadith and Sharia. Hence, there is a growing need and subsequent practice of constituting the Sharia Advisory Boards. Sharia Advisory Boards play a very important role in managing Islamic finance in the 21st century. These boards ensure that all the practices, financial instruments and trading activities fall within the purview of Islamic laws and principles and that these are followed not just in letter but also in spirit. 63

These boards also check if the existing Islamic instruments really adhere to Sharia or if any discrepancies are found, these boards advise necessary corrections87. For these boards to be successful, it is important that they elect the right members who have sufficient knowledge of the various aspects of Sharia for financial dealings and are given sufficient autonomy to function independently without any interferences88. Sharia Supervisory Boards (SSB) have different formats in different countries and organisations. However, most of them have a relatively common structure in terms of their constituent elements and reporting process. These boards report to the Board of Directors of the company. These boards usually have between three and six members who are Islamic scholars and experts in Islamic general laws and financial matters89. In most of the countries, there is no restriction on women members on Sharia boards. The requirement is that all the board members should have sound knowledge of Islam and its tenets. They must also possess decent knowledge of the broad financial markets and their products90. The major difference from one country to another is that different countries have different legal systems and laws and Islamic financial institutions on those countries have to manage their operations and products accordingly. The Sharia board members must therefore have knowledge of the local laws of the country. There are several Islamic nations that have Sharia Advisory Boards or their equivalent. Below is a list of such nations91. 87 El-Gamal and Mahmoud, A. (2006). Islamic Finance. Cambridge: Cambridge University Press. 88 Q Finance. (2016). The Role of the Sharia Advisory Board in Islamic Finance, . 89 Faleel Jamalden (2016). The Structure of Sharia Boards for Islamic Financial Institutions, . 90 Ibid. 91 Islamic Banker (2016). Sharia Supervisory Board. < https://www.islamicbanker.com/education/shariah-supervisory-board>.

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Nation

Presence Banking

Bahrain

Yes

of

Indonesia Jordan Kuwait Malaysia Sudan

Islamic

Yes No No Yes Yes – entire banking system is Islamic Pakistan Yes UAE No (Source: Islamic Banker)

Centralised Sharia Advisory or Supervisory Board International Rating Agency National Sharia Board No The Fatwa Board Sharia Council Not Applicable as the entire system is Islamic No No

Sharia as an International Islamic financial law in 21st century

(Source: Hkhlegal.com)

Sharia laws have existed for over 1,400 years and have guided every aspect of the lives of Muslims for centuries. Trade and commerce have also been influenced extensively by the Sharia laws. In the 21st century in a more globalised economic environment, Sharia laws continue as the guiding principles for Islamic financial world. Islamic finance has gained significant prominence among the large global Muslim population that constitutes 25 per cent of the total population of the world92. 92 Hamza, Mohamed, (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd.

65

Governments of Islamic nations have also contributed towards the growth of development of Islamic finance by extending their support. Sharia laws for Islamic finance now find an international resonance among the economies of the various Muslim nations. Despite the individual differences among the various Islamic nations in terms of the Islamic financial laws, Sharia remains at the core. The differences among the various Islamic nations are discussed later in this chapter. However, it is important to note that despite the differences, the core principles of Sharia when it comes to financial dealings cannot be overlooked. According to Sharia, money is just a means and not a commodity. It is therefore must not be used to generate more money (for example interest income). Sharia prohibits any form of exploitation or unfair practices in any aspect of life and the same is true even for the financial transactions. Muslims should not use money or trade as an exploitative tool. Investors should share the risks and cannot be mere lenders who earn exorbitant interests without being a partner in the business. It also necessitates that all the trades should have assets supporting them to avoid any instances of speculations93. Sharia also allows wilfully entering into financial contracts for trade and commerce. But, it must be ensured that these contracts by their nature are not forbidden by Sharia. In the recent times, Islamic financial laws have become more robust and sophisticated. Hence, a need is felt to remove uncertainties to avoid any inadvertent breaches of the Sharia laws. The various boards and especially IFSB are working relentlessly in this regard. Also, the governments of the various nations have implemented laws that help with the compliance with Sharia laws for financial matters. Most of the countries have separate laws for civil matters and commercial issues. Therefore, for civil matters adherence to Sharia is much more stringent than for commercial matters. But, it is crucial 93

Ibid.

66

that even for the financial matters, the adherence levels should be high and the governments world over are working in this regard94. In most parts of the world, Islamic finance is used widely by the micro financial institutions. Although there are several banks that adhere to Sharia, Islamic finance and received much more prominence among the micro finance institutions. Most of these institutions, irrespective of their countries follow five main types of financial contracts that are used to develop the Sharia compliant financial instruments. These are Ijarah, Mudarabah, Murabaha, Musharakah and Takaful95. These instruments were discussed in the first chapter, except Takaful. These are again being revisited here. Ijarah

(Source: mcca.com.au)

It is a form of Islamic contract where a financer or a lessor and the purchaser or the lessee of an asset enter into a contract. The financer does not lend to the lessee; instead acquires the ownership of the asset. The lessee pays to the financer according to the terms and conditions specified in the contract. Once the complete payment is made, the ownership of the asset is transferred to the lessee96. 94 95 96

Ibid. Ibid. Financial Islam (2016). Ijarah. < http://www.financialislam.com/ijarah.html>.

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Mudarabah

(Source: IslamicBanking.info)

In this form of contract, the different parties bring in their expertise and resources to form a group for running an enterprise. While some of the parties invest money, others might contribute through their knowledge and skills. It results in a mutually beneficial relationship for all the parties involved. Parties and enter and exit the contracts easily and share the profits according to the terms and conditions of the contract97. Mudarabah is also used in the modern times to constitute Islamic Mutual Funds.

97 Ross, Marc L. (2016). Working With Islamic Finance. < http://www.investopedia.com/articles/07/islamic_investing.asp>.

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Murabaha

(Source: basicsofislamicfinance.files.wordpress.com)

As a part of this contract, an institution, such as a financer buys the asset and sells it to the buyer in lump sum or instalments. The difference is the profit for the institution98. The sale price is cost plus profit. Musharakah

(Source: Albaraka.com)

This type of contract is a Sharia compliant alternative to the traditional bank loans. The financer owns a part in the asset in 98 Institute of Islamic Banking and Insurance (2016).Murabaha on Shari'ah Ruling. < http://www.islamic-banking.com/murabaha_sruling.aspx>.

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proportion to their financed amount. The buyer of the asset then pays the amount to the financer either in instalments or lump sum and acquire the complete ownership99. Takaful

(Source: AllDubai.ae)

Takaful is an Islamic version of insurance. Sharia prohibits speculation and dealing with uncertainties. In traditional insurance products, there is an inherent uncertainty as the possible outcome is not known. Therefore, Sharia does not allow investing in insurance products. Takaful, on the other hand allows forming for groups for forming a combined or a joint guarantee for the future. Members of the group make their contributions to the group and if a liability for one of the 99 Institute of Islamic Banking and Insurance (2016). Musharakah on shari'ah Ruling. < http://www.islamic-banking.com/Musharakah_sruling.aspx>.

70

members of the group arises in the future, the pooled money is used to pay the liability. The liability can be death, illnesses, loss of cattle and crop or other such instances100. The final outcome is very similar to an insurance product, albeit Takaful is not insurance and complies with the principles of Sharia. Apart from the aforementioned contracts, the other types of Islamic financial instruments that are popular among the various Islamic nations include Muawadat Exchange – a contract similar to barter system, Islamic equity funds and commodity funds. Sukuk (explained in the first chapter) is the widest used Islamic instrument globally. Country Specific Islamic Finance and Financial Instruments Islamic financial industry has grown rapidly in the recent years and continue to grow rapidly. The size of the Islamic financial industry is currently around US$2 trillion101. Around 35 per cent of the industry is concentrated in the Gulf Cooperation Council or the GCC nations which include Bahrain, Kuwait, Oman, Saudi Arabia, Qatar and the UAE.

(GCC Nations – Source: 2b1stconsulting.com) 100

Hamza, Mohamed, (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd. 101 The World Bank (2015). Islamic Finance. < http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance>.

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Another 35 per cent of the industry is constituted by the countries in South West Asia and Northern Africa, while 20 per cent is in countries such as Malaysia, Pakistan, Bangladesh and other South East Asian nations102. These nations or group of nations use specific types of Islamic financial instruments. Although their basic characteristics are derived from the core Islamic financial contracts and instruments as described above, there are certain differences among the instruments used by them. Bangladesh

(Mr Muhammad Yunus – Source: thenational.ae)

The Islamic microfinance was most successful in Bangladesh. It was the initiative of Mr Muhammad Yunus, who won the Nobel Prize for his initiatives. Islamic financial instruments in Bangladesh are more in line with the needs of microfinance103. These are small amounts of financing done to the poor to help them setup their own small businesses. Microfinance in Bangladesh, which initially began giving small finances to women, now also finance men104. 102

See Above 19. Ibid. 104 Rhyne, Elisabeth (2012) Microfinance in Bangladesh: It's Not What You Thought. < http://www.huffingtonpost.com/entry/microfinance-inbanglades_b_1266759.html?section=india>. 103

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The microfinance in Bangladesh, follow values that are close to the tenets of Islam. Unlike conventional microfinance, Islamic microfinance follow Islamic ethical guidelines and finance the needy and the poor. The financing includes Zakah or giving which means that there is a concept of helping the poor in an ethical manner. In the conventional microfinance models, poor are usually left out of the system. However, in Islamic microfinance, even the extremely poor are supported105. Islamic Microfinance in Bangladesh has followed these principles and has concentrated its efforts to uplift the rural poor106. Islamic finance in Bangladesh is developed around the conventional banking and financial systems with little adjustments for making them comply with the Sharia principles. Around 19 per cent of the banking deposits in the country are in the form of non-interest bearing instruments. However, there is a lack of Sukuk instruments in the country107. Most of the financial instruments in the country are still designed on the basis of the conventional banking and financing instruments. Indonesia

(Source: GBGIndonedia.com) 105

United Nations Development Program (2012) Poverty Reduction: Scaling up Local Innovations for Transformational Change. 106 Sakib, Mohammad Nazmus (2013), Islamic microfinance as a poverty mitigation instrument. < http://print.thefinancialexpress-bd.com/2013/11/28/6154>. 107 Reuters (2014) Sukuk the missing link in Bangladesh Islamic finance sector. < http://www.reuters.com/article/islamic-finance-bangladesh-idUSL6N0O82ES20140602>.

73

Indonesia has a dual banking model where the conventional banking system and the Islamic banking system coexist. Banks in the country offer regular savings and deposit products. Indonesian commercial and civil laws are highly influenced by the Dutch laws. The financial instruments in the country are influenced by both Sharia and Dutch regulations. In terms of Islamic finance, products based on Murabaha are used widely in the country108. The National Sharia Board of Indonesia, approved issuance of currency hedging tools that comply with the Sharia laws in April 2015. It resulted in issuance of US$500 million Sukuk by Garuda Indonesia, the national air carrier in May 2015. Around 56 per cent of these Sukuk investors were from Middle East.109 Also, the Islamic banks in the country have adopted a standard template for Sharia compliant contracts and repurchase agreements. It allows pledging Sukuk issued by the government as a collateral. Morocco

(Source: BBC.co.uk)

Morocco is influenced by the European laws. The financial laws of the country therefore are of dual characteristics. In the country, the 108

Hamza, Mohamed, (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd. 109 Indonesia Investments (2016) Islamic Banking in Indonesia Explained: New Rules & Foreign Ownership. < http://www.indonesia-investments.com/news/news-columns/islamicbanking-in-indonesia-explained-new-rules-foreign-ownership/item5720>.

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contracts between individuals cannot include interest. However, interest is allowed when the contract is between entities110. Moroccan banks currently participate in Sukuk trading and many of the banks in the country have dedicated departments for trading in international Sukuk bonds. However, the country still does not have a strong sovereign Sukuk111. However, there is a clear intent on the part of the government to introduce sovereign Sukuk and make Islamic finance in the country more robust and efficient112. UAE

(Islamic Banking in the UAE – Source: UAEinteract.com)

The United Arab Emirates has adopted specific codes for Islamic finance. The country has separate codes for civil and commercial laws and the codes of both of these laws are significantly influenced 110

See Above 27. Abinader, Jean (2013). Is there a future for Islamic Finance in Morocco? Islamic finance in Morocco: Right tool to meet economic challenges?< http://jeanabinader.com/uncategorized/isthere-a-future-for-islamic-finance-in-morocco/>. 112 Souissi, Mohamed and Mohamed Tkiouat (2013). SOUTHWESTERN FINANCE ASSOCIATION CONFERENCE: 54TH ANNUAL MEETING: Introduction of Sukuk in Morocco: Issues and Risks 111

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by the Sharia laws. For most of the transactions, the country follows Sharia principles. However, it allows commercial loans that can charge maximum 12 per cent interest113. Although commercial loans are interest bearing, the quantum of interest is fixed and is kept at a reasonable level. Malaysia

(Source: BNM.gov.my)

Malaysian laws are influenced by the English common law and its financial instruments are flexible in nature and are not strictly Sharia compliant114. The Islamic financial instruments in the country are based on Mudharaba and Murabaha; the latter being used primarily for commodity investments115. Malaysia has played a crucial role in the development of the global Islamic financial system. Sukuk bonds are widely used in the country and it also has a strong presence of Islamic equity and capital market finance, and Takaful116. 113

Hamza, Mohamed, (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd. 114 Ibid. 115 Islamic Banker (2016). Investment in Islamic Financial Instruments: Tabung Haji. < https://www.islamicbanker.com/education/investment-islamic-financial-instruments-tabunghaji>. 116 Laldin, Mohamad Akram. ISLAMIC FINANCIAL SYSTEM: THE MALAYSIAN EXPERIENCE AND THE WAY FORWARD. < https://uaelaws.files.wordpress.com/2012/05/islamic-financial-system-the-malaysianexperience-and-the-way-forward.pdf>.

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Saudi Arabia

(Source: Argaam.com)

The Sharia laws for financial transactions and instruments are strictly implemented in Saudi Arabia. The contracts signed within the country are lengthy as there is a strict adherence to the Sharia laws with very little scope for deviation117. Saudi Arabia has a large number of banks and financial institutions that adhere to Sharia principles. The financial regulations in the country are stringent and both, domestic as well as international parties have to sign contracts in accordance with the Sharia laws and Islamic financial principles. Questions 1. What are the main pillars of Islamic finance? 2. Which phrase in Quran summarises Sharia principles on financial transactions? 3. Which are the two sources of Sharia? 4. Which are the five main prohibitions according to Sharia that define the framework of financial transactions? 5. What does the Sharia Advisory Board ensures regarding Islamic Finance? 6. How many members do SSBs usually have? 7. Who can be the members of SSBs? 117

Ibid.

77

8. Name a country which entire banking system is based on Islamic principles? 9. Which nation has the International Rating Agency at its advisory board? 10. Which prominent Islamic nations neither have Islamic Banking nor a Sharia Advisory Board? 11. Which country has a Sharia Council? 12. Which nation has the Fatwa Board? 13. Which types of financial institutions largely use Islamic financial systems? 14. What are the five types of financial contracts? 15. What is Ijarah? 16. Which financial instrument is also considered an Islamic Mutual Fund? 17. In which type of contract, does the financer buys the assets and sells it to the buyer in lump sum or instalments? 18. Which contract is similar to the traditional banking loans? 19. Which is the Islamic version of Insurance? 20. Which contract is similar to the barter system? 21. Who initiated Islamic microfinance in Bangladesh? 22. What does the term Zakah mean? 23. Which country has a dual banking model? 24. Which laws have influenced the laws of Morocco? 25. What is the maximum interest that banks in the UAE can charge? 26. Which nation has a strong Islamic equity and capital market finance?

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BIBLIOGRAPHY Jean Abinader (2013). Is there a future for Islamic Finance in Morocco? Islamic finance in Morocco: Right tool to meet economic challenges? < http://jeanabinader.com/uncategorized/is-there-a-future-for-islamic-finance-inmorocco/>. El-Gamal and Mahmoud, A. (2006). Islamic Finance. Cambridge: Cambridge University Press. Financial Islam (2016). Ijarah. < http://www.financialislam.com/ijarah.html>. Mohamed Hamza (2010), Islamic Finance: Instruments and Markets. London: Bloomsbury Information Ltd. IFSB (2010). Background, < http://www.ifsb.org/background.php>. IFSB (2010). Defining New Standards in Islamic Finance, . IFSB (2010). List of Members: By Category, . Indonesia Investments (2016) Islamic Banking in Indonesia Explained: New Rules & Foreign Ownership. < http://www.indonesia-investments.com/news/newscolumns/islamic-banking-in-indonesia-explained-new-rules-foreignownership/item5720>. Institute of Islamic Banking and Insurance (2016). Murabaha on Shari'ah Ruling. . Islamic Banker (2016). Investment in Islamic Financial Instruments: Tabung Haji. < https://www.islamicbanker.com/education/investment-islamic-financialinstruments-tabung-haji>. Jamalden, Faleel (2016). The Structure of Sharia Boards for Islamic Financial Institutions, . Laldin, Mohamad Akram. ISLAMIC FINANCIAL SYSTEM: THE MALAYSIAN EXPERIENCE AND THE WAY FORWARD. . Q Finance. (2016). The Role of the Sharia Advisory Board in Islamic Finance, . Reuters (2014) Sukuk the missing link in Bangladesh Islamic finance sector. < http://www.reuters.com/article/islamic-finance-bangladeshidUSL6N0O82ES20140602>. Rhyne, Elisabeth (2012) Microfinance in Bangladesh: It's Not What You Thought. . Ross, Marc L. (2016). Working With Islamic Finance. .

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Sakib, Mohammad Nazmus (2013), Islamic microfinance as a poverty mitigation instrument. < http://print.thefinancialexpress-bd.com/2013/11/28/6154>. Souissi, Mohamed and Mohamed Tkiouat (2013). SOUTHWESTERN FINANCE ASSOCIATION CONFERENCE: 54TH ANNUAL MEETING: Introduction of Sukuk in Morocco: Issues and Risks The World Bank (2015). Islamic Finance. . United Nations Development Program (2012) Poverty Reduction: Scaling up Local Innovations for Transformational Change.

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Chapter 3 Challenges to the development of Islamic Finance Challenges to Islamic Finance – Introduction The development and the progress of Islamic finance is rapid and there has been a large scale acceptance of the principles of Sharia in the financial matters among most of the Islamic nations. However, the path to progress of Islamic finance is fraught with several uncertainties and risks. These risks and threats pose challenges to the steady and consistent development of Islamic finance. This chapter includes an analysis of the various impediments that threaten to block the path of Islamic finance. Challenges highlighted by the International Monetary Fund

(IMF Chief Ms Christine Lagarde – Source: Reuters.com)

The challenges to the development of Islamic finance as highlighted by the International Monetary Fund (IMF) are regulatory 81

and supervisory118. The IMF has specified the type of risks that Islamic finance faces. According to the IMF, several of these risks and impediments are unprecedented as they have not been seen earlier.

(IMF MD on Islamic Finance – Source: IMF.org)

Islamic financial system has sever marked differences from the traditional financial and banking systems. Hence, several of the impediments that the Islamic system faces are not found in the traditional financial systems. Islamic finance faces regulatory and systemic risks as well as risks of not being able to adhere to the tenets of Sharia laws on which the Islamic Finance is founded. One of the primary risks highlighted by the IMF is that Islamic banks that adhere to the Sharia principles have to deal with “displaced commercial risks”119. It is the risk that arises when the Islamic banks try to compete with the conventional banks. 118

Alfred Kammer, Alfred Kammer, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe and Zeine Zeidane (2015). Islamic Finance: Opportunities, Challenges, and Policy Options, IMF Staff Discussion Note. 119 Ibid.

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(Source: Lariba.com)

Since Islamic finance does not permit paying interests (Riba), the Islamic banks have to compete with the conventional banks by compensating to their customers by sharing a part of their profits. It will reduce the profits of the banks and their shareholders. It increases the commercial risks of the banks as they have to compensate their clients from their equity. Alternately, if the banks do not take steps to offer comparative returns to their clients that are equivalent to the conventional banks, it will reduce the value delivered to their customers120. Another major impediment to Islamic finance is that the investments of Islamic banks are in equities that are backed by physical assets. The banks are under constant pressure to deliver high returns to their investors to compete with the conventional banks. However, as Islamic banks need to stay away from interest bearing lending, their investments should primarily be equity based. This fact, coupled with the need to deliver superior value to their clients can cause severe stress on the assets of the banks, especially if the interest rate risk increases to an extent where it is higher than the returns delivered by the assets of these Islamic banks121. Another major regulatory and statutory risk that Islamic finance faces is the inability to determine the exact sources of funds invested 120 121

Ibid. Ibid.

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with the bank or the financial institutions122. Sharia does not allow money generated from certain activities such as gambling, sale of alcohol or arms. These are against the basic principles of Sharia. Therefore, money from such sources is prohibited and must not enter into the banking or the financial system that are guided by the Sharia laws. Problems faced by Islamic Investors While screening for a company to determine if it is compliant with the tenets of Sharia, there is a requirement of more than evaluating its financial statements. This creates a lot of problems for the Islamic investors who tend to invest in the equity capital, since it is difficult for them to ascertain for sure that the company they are contemplating to invest in is not either directly or indirectly involved in any prohibited activity. To avoid such instances of doubts and confusions, Islamic investment firms such as Amiri Capital use their efficient analytical systems. Amiri Capital uses Amiri S3, which checks and screens a company to check whether it has excessive debts on its books and then to check if it is involved into prohibited activities such as gambling, etc123. Another issue faced by the Muslim investors is that they are unable to follow Islamic financial practices in secular countries that have the conventional banking system. In such cases, the investors can take low interests or donate entire interests for charitable causes. It will help them purify their investments as well as free them from the sins of taking interests on their investments124. It becomes difficult for the banks or financial institutions to determine and validate the real sources of money. It can lead to compliance issues and has the potential to impede a smooth progress and development of Islamic finance. Islamic financial products are also highly complex as compared to the products of the conventional financial and banking systems. 122122

Ibid. See Amiri Capital. 124 Ibid. 123

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Sharia mandates that the contracts should have tangible underlying assets and uncertainty, undue risks and speculations should be strictly avoided. It increases the dependence on commodities as underlying assets. Since, Sharia disallows ambiguity and uncertainty, there are very few derivative products that are Sharia compliant. This makes Sharia compliant financial products complex and inherently risky. Therefore, in volatile markets, investors might choose to invest in traditional products instead of Sharia products125. Another major impediment to the development of Islamic finance is a lack of clear definition of defaults similar to non-performing loans. In conventional banking, it is possible to clearly define default and non-performing assets and loans. Due to the nature of Sharia products, that involve equity ownership and loss sharing, such clear distinctions between performing and non-performing assets becomes difficult. Additionally, in conventional banking, in the instances of loan defaults, the banks can charge penalties and accrued interests. These penalties help set off the losses that arise due to the non-performance of assets to a certain extent. However, Islamic finance does not allow penalising the defaulters in a similar manner. It increases the credit risks of the financial institutions126. Other major issues that can potentially block the development of Islamic finance include lack of sufficient liquidity in Sharia compliant instruments making them less attractive to the investors and financial institutions and a large concentration of wealth in physical assets. These assets usually include commodity and real estate. Since speculative investments are prohibited and an investment needs to have an underlying assets, the concentration of funds in real estate and commodities increases127. It makes the investments highly illiquid and therefore investors find it difficult to withdraw money when they need it or perceive a downward trend in the market. 125

Ibid. Ibid. 127 Ibid. 126

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One of the biggest threats to the success of Islamic finance is the lack of a single uniform code or governing body. There are no standard bodies or codes which administer all the nations that have Islamic financial markets and institutes. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was founded in 1990 and the IFSB was established in 2002. These bodies were created with the intent of creating common guidelines for the entire Islamic world and the governments and institutions that promote Sharia compliant finance.

(Source: CNBCArabia.com)

However, the AAOIFI standards are currently followed only by 8 out of 29 countries. Despite being in existence for almost 26 years, AAOIFI has not been able to achieve the desired results. Similarly, IFSB, which has existed for 14 years and prescribes risk management guidelines is only followed by institutions in 6 nations128. These observations from IMF prove that among the biggest threats to the development of Islamic finance are the lack of coherent 128

Ibid.

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guidelines, non-existence of a single governing and risk management body and the risky nature of Islamic financial instruments. The risk is magnified further due to lack of efficient hedging instruments. The rate of development of Islamic finance is also slow and conventional financial institutions offer products that are perceived by the majority even in the Islamic world to be less risky and more profit generating than the Sharia compliant instruments. The IMF further states that in several nations, such as the United Arab Emirates, Kazakhstan, Ethiopia and the UK, the financial framework for capital adequacy adopted by the Islamic financial institutions is Basel. While in nations such as Malaysia, Jordan, Sudan and Bahrain, the adopted framework is based on the standards defined by IFSB129. At the organisational level, a major issue faced by the Islamic financial institutions is the conflicts between the shareholders and the individual account holders130. In conventional banking systems, the shareholders invest in the equity capital of the banks and the investors are the lenders who invest in banking deposits and earn interest income. But, in Islamic banking, earning interest is prohibited (Riba). It means that the investments made by the individual investors are also in invested in instruments that are similar in nature to equity investments. Despite such investments that are similar to equity investments, the individual investors do not enjoy the rights similar to those of shareholders. They are not entitled to full disclosure by the banks like the equity investors. It increases the distrust among the individual investors, who, despite investing in instruments similar to equity, face a differential treatment as compared to the equity investors131. The need therefore is to improve the regulatory framework of such banks and financial institutions to reduce the disparity between the individual account holders and the equity shareholders. 129

Ibid. Ibid. 131 Ibid. 130

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Analysis of the challenges by Islamic Finance News

(Source: Islamic Finance News)

An in depth analysis of the impediments and challenges in the path of the development of Islamic finance is done by Islamic Finance News132. The analysis is carried out across divergent factors that include organisational and technical competencies and political and social facts. Compatibility of Islamic finance with the conventional financial system is also an impediment that has been evaluated. One of the primary challenges faced by Islamic finance is the lack of expertise and a consistent standard for transactions and investments133. Although there are specific financial standard boards that prescribe the practices and principles of Islamic finance, there is no single global authority followed by the Islamic financial institutions and the governments. There is a high degree of disparity among the various boards. Sharia laws, especially those concerning financial matters are subjective and require interpretation. It can only be done by Islamic scholars having in depth knowledge of both – Sharia laws as well as modern financial practices. It is difficult for financial boards to have such scholars associated with them resulting in a heightened risk of improper interpretation due to the lack of expertise134. Political factors are also responsible for creating impediments for Islamic finance. Different Islamic nations have different forms of government. While several nations follow a strict Sharia based legal and social systems, there are several other countries such as Turkey that follow a secular system of government135. Hence, it is not possible to have a single standard for all these countries as they have different forms of government and social and 132

Murat Yoluker (2011). Current challenges of Islamic finance, Islamic Finance News. . 133 Ibid. 134 Ibid. 135 Ibid.

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judicial systems. Various Muslim majority countries have derived their legal systems from their erstwhile colonial masters such as the English or the Dutch. Thus, there is a large scale disparity among their laws, rules, regulations and even the interpretation of Sharia. A large Muslim population also reside in non-Muslim dominant nations such as India. These countries follow conventional banking practices and Islamic financial institutions in these countries function within a financial framework that is different from Muslim majority nations136. The article by the Islamic Finance News identifies the compatibility issues in the Islamic finance as the biggest challenge for its development. According to the article, Islamic financial instruments face an issue of adjustment with conventional financial systems. For example, several nations allow opening a bank deposit for individual investors that do not pay interests. However, there are several nations where this facility is not available. Hence, individual account holders who wish to open accounts for depositing and saving money and for making small payments find it difficult to have bank accounts without interests137. There is a clear lack of adjustments in such cases where the Sharia laws and conventional financial laws do not fit together. Another example cited in the article is when few governments, at the time of global financial crisis, gave a guarantee to protect 100 per cent of the deposits of the investors in the financial institutions and banks of these nations. It is against the Islamic financial practices that require risk sharing138. There is also a lack of clear understanding of which institutions are genuine and which pretend to be compliant with Sharia laws. In 1988, during the financial crisis in Egypt, around a million investors lost their small investments made in the Islamic financial companies. The Central Bank of Egypt did not protect the investors who had invested in such companies resulting in their failure and subsequent losses to the investors139. 136

Ibid. Ibid. 138 Ibid. 139 Ibid. 137

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Such an instance also occurred in Kuwait when the investors lost their money in the collapse of Souk Al Manakh, an unofficial stock exchange. It affected other financial institutions including Islamic financial companies and banks who had to face issues of loan defaults and liquidity crunch. However, in this instance, the Government of Kuwait took the initiative to bail out the economy and implement a more robust financial system140. Such compatibility and adjustment issues can have adverse impact on the development of Islamic Finance. Due to the regional, political and economic differences and the variations in the administrative and judicial systems, Islamic finance faces severe challenges in terms of its efficient growth and development. Social issues may also obstruct the development of Islamic finance. In counties that are predominantly Muslim, the investors will have a different opinion about Islamic financial institutions and products as compared to secular or non-Muslim majority nations that have conventional banking systems. Also, differences of opinion among the Muslim scholars on Sharia and its interpretation of financial systems can result in a conflicting situations confusing the investors which interpretation of the Islamic principles to follow141. Contemporary issues faced in the practice of Islamic Banking

(Source: Muslim-institute.org) 140 141

Ibid. Ibid.

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Sayyid Tahir, Professor of Economics at the International Institute of Islamic Economics of the International Islamic University, Islamabad, has highlighted issues that are currently being faced by the Islamic Banking system142. Among the various factors stated in the paper that impede the progress of Islamic finance, the most prominent are the lack of standardisation, limited public awareness, insufficient training among the banking professionals with regards to the Islamic financial products and risk management143. Standardisation is something that is clearly lacking in Islamic finance and banking. The vocabulary used in Islamic banking is interpreted differently by different institutions and in different nations. There is also a lack of clarity on the financial instruments and their nature as well as their documentations. The standard pricing formula for Islamic financial instruments is also lacking as there are no specific formulas that are used144. These factors make it difficult to implement a standardised practice and set of guidelines for the Islamic banks and other financial institutions. The vocabularies and their corresponding meaning are different in different Islamic nations. The interpretation and the characteristics of financial instruments also differ from country to country and the formula for calculating returns or charges for products equivalent to loans are also not standardised. Apart from the lack of a standardised approach, the limited awareness among the common people about Sharia compliant banking and financial systems is also a major roadblock in its development145. There is no general awareness among the individuals regarding the Islamic financial products. Even the masses in Muslim dominant countries do not have sufficient knowledge about these products. It makes them sceptical about investing in these products as they feel these could be risky 142

Sayyid Tahir (2003). Current Issues in the Practice of Islamic Banking. . 143 Ibid. 144 Ibid. 145 Ibid.

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investment options and instead prefer investing in conventional banking and financial products. Despite the fact that several banks and financial institutions have started offering Sharia compliant products, the employees of these banks and institutes do not have sufficient training146. It is because the Islamic finance and its instruments require scholarly interpretation of Sharia, which is a complicated process. Bank or financial institution employees do not have sufficient knowledge on Sharia and they lack information required for these products. For any financial market or system, management of risk is crucial for its survival and development. In Islamic financial system, risk management is also one of the major issues that has been acting as a roadblock to its development147. Most of the principles of Sharia require interpretation by the scholars and even then there are disparities among these interpretation. Financial institutes follow certain Islamic finance boards and implement regulations specified by them. However, there is a lack of objectivity. Whether a bank or a financial institution implements the guidelines issued by these boards efficiently can only be checked retrospectively. There is a lack of implementation of proactive measures which increases the risk and dilutes risk management148. There are various articles and research papers that focus on the threats faced by the Islamic financial sector. These factors impede the progress of Islamic finance. Some of the main factors are evaluated in this chapter. However, there has been consistent progress in the field of Islamic finance and also there has been a growing awareness among the people regarding Sharia compliant financial system and its products. An incremental progress is being made in the field of Islamic finance and more and more countries and institutions are adopting Islamic financial practices and offer Sharia compliant products. 146

Ibid. Ibid. 148 Ibid. 147

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Even in non-Muslim countries, several conventional banking and financial institutions are offering Islamic financial products along with their regular banking deposit and loan products. Questions 1. Which types of challenges in the Islamic finance have been highlighted by the IMF? 2. What according to the IMF is the Displaced Commercial Risk? 3. Funds from which sources are prohibited by Sharia? 4. Can Islamic financial institutions penalise defaulters? 5. Does Islamic finance have high or low liquidity as compared to conventional finance? 6. Is there a uniform code or governing body managing Islamic finance? 7. What is the full form of AAOIFI? 8. When was AAOIFI founded? 9. When was IFSB founded? 10. How many countries currently follow AAOIFI standards? 11. Which countries use Basel as framework for Islamic finance? 12. What type of analysis is done by the Islamic Finance News? 13. Is there is single global authority to monitor the implementation of Islamic finance principles? 14. Who are the most efficient persons to implement Sharia Laws? 15. Can Islamic banks give a guarantee for the bank deposits to investors? 16. How many investors lost their investment in Egypt in 1988? 17. What is the name of the unofficial stock exchange in Kuwait that collapsed? 18. Are Muslim scholars unanimous in their interpretation of Islamic Finance?

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BIBLIOGRAPHY Kammer, Alfred, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe and Zeine Zeidane (2015). Islamic Finance: Opportunities, Challenges, and Policy Options, IMF Staff Discussion Note. Tahir, Sayyid, (2003). Current Issues in the Practice of Islamic Banking.

Yoluker, Murat, (2011). Current challenges of Islamic finance, Islamic Finance News.

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CONCLUSION This book is a detailed research and analysis into the domain of Islamic Finance. The overall work is divided into two parts and three chapters. The first part consists of the first chapter and the second part includes the second and third chapters. The first chapter evaluates the background and history of Islamic Finance. It takes references directly from the Holy Quran and Sharia to lay the foundation for the sources of the financial principles in Islam. The discussion then moves onto the notion of money in Islam followed by the key concepts in Islamic finance including the types of instruments. This chapter further reviews the situation of Islamic finance around the world, in the Muslim nations, and in the secular countries. A close look at Islamic fiancé in Kazakhstan is also taken along with its developments, goals, and aims. The second chapter looks at Islamic finance and its financial instruments in an international perspective. There is an analysis of the role of Sharia advisory boards in the 21st century Islamic finance. Country specific detailed evaluation of Islamic finance is also done in this chapter. The third and last chapter evaluates the challenges faced by Islamic finance. It includes the challenges highlighted by the International Monetary Fund and Islamic Finance News, and the contemporary issues faced in the practice of Islamic finance. Based on the overall discussion, it is concluded that Islamic finance has developed tremendously in the recent years. Countries like Kazakhstan have realised its importance as an alternative system of finance which has integrated measures capable of avoiding financial crisis.

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Еducational issue

Zhanat Kazbekova Diana Kulibayeva ISLAMIC FINANCE Textbook manual Typesetting and cover design: K. Umirbekova IB No. 10435

Signed for publishing 13.02.2017. Format 60x84 1/12. Offset paper. Digital printing. Volume 6,12 printer’s sheet 100 copies. Order No. 293. Publishing house «Qazaq university» Al-Farabi Kazakh National University KazNU, 71 Al-Farabi, 050040, Almaty Printed in the printing office of the «Kazakh University» publishing house

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