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Islamic Banking and Finance

Islamic Banking and Finance

Edited by

Mondher Bellalah and Omar Masood

Islamic Banking and Finance, Edited by Mondher Bellalah and Omar Masood This book first published 2013 Cambridge Scholars Publishing 12 Back Chapman Street, Newcastle upon Tyne, NE6 2XX, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2013 by Mondher Bellalah and Omar Masood and contributors All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-4438-4770-4, ISBN (13): 978-1-4438-4770-4

TABLE OF CONTENTS Preface ...................................................................................................... viii Adnan Ahmed Yousif, President and CEO of Albaraka Banking Group, Chairman of the Board of Directors, Union of Arab Banks Introduction ................................................................................................. x Chapter One ................................................................................................. 1 Introduction to Islamic Finance and Islamic Banking: From Theory to Innovations Shayeh Zineb and Mondher Bellalah Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality Section 2: An Overview on the Framework of Islamic Finance and Banking13 Section 3: Islamic Financial Contracts and Products Conclusion: On the Challenges and Issues of Structuring Innovative Shariah Compliant Products Chapter Two .............................................................................................. 71 Productivity Growth in the GCC Banking Industry 1999–2007: Conventional Versus Islamic Banks Samir Abderrazek Srairi Section 1. Introduction Section 2. Revue of Literature Section 3. Methodology Section 4. Data and Variables Section 5. Empirical Results and Analysis Conclusion

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Chapter Three .......................................................................................... 109 An Analysis for the Growth and Rise of Smaller Islamic Banks in the Last Decade Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Literature Review Section 3. Islamic Banking: an Overview Section 4. Methodology Section 5. Empirical Analysis Conclusions Chapter Four ............................................................................................ 126 Development and Scope of Islamic Bank Bonds (Sukuks) Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Aims and Objectives Section 3. Cases of Non-Muslim Sukuk Issuers and Investors Section 4. Britain and Islamic finance Section 5. Islamic Home Financing Section 6. Methodology Section 7. Results Section 8.Discussion Conclusion Recommendations Chapter Five ............................................................................................ 159 Iran’s Islamic Banking Experience and Future Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. The Islamic Banking Law—Did the Banking System Implement It? Conclusion Chapter Six .............................................................................................. 169 Islamic Banking Structure and Growth in the Sudanese Islamic Banking Sector Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Sudanese Banking Industry Section 3. Research Methodology Section 4. Data Analysis and Findings Conclusion

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Chapter Seven.......................................................................................... 196 Islamic Mortgages Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Major Principles of Islamic Finance Section 3. The Islamic Mortgage Market in UK Section 4. Empirical Analysis Conclusion Chapter Eight ........................................................................................... 221 Role of Islamic Mortgages in the UK Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Uk Sharia-compliant Market Analysis Section 3. Islamic Modes of Financing Section 4. The Growth of Islamic Financial Instittions Section 5. Comparison between Islamic and Conventional Mortgages Conclusion Chapter Nine............................................................................................ 244 The “Islamic Bank of Britain”: Case Study Analysis Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Objectives of thɟ Study Section 3. Islamic Banking in the United Kingdom Section 4. The Islamic Bank of Britain Section 5. Methodology Section 6. Results and Analysis Section 7. Author Findings Summary and Conclusions Recommendations Chapter Ten ............................................................................................. 261 Growth of Islamic Banking and Employee Satisfaction in Bangladesh Omar Masood and Mondher Bellalah Section 1. Introduction Section 2. Aims and Objectives Section 3. Literature Review for Bangladesh Section 4. Methodology Conclusions Policy and Recommendation

PREFACE

Islamic banking has seen rapid growth during the last two decades. There are many contributory factors for such growth, most notable of which are the liberalisation of financial regulation; the globalisation of financial markets; changes in technology; product innovation; the birth of several new Islamic states; and the growing Islamic presence in the West. Product innovations have helped economists and religious scholars to bring new products to almost all areas of banking and insurance, some of which were previously thought to be extremely controversial. There is no accurate data on the extent and volume of Islamic banking. Islamic banking assets are currently estimated at being between USD 500 and 800 Billion, and there are nearly three hundred Islamic Financial Institutions worldwide, including “Islamic windows” of conventional banks. The Islamic sukuk, (equivalent to bonds in Western finance) are the fastest growing product on the financial market, and the sukuk market has increased at an average annual rate of 40 per cent, with a current size of more than USD 82 billion. In Pakistan and Malaysia, Sharia-compliant funds have exceeded over 50% of total market capitalization. Today, Islamic banking is growing at approximately 15% per annum, as a result of economic expansion in the Islamic world, fuelled primarily by oil wealth. This growth has created a expanding middle-wealth segment and hence made banking a necessary service to a larger segment of the population rather than a service for a minority, as had been the case for the preceding ten to fifteen year period. The Islamic banking system is popular with not only Islamic banks themselves, but also well-known international and other conventional banks. Presently the majority of international banks are adopting Islamic banking to serve their new clients and their specific needs. Examples of such banks are Citibank and HSBC, both of which have started Islamic operations worldwide to expand their businesses. Although interest in Islamic banking has grown considerably during the last decade, Islamic banking today continues to evolve as an industry. The financial world has set conventional banking as a standard practice driven mainly by the profit maximisation principle. However, Islamic banking principles have attracted attention from academic researchers and regulators both in developing and developed countries as a result of their distinguished micro-operating fundamentals. The prohibition of interest payments by Islamic Sharia (Islamic law) has instead made equity and profit sharing the

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cornerstones of its operational structure activities. This ban on interest does not mean that capital is costless in an Islamic system; in fact, it recognises funds as a factor of production but does not allow the fundproviders to make a prior or pre-determined claim in the form of interest. This risk-sharing principle provides theoretically better long-term allocation of funds to investments with higher risk-return profiles and subsequently greater economic growth. This book addresses the main issues of concern within Islamic banking, namely the conceptual framework and viability of interest-free banking and the assessment of its performance and future. In a world where conventional interest-based finance is the dominant framework, Islamic banking faces many challenges that must be addressed. This book discusses the contemporary issues and challenges confronting the Islamic banking system and was written for both researchers and practitioners. It analyses the past experiences of Islamic banks worldwide and provides an objective assessment of their successes and failures. Adnan Ahmed Yousif President and CEO of Al Baraka Banking Group President of Union des Banques Arabes

INTRODUCTION

General Introduction What distinguishes Islamic finance and banking from the conventional financial system is based on a comprehensive system of ethics and moral values stemming from the Islamic religion. Unlike conventional finance, Islamic finance is founded on overarching principles that constitute the guidelines governing any Islamic economic or financial dealings. The principles that underline the distinguishing features of Islamic finance and banking as well as Islamic economics as a whole stem from the Sharia of Mu’amalat or Islamic law governing human relationships. Islamic Law refers to the divine injunctions in the Koran and the prophet’s (PBUH) traditions that regulate the conduct of human beings in their individual and collective lives. In this regard, it is worth pointing out that Islam does not refer only to the Islamic religion but encompasses a comprehensive social system where people live in accordance with divine guidance. Islamic finance was developed from a conceptual idea in regard to an evolving and fast reality. With the involvement of many actors in the industry and the culmination of economic, political and demographic factors, Islamic Finance has shown a strong growth. Basic Sharia-compliant contracts have been used innovatively in structuring various Islamic financial and deposit products for banking, project finance, capital market, insurance products and risk management instruments. The structuring of innovative finance and derivative Shariacompliant instruments plays an important role in the enhancement of Islamic financial markets and Islamic risk-management practices. For future challenges, the immediate need is to develop instruments that enhance liquidity, and to develop secondary, monetary and inter-bank markets; and to perform asset liability and risk management. My personal view is that it is a “huge mistake” to use the LIBOR as a benchmark. The benchmark must be the “real cost”’ or “Actual costs” incurred by Islamic banks and mainly information costs to which a margin must be added. These costs are well known in the literature (the reader can refer to Bellalah [2008, 2009]). These costs are defined in Appendix 1 of Chapter 1.

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This Book is organized as follows. Chapter one draws attention to the important development that Islamic Finance and banking have known from a conceptual idea to an evolving and fast reality. It deals with the different principles governing Islamic financial dealing and transactions and gives an overview of the added value of Islamic finance to the international financial system. The chapter covers the main Sharia-compliant structured project finance solutions and the sukuk market, and presents new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility. Chapter two studies the productivity growth in the GCC Banking Industry for the period 1999-2007. It compares conventional versus Islamic banks. This study examines the impact of financial liberalization on banking productivity growth in the Gulf Cooperation Council (GCC) countries during the period 1999–2007. Employing a non-parametric approach (DEA), productivity change has been measured by computing total factor productivity index for two groups of banks: conventional and Islamic. The findings indicate that during the period of deregulation, GCC banks have experienced a gain in productivity change of about 1.8%, attributed mainly to the progress of technical change rather than increase in efficiency change. We also found that conventional banks tend to outperform Islamic banks in most productivity measures. In this chapter, we also investigate the determinants of bank productivity. The results show that bank size has a positive impact on productivity growth for all models, while capitalization is related negatively to efficiency change for the model of Islamic banks only. Finally, the regression findings also demonstrate the strong links of macroeconomic and financial sector indicators with bank productivity. Chapter three presents an analysis for the growth and rise of smaller Islamic banks in last decade. Chapter four studies the development and scope of Islamic bank bonds (known as Sukuks). Raising finance through investment Sukuks is becoming more and more popular in the Middle East, Europe and the Far East. Sukuk is a thriving new market in many Islamic Economies, especially in GCC countries and Malaysia This is attracting a lot of interest from European countries like the UK, Portugal and some other major countries like Japan and Singapore. Given their novelty and unique characteristics and varieties, Sukuks can be researched extensively and discussed from various angles. However, under this heading, the focus will be on the definition of Sukuk types, nature and salient features distinguishing each type of Sukuk from

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Introduction

others, and consequently offering a critical appraisal of Sukuk as Islamic alternatives to conventional Bonds or securitization. The other chapters investigate Islamic banking and finance in several countries. Chapter five develops Iran’s Islamic banking experience. The practice began in Iran in 1984, and the transformation from a conventional form of banking has been a subject of debate among scholars. Analysis of Islamic modes of financing shows that bank authorities and economic policy makers have followed the same path of traditional banking and switch their funds towards a more profitable type of contract. This chapter describes that due to the heavy concentration of the banking assets on short term deposits, and the private sector’s reluctance to commit funds for long term financing, bank loans were also utilized to mainly finance shortterm trade transactions, for example hire purchases, forward purchases and service contracts. Long-term partnerships for project financing and direct investment by the banking system in the long term undertakings constituted a small percentage of the total operation. Chapter six studies the Islamic banking structure and growth in the Sudanese Islamic banking sector. Goes back to 1977 when the Faisal Islamic bank of Sudan was established in the country. With the introduction of Sharia law in 1984, the entire banking industry converted to Islamic Sharia principles. The Sudanese Islamic banking industry now encompasses more than thirty banks, and some of them, like the Faisal Islamic bank of Sudan, have twenty-eight branches alone. This chapter seeks to analyze the financial performance of selected Sudanese Islamic banks and highlight their growth using financial statement analysis (FSA). The procedure involves calculating numerous financial ratios and categorizing them into five key groups in order to examine profitability, earning potential, liquidity, credit risk, and assets activity. Findings revealed that the Sudanese Islamic banks are doing very well in terms of generating reasonable profits. In addition we discovered that the liquidity earning performance and assets activity performance of the three selected bank was satisfactory. Finally, while analyzing credit risk we found that Sudanese Islamic banks are taking excessive risks. Chapter seven looks at Islamic mortgages. Mortgages are considered to be a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in the UK. In this chapter, we critically analyse the Islamic mortgage system in the UK and also find out if it might help to create a stable financial environment. The chapter gives a

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preliminary empirical assessment of role of Sharia board and corporate governance with reference to the UK. The information was gathered through a well-designed questionnaire assessing a professional banking point of view on Islamic mortgage. This study also sought two important answers to: (1) whether Islamic banking is based on Islamic economic principles or is just a replica of conventional banking, and; (2) if we would still be facing a financial crisis if the market was regulated by Islamic Sharia. Chapter eight investigates the role of Islamic mortgages in the UK. Mortgages are considered a major determinant factor not only for the UK, but for other Western economies as well. Therefore, we thought it fit to conduct an empirical study on Islamic mortgages in UK. In this chapter we study and elaborate principles behind the overall Islamic banking system, main focus in the role of Islamic mortgages in the UK. This chapter gives a preliminary empirical assessment of the role of sharia board and corporate governance with reference to the UK. This study also sought to find out whether Islamic banking is based on Islamic economic principles or just a replica of conventional banking. Chapter nine studies the “Islamic bank of Britain” in a case study analysis. There is no specific difference between Islamic and conventional banking on a functions basis. Both provide and perform almost the same functions. The only difference between them is for the Islamic bank to follow the rules and principles of Islam in all their transactions (Henry and Wilson 2004; Iqbal and Mirakhor 2007). Many conventional banks also have started to open branches, which operate in accordance with Islamic Sharia principles. The Islamic banking system is expected to face strong competition not only from the Islamic banks but also from wellestablished conventional banks offering Islamic products and services. In this study, we focus on the Islamic Bank of Britain, the only indigenous bank of its kind in United Kingdom. An assessment of the degree of customer awareness satisfaction is made, as well as selection criteria. A sample of two hundred respondents took part in this study. The responses show a certain degree of satisfaction, and a few respondents also expressed their dissatisfaction with some of the Islamic bank's services. Chapter ten studies the growth of Islamic banking and employee satisfaction in Bangladesh. Twenty-five years ago, Islamic banking was virtually unknown. Now, fifty-five developing and emerging market countries have some involvement with Islamic banking and finance. In Bangladesh, the Islamic banks are in a minority and operate alongside conventional banks. The objective of this research is to provide a brief analysis of the performance

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of Islamic banks in Bangladesh. The Islamic banks in Bangladesh show strong growth. The products range from consumer credit to long-term finance for big investment projects using Islamic modes of financing such as Marahaba, Bia-Muazzal and Ijarah. Currently, in Bangladesh, the higher import cost of commodity prices, price hike in international oil market as well as money and credit growth resulted in higher inflation. As a result, the economy of the country showed every sign of recession. Despite numerous adversities, Islamic banks made significant pre-tax profit in the last few years. Islamic banks maintained and achieved a strong position in the key areas like capital adequacy, liquidity, assets quality, management and earnings. Moreover, Islamic banks in Bangladesh are keeping pace with the advancement of information technology by providing online banking, debit card facilities and money transfers. The research is based on primary data collected through a questionnaire to the employees of four selected banks on a random basis.

CHAPTER ONE INTRODUCTION TO ISLAMIC FINANCE AND ISLAMIC BANKING: FROM THEORY TO INNOVATIONS SHAYEH ZINEB AND MONDHER BELLALAH

Islamic finance is founded on overarching principles that constitute the guideline governing any Islamic economic or financial dealings. The reader can refer to the cited websites. This chapter is organized as follows. The first section tries to draw attention towards the important development that Islamic finance and banking have known from a conceptual idea to an evolving and fast reality. The second section deals with the different principles governing Islamic financial dealings and transactions and gives an overview of the added value of Islamic finance to the international financial system. The third section starts with a summary on the different basic Islamic financial contracts and points out the importance of financial innovation. We shed light on the main Sharia-compliant structured project finance solutions. Moreover, we focus on the sukuk market and present new practices in the industry such as sukuk restructuring, credit enhancement, redemption and convertibility. We point out the importance of the Waad as an interesting instrument, leading to the development of Islamic derivatives and innovative hedging and financing Shariacompliant structures. We present the main Sharia-compliant derivative based on instruments along with recent Sharia-compliant portfolio insurance practices. Finally, we highlight the major challenges facing the development of Islamic capital market standing from the need for liquidity and risk management-innovative structures to the urgent need to an international central regulatory body ensuring international standardization and uniformity.

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Chapter One

Section 1: From a Conceptual Idea to an Evolving and Fast Growing Reality 1.1. Islamic Finance Industry Growth The infancy of the Islamic finance and banking was in Egypt and Malaysia during the 1960s. The establishment of the first Islamic bank, pioneered by the Mit Ghamr Local Saving Bank, can be traced back to 1963 in Egypt. In the same year, the first Sharia-compliant fund was established in Malaysia known as the Pilgrim’s Savings Corporation. According to the 2009 Banker report, the number of Islamic financial institutions worldwide is about 626 in approximately fifty countries in 2009, compared to 525 in 2007, with total balance sheet assets estimated to be about $822 million in 2009 compared to $500 million at 2007. The global total of Islamic assets grew at rate of 28.6% in 2009 for the preceding year. The Middle East and North Africa region accounts for the largest share at 81.3% of total global Islamic assets in 2009. Islamic banking had a real boom at the beginning of the twenty-first century with an increasing number of Islamic banks and Islamic windows (see table. 1.1 above) and exponential growth of its geographical spread (see fig. 1.2 above). The top twenty banks in the GCC countries have seen their combined assets grow by 24% in 2008. The diversification of market players in the Islamic bank resulted in a growth of geographical reach and the emergence of new financial centres for Islamic banking, different from the historical ones such as Dubai, Bahrain and Kuala Lumpur. The emergence of an increasingly broad range of retail products and services has largely contributed to make Islamic banking as competitive as the conventional method. The Takaful or Islamic Insurance industry, introduced in the 1990s, is expected to reach $8 billion by the end of 2012 at an annual growth rate of 35%, especially for the life takaful industry. The Gulf Countries council represents 60% of the market size followed by Malaysia with 21%. Gross takaful contributions have grown from $1.4 billion in 2004 to over $3.4 billion in 2007. There still exists a large, expanding and untapped Muslim population on almost every continent (the World Takaful Report 2009).

mic Banking Introductioon to Islamic Fiinance and Islam

3

Table 1.1. R Regional and d global grow wth totals—Isslamic financcial asset ($m). Sourcce: Maris Strategies & Th he Banker (Noovember 2009)

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Fig. 1.1. Geoggraphical distribbution of Islam mic banking Source: May Bank (May 20009)

With reespect to thee Islamic caapital markett, which has gained momentum in recent yearrs, the sukuk, or Islamic assset, market haas backed certificates introduced inn the early 2000s 2 has beeen one of th he fastest growing finnancial marketts the last fivee years and iss expected to continue expanding aat an even faster f rate. Different D strucctures of sukkuk were launched wiith the objectiive of catering g to an increaasing Muslim and nonMuslim finance and invvestment need ds. With a ddepth exceediing $133 billion, the market of Isslamic bond experienced eexceptional growth g in 2007 with a rise of over 50% 5 (IFIS, 20 009). Howeverr, the sukuk market m has not been spaared from the current econo omic crisis, as shown below w.

Introductioon to Islamic Fiinance and Islam mic Banking

5

Fig. 1.2. Grow wth of ukuk issuuance ($ billion ns) Source: IFIS (2009)

The Lannd Germany's Saxony-Anh halt has alreaddy used this financing instrument. The United Kingdom hass already issuued sovereign n Islamic Bond. Japann and even Frrance have an nnounced theiir desire to prroceed to issuing sovvereign sukukk. Malaysia counts c as onee of the mo ost active countries inn the Global sukuk s markett with a 76.2 % of market share of about USD $13,000 milliion. The majo ority of sukukk rates range from f A to Baa, due to ttheir asset-baccked and baseed features. Islamic iinvestment fuunds have had d a major imppact on globaal Islamic finance. Inddeed, the Islam mic fund indusstry in global financial instiitutions is estimated too be about $1.33 trillion and is projected too reach $2.7 trillion t by 2010, at ann annual grow wth rate of 15–20%.2 Thhe number of Shariacompliant innvestment funnds is estimatted to be oveer five hundreed by the end of 20088, and new funnd issuance has h increased ssignificantly, with 153 established in 2007 alonee. It is also estimated that the total Islaamic fund universe couuld easily reacch one thousan nd funds by thhe end of 2010.3 These funds are a portfolio of different d assett classes, suchh as commodiity funds, equity fundss, Ijara or leaase funds, Mo oney market fu funds are actu ually used as a crucial liquidity riskk managementt instrument inn the interban nk market and real estaate funds. Thee largest conceentration of Is lamic funds reemains in the Middle East and Noorth Africa. The T equity fuunds lead the field for 2 3

www.failakaa.com Ernst and Yooung «The Islam mic Funds and investment repport ». 2008.

Chapter One

6

choice of asset type with 40–60% depending on the region of the total assets.4 Several Islamic Equity funds emerged during the equities market boom of the 1990s and the introduction of the Islamic stock index in the 1999, the Dow Jones and FTSE Sharia index has largely contributed to this industry. Conscious of the rapid growth and dynamic of the Islamic Finance sector, many large Western financial institutions including Citibank, Barclays Capital, Morgan Stanley, Merrill Lynch and HSBC have established subsidiaries that provide financial Islamic products. Moreover, the major French banks have also actively developed Islamic banking activities, mainly in the Gulf but also at a lesser scale on French territory. BNP Paribas, Credit Agricole and Societe Generale are the most advanced in this field. Today, the number of conventional financial institutions with Islamic windows is about 191 worldwide (The banker, 2009). Western regulators, investors and other agents have also shown a greater interest in and a receptive attitude towards Islamic banking and finance (M. Khan et al. 2008). It is interesting to note that among the top twenty-five countries by size of Sharia-compliant assets include such non-Muslim countries such as the United Kingdom in ninth place with $19.4 million and Switzerland in twentieth place with $4.6 million. Recently, France is gaining momentum in its bid to become a centre for Islamic finance. In fact, the French government has taken a comprehensive approach to understanding how to seamlessly assimilate Sharia-based finance into the existing regulatory and legislative structures. An amendment to article 2011 of the French Civil Code, passed on by the French National Assembly, shows the determination to adjust French legislation to the requirements of Islamic finance. Many important players from both the conventional and Islamic finance stream have pooled their expertise and knowhow to devise more ethical and efficient Islamic financing and hedging solutions. For instance, the launch of the Tahawut (Hedging) Master Agreement (TMA) in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM), in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA), gives the global Islamic financial industry the ability to trade Sharia-compliant hedging transactions such as profit rate and currency swaps, which are estimated to represent most of today's Islamic hedging transactions. While the first steps toward the materialization of the idea to pursue an Islamic mode of economic and financial dealings were taken by a minority community of Muslims in India in the early twentieth century (Interest 4

Ernst and Young 2009

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Credit Society 1923), real state sponsorship of the establishment of an interest-free institution can be traced back to the 1970s, mainly in Egypt and Iran when a presidential decree in 1971 in Egypt gave birth to the Nasir Social Bank. The introduction of President Zia UlHaq in 1977 was an important step in the process of establishing interest-free banking in Iran. These initiatives were followed in the 1980s by the Islamization of economies in the Islamic Republics of Iran, Pakistan and Sudan where banking systems are converted to interest-free banking systems. The GCC countries and Malaysia worked for the promotion of Islamic banking parallel with the conventional banking system. The Malaysian Islamic banking industry has seen the most spectacular expansion with the enactment of the Islamic banking act in 1983 and the establishment of the Bank Islamic Malaysia as well as important government involvement. In 1974, the first Islamic modern commercial bank, the Islamic Dubai bank, was established. The Islamic Dubai bank, one of the earliest private initiatives in the UAE, could be considered one of the first proofs of the feasibility and efficiency of an Islamic banking system. The bank continues to prosper and be involved in the development of Islamic finance. The IDB is not a unique example in this regard, as the major Islamic banks have proved to be as efficient and profitable as conventional banks. One year later, in 1975, the Islamic Development Bank was established in Jeddah. This institution has played a crucial role in expanding Islamic modes of finance and in fostering interesting research in Islamic economics, finance and banking. In 1977, the Kuwait Finance House was founded as the first Islamic bank in the country. Recently, the KFH accounted for about a quarter of all deposits in the Kuwaiti market and continues to expand its overseas dealings.

1.2. Determinants of Islamic Finance and Banking Spread Many factors have contributed to the development of Islamic finance and the spread of Islamic banking. The growth in Islamic financial services may be attributed to the important growth that the GCC countries and Asian economies have seen as well as the increasing numbers in the Muslim community. (IMF 2009) has investigated the determinants of the pattern of Islamic bank diffusion around the world using country-level data for 1992–2006. It was argued that the huge influx of petrodollars from the late 1970s, as well as the consistently high oil prices in international markets, has provided a strong impetus for the development of several Islamic banks in the Middle East. Islamic banking is spreading

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Chapter One

wherever there is a sizable Muslim community and is not restricted to Muslim countries. The probability for Islamic banking to spread in a given country rises with the share of the Muslim population, income per capita, and whether the country is a net exporter of oil. Trading with the Middle East and economic stability are also conducive to the diffusion of Islamic banking. Proximity to Malaysia and Bahrain, the two Islamic financial centres, does matter. The interest rates’ decrease enhances the development of Islamic banking because they reduce the opportunity cost for less pious individuals to put their money in a conventional bank. According to the authors, the terrorist attacks of September 2001 were not important to the spread of Islamic banking. However, they coincided with rising oil prices, which are the real drivers of Islamic banking growth. Moreover, because the Islamic banking is guided by Sharia law, the quality of institutions, which traditionally count for conventional banking, is not important for the diffusion of Islamic banking. In addition, the major determinants of the development of Islamic banking and finance include the continuation of serious conceptual and theoretical work both in academic and professional circles. The involvement of international institutions in the development of serious research in Islamic finance and banking was of great interest to the industry. Many well-regarded academic institutions in both Western countries such as Harvard University, Durham University, La Sapienza University & ISME and in Muslim countries such as the Cass Business school, the Faculty of Islamic Studies (Qatar), Effat Women’s University (Saudi Arabia), Bahrain Institute of Banking and Finance, International Institute of Islamic Finance Incorporated (Malaysia) organized seminars and conferences and offered degree programs and scholarships in postgraduate Islamic finance study.

1.3. Research Breakthrough The emergence of an opposition and reluctance to the interest rate started in Egypt in the late nineteenth century when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal (Iqbal at al. 1998, 2001). Several formal critiques have been conducted to highlight, on the one hand, the main critical areas where the conventional economic system conflicted with Islamic values, and on the other to lay out alternatives to interest-based financial systems and banking that have started to gain momentum in Muslim countries. The contributions of Qureshi 1967, Siddiqi (1983, 1985, 1988), were considered important in this regard. Their works focused on studying how Islam could propose a

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framework to organize an economy and providing a formal definition of Riba, as well as explanations and rationales behind the prohibition of interest. The main studies proposed a comparison framework between the economies based on Islamic tenets, socialism and capitalism and emphasized the operational and organizational model of an Islamic bank based on partnership. Interest grew in undertaking theoretical work and research to understand the functioning of an economic and banking system designed to be an interest-free system, in line with the tenets of Islam, with the first international conference on Islamic economics held Saudi Arabia in 1976. The involvement of institutions and governments led to the application of theory and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. Parallel to the research initiatives taken by Islamic international institutions such as the IDB and its research arm the Islamic Research and Training Institute established in 1981, the World Bank as well as the International Monetary fund were among the first conventional institutions initiate research on understanding the macroeconomic efficiency and financial stability of an interest-free economic system as well as the financial implications of a loss and profit sharing mechanism (Khan 1986, Khan and Mirakhor 1990). There has also been an outpouring of continuous research on the nature and operation of interest free banks by Muslim economists such as Siddiqi (1983), Bashir (1983, 2000), Chapra 1982, 1985). By exploring the different Islamic contacts, these researches led to the laying out of alternatives to the conventional banking system. In fact, the main results of their efforts were to provide a framework to the early theoretical models of Islamic banking based on the concept of Profit and loss sharing through the Musharakah and Mudarabah contracts. The two-tier Mudarabah financial intermediary model was thus designed and its efficiency and performance assessed. While academic research on Islamic economics has taken back seat and interest has increased toward the Islamic finance and banking field due to the growing demand for Islamic products and services and the important spread of Islamic banks all over the word, research on corporate governance, Islamic accounting, asset liability management, risk management, capital adequacy and regulation of Islamic banking as well as Islamic financial engineering and innovation in Sharia-compliant derivatives have drawn attention to what Islamic financial institutions and academic researchers need to watch out for in the rapidly changing and competitive financial world.

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Chapter One

Chapra (1995) initiated discussions on corporate governance in Islamic financial institutions. They underlined that Sharia compliance in Islamic banks will lead to differences in governance mechanisms in Islamic banks compared to conventional banks. They pointed out that the core element of corporate governance framework for Islamic banks is the Sharia Supervisory Board (SSB) and the internal controls which support it. Chapra provided an overview of corporate governance from an Islamic perspective, focusing on the Islamic financial institution and presented a model defining stakeholders in Islamic banks. They argued that, in contrast with the conventional bank’s corporate governance mechanism where in the depositors’ interest does not receive much attention, Islamic banks’ corporate governance should give emphasis to protect depositors’ interest in their business. Z. Hasan (1996) brought out the basic elements of Islamic corporate governance with the Western counterpart in the aspects of conceptual definition, episteme, corporate objective, nature of management and corporate structure. There is some need for special regulations for Islamic banks for special capital adequacy framework. Drawing from the specific features of Islamic finance and its inherent features of risk sharing, questioned the relevance of the Basle norms and d certain modifications and alternative ways to compute capital adequacy measures for Islamic financial institutions. As Islamic financial institutions endeavour to cope with the challenges of globalization, efficient risk management has assumed particular importance. This requires the development of not only a more suitable regulatory framework, but also new financial instruments and institutional arrangements to provide an enabling operational environment for Islamic finance. The recent establishment of the Islamic Financial Services Board, facilitated by the International Monetary Fund, addresses this need. han (2001) highlighted the unique risks of the Islamic financial services industry and the main regulatory concerns with respect to risks and their treatment. They identified a number of Sharia-related challenges concerning risk management. As far as the asset liability management is concerned, interest toward the development of Sharia-compliant derivative, securitized and structured based instruments has gained momentum. Iqbal (1999) pointed out that the Islamic system of contracting allows for designing risk management solutions using the framework of financial derivative products. The paper analyzes and discusses the case of a specific Islamic contract, istijrar, and highlights its possible use in managing certain forms of risk. Iqbal (1999) argued that Islamic finance provides the basic building blocks that can be used to construct more complex financial instruments that will enhance

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liquidity and offer risk management tools. With the introduction of asset securitization and swap transactions conforming to Islamic principles, the issues of secondary markets and risk management can be addressed.

1.4. Regulating and Supervising Islamic Finance and Banking Industry The Institutional Development For the sake of supporting the development of Islamic banking and finance, an institutional infrastructure has been evolving since the emergence of the Islamic Development Bank in 1975 as one of the major actors in the enhancement of the Islamic financial industry. The rapid expansion in the breadth and depth of Islamic banking and capital market activity as measured in terms of the number of institutions as well as by the variety, complexity and sophistication of products and services has triggered a strong awareness among scholars, professionals and regulators about the necessity to institutionalize Islamic finance through the establishment of international regulating and supervising organizations. Undoubtedly, one of the biggest challenges for the Islamic financial system is the development of a framework for governing, supervising and regulating Islamic finance. For instance, Islamic banks have to be subject to a supervisory and regulatory regime of central banks that is entirely different from that of conventional banks as well as conventional central banks in order to promote a true and fair view of Islamic financial transactions. The Islamic Development Bank In this regard, it is meaningful to highlight the important role played by the Islamic Development Bank in developing internationally acceptable standards and procedures and strengthening the sector's architecture in different countries. The IDB was established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in December 1973. Moreover, several other international institutions are working to enhance the regulatory framework and standardization of the Islamic finance and banking industry. These include the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Finance Service Board (IFSB), the International Islamic Financial Market

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(IIFM), the Liquidity Management (LMC), the International Islamic Rating Agency (IIRA), the Islamic Research and Training Institute (IRTI) and the International Sharia Research Academy for Islamic Finance (ISRA). Auditing Organization for Islamic Financial Institutions Thanks to the effort of the Islamic Development Bank, the Accounting and Auditing Organization for Islamic Finance was established and registered in 1991 in Bahrain as an international, autonomous self-regulation for the industry. The main objective of the organization is to prepare and develop accounting, auditing, governance and ethical standards relating to the activities of Islamic financial institutions, taking into consideration international standards and practices and the need to comply with Sharia rules. The Islamic Finance Service Board With the growth of the market, the IFSB was established in 2000 as a dedicated regulatory agency. The IFSB, together with the AAOIF, aims to promote the development of a prudent and transparent Islamic financial services industry and provides guidance on the effective supervision and regulation of institutions offering Islamic financial products. The IFSB has recently finalized standards on capital adequacy and risk management and has made progress in developing standards on corporate governance. Once developed and accepted, these international standards will assist supervisors in pursuing soundness, stability and integrity in the world of Islamic finance. The Liquidity Management Center As Islamic financial transactions increasingly become global in nature, there are concerns over the sufficiency of supply of appropriate instruments to address the global liquidity management needs of Islamic financial institutions. These concerns led to the establishment of the Liquidity Management Centre (LMC) in February 2002. The LMC is based in Bahrain and is part of a larger project to create an International Islamic Financial Market (IIFM). The LMC facilitates investment of the surplus funds of Islamic banks and financial institutions into quality shortand medium-term financial instruments. It aims to enhance the creation of

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an Islamic interbank money market that would enable Islamic financial institutions to manage their liquidity. The International Sharia Research Academy for Islamic Finance The International Sharia Research Academy for Islamic Finance was established by the Malaysian Central Bank in Mei 2008 with the vision and mission of Integration of Sharia experts and industry practitioners as well as synergizing total human capital development in Islamic Finance. Furthermore, the academy contributes to the study of the potential market needs and innovation in research findings.

Section 2: An Overview on the Framework of Islamic Finance and Banking Referring to Islamic banking or Islamic financial system as simply an interest-free system does not reflect the real image of the Islamic financial system. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but is supported by other principles of Islamic doctrine advocating social justice and risk sharing. Islam recognizes the role of Markets and freedom of individuals and trade. History cannot deny, as expressed by Gordon Brown, that: “it was mainly through peaceful trade that the faith of Islam arrived in different countries.” The profit motive and private ownership are acceptable, but to a reasonable extent. In fact, the Islamic finance defines this extent regarding the Islamic Law, which upholds the principles of integrity, transparency, justice, fairness, solidarity and good corporate governance in financial dealings.

2.1. Materiality and Validity of Economic and Financial Transaction and Dealing 2.1.1. Asset Backed or Based Finance One of the most important features of Islamic finance, of which the economic crisis has demonstrated relevance, is that Islamic finance is based on an asset-backed financing principal. In fact, Sharia law, which grounds the principles of Islamic finance, encourages business and trade activities that generate fair and legitimate profit through which business dealings must be accompanied by an underlying genuine trade and business-related activity. Any transaction in the financial sphere must

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necessarily reflect a transaction in the economic sphere. The two spheres must increase or decrease in terms of value overall. This was not the case for the current financial crisis where the massive injections of money into the real economic sphere were not been able to cope with the enormous gap that stood between the two. Thus, every financing mode5 in the Islamic financial system enforces the close link between financial and productive flows and hence ensures that funds are channelled into real financial business activities, thus entailing the appropriate due diligence. It is worth noting that the assetbacked financing principal has widely contributed to insulating the Islamic financial system from the risks associated with excessive financial leveraging and speculative activities that have characterized the recent crisis. 2.1.2. The Three Main Prohibitions in Islamic Finance: the Prohibition of Riba (interest), Gharar (uncertainty) and Maysir (gambling) Islamic finance does not deny that the transfers of credit and risk are at the heart of finance, without which an economic system cannot function. However, it is wise to state that these two vehicles are a double-edged sword. Although they can be used judiciously to reduce risk and enhance welfare, they can easily entice otherwise cautious individuals to engage in ruinous gambling behaviour, such as what we have seen with the current financial crisis. According to El-Gamal, the two main prohibitions of Riba as well as Gharar and its subsequent Maysir, in Islamic law, are best characterized as trading in unbundled credit and trading in unbundled risk, respectively. In this respect, Islamic jurisprudence uses those two prohibitions to allow only for the appropriate measure of permissibility of transferring credit and risk to achieve economic ends. Moreover, while financial secular regulators seek to limit the scope of credit and risk trading to prevent systemic failures, Islamic law provides injunctions that also aim to protect individuals from their own greed and the potentially addictive nature of living beyond one’s mean or addictive behaviour of gambling and corrupting intelligently.

5

The Islamic financing mode will be discussed in the next section, pointing out this prominent feature and how in spite of the fact that such financing modes as Murabaha and Leasing are not believed to be ideal they remain a real guarantee to keeping the two economic spheres synchronized.

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2.1.2.1. The Prohibition of Riba (Interest) or Trading in Credit One of the main features of the Islamic financial system is the prohibition of the payment and receipt of Riba, which refers to any conditional increase in the principal of a loan or a debt in return for deferred payment. Generally, Riba includes all gains from loans and debts and anything over or above the principal of loans and debts, and covers all forms of interest on conventional commercial or personal loans. This does not mean by any means that Islamic finance does not recognize that time has a strong influence on economic activity and decisions. In fact, the juristic consensus permits the possibility of increasing the item’s price for deferred payment in the case of sale contract. However, the Islamic perception of the role of time differs from sale contract to loan or debt contract. This dual perception of time in financial transactions governed by Islamic law seems contrary to the uniform treatment of time in conventional finance that considers an instalment sale as a dual operation of sale-cum-loan. 2.1.2.1.1. The Concept of Time in Islam In this regard, it is worthwhile to enlighten this different dual time perception and point out the rationale behind it. On one hand, Islamic Law establishes the legitimacy of price increase in credit sale dealing by admitting that time has a value and recognizes the innate human preference of what is in hand to what is loaned and immediate to the deferred. In this respect, the justification of increasing price when payment is deferred is that the intervening time between passing on commodity and receiving its price involves possibilities of opportunity benefits which are waived in the interest of the buyer. Furthermore, the credit sale does not involve a contract or agreement to pay an equivalent to time as in the case of the credit loan. It is rather a contract to sell a commodity where time is observed as a factor in fixing the price. Here, time is dependent on the commodity and its presence contributes to the determination of the price, but is not, in itself, paid for. The equation in such a sale consists of a commodity tied to a time frame and a price which includes an element to compensate for time and that cannot be perceived as unjust as the dealing, concluded by mutual consent. On the other hand, Islamic law bans dealing with Riba in the case of a loan contract. It is clear to see that the interdiction holds to the unproductive aspect of lending money for itself and adds an interest factor to it. Money, in Islam, is by no means a commodity and ought mainly to serve a productive means, the lender having to participate in the profit/losses from the money injection for a particular investment.

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(2.275) "Those who eat Riba (usury) will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan (Satan) leading him to insanity. That is because they say, "Trading is only like Riba or usury, whereas Allah has permitted sales and forbidden Riba. So whosoever receives an admonition from his Lord and stops eating Riba shall not be punished for the past; his case is for Allah (to judge): but whoever returns to Riba, are dwellers of the Fire - they will abide therein.” From the above verse, we can touch the severity of the sin of Riba and to what extent Muslims are instructed by the Holy Qur’an to shun it. At the same time, however, they are encouraged by the Holy Qur’an to pursue trade. Furthermore, the word Riba, meaning “prohibited gain,” is explained in the Holy Qur’an by juxtaposing it against (profit form) sale. It explains that all income and earnings can be categorized either as profit from trade and business along with its liability or return on cash or a converted form of cash without bearing liability in term of the result of deployed cash or capital. The former kind of return is permitted and well encouraged in the Islamic financial framework and the latter is severely prohibited. 2.1.2.1.2. Rationale behind Interest Rate Prohibition 2.1.2.1.2.1. Ethical and Religious View The rationale behind the ban of the interest is well clarified by Al-Razi in his exegesis of the Qur’an, considering Riba as a cause of injustice that consists in the unbalanced equation linked to the interest-based loan: the increase, on one hand, and the opportunity cost, on the other. The variance in certitude between the interest over the principal which is certain and its amount is known, and the yield resulting from investing the loan by the creditor, who is not sure it will materialize or its amount is not certain in advance constituting the essence of the injustice of imposing interest on loans. Justice requires that the provider of money capital should share the risk with the entrepreneur. Thus, there is a basic difference between principals of the Islamic economic system and the conventional one in regard to the treatment of money capital as a factor of production. Whereas in the conventional system, money is treated on a par with labour and land, each being entitled to return irrespective of profit or loss, this is not so in the Islamic system which treats money capital on a par with enterprise. Hence the interest of highlighting, in the next section, the prominent feature of loss profit sharing that distinguishes the Islamic financial system from the conventional one.

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Moreover, the prohibition of Riba aims to substantively protect individuals from getting excessively indebted and overwhelmed by interest payment, as well as paying for receipt or the extension of credit. Compared to the conventional regulators who also strive to prevent individuals from borrowing excessive amounts, or falling prey to unfair predatory lending, they care primarily about the general health of the financial system, and their concern about the financial health of specific individuals is secondary at best. Furthermore, this aim is among the interests of conventional bankers who work primarily for financial corporations that care little about systemic or individual financial health and care mostly about their own profitability. Thus, they generally permit customers to borrow excessively if the expected rate of repayment remains sufficiently high to ensure profitability. As a whole, socio-economic and distributive justices as well as intergenerational equity are considered the basis of prohibition under Islamic law. Al-Razi states that the illegality of Riba is proved by the text of Holy Qur’an, the real wisdom from the prohibition of Riba is known to God and we only apply our minds to deduce this Historically, interest was opposed on the grounds of the social divisions it creates. The Old Testament recommended loans without interest. Lending on interest is blame-worthy action and is often equated with the exploitation of those in need. According to Dar & Presley (1999), Judaea-Christianity recognizes economic brotherhood and the sharing of risks. Christianity teaches to “love thine enemies,” which is compliant with the prohibition of interest. Brunner (1937) regarded interest as encouraging a “parasitical existence” literature. Aristotle considered money as only a medium of exchange and not a store of value, as seen by Western literature. 2.1.2.1.2.2. On the Theory of Interest While the original basis of the prohibition of interest was divine authority, Muslim economists and scholars have recently emphasized the lack of theory to justify interest. Existing theories of interest are attempts to rationalize an institution deeply entrenched in modern economies and brought out through a study of several theories of interest developed since Adam Smith of which there has been no satisfactory explanation of the fixed and predetermined rate of return. He stated that: … leaving out some notable exceptions, like Bohm Bawerk’s Capital and Interest, significant parts of Keynes’ General Theory and parts of Harrod, Hawtey and Kurihara, questioning the validity of interest, bulk of the effort of economics has been to justify it, yet not a single argument

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advanced in favour of this institution has a leg to stand on. All theories of interest evolved till the time of Bohm Bawerk, including those resting on productivity, abstinence and demand and supply concepts, were unanswerably repudiated by him. Yet economics continues whipping these dead horses, without evolving any persuasive answers to his criticism. In this respect, Muslim economists consider three main arguments in response to the typical justification for interest in conventional finance. Table 1.2 below presents the opposing arguments. Western economists who had questioned the validity of interest and its consequences on economy and financial system held a reasonably strong conviction that a fixed and predetermined rate of interest constitutes a hurdle to economic development and financial instability. They shed light on the strong relationship between interest rates and the instability of economy through the inflation, unemployment, negative growth and blamed interest rates and associated bank credit expansions and contractions for many of the economic issues. A bulk effort attempted to explain cyclical fluctuations in terms of a divergence between the natural and the market rate of interest. The difference between market and natural interest rates is that the former is determined by monetary forces in loanable funds market, e.g. money supply growth and bank credit creation, and the latter is determined by the profitability of investment and could be associated with profit rate at the microeconomic level. If market and natural rates of interest do not coincide over time, some claim that cyclical fluctuation must result. Keynes (1931) criticized the role of interest rates and bank credit in cyclical process and emphasised the role of interest rates in promoting economic instability.

Introduction to Islamic Finance and Islamic Banking

Justification for interest Interest is a reward for saving

Interest is considered as marginal productivity of capital

Interest is the time-value of money

Interest is a reward to cost opportunity

Justification against interest Such a reward could only be rationalized if savings were used for investment and to create a real additional value. Abstention from consumption is not entitled to a return. Interest per se has no relation with the productivity of capital. Interest is paid as a charge for the use on money and not as a yield from the investment of capital. Money is not capital. Money is potential capital needed to be invested. To transform money into capital requires the application of enterprise, that is risk taking and the knowledge required to bring factors of production together to create profit (or loss). Even if the basis for time preference is the difference between the value of commodities this year and the next, it seems more reasonable to allow next year’s economic conditions to determine the extent of the reward. As for the modern capital-holder, who has their capital deposited in a bank, money is available to them anytime they want. Lost opportunity is an illusory argument. Not only did they not lose any opportunity, their money was earning interest even when they had no opportunities. Moneylenders such as banks are generally not businessmen on the lookout for business opportunities that involve risk. The argument of opportunity cost is an unreal argument.

Table 1.2. Opposing arguments regarding interest rates and Money

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2.1.2.2. The Prohibition of Gharar and Maysir, or Trading in Risk 2.1.2.2.1. The Prohibition of Gharar (Uncertainty) A second feature that is banned and severely condemned by Islamic law is economic dealings entailed uncertainty or Gharar. The latter includes ambiguity about the end result of a contract and the nature, quality and specification of the subject matter of the contract or the rights and obligations of the parties, possession and delivery of the item of exchange. Generally, it relates to uncertainty in the basic element of any agreement. The prohibition of Gharar in Islamic economic transactions promotes business ethics and enforces justice among participants dealings, limits deception and leaves no space for speculation and asymmetry of information that contribute to the lack of confidence as well as to the deterioration of moral values, elements that were noticed during the current financial crisis. The injustice that underpins such prohibited transaction comes from the fact that the latter may lead one side to impose a burden on another or may cause a vendor to erode the property of others unlawfully. Although Islamic law strongly denies the uncertainty related to the essential pillars of contract, it accepts its presence in some cases. In fact, scholars distinguish between excessive uncertainty that invalidates contracts and minor uncertainty, which is tolerated as a necessary evil. A canonical example to the latter situation is the Sharia law acceptance of the Salam and Istisna’a contract (prepaid forward sale), wherein the object of sale does not exist at contract inception, but since the contract allows for the financing of agricultural and industrial activities that cannot be financed otherwise, it is allowed despite this Gharar. 2.1.2.2.2. The Prohibition of Maysir (Gambling) The rationale behind the prohibition of Gharar in Islam is by no means far from that for the forbidding of Maysir or gambling, as the former was often characterized by prominent scholars in the light of its similarity to gambling. In this respect, the forbidden trading in risk is defined as the sale of probable items whose existence or characteristics are not certain, the risky nature of which makes the transaction akin to gambling. In fact, the latter is a form of Gharar because the gambler is ignorant of the result of the gamble. A person puts their money at stake wherein the amount being risked may bring huge sums of money or may be lost (5.90–91) In this regard, the Prohibition of Maysir or gambling constitutes another major principals of the Islamic Finance, as it is explicitly stated in the Holy Qur’an: “O ye who believe! Wine and

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gambling, (dedication of) stones, and (divination by) arrows, are an abomination, of Satan's handwork: eschew such (abomination), that ye may prosper.” It uses the word Maysir for games of hazard, derived from Usr (ease and convenience), implying that the gambler strives to amass wealth without eơort, and the term is now applied generally to all gambling activities. In Islamic jurisprudence, all kinds of gambling are strongly banned, from explicit forms of gambling to any business activities entailing any element of gambling, such as the conventional insurance contracts in which the uncertainty element is persistent, as well as futures and options contracts that are settled price differences only covered under gambling. In this regard, it is worth noting the alternative given by Islamic finance to conventional insurance. This alternative is Takaful, which means guaranteeing each other. The takaful system embodies the element of shared responsibility, common benefit and mutual solidarity as well as avoiding the prohibited uncertainty in respect of rights and liabilities of the economic parties In practice, every policyholder pays their subscription or premium, considered as a donation or Tabarru, in order to assist those who need it. The collected premiums constitute the Takaful fund from which any damage giving rise to claim is covered. Indeed, at the end of each financial year, after the deduction of expenses, the remaining cash surplus will be returned to the policyholders in the form of dividends. In this respect, the conception of Islamic insurance is far from the conventional one in which the policyholders, rather than the shareholders, benefit from the surplus generated from the business and investment assets. 2.1.3. The Screening of Sector Activities All activities in Islamic finance are permitted except those specifically forbidden by Sharia due to their harmful and destructive implications. The most fundamental pillar of this evolving but extensive industry is the concept of Sharia-compliance. This dictates that the financial approach of Muslims should be governed by two major sets of rules. Firstly, unlike conventional finance, Muslims are strictly prohibited from investing in or dealing with economic activities that involve interest, uncertainty and speculation, regardless of their form or shape or the pretexts often used to justify them. Furthermore, Muslims are not only discouraged but forbidden from investing in businesses engaged in illicit activities, such as the production and the distribution of goods and services that stand against

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the tenets of the Islamic value system such as alcohol beverages, porkrelated products, drugs, gambling, conventional insurance and banking, war industry and indecent entertainment.

2.2. Mutuality of Risk Sharing 2.2.1. The Principal of Profit and Loss Sharing This is also the essence of the principle of no profit sharing without risk sharing al-ghunm bi-‘l-ghurm6 (“no pain no gain”), and the earning profit is legitimized only by engaging in an economic venture and thereby contributing to the economic development. In this regard, the assumption of business risk is a precondition for the validity of entitlement to any profit over the principal. Profit has to be earned by sharing risk and reward of ownership through the pricing of goods, services or usufruct of goods. Investment in the Islamic context is not merely a financial or monetary transaction in which transfer of funds is the only activity. Investment is considered only if it is a part of real activity or is itself a real activity. This is because money has the potential for growth when it joins hands with entrepreneurship. It is not recognized as capital and therefore it cannot earn a return. The principle of fairness is also reflected in the risk and profit-sharing characteristics of Islamic financial transactions. This requirement must be clearly defined at the onset, and serves as an additional in-built mechanism that promotes the adoption of sound risk management practices by Islamic financial institutions. In particular, these features demand the exercise of appropriate due diligence and higher standards of disclosure and transparency to be observed by the Islamic financial institution, which in turn enforces market discipline and minimizes informational asymmetries. Terms and conditions need to be honestly and clearly laid out; ambiguity based on future events cannot be part of Islamic transactions to avoid potential conflicts in future.7 Thanks to this mechanism, Islamic banks are more involved in financed project profitability than conventional banks. The latter focus mainly on receiving interest payments as its profitability is directly linked to this payment. However, Islamic banks are concerned about the real rate of return and focus in the long term in their relationships with their clients. This partnership engagement obliged the Islamic bank to oversee and monitor projects as closely as possible. 6 7

A Shariah maxim. Financial Stability and Payment Systems Report 2007.

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2.2.2. Business Ethics of Islamic Finance Islamic Finance is a model "based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing." 2.2.2.1. Social Sphere Kamla et al. (2009) argue that the philosophical reasoning underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The holy Qur’an and the Sunna refer to a number of norms and principals which govern the rights and obligations of parties to the contracts. Principles enunciating justice, mutual help, free consent and honesty on the part of the parties to a contract, transparency, fraud avoidance, mispresentation and misstatement and negation of injustice or exploitation provide grounds for actual sound governance. Indeed, the ultimate aim of Islamic law is to spread socio-economic justice amongst all people regardless of their whereabouts. Sharia-compliant debt financing and equity mode proposes a comprehensive moral guideline for dealing with money. Creating money, therefore, has to be in line with the prospects of real growth in the economy in order to provide a sustainable development and more equitable distribution of wealth. Furthermore, it is worth noting that each of the Islamic finance principals demand the real exercise of appropriate due diligence by Islamic financial institutions and economic agents along with higher norms of disclosure and transparency which could enforce market discipline and mitigate informational asymmetry. Collectively, these intrinsic features of Islamic finance act as natural stabilizers and restraints against the risks and excesses associated with excessive leverage, financial speculation and mis-selling that can threaten the effective functioning of financial systems. The Zakat System—Income Redistribution Mechanism in Islam According to the Holy Qur’an, God owns all wealth, and private property is seen as trust from God. Property has a social function in Islam and must be used for the benefit of society. Moreover, there is a divine duty to work. Social justice is the result of organizing society on Islamic social and legal precepts, including employment of productive labour and equal opportunities, such that everyone can use all of their abilities in work and gain just rewards from that work eơort. Justice and equality in Islam means that people should have equal opportunity and does not imply that they should be equal either in poverty or riches (Chapra 1985).

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However, it is incumbent on the Islamic state to guarantee a subsistence level to its citizens in the form of a minimum level of food, clothing, shelter, medical care and education (Holy Qur’an 58, 11). The major purpose here is to moderate social variances in Islamic society and to enable the poor to lead a normal, spiritual and material life in dignity and contentment.8 A mechanism for the redistribution of income and wealth is inherent in Islam so that every Muslim is guaranteed a fair standard of living (nisab). Zakat is the most important instrument for the redistribution of wealth. This almsgiving is a compulsory levy, and constitutes one of the five basic tenets of Islam. The generally accepted amount of Zakat is a one-fortieth (2.5%) assessment on assets held for a full year (after a small initial exclusion), the purpose of which is to transfer income from the wealthy to the needy. 2.2.2.2. Environmental Sphere In this regard, Al-Qaradawi9 (2000) elucidates that safeguarding, protecting and caring for the environment scarcely constitutes a new Western concept; rather, such concerns are deeply rooted in all fields of Islamic value. Furthermore, Islamic law has enunciated a set of principles that provide a basic framework for the conduct of economic activities in general, and financial and commercial dealings in particular. The most salient values of Islamic finance are fairness, socio-economic justice and its uncompromising commitment towards the well-being of future generations through caring for the environment and preserving earth's valuable resources. 10

8

Handbook Islamic banking (2007). Al-Qaradawi, Y. (2000). “Safeguarding the environment in Islamic Shariah”. AlKhaleej. 10 For further details, see Kamla et al. (2009) “Islam, nature and accounting: Islamic principles and the notion of accounting for the environment” point out that such concerns for the environment are deeply rooted in all fields of Islamic teaching and culture. 9

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2.3. The Added Value of Islamic Finance Principles to the Financial System 2.3.1. The Inherent Stability of Islamic Finance: Controlling Excessive Credit and Risk Trading in the System and Enhancing Real Economic Sphere Over investment is important but would have far less serious results if it was financed by equity, as opposed to financing from borrowed money and leverage. Easy money that usually causes over indebtedness followed by deflation is one of the main factors of financial instability. Friedman et al. (1963) considered that faster money expansion resulting from unchecked credit expansion is the dominant cause of financial instability. Some authors prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with economic growth. Through the expansion of money and credit supported by financial deregulation, speculation gathers speed and reinforces financial crisis. Moreover, unbacked credit expansion and money creation is conceived to be one of the main factors responsible for financial instability. Financial instability emerges when there are not sufficient real savings to support lending. These main factors are found to cause financial instability and are exactly the contrary of what distinguishes Islamic finance. Islamic finance fosters equity-based financing and investing instruments and enhances profit- and risk-sharing mechanisms. Islamic finance prohibits interest as well as speculation and promotes an important aspect often missing in conventional finance, which is asset backing. Maurice Allais held the view of the inevitability of the current structural global economic crisis and warned against its consequences. He considered structural reforms that go far beyond addressing the symptoms of the crises by devising an efficient monetary system, capable of preventing such crises from happening in the future as the unique solution. The two basic components at the heart of the proposed system are adjusting the rate of interest to 0% and revising the tax rate to about 2%. Incidentally, these are the core elements of Islamic economics. Islam prohibits interest (Riba) and requires all Muslims who possess minimum net worth above their basic needs (Nisab) to pay Zakat (2.5% of their assets a year). Zakat is a major economic instrument premeditated to spread socio-economic justice amongst Muslims. Unsurprisingly, the US Federal Reserve announced the cut in lending rate to be between 0 and

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0.0025%, and the demand for meaningful tax cuts has also been building up.11 Khan (1987) investigated the stability of Islamic banking in comparison to the conventional system based on a mathematical approach and found that the Islamic system may turn out to better suit for adjusting to shocks that result in banking crises and disruption of the payments mechanism. The authors compared the application of the balance sheet characteristics of Islamic PLS banks with traditional banks. The balance sheet of the Islamic bank has no fixed liabilities and deposits are considered as shares. Any shock on the asset’s side would automatically be absorbed and adjusted on the liability side. This can lead to stability in Islamic banks. However, in conventional banks, when a crisis arises on the asset’s side the banks turn to liability management and this leads to instability. Bankruptcy is less likely to happen in Islamic banks, because PLS and mark-up operations are based on the solvency and trustee of partners. In the Islamic financial system, the term and structure of the assets and liabilities of the financial intermediary, as we will bring out the latter in the section which deals with Islamic banking, are closely matched through the profit sharing system and hence Islamic finance offers a “pass through” of risk to investors and depositors. On the microeconomic level, all Islamic modes of trade financing are asset-backed and thus involve money on the one hand and goods or services on the other. Monetary flows would have to be tied directly to commodity flows. Changes in spending would be reflected in the supply and demand of goods and services, causing the quantities of output produced to respond more quickly to market forces. Islamic finance removes the dichotomy between financial and real activities. 2.3.2. Resource Allocation Efficiency In this regard, Friedman (1969) conceived zero nominal interest as a necessary condition to achieve optimal allocation of resources. In general equilibrium models, a zero interest rate is both necessary and sufficient for allocative efficiency. Instead of proposing an institutional monetary policy based on steady deflation, Islamic finance propose an alternative restructuring based on replacing interest rate with rate of profit and risk sharing framework through the profit and loss sharing mechanism. In fact, the cornerstone of the Islamic financial system is that any financial development should cause investment alternatives to be compared to one another, based only 11

Hassan (1998).

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on their productivity and rates of return. Such a condition is bound to produce improved allocation. 2.3.3. Velocity of Money in Islamic banking Introducing interest-free banking in Iran and Pakistan in the last two decades has improved or at least did not hamper their overall macroeconomic performance. These structural changes have led to a smoother behaviour of money velocity, have provided policymakers with a more controllable monetary environment and strengthened the linkage between policy instruments and the main policy goal of price stability.

Section 3: Islamic Financial Contracts and Products The application of the different Sharia principles seen above, which are prominent features in Islamic finance, has contributed to the emergence of a panoply of Islamic financial products and instruments. These latter are developed by applying or combining the appropriate Islamic financial contracts to cater to the financial needs of the investors and consumers. The range of Islamic financial products has broadened considerably in recent years thanks to financial engineering; however, much more effort is needed in this way. The Islamic economic system has a set of basic and core contracts which constitute pillars for designing more sophisticated financial products. Sharia-compliant contracts have to obey the bans on Riba, Gharar, Maysir, illicit activities and ignorance. For the sake of responding to the more diverse and differentiated requirements of investors and clients, Islamic financial institutions have developed three kinds of Islamic financial instruments—derivative-based instruments, securitized-based instruments and structured-based instruments—by utilizing the set of basic Sharia-compliant contracts. This section deals firstly with the set of core and basic contracts which are deemed legal and lawful by the Sharia as they are free from any prohibitions detailed above. Further attention will be paid to intermediation contracts in order to well understand how the function of intermediation is performed mainly by Islamic banking and to point out the nature of Islamic financial intermediation and its importance in designing the landscape of the Islamic financial system. As far as the critical role of the capital market in promoting an efficient financial system and enhancing the development of the financial intermediation by improving the resource allocation, providing liquidity and diversified investment opportunities, is considered, the second subsection focuses on

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the main developed and implemented securitized and derivative Shariacompliant financial instruments and sheds light on the main features of Islamic equity-based securities. Islamic financial contracts can be subdivided into four categories: transactional contracts, intermediation contracts, financing contracts and social welfare contracts. Transactional contracts concern transactions that deal with exchange and trading in goods and services and deals mainly with terms linked to the subject of the transaction or the underlying asset as well as to the delivery mode. The financing contracts include contracts which seek to define the terms relating to payment and financing mode of economic activities. The intermediation contracts promote the efficient and transparent execution of these transactional and financing contracts. The Islamic intermediation contracts offer a regulatory framework to propose fee-based service contracts based on the concept of trust and security, partnership-based contracts and takaful or insurance-based contracts. The social welfare contracts include gratuitous loans (Qard Hasan). Qard Hasan is an interest free loan and a kind of gratuitous loan given to the needy people for a fixed period without requiring the payment of interest or profit. The receiver of Qard Hasan is only required to repay the original amount of the loan. These contracts aim to promote the wellbeing of people in need. The institutionalizing of welfare contracts could be developed by intermediary institutions.

Introductioon to Islamic Fiinance and Islam mic Banking

3.11. The contrract Framew work in Islam mic Financee 3.1.1. Threee Kinds of Baasic Contract 3.1.1.1. Traansactional Contracts

Fig. 1.3 Trannsactional contrracts Source: Author’s contributioon

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Future Transactional Contract We can distinguish two transactional contracts where the general condition under which the existence of the object of the contract is required to validate the latter, infringed in order to finance some activities as agriculture or industry that cannot be financed otherwise: Bay Salam or advanced purchase is an ancient form of forward sale contract wherein the full price was paid in advance at the time of making the contract for prescribed goods to be delivered later. Salam has been permitted by the Sunna. The rationale for this permission is the concept of genuine need as clarified by Zaman (1991), both for the seller and the buyer. The basic difference between the bay Salam and the conventional forward is that in the former the payment of the full negotiated price is paid at the time of contract conclusion, which is not compulsory for the latter. Istisna’a or Purchase order is a sale contract where the sale of commodity is transacted before the commodity comes into existence. In other words, it is an agreement culminating in a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or construct anything to be delivered in the future. The Istisna’a contract has been legalized on the basis of the benefit analysis.12 It is very similar to the Salam contract as it shared with the latter the function of financing the production of non-existent items. However, it differs from Salam in a few points. Indeed, scholars did not require price in Istisna’a to be fully paid at contract inception to facilitate the financing of multistage manufacturing or construction projects, wherein the buyer may pay for each phase separately. Moreover, the term of deferment in an Istisna’a contract does not need to be fixed in the contract inception. Although the object of a Salam sale is a natural resource, the object of an Istisna’a contract is nonnatural and is required to be manufactured or constructed (a public or corporate infrastructure). Bay’al Muajjil (Deferred payment sale) refers to a sale contract wherein the payment is deferred in instalments or in a lump sum payment. Al-Mousawamah is a sale by mutual consent reached by negotiations between the seller and the buyer. No reference to the good’s original price is made. Therefore, the cost of the good and the profit made is not known by the buyer. At-Tawliyyah refers to the sale of goods at its real cost without any surplus. Al-Wadiah refers to the sale between two parties who agree to trade at a marked-down price. 12

Islamic Fiqh Council of the OIC, resolutions No.65.

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Ijara or leasing is a contract undeer which the rright to use is sold and not the undeerlying asset. The Ijara con ntract refers too hiring or ren nting any asset to benefit from its usufruct; u it alsso encompassses the hiring of labour and any conntract of work for anyone ag gainst a returnn. Furthermoree, Ijara is contract of a known annd proposed usufruct of specified assset for a specified peeriod against a specified an nd lawful returrn or considerration for the service, or return for the benefit prroposed to be taken, or for the effort or work propposed to be exxpended. Desspite the fact tthat the Islamiic leasing (Ijara) and conventionall leasing are alike in term ms of their financing function, thhere is some difference. In n fact, unlike conventionall leasing, Ijara entailss that the lessoor must be the owner of thhe leased objeect for the period of thee lease and haas the responsiibility of mainntenance. Hawalah h (Transfer of o debt) contrract refers to a debt transferr contract by which aan agent trannsfers a debt to a third pparty. Then, the t latter becomes thee sole interloccutor of the creditor. c This contract shou uld not in any way gennerate costs beeyond adminisstration fees. 3.1.1.2. Finaancing Contrracts

Figure 1.4. F Financing contrracts Source: Author’s contributioon

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The partnership financing contracts are a large range of financing or investing contracts in which two or more parties combine their financial and/or human capital to develop a new commercial project or participate in an existing business. Karich (2005) subdivides this range of contract into two types of partnership: Musharakah or capital partnership contract; with unequal capital contribution Al-Inan or equal capital contribution Al-Moufawada, characterized by a long- to medium-term and a high risk based on profit and loss sharing. The Musharakah contract entails that every partner enjoys equal rights in all respects and could participate actively in the affairs. The ratio of sharing profit should be predetermined and no fixed amount can be pre-agreed. The losses should be borne based on ratio of capital contribution. Upon this basic contract, Islamic financial intermediary has developed other forms of partnership to manage mobilized funds known as the consecutive Musharakah or to cater other financing needs such as housing finance. In order to provide housing or property mortgages, Musharakah Mutanaqisah or Diminishing Musharakah was developed. This contract is initially a Musharakah contract on property ownership between the financier and the person or the company in need. The special feature of this form of partnership contract is in the fact that the financier ownership will diminish over time as the second partner buys the financer ownership shares with each payment instalment until acquiring complete ownership. The former kind of Musharakah used to manage mobilized funds from depositors in Islamic bank named the consecutive Musharakah will be detailed in the next section when dealing with Islamic banking. Mudarabah (profit sharing) or capital and labour based partnership; this kind of partnership is actually a partnership in the profit rather than its capital. One party provides the financial capital; it is called the RabElmalior financer/investor. The other party provides its work; it is called the Mudharib or the entrepreneur who acts as an agent of the investor to invest the money based on his skill. Only the profits are shared between them at a predetermined ratio, any losses are exclusively borne by the lender. Before the activity starts, the user of funds is considered as trustee on the capital of the owner, and after activity starts he is considered as a proxy for the owner of capital. The two parties become partners. The capital should be in the form of money and must be well defined by its amount. It should also be delivered to the entrepreneur in full to enable him to trade freely with it. The Mudarabah contract is usually limited to a certain period of time at the end of which profits are distributed at a pre-agreed proportion. Profits stand as a guarantee for the capital, mean that profits are given to

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the entrepreneur only if they refund the total amount of principal. There are some activities that the entrepreneur is not allowed to do without the approval or permission from the owner of capital, e.g. to establish a new company or a new Mudarabah with others. To cancel the Mudarabah contract, the Sharia scholars see that it could be cancelled by any of the two partners at any time. Thus, capital should be liquidated. Many forms of Mudarabah contract exist: Mudarabah can be restricted or unrestricted. In restricted Mudarabah, the owner of capital specifies to the entrepreneur the type of commodity to use, and the time and place of trade. In this case, Mudarabah is similar to the Wakalah contract seen later. However, in unrestricted Mudarabah, the user of funds is free in their choice of circumstance of trade. Non-contractual Mudarabah (Mudarabah Mutlaq) and contractual Mudarabah (Mudarabah Muqaiadah) Single Mudarabah (there is one entrepreneur and one financier) or compound Mudarabah (there are more than a Mudharib [entrepreneur] and more than a provider of funds) Limited-term Mudarabah where profits are accounted for at the time the work is terminated, or continuous Mudarabah where profits are accounted for on a periodical basis. Commingled Mudarabah in which there are two providers of funds Mudharib and a financier, but only the Mudharib can participate in the work, or non-commingled Mudarabah in which there is only one financier. The Debt Based Financing Contract Murabaha refers to a sale financing contract wherein the subject of the contract is sold at a price which includes a profit margin as agreed by both parties. Such a sales contract is valid on the condition that the price, other costs and the profit margin of the seller are stated at the time of the agreement of sale. With a short-term and low-risk, this contract has become a common financial product offered by the majority of financial institutions to cater to the ascending consumer’s or investor’s need of financing. It involves a profit mark-up. The latter, in practice, can consist of remuneration for the service and administration cost, the credit risk and the use of the financed commodity. Compensation for inflation is also charged. This kind of transaction contract is often used as an alternative to the interest debt granting by conventional banks. It guarantees, first of all, the asset-based principal of Islamic finance and thus the financing of real economy. The Murabaha transaction involves three parties in practice: the financier, the seller and the entity in need. The transaction takes place over four phases. The first step is a need expression, wherein the financier or

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the bank’s client details their request in terms of product quality, quantity and quoted price to be purchased by the Islamic bank. The next step involves a spot-sale contract between the bank and the vendor and thus the bank becomes the owner of the product. Before the bank purchases the product required by the client, it reaches an agreement with them on the resale price and delivery terms. The resale price is composed of two elements: the original price paid by the bank plus a profit or a mark-up to be agreed upon between the bank and the client. Generally, the customer is responsible for the product’s delivery and storage, although the product is still under the ownership of the bank. The last step involves a Murabaha contract between the client and the bank which is a credit sale contract in instalments or lump sum payment where the two compounds of the resale price, the original cost and the mark-up are precisely indicated. The ownership transfer from the bank to the client is thanks to this contract. Bay’ Bithamanin Ajil contract is a well-used contract in Malaysia in trade financing. It is similar to the Murabaha contract as the payment is made after the delivery and in instalments. However, the BBA contract is usually used in long-term financing and the profit margin is not usually communicated to the buyer.

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3.1.1.3. Inteermediation contracts c

Fig. 1.5 Inteermediation conntracts Source: Author’s contributioon

Partnership p Intermediattion Contracts As far ass the basic feaatures of the partnership p coontracts detaileed above, we will focuus mainly on a special form m of partnership ip contracts in nvolved in Islamic finaancial intermeediation in orrder to organnize relations between clients and iintermediariess. The Coonsecutive Musharakah M contract iss a special type of partnership contract useed by the Isslamic bank and upon which w the depositors aare not considdered as debto or like a convventional bank k but as a partner in thhe bank’s proofits during a full financiaal year, regarrdless the usage of thheir funds. The T depositors’ profits aree computed upon u the accrued procceeds and the period of dep posits. The Mu udarabah coontract is the cornerstonee of modern n Islamic financial inttermediation. This contracct distinguishhes the relatio onship of depositors aand the Islamiic bank from the t conventioonal one. Baseed on this

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contract, the funds of the depositors, especially those deposited in an investment account, will be invested by Islamic banks thanks to its expertise in Sharia-compliant investment, both in financial markets and identifying profitable projects. The contract is usually limited to a certain period of time at the end of which profits are shared based on a predetermined profit sharing ratio. Any losses are borne only by depositors provided they are not due to bank negligence and professional error. Trust Contracts The Wikalah contract (representation or agency) refers to a contract that gives to the Wakil (mandatory) the right to act on behalf of the principal and the power to perform certain tasks according to principal instructions. This contract is widely used in Islamic financial intermediary such as in Islamic banking, the brokerage and asset management institutions. The Wakalah contract is used as an alternative to Mudarabah contract when the principal would limit the freedom of the mandatory to the given instructions. Despite the fact that Mudarabah and Wikalah are both principal agent contracts, the Mudarabah contract gives the agent the full control and freedom to invest the principal funds based on their expertise which constitute the main difference between the two contracts. The Wakalah contract may generate cost beyond the administration fees. The Amanah contract involves the custody and safekeeping of someone’s property. This contract is widely used in Islamic financial intermediation. Based on this contract, the Islamic bank’s depositors deposit their funds in special account in order to safe keep them. The bank has no right to use these funds in any way which constitutes the basic difference between the Amanah and the Wadia contract. The Wadia contract is a contract of safekeeping wherein the first party deposits money or goods in the second party’s hands as a trust. The latter is liable to compensate any loss if the contract involves service fees. Upon the owner agreement, the trustee could utilize the trust in a different manner (pledge, lend) and must return it upon the owner’s demand. The Jawala contract refers to an agreement wherein one party undertakes to pay a predetermined commission or to offer specified compensation to the second party able to realize a specific service or uncertain required result. The Jawala is a relevant and useful contract to offer advisory, asset management, consulting and trust services as well as a large scope of feeearning financial services. The Jawala contract may be used by Islamic banks for the recovery of overdue debts and where the entitlement to compensation is contingent upon collection of defaulted debts. The Jawala contract may also be used by a financial intermediary to

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offer custodial services for customers in the securities market. This contract offers a large scope of innovative financial products and structures by opening up several fee based financial services. Security Contract The Kafalah (Suretyship) is a contract by which a third party guarantees the debt of the actual debtor. The debt responsibility is vis-à-vis the creditor incumbent to the two counterparties. The Rahn (Pledge) is a contract wherein the lender takes an asset as collateral to make sure that the borrower will repay back the debt. Takaful Contract This kind of contract is used in Islamic insurance companies, more commonly known as takaful or mutual guarantee companies. These are contractual saving institutions that mobilize funds through a Mudarabah or Wakalah contract based on a variety of takaful policies. The funds mobilized, in turn, are invested in Sharia-compliant avenues. 3.1.2. On Critics of Debt Similar to Islamic Financing Contracts We can highlight through the previous development on Islamic contracts, that although Islamic finance is considered equity or partnership finance structured through profit and loss sharing and risk sharing, thanks to the two widely developed financial instruments of Musharakah and Mudarabah, debt has to remain a part of Islamic finance. The Islamic debt-financing, structured through contemporaneous underlying contracts of exchange such as sale and purchase contracts, creates debt that is genuinely backed to real asset, as opposed to a mere debt system in conventional finance. It is worth stating that the two further financing contracts, Murabaha and Ijara, have sometimes been criticized on the grounds that their net result is often the same as that of interest-based borrowing. This criticism is justified to some extent. In fact, in the absence of a suitable profit-rate benchmark, compatible with the principles of the Islamic financial system, Islamic banks have often resorted to the use of interest-based benchmarks such as LIBOR and conventional profitability theories in order to determine mark up rates and returns in advance (Homoud 1980; Haron et al. 1993, 1994). Such reliance on conventional instruments is due to the shortage in Sharia-compliant financial engineering and the poor record in financial research and development in Islamic banks. Sharia Scholars are unanimous on the point that Murabaha and Ijara contracts are not ideal modes of financing and that they should

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be used only in case of need in some sector where partnership-based finance is not workable for many reasons. Therefore, scholars have to guarantee sound measures to control the use of these instruments to reach both the form and the substance of Islamic law.

3.2. From Basic Financial Instruments to Structured, Securitized and Derivative Instruments These different kinds of Islamic contract have been used innovatively in structuring various Islamic financial and deposit products for banking, project finance, capital market and insurance sectors. Indeed, Islamic financial products have progressed and grown in sophistication, as can be seen from the offering of a wider range of products with various product structures, multiple categories of service providers and a different mix of consumer composition. Islamic banking products have evolved from basic contracts into a full range of deposit and investing product offers under various Islamic contracts. The range of Islamic financial products has diversified to include structured financing products, securitized equity and asset-backed land – based, as well as derivative-based instrument as hedging instruments. In order to cater to the different kinds of Sharia-compliant financing, demand ranging from the short term to the long term and from the cash demand to the financing of huge projects, innovative structured financing products have been developed in this respect. Although Islamic capital markets are at a rather early stage of growth, the development of Sharia-compliant securitized and derivative financial products has largely contributed to the improvement of the risk management ability of the Islamic financial institutions. For Islamic financial institutions, a financial engineering challenge is to introduce new Sharia-compliant products that develop much needed money and capital markets and enhance liquidity, risk management, and portfolio diversification (Iqbal 2001). In its early days, financial engineering was limited to the development of a product for Islamic banking, but with the development of the capital market the focus of product innovation has shifted more towards the development of marketable securities such as Sharia-compliant bond or Sukuk, stocks, funds, equity indexes and derivatives.

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3.2.1. Islamic Financing Structured Products 3.2.1.1. Debt Financing Structured Products These products are grey areas since they are considered the most important disputed financial instruments among scholars. These products are seen as a case of legal stratagem to circumvent the payment of interest. Chapra (2007) argued that such instruments differ from the conventional as Islamic finance debts are not created by borrowing and lending money, but as by-products of real transactions, and Gharar is not involved as the debtor is often a well-known company with a high credit rate. However, when focusing on the main cause of the recent financial crisis we understand the real danger of such trading. According to Chapra, these products would improve the Islamic secondary market which would give banks the opportunities for liquidity management and securitization. Basically, we can distinguish two main debt financing structured products: Tawarruq refers to a structured financing transaction of borrowing cash by undertaking two separate transactions. The first transaction involves a basic Murabaha or Bay’ Bithamanin Ajil contract between two parties: the Islamic bank and the client. The second transaction involves a spot sale contract of the same product subject of the Murabaha contract to a third party, for instance a bank. The two transactions are formally Sharia compliant, but in substance they are deemed not compliant by a few scholars as it is alike the creation of a zero coupon loan where the interest rate is the same at which the original seller might be charging to defer the payment. The scholars permit such a product on the grounds of darura, or necessity. For the sake of managing their liquidity, Islamic bank resort to Tawarruq and for large transactions use metal as the underlying asset trade in the London Metal exchange market. Bay Inah is the same as the Tawarruq as it entails the same two transactions. However, the unique difference is that the third party is the same as the first, which means that the first seller who sold the product on credit to the second party in need of cash repurchases it. Although this transaction is widely used in Malaysia and accepted by Malaysian and south-east Asian Scholars, it is deemed unlawful by gulf scholars. It is worth noting that Sharia scholars have considered this structure in compliance with Islamic law in case the difference in time between the entry into the first sale transaction and the second is one year minimum.

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Fig. 1.6 Bayy Inah

3.2.1.2. Islaamic Project Financing F Strructured Solu utions The devvelopment of innovative, Sharia-complliant project financing structures haas been amonngst the first preoccupation p ns in the industry, as it allows Islam mic finance to be as comp petitive as coonventional finance fi in response to project financcing requirem ments. The groowth demand mainly m in the rich economies of the GCC to finance critiical infrastruccture has enhanced innnovation in Sharia-compliaant project finaance. The inv volvement of Islamic fiinance in this field goes baccks to 1995 w with the co-financing of the Hub Rivver Power Prooject13 in Pakiistan. In 1996 , the Islamic financing tranche project, providingg finances to the $2 billionn petrochemicaal project in Kuwait, rreached 10%. The engagem ment of Islamiic financial in nstitutions in project fi finance has beeen increasing g and their trranches have grown to gain 100% in many laarge critical projects, succh as the Greenfield G petrochemiccal project for the Al-Wah ha company. The kind of structure used to finnance projectss depends on n the industrry, the projecct phase, whether it iss single- or muulti-sourced and a whether it is a new project or the extension off an existing one. Two baasic Islamic ccontracts, the Istisna’a

13

The Projecct Finance Inteernational magaazine has consiidered this projject as the deal of the yeear as it was co--financed by Isllamic and conveentional sourcees.

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and the Ijarah, constitute the current pillars of different project financing structures. Istisna’a and Forward Ijarah Structure In order to mobilize the required funds, the project company involves the financing services of an Islamic bank. Under an Istisna’a contract, the latter undertakes to finance the project with agreed specifications for a fixed price to be paid on a deferred instalment. However, to avoid any involvement in the engineering, construction or building, the Islamic banks enter into an investment agency agreement with an Islamic facility agent acting on behalf of the Islamic bank. The investment agent may either enter into an Istisna’a contract with the project company in which the project specifications are set up or appoints the project company to act as a Wakil under a Wakalah agreement, and procures the construction and delivery of the project assets. The investment agent and the project company may also enter into a Musharakah agreement and mutually provide funds to construct the project. Under the Istisna’a contract, the project company usually subcontracts the construction tasks to engineering, construction and building contractor. In both agreements, the Islamic bank continues to disburse funds as long as the project company is satisfied with the construction milestones. In parallel with the Istisna’a contract, the investment agent on behalf of the Islamic bank enters into a forward leasing or an Ijarah mawsufah al dhimmah agreement with the project company to allow a return during the construction phase of the project. The forward Ijarah differs from the basic Ijarah contract as the assets matter of the leasing will come into existence once the project is completed. As a lessee, the project company pays advance periodic rental to the investment agent as profit payment date. Along with the forward Ijarah, the project company signed a purchase undertaking of the project in favour of the investment agent through the payment of the total sum minus the paid rentals. In return, the investment agent grants a sale at a pre-agreed price. The Doraleh Container Terminal (DCT) project constitutes a real example of implementation of such Islamic Project financing structure. The project involves the development, design, construction, management, operation and maintenance of a new container port terminal in the city of Doraleh, Republic of Djibouti. The government of Djibouti grants a thirtyyear concession to the DP World Djibouti and Port Autonome International of Djibouti. The Doraleh Container Terminal S.A. (DCT) was developed as a project company via their joint-venture vehicle. The project financing structure was executed by combining three basic Sharia-

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compliant ccontracts: Muusharakah, Istisna’a and F Forward Leasing (see figure below w). The DCT and project fiinanciers (Stanndard Charterred Bank, the West LB B AG and thhe Dubai Islam mic Bank PJS SC) agreed to o procure assets for thhe project joinntly and comm mitted to makking respectiv ve capital contributionns. Under the Istisna’a agreement, a thhe partners signed a procurementt agreement with w the DCT T to construct the containerr terminal and ensure delivery of assets a at the end e of the connstruction perriod. The Forward Lease Agreemennt allowed thee investment agent on behalf of the financers (thhe lessor) to lease l their co--ownership innterest in the project p to DCT (the leessee) in exchhange for perriodical rentall payments lin nked to a floating bennchmark.

Fig. 1.7. Mastter purchase unndertaking The Doraleh C Container Term minal (DCT) pro oject financing Structure

The Purrchase Underrtaking Agreeement is signned in parralel to the Istisna’a agrreement, thus allowing the financiers to ssell their co-o ownership interest to DCT in casee of a dissolution event. The strike price p was equivalent tto the amountt of the outstaanding facilityy. The sale allows a the DCT to preepay the finanncers and buy y out its parttner by payin ng off its contributionn in full, equivvalent to the prrincipal of finnancing.

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Fig. 1.8. Mussharakah agreem ment

3.2.2. Islam mic Capital Market—Islam M mic Financial Products 3.2.2.1. Secu uritized Baseed Financial Instruments I S Sukuk 3.2.2.1.1. An n Overview on o the Sukuk k The devvelopment of the earliest sukuk goes baack to the earrly 1980s with the intrroduction of the Muqarada ah Bond act oof 1981 in Jo ordan and the issuancee of the Mallaysian goverrnment investtment issues in 1983. Before thesee initiatives, it i was consideered that onlyy an equity maarket was possible in an Islamic finance f frameework. The F Fiqh Academ my of the organizationn of the Islam mic conferencce legitimizedd the use of sukuk in 1988, but it took some yeears before the market deveeloped. From the early 2000s the Suukuk market gained g momen ntum and popuularity as an alternative source of Sharia-complliant funding, particularlyy for sovereigns and corporate. SSukuk has takken a crucial position amoong the instru uments of Islamic capiital market byy providing an a alternative to conventio onal fixed income. Thee developmennt of a strong framework off asset securitization in the conventtional financee contributed d largely to enhancing th heoretical research forr Islamic certiificates. In fact, although tthe substance of sukuk differs from m the convenntional bond, in many caases payoffs of sukuk

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resemble a conventional fixed income debt security. Sukuk are considered to be the catalyst that put Islamic finance on the global capital markets map. A developed primary and secondary sukuk market widens investment and financing opportunities and provides liquidity management tools to Islamic intermediation. The AAOIFI has defined investment sukuk in Standard 17 as certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or in the ownership of the assets of particular projects or special investment activity. The Sukuk are financial asset that derive their return from the performance of an underlying real asset or a pool of real assets. The table below points out the main differences between Sukuk and Conventional bonds: Sukuk

Bond

Sukuk involves beneficial ownership of the underlying asset or project

Bonds involve debt obligations due from the issuer

Asset underlying the sukuk involves ownership rights either physical or usufruct

Asset backing structure in some conventional bonds takes the form of collateral rights, not ownership rights

The sukuk would be tied to eligible Shariacompliant contracts such as an Ijara, Murabaha, Musharakah, Mudarabah, Salam, Istisna’a, Wakalah contract etc.

The underlying contract is a contract of loan that generates interest

The purpose for sukuk issuance must be Sharia-compliant

Bonds can be issued to finance almost any purpose which is legal in its jurisdiction

Trading in sukuk represents trading in shares of an asset

Trading in conventional bonds represents trading in debt

Sukuk value depends on the market value of the underlying asset and do not actually depend on the obligor’s or the issuer’s creditworthiness

The value of bonds depends solely on the creditworthiness of the issuer

Asset-related expenses may attach to Sukuk holders

Bond holders are not concerned with asset-related expenses

Table 1.3. main differences between Sukuk and Conventional bonds Source: Author’s contribution

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The IFSB (2005) categorized the sukuk into two broad types: The asset based or backed sukuk, where the underlying assets offer fairly predictable returns to the sukuk holders, such as in the case of Salam, Istisna’a and Ijarah. The assets in question may be held by a Musharakah or Mudarabah which is securitized. This is not the same as the equity sukuk. The equity-based sukuk or partnership-based sukuk, namely the Musharakah and Mudarabah Sukuk, where the returns are determined on profit and loss sharing in the underlying investment which does not offer predictable returns Under the first type of sukuk, the IFSB (2009) distinguishes three different sukuk structures: Asset-backed Sukuk structure which involves actual ownership rights in the underlying asset. Asset-based Sukuk structure wherein the ownership rights over the underlying asset may not reliably result in an effective right of possession in case of default given the applicable legal environment, and in consequence the sukuk holders need to have a right of recourse to the issuer. Pass-through Asset-based Sukuk structure which is the typical structure of sukuk when a SPV is involved in the purchase of the underlying assets from the originator, in the packaging of them into a pool and in the issuance. This SPV requires the originator to give the holders recourse, but provides Sharia-compliant credit enhancement by guaranteeing repayment in case of default by the originator. Usually, the sukuk transactions involve three general key players except for the equity-based sukuk: The Issuer of Sukuk is the originator who sells its assets to the SPV and to whom funds are collected from subscribers of sukuk. By transferring the asset to this SPV, the asset is taken off the issuer’s balance sheet and is therefore immune to any financial distress the issuer may face in the future. The Special Purpose Vehicle (SPV) is formed as a separate legal entity based on the Mudarabah contract for the only purpose of managing the securitization process and the issue. The SPV plays the role of agent who acts on behalf of sukuk holders. The purchase of the asset from the originator is funded by issuing sukuk. Depending on the nature of the asset, usufruct of assets or services involved, sukuk can be structured to be designed as Ijara sukuk, Murabaha Sukuk Salam Sukuk and Istisna’a Sukuk. Investment sukuks are structured on the principal of partnership such as Musharakah sukuk and Mudarabah or Muqaradah Sukuk. The existence of an SPM provides confidence to investors about the certainty of cash flows on the certificates and thus their credit rating.

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The Investors or sukuk holders who subscribe to sukuk issued by the SVP. The rate of return on sukuk could be either variable in the case of Musharakah or Mudarabah sukuk or quasi fixed in the case of Ijara sukuk, Murabaha, Salam or Istisna’a Sukuk.

Fig. 1.9. Basic Sukuk Structure Basic Sukuk Structure

Sukuks are Sharia-compatible for trading in the secondary market, except for the Salam, Istisna’a and Murabaha sukuk as they involve debt trading or Bay Dayn at negotiated price. Sharia considers that the sale of debt other than at face value entails dealing with interest. Salam, Istisna’a and Murabaha contracts create debt as the result of credit sale. Below, we distinguish the main known and used kinds of sukuk depending on what the basic contracts are tied to. Ijara Sukuk Ijara sukuks are certificates of ownership of leased asset, and held by investors who lease the asset underlying the certificate to the originator after purchased it from them. Funds collected through sukuk issuance are used to purchase the asset from the originator. After the transfer of ownership, the SPV lease the asset to the originator. During the course of the life of the Ijara sukuk, periodic payments which are made by the originator (lessee) are transferred to the investors through the SPV. At maturity, the SPV sell the asset back to the originator at a pre-determined price and then pay back the sukuk holders. Most of the sukuk issues are

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based on the Ijara contract as Ijara sukuks are distinguished by several advantages such as flexibility in the time of inflows and outflows and the maturity length. The maturity of the Ijara sukuk can be of any length as long as the asset can be subject to the Ijara contract. According Sharia, the transfer of ownership is possible during the leasing period. Such criterion is important for a developed secondary market for Ijara sukuk. From the fact that the asset underlying the Ijara contract is always a physical asset, the Ijara contract could be widely negotiated in the secondary market.

Fig. 1.10. Salam Sukuk Salam Sukuk

The SPV purchase the asset based on the Salam contract. It pays the price thanks to proceeds from the sukuk certificates. The sukuk holders are the owners of the asset purchased. Subsequently to the Salam contract, the originator promises to buy the asset from the SPV when it will be delivered at a predetermined price with a profit margin. The rate of Return on the Salam Sukuk is fixed to the margin profit. The Salam Sukuk resembles a zero coupon. In countries with large public sectors or where the government has a substantial deposit of natural resources, they can issue certificates for the future delivery of such products, which are fully paid for on the spot by investors, who receive certificates of purchase in

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Chapter One

return. The Salam purchaser can choose to hold onto the Salam contract and receive the shipment on the designated date, or elect to sell the goods involved in the contract through parallel Salam. Istisna’a Sukuk The SPV which acts as an agent on behalf of sukuk holders in the Istisna’a sukuk issue process becomes the seller and contractormanufacturer of an asset to the buyer who is the originator. The sukuk sold to investors may have different maturities to match the instalment plan agreed upon by the SVP and the originator. The Istisna’a sukuk, along with the Salam sukuk, are not allowed to be traded in the secondary market except at its nominal value. Murabaha Sukuk The SVP purchase the asset needed by the originator and resells it to them under a Murabaha contract. The return of the Murabaha sukuk is a steady stream of income based on the mark up of the Murabaha contract. Mudarabah or Muqaradah Sukuk This kind of Sukuk is very suitable to finance infrastructure projects or the development of great projects. The relationship between the originator and the investors represented by the SPV is based upon a Mudarabah contract. The originator is the Mudharib or the entrepreneur, and the Mudarabah sukuk holders are the capital investors. The rate of return of the sukuk Mudarabah depends on the profit rate realized by the financed projects and the return to sukuk holders is based on the profit sharing rate pre-agreed between the SPV/ investors and the originator. At sukuk maturity, investors may sell their sukuk on the secondary market. Musharakah Sukuk The Musharakah and Mudarabah sukuk are very similar as they are both based on risk and profit sharing. However, in the case of the Musharakah sukuk, the sukuk holders and the SPV or the originator are partners as well, as the latter plays the role of the entrepreneur. Both are generally used for financing public or corporate developed projects that need large funds or real estate. They are not well-spread as their development requires a high level of transparency and monitoring. Table 1.4 below deals with some differences and similarities between Partnership Sukuk, Bond as well as Sharia-compliant stocks.

Introduction to Islamic Finance and Islamic Banking Mudarabah and Musharakah Sukuk

Bonds

49

Sharia-compliant stocks

Nature

Not a debt but Debt of Issuer undivided ownership With defined shares in assets/ maturity. projects with defined or undefined maturity.

Ownership share in specific company deemed Shariacompliant. With undefined maturity.

Asset Backed

A minimum of 51% tangible assets (or their contracts are required to back issuance of Sukuk)

Generally not required

Liquidity test: the amount of account receivables divided by twelve- month average M.Capita