RESEARCH IN ISLAMIC FINANCIAL PRODUCTS
SALEH MALAIKAH
It has been well over two decades now since the concept of Islamic banking was first put into practice, but this has not been enough time for its evolution as a fully integrated financial system. Th e conventional (interest-based) system has evolved over two centuries and has reached an impressive level of organisation and depth globally, yet it is still not foolproof and involves many hazards for its users.
The many failures of conventional banking in recent years have often threatened a collapse of the whole financial system in several countries. The current international debt crisis, which is hovering menacingly over Western banks, may result in the crumbling of the present monetary system.
In contrast to this, the record of Islamic banks in the past two decades has been devoid of such failings. There are now over 100 Islamic banks functioning in both Islamic and non-Islamic countries, all at par with regard to labour and land and each being entitled to a return based on the profit-and-loss system.
It is interesting to note how much more complex both conventional banking and Islamic banking has become over the last two decades. It has been a time of change and, from all indications, this rapid change in both types of banking is not likely to abate in the foreseeable future but rathe r to increase geometrically.
Increasing communication techniques and increasingly diverse and demanding market forces have led to more complex arrangements for lending, funding, money transfers and other banking services. At the same time, increased competition has made it necessary for financial institutions to market their products and services more vigorously and effectively.
New markets, new products, new regulatory constraints, new participants and new competitors in the financial market places all represent challenges to clear understanding and communication in an increasingly complex and evolving business.
Islamic banking is unique in many respects, operating on the principle of pooling risks and equity banking. It has another advantage over conventional banking in as much as the bankers do not have fixed liability for interest payments to their depositors, and this makes them less vulnerable in a loss situation, should it arise.
Records of Islamic banks indicate that there is no likelihood of a liquidity problem arising in the profit-and-loss (PLS) system. In this system, there is a built-in cushion for the maintenance of a compatible balance between short- medium- and long-term financing, which ensures enough cash flow to meet the normal demand for withdrawals of deposits.
After well over two decades of Islamic banking practice, it is now time to reassess our goals and objectives and the methods by which we propose to achieve them.
What is it that Islamic banking has set out to achieve? How successful has been the implementation of the concept so far? Where do we envisage Islamic banking going in the next stage, in the 2Ist century?
In giving a comprehensive moral code for all areas of life, the Qur’an simultaneously gave the broad outlines for an Islamic economic and financial system, but this has since been misconceived by some members of the intellectual religious community, though speakers for the Islamic economic and financial system have clearly defined it.
The concept and its merits have been clearly defined by Islamic scholars. However, when it comes to the implementation of the concept, there has been enormous criticism from those who have pioneered it. The main criticism is that Islamic banks have resorted too much to short-term financing methods, specifically Murabaha and trade financing.
A majority of the assets in Islamic banks’ balance sheets are made up of Murabaha and trade financing. While this is not the first time it has been mentioned, we find Islamic banks still continuing this practice.
Furthermore, critics of the procedures for implementing Murabaha in many banks have gone to the length of saying that Murabaha transactions are merely interest-based loans under another name. One reason for this criticism is the bank’s practice of appointing the Murabaha customer as its agent to purchase the required goods on its behalf and then settling the purchase price from its own funds.
This practice was rejected by a group of renowned Sharia scholars in the Third Annual Symposium on Sharia Issues in Islamic Banking organised by the Dallah Albaraka Group. Sharia scholars insist that the bank must either act as its own agent or appoint a third party. They also stress that the customer’s order for Murabaha transactions is non-binding until the bank holds possession of the goods and thereafter until it actually executes a sale agreement with the customer.
Despite such abstractions on procedures for Murabaha, the fact remains that the Islamic banks are evading risk in their present dealings. There is no doubt that Islamic banks are trying to assimilate conventional banking methods as much as possible and this is where the problem lies. Are we trying to establish a system of our own or are we trying to follow another system that has its roots in grounds that are not acceptable to us?
The fundamental difference between Islamic banks and conventional banks is that conventional banking is all about intermediation while Islamic banking concerns direct investment. Conventional banks invest depositors’ monies at their own (the bank’s) risk, while Islamic banks invest depositors’ monies on the depositors’ behalf, thus exposing the latter to direct risk. By good management, Islamic banks should diversify the risk in order to yield a higher return to their investors as against the conventional banks’ return on deposits.
Here we see that the macro-economic benefits of the Islamic method – the liquidity, the reserve, the capital sufficiency requirement and other things – does not become the issue in monitoring an Islamic bank’s investment. Rather, it should be the integrity of the investments and the quality of the return which are the ultimate determinants. If an Islamic bank suffers from inferior asset management, it will be reflected in the quality of returns, which ultimately leads to the loss of investors’ funds.
Why are Islamic banks acting as intermediaries and not as investors? This is mainly due to a lack of development of Islamic financial instruments and products, among other things. Before discussing Islamic financial products, it is important to cover the Islamic methods of financing and investment.
Methods of financing and investment are concerned with the asset side of the balance sheet of Islamic banks. The main methods of financing in Islamic banking are: Bai Bithaman al-Ajil, instalment sales; Murabaha and trade finance, a variation of instalment selling; Ijara wa Iktina, lease purchase or financial leasing; and Salam, advance purchase at a discount. There are other methods, such as Muzara and Musaqat, but these are less commonly used.
These methods are all based on financing activities. They can be structured to yield a highly predictable, and in most cases fixed, return, largely because the profits result from sale or lease agreements. It is worth noting that after a bank enters into a sale or lease agreement, debt is created, and here lies a similarity with conventional banking. However, the organisation of credit in conventional banking is a loan, while in Islamic financing, it is in a sale or lease agreement.
It is of the utmost importance that these financing methods become standardised, otherwise the development of Islamic banking will be impeded. Islamic banks must increase their level of co-operation and interaction in order to achieve common standards for these methods, just as interest-bearing methods have been standardised. Standardisation would lead the way for syndication of many of the above transactions among Islamic banks. It would also pave the way for developing Islamic instruments and financial products.
The securitisation of Islamic financing methods is a very important trend in the development of the Islamic financial system. The ability to trade securities can provide much-needed liquidity in the financial system. For this to be possible, standardisation of finance investment methods is necessary and this is why standardisation is important.
With regard to tradability and liquidity, it is important to note that the Sharia prohibits the trading of debt, though it is allowed to trade a pool of assets, debts (receivables) and cash in which assets represent more than 50 per cent of the total pool value. It is thus allowed to buy shares in a company that has assets, cash and receivables, where the assets make up the larger part of the value.
The Al-Amin Securities Company was launched in 1987 with the purpose of developing Islamic financial instruments based on securitisation of Islamic financing methods and investment funds. Some of the instruments are fixed-term with no trading allowed, while others, composed of more than 50 per cent assets, are tradable.
Investment has a higher inherent risk than trade financing as investments tends to be held for longer terms. They also decrease liquidity and for these reasons Islamic banks tend to be cautious in their use of them. It follows that if investment products were structured, designed, well-managed and promoted, investors could be persuaded to have a direct participation in them, thus carrying the burden of higher the risk and illiquidity of longer terms.
For this reason, the role of Islamic financial institutions other than banks becomes very important, not only in originating investments, but also in managing, monitoring, packaging, promoting, marketing, valuing and pricing them. They can also structure investments in such a way as to minimise risk, using portfolio theory, and to provide means of creating liquidity through redemption.
The chains of Faisal Islamic banks and Al-Baraka Islamic banks have played a prominent role globally in the spreading of Islamic banking concepts. The latter has well over 23 banks and investment companies, including sister companies, a large number of industrial and trading companies in various fields, seven insurance and reinsurance companies, and leasing companies. The Al-Baraka Group stands as a model in combining banking and extensive direct investment capabilities.
After the successful introduction of the banks, the Dallah Albaraka Group, in consultation with prominent Muslim scholars, embarked upon introducing investment funds for the purpose of creating a secondary Islamic capital market in the light of Islamic principles. This resulted in the establishment of the AI-Tawfeek Company for Investment Funds (ATCIF) and the AI-Amin Securities Company. These two companies became the main channels for the management of large-scale investments all over the world and, duly assisted and approved by the Sharia Board, have become the nucleus of an Islamic secondary capital market.
It is of interest to note that ATCIF and the Al-Amin Securities Company recently embarked on offering a new type of investment instrument called a “specialised fund”. High periodical yields and capital gains accrue as a result of the increase in value of the assets during the term of the funds.
The two companies, established in 1987, already have, to their credit, been very successful in raising investment funds exceeding US $2 billion. These include specialised funds on a geographical basis, such as the Lebanon Reconstruction Fund, the Albaraka General Fund, the US Real Estate Fund and the Madina Real Estate Fund. The Lebanon Reconstruction Fund, in December 1992, with issued capital of US $ 200 million, resulted in a profit of 32% for its first year.
The Al-Tawfeek Company has recently successfully introduced its first leasing fund and is planning to introduce an Islamic money market fund in the very near future.
The Dallah Albaraka Group is constantly researching products for the formation of an Islamic capital market, without which Islamic banking cannot progress beyond its current short-term activities. An Islamic capital market and interbank market system will open vast new opportunities in long-term trading, project-related financing and investment banking. It will encourage products such as Musharaka (equity financing), joint ventures and unit trusts.
Already, the Malaysian Central Bank, the Bank Negara, has pioneered an interbank system which will have major implications for Islamic trade financing and other banking activities, obviating hurdles and taboos, especially for overnight deposits and other conventional transactions. It has also approved a total of 21 Islamic financial products.
Much effort and work still has to be done if the Islamic system is to be able to run in parallel with, and compete with, the conventional banking system. Needless to say. Islamic banking is receiving increased attention, not just in the Islamic world, but in the established and recognised markets of Europe and America.
It has been recognised as the key to attracting petro-dollars, not only through the new Islamic institutions being established, but because some of the larger and more influential global banks of Swiss, German, British and American origin have either established an Islamic banking division within their realm or have introduced Islamic banking products which they now actively market in the world.
This makes it imperative for new Islamic innovation vehicles and products to be introduced to conform to the present demand on Islamic banks. The world has changed politically, socially, economically and financially. The banking sector has also changed considerably world-wide, and if Islamic banking is successfully to compete with conventional banking and meet the demands of the Muslim community, the few tools currently being used must be augmented with new ones.
This can only be achieved through consultation (Ijtihad) between Sharia scholars, economists, bankers and investment experts. A committee should be chosen from countries where Islamic banking has been officially introduced. Its decisions should be communicated to all Islamic banks throughout the world, who should, wherever possible, adopt them. This committee could be formed under the auspices of the International Association of Islamic Banks (lAIB) or through the Organisation of Islamic Conference (OIC).
Reform of the institutional monetary framework to give it an Islamic perspective, ensuring that it can achieve the goals of the Islamic society, is also badly needed, since the Islamic financial system pivots on equity financing. This would give an impetus to the formation of stock exchanges, investment trusts and the co-operative financing of institutions.
The development of Islamic banking techniques exists in a rudimentary form, but further research and work is needed. Matters which need urgent attention include: finding a uniform method of profit-sharing in the financing of small businesses; the indexation of deposits and loans; financing the needs of the government sector; and definition of a discount rate for public sector projects.
The introduction of new products has always been a cumbersome and time-consuming process. What is needed is a central research body to cover this subject for all Islamic banks and institutions, so that its recommendations may be implemented by all.
The marketing of new products, funds and issues is another field which needs not only expertise but a level of manpower which many smaller institutions cannot afford. Appointing agents on a commission basis has been found to be costly.
Finding scrupulous agencies is difficult and hazardous. The existence of a central body in this field might obviate the difficulties faced by small institutions dealing with areas far afield. Such a body, having reputable institutions on its panel, could act as an agent for small institutions and this would save time, money and undue hazards.
In order to compete with interest-based banks and stock markets. Islamic banks need to evolve non-usurious tools to attract depositors for savings accounts and investment accounts.
Finally, owing to the lack of resources and planning, Islamic banking does not get much coverage in the media and whatever it does get is most often adverse. There is a body called the International Islamic News Agency (UNA), but its activities are not well known. The OIC should make a concerted effort to enable this body to work more efficiently.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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