Category Archives: Innovations and developments

Hedging in Islamic finance, by Sami Al-Suwailem

Hedging in Islamic finance, by Sami Al-Suwailem

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A study on Shariah-compliant hedging techniques and associated financial engineering and fiqh-related issues.

AAOIFI May Limit Shariah scholars’ role

Business Week: AAOIFI May Limit Shariah scholars’ role

regulation

A Bahrain-based agency is proposing new rules for religious scholars involved in the $1 trillion Islamic finance market, aiming to reduce the risk of conflicts of interest or improper disclosure.

The guidelines may address whether Shariah scholars can own shares in the institutions they serve and how many advisory boards they join, said Mohamad Nedal Alchaar, secretary-general of the Accounting & Auditing Organization for Islamic Financial Institutions, whose standards have been adopted in countries including the United Arab Emirates and Qatar.

“There’s a potential case for conflict of interest, and a case of information leakage or perhaps competition impact,” Alchaar said in an Aug. 5 telephone interview in Kuala Lumpur. “We wanted to address the concerns in an unbiased manner. When the guideline is published it will be a bold move and it may cause a stir.”

The proposals underline concern that Islamic financial products, designed to comply with Shariah law to be acceptable to devout Muslims, may be overseen by scholars who have a financial interest in their issuance. Global standards are still developing in the industry, whose assets are forecast by the Kuala Lumpur-based Islamic Financial Services Board to almost triple to $2.8 trillion by 2015.

AAOIFI, which has 200 members, sets accounting and auditing standards that are used in Bahrain, the Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria, according to its website. The agency said its guidelines have also been used to help frame policy in Australia, Indonesia, Malaysia, Pakistan, Saudi Arabia and South Africa.

Financial Fatwas

Fatwas, the judgment of a scholar based on his interpretation of Shariah law, are essential for products to be vetted and offered by financial institutions to Muslims. Islamic law restricts investors to transactions based on the exchange of assets rather than money alone because interest payments are banned.

Chicago-based Failaka Advisors LLC, an advisory company which monitors and publishes data on Islamic funds, lists 253 practicing scholars worldwide in its 2008 report. The top 10 include Sheikh Nizam Yaquby of Bahrain, Mohammad Daud Bakar of Malaysia, Pakistan’s Muhammad Taqi Usmani, Abdul Sattar Abu Ghuddah of Syria, and Saudi Arabia’s Mohammed Elgari, it said.

Yaquby serves on the Islamic boards of 52 institutions including New York-based Citigroup Inc. and London-based HSBC Holdings Plc. Bakar advises firms such as Paris-based BNP Paribas SA, according to the data. Credit Suisse Group AG of Zurich and Standard & Poor’s are among 31 firms that seek advice from Elgari, the report shows. Yaquby didn’t respond to an e- mail request for an interview and Mohammad Daud Bakar said he couldn’t respond to questions immediately.

Scholar Shortage

The Bahrain-based agency also plans to address concerns that scholars’ private companies receive preferential treatment from banks they advise, Alchaar said.

The Islamic finance industry is “increasingly scrutinizing the role of scholars, and questioning what the best practice should be,” Omar Shaikh, a board member of the Glasgow-based Islamic Finance Council U.K., said in May. “As the industry is beginning to work toward critical mass, scholars may need to tweak their roles at financial institutions.”

Financial institutions can’t find enough scholars to accommodate the demand for new Shariah-compliant products, Khalid Howladar, a Dubai-based senior analyst at Moody’s Investors Service, wrote in a report in May.

“The shortage of top Islamic finance scholars means that a small group of reputable individuals are a key factor in the Shariah compliance process,” he wrote. “This concentration creates a bottleneck when demand is high, and puts them and their offices under considerable pressure to deliver their approvals quickly.”

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Islamic rate of return: the new IRR

Islamic rate of return: the new IRR

The issue is discussed by Joseph DiVanna, MD of Maris Strategies, a Cambridge-based strategy think tank for financial services specialising in economic, demographic and consumer intelligence in emerging markets.

Islamic finance is poised for a significant surge as world markets reorganise and Shari’ah-compliant banks reassess their position in local markets. As a global market, Islamic banking has grown at an impressive 27 per cent per annum over the past five years, and is estimated to reach $1 trillion in 2010. Growth in the Islamic finance industry will occur along three distinct fronts: organic growth, new market growth and product growth. Organic growth will continue as Shari’ah-compliant banks persist in engaging their clients with additional services (aiming to increase deposits). New market growth will consistently rise as more banks are engaging previously unbanked populations in Africa, the Middle East and Southern Asia where the ratio of people banked is very low. It is however the third area of product growth which holds the most long-term benefits for Islamic finance.

Shari’ah-compliant institutions are emerging from 2009 with a renewed sense of confidence as the impact of the financial crisis is passing from a panicked search for guilty parties to a refocused approach to risk management. Islamic banks have been somewhat insulated from the global financial crisis because of their lack of access to what is now labelled as ‘toxic assets’. What Islamic banks have noticed during the crisis is a steady increase in assets as investors/depositors take conservative postures and a marked reduction in the generation of fee and investment income. Unlike their conventional counterparts, during 2008-09 Shari’ah-compliant institutions continued a deliberate plan of innovation, mainly in retail banking distribution, experimenting with technology. Now these banks are turning their attentions toward a longer-term growth agenda which includes product innovation that is more distinctly a representation of Islamic values and beliefs.

However, the rate at which this potential for growth is achieved is predicated on the establishment of additional national and international financial infrastructure. One key area of discussion is in the use of LIBOR (London Interbank Offered Rate) as an industry benchmark for sukuk and other instruments. Today, the performance of Shari’ah-compliant products such as sukuk are measured (or linked) to LIBOR as a benchmark, not by design, simply as a matter of convenience in the early stage of market development. To compete with conventional banks, which many of their clients have been using for decades, Shari’ah-compliant institutions have adopted the use of LIBOR so customers have a readily recognised mechanism to assess the relative rate of return on their product offerings.

Shari’ah scholars have been divided on the use of LIBOR as it gives the appearance of an interest-like quality to Shari’ah-compliant financial instruments. Conversely, some Islamic scholars have argued that simply using an interest rate as a benchmark for determining the relative rate of return for a Shari’ah-compliant instrument does not render the instrument non-compliant.

‘In the final analysis, a benchmark is no more than a number, and therefore non-objectionable from a Shari’ah perspective. If it is used to determine the rate of repayment on a loan, then it is the interest-bearing loan that will be haram. LIBOR, as a mere benchmark, has nothing to do with the actual transaction or, more specifically, with the creation of revenues or returns,’ says Shaykh Yusuf Talal DeLorenzo, chief Shari’ah officer and board member of Shariah Capital, a US-based Shari’ah advisory firm.

The key point of debate is the appearance of a Shari’ah-compliant financial instrument to generate a fixed rate return. Under Shari’ah principles, money cannot generate money, which in modern times is represented by interest. Numerous Shari’ah scholars have argued that instruments such as murabaha (debt) cannot be securitised, since sukuk-backed pools of murabaha are simply the sale of documents representing money, which can be interpreted as merely trading of monies. On the other hand, Malaysian scholars have argued that if the underlying receivable is associated with a true trade transaction or to a commercial transfer of a non-monetary interest, such a receivable can be traded freely for the purposes of Shari’ah.

Theoretically, a hybrid (debt/equity) sukuk could be structured to emulate a quasi-fixed return found in conventional bonds whereby the LIBOR benchmark would give investors an understanding of the instrument’s return relative to a conventional counterpart. Thus if structured properly the hybrid sukuk can generate a profit-based return that is comparable to a conventional LIBOR-based product. What this boils down to is the fundamental need for the industry to mature to a new level through a process of product/market innovation that increases the depth of market offerings. Market infrastructure such as a Shari’ah-compliant money market instrument, the establishment of a secondary market and secondary market pricing are but a few of challenges in the years to come, which will reach higher levels of discussion in 2010. Islamic rate of return (IRR)

Fundamentally, the industry, or more specifically central banks, must address the creation of a benchmark that represents the cost of capital in Shari’ah-compliant terms. Without a clear Islamic rate of return (IRR) LIBOR will continue to be used. The use of LIBOR and the development of an alternative has been discussed and debated during the past five years resulting in few alternatives. The central issue is the cost of capital and the establishment of an Islamic rate of return for procurement and placement of funds. Some scholars advocate the development of a mechanism similar to a rent index used when working with ijara instruments. Hence the industry will continue to use LIBOR as the only recognised benchmark. That said, the Islamic International Financial Market (IIFM), a Bahrain-based non-profit international infrastructure development institution, identifies several alternative theories:

  • Abbas Mirakhor approach: proposes that the cost of capital be measured without resort to a fixed and predetermined interest rate using equity financing as the source of financial capital (Tobin ‘q’ theory).
  • Sheikh Taqi Usamni approach: a benchmark can be achieved by creating a common pool which invests in asset-backed instruments (e.g. musharakah, ijara) where units can be sold and purchased on the basis of their net asset value determined on a periodic or daily basis.
  • Bank Negara Malaysia (Malaysia’s central bank) approach: proposed in ‘Framework of the Rate of Return’ sometimes referred to as mudarabah interbank investments (MII) – a standard methodology to calculate the distribution of profits and the derivation of the rates of return to depositors. A calculation table prescribes the income and expense items that need to be reported. It also sets out the standard calculation in deriving the net distributable income and a distribution table sets out the distribution of the net distributable income posted from the calculation table among demand, savings and general investment deposits according to their structures, maturities and the pre-agreed profit sharing ratios between the bank and the depositors.

Another alternative, which was introduced in 2004 by the State Bank of Pakistan (SBP) and the Pakistan Banks’ Association (PBA), is the KIBOR (Karachi Interbank Offered Rate) a benchmark for corporate lending in local currency defined as ‘the Average rate, Ask Side, for the relevant tenor, as published on Reuters page KIBOR or as published by the Financial Markets Association of Pakistan in case the Reuters page is unavailable. The banks and the borrowers are free to decide the relevant tenor of KIBOR and the spread over KIBOR at their discretion. KIBOR will be set for the lending facility on the date of drawdown or on the mark-up reset date. The offer letters from the banks to their clients should clearly indicate the KIBOR’s tenor and the agreed spread, frequency of revision’. The six-month KIBOR is most widely used as a benchmark.

How will an Islamic interbank rate work?

One theoretical construct is the use of a mudarabah concept whereby Shari’ah-compliant institutions with excess reserves (surplus banks) can invest in the interbank money market which in turn provides funding to banks looking for funds (deficit banks). Surplus banks act as investors while the central bank acts as an entrepreneur. The parties agree on a profit sharing ratio between the surplus banks (70 per cent) and the central bank (30 per cent). The surplus bank receives 70 per cent profit while the central bank will receive 30 per cent. The profit rate is based on the benchmark calculation of the profit as: profit equals (principal x profit rate x time x profit sharing ratio) divided by 365. Although theoretically, profit rates are acting under a similar means as an interest rate there is a built-in risk associated with the performance of the underlying assets associated with all the transactions initiated by the banks. Clearly, these types of mechanisms are in their infancy and will require a great deal of discussion between Shari’ah scholars, central bankers, monetary policy makers and bankers.

Conclusion

The Islamic finance market will continue to grow and strengthen during 2010. The rate at which the growth will occur is dependent on two things: the development of supporting market infrastructure such as a replacement for LIBOR and the confidence in the bankers themselves to conduct business in challenging economic times. The development of alternative benchmarks demonstrates the rising independence of Islamic finance as a viable alternative to conventional financing. As new economic data slowly reveals the emergence of renewed growth, Islamic finance is poised to enter 2010 as the first year of a new generation of development.

Al Yusr Islamic banking service launches new Car Murabaha

Al Yusr Islamic banking service launches new Car Murabaha

car

In line with its strategy of developing unique and innovative financing solutions to meet different customer needs, Al Yusr Islamic banking service of IBQ announced today the launch of its latest Sharia-compliant financing product. The new Car Murabaha product aims at providing customers enhanced flexibility and favourable repayment tenure while upholding the highest standards of Sharia compliance.

"The Al Yusr Car Murabaha has been developed to enable our customers to meet their financing requirements while benefitting from enhanced flexibility, competitive rates and a unique personalised service while adhering to the prudent risk management principles prescribed under Sharia," said Hassan Al Mulla, Head of Islamic Banking.

"At Al Yusr, our product development strategy is driven by innovation and a commitment to making the banking experience simpler and more rewarding for our customers, while having a positive impact on the overall economy. We believe Car Murabaha is a valuable addition to our product suite that will prove extremely beneficial to customers looking for Sharia-compliant and flexible financing options."

Al Yusr Car Murabaha enables customers to benefit from rewarding financing terms and flexible repayment tenures, without any requirements for salary transfer or guarantor.

The new product also allows customers to benefit from a fast approval process and an exceptional level of personalised service from Al Yusr’s highly competent and sophisticated customer service professionals.

Al Mulla added, "The growing range of Sharia-compliant financing products from Al Yusr Islamic banking service will not only provide customers with favourable financing options, but also enable them to achieve their short and long-term financing goals, while positively impacting the development of a sophisticated financing infrastructure in the state of Qatar."

IBQ launched its first Al Yusr Islamic banking service retail branch in May this year. The branch, which is located on the C-Ring road in Doha, offers a comprehensive range of banking and finance products to suit all needs.

World’s first shariah-compliant law firm opened in Dubai

World’s first shariah-compliant law firm opened in Dubai

United Arab Emirates-based law firm Agha & Shamshi is believed to be the first firm in compliance with Islamic law, a move which the firm’s founding partner, Oliver Agha, said is motivated by principle and philosophy. “The vision is to create a firm that lives true to the principles of Islamic finance, which means having an ethically based law firm that ensures it is practicing law. Also, not engaging in activities that are impermissible under the shariah,” Agha said in a radio interview with talk show FM station, Dubai Eye.

But just how does a firm operate in compliance with shariah principles? Agha said that Agha & Shamshi abstains from investing the funds at its disposal in conventional instruments. More significantly, the firm turns away clients and legal work that does not comply with Islamic principles, like those in the casino or interest-lending businesses.

“We have had to turn work away,” Agha said. “We have had to say ‘no’ to conventional finance work. Large banks asked us to represent them on conventional transactions, which in my past life would have been fantastic. We have had to say ‘no’ to dispute resolution matters that entailed pursuing a debt with interest. So these are the sort of things that we have had to decline … because we’re sticking to our principles.”

Agha said that even with having to turn away work as a result of its shariah-compliance policy, there is still more than enough on offer. “We believe that in this region there ought to be enough business to allow a small firm like ours to get by,” he said. “Let’s not forget that a huge amount of law has nothing to do with interest-bearing debt. You have projects, construction and EPC contracts, energy projects, and project finance done through Islamic financing. There is a lot that we can keep busy with and we will be able to do that.”

Agha also made headlines late last year, after walking away from a top position as DLA Piper‘s head of Islamic Finance. In January, he opened his own firm and formed an alliance with US firm Pillsbury, citing the “right cultural and strategic fit” between the two businesses. At the time, Agha had intended to develop his firm “based on ethical Islamic principles.”

But this is not the only legal business to have signalled interest in structuring itself along shariah-law lines. In late July 2009, UK firm Norton Rose highlighted the importance of Islamic finance to its long-term Gulf strategy, and strongly implied that a similar model may be on the cards. “The spread of Islamic finance and principles in international business is set to continue,” said Middle East international managing partner and head of finance, Campbell Steedman. “An understanding of Islamic culture and the development of shariah-compliant products throughout all our practice areas will be an essential part of both our development and the development of the market, in the years ahead.”

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