Tag Archives: Yusuf Talal DeLorenzo

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.


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.

Islam’s approach to ethical investment

Islam’s approach to ethical investment


Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered.

These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.

The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

*Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation

*Investments are made in permissible activities

*Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity

“The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service,” the Vatican’s official newspaper Osservatore Romano said in an article its latest March 2009 issue.

Shariah authenticity

Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product’s authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.

Shari’ah supervisory board (Religious Board)

Islamic financial institutions must adhere to the best practices of corporate governance however they have one extra layer of supervision in the form of religious boards. The religious boards have both supervisory and consultative functions. Since the Shari’h scholars on the religious boards carry great responsibility, it is important that only high calibre scholars are appointed to the religious boards.

Islamic financial institutions that offer products and services conforming to Islamic principles must, therefore, be governed by a religious board that acts as an independent Shari’ah Supervisory Board comprising of at least three Shari’ah scholars with specialised knowledge of the Islamic laws for transacting, fiqh al mu‘amalat, in addition to knowledge of modern business, finance and economics.

They are responsible primarily to give approval that banking and other financial products and services offered comply with the Shari’ah and subsequent verification that of the operations and activities of the financial institutions have complied with the Shari’ah principles (a form of post Shari’ah audit). The Shari’ah Supervisory Board is required to issue independently a certificate of Shari’ah compliance.

The day-to-day application of Shari’ah by the Shari’ah Supervisory Boards is two-fold. First, in the increasingly complex and sophisticated world of modern finance they endeavours to answer the question on whether or not proposals for new transactions or products conform to the Shari’ah. Second, they act to a large extent in an investigatory role in reviewing the operations of the financial institution to ensure that they comply with the Shari’ah.

The concept of collective decision-making, in other words, decisions made by more than one scholar, is especially important. Shari’ah Supervisory Boards function is to ensure that decisions are not unilateral, and that difficult issues of finance receive adequate consideration by a number of qualified people.

Source: Institute of Islamic Banking and Insurance (IIBI)

Don’t fear the riba: Sheikh Yusuf Talal DeLorenzo criticizes the Wa’d scheme promoted by Dr. Hussein Hamid Hassan

Don’t fear the riba: Sheikh Yusuf Talal DeLorenzo criticizes the Wa’d scheme promoted by Dr. Hussein Hamid Hassan

There has always been room for disagreement within Islamic finance, but one issue has caused particular controversy in the past months.

At the recent Islamic Funds World conference held in Dubai, two top industry figures put forward opposing views on the wa’ad swap – the promise agreement with which returns from one basket of assets are swapped with returns from another. Increasingly, this mechanism is being used to give Shariah compliant investors exposure to returns from haram, or non-Shariah compliant, assets.

Supporters of the technique say that it is no different to issuing a sukuk, for example, against the LIBOR (London Inter-Bank Offered Rate) benchmark, which is widely used in pricing Islamic bonds even though it is an interest rate.

Shaykh Yusuf Talal DeLorenzo, chief Shariah officer and board member, Shariah Capital, is a staunch opponent of the wa’ad swap with haram returns.

“The purpose of this swap is to bring returns that are not compliant to Shariah investors – and everyone knows it,” he told the audience.

“It is a mistake to say that the haram basket is no more than a benchmark. All that happens is the non-Shariah basket of assets sets a benchmark and it’s no different from LIBOR – wrong.”

He said that the comparison with LIBOR was inappropriate, since the interest itself, rather than the benchmark rate, is the forbidden part.

“As a mere benchmark it has nothing to do with the transaction,” DeLorenzo said. “In a wa’ad swap it is what creates the returns, and that is the problem.

“LIBOR for ijara is totally unrelated to the ijara transaction. With the haram basket of assets, its performance is directly related to the return. The funding, whether it’s direct or indirect, is there.”

He pointed out that LIBOR has been approved by Shariah boards for use as a benchmark for Islamic returns.

“There is no participation by Muslim investors in LIBOR – it’s the business of the London banks,” he added.

DeLorenzo argued that a Muslim investor taking part in a wa’ad swap is implicated in every investment decision the bank subsequently takes with his funds.

“When you accept this investment product, you accept the whole series, whether you know it or not,” he said. “As the money moves, its character changes.”

DeLorenzo concluded by saying: “If you’re going to swap returns of one basket of performing assets for another, then you must insist that the assets in both baskets are halal.

“Only then can you be sure of receiving returns that are halal.”

Taking a slightly different view was Dr Hussein Hassan, director of Islamic finance structuring for Deutsche Bank UAE, which has pioneered Shariah compliant products that give Islamic investors exposure to non-Shariah returns.

Dr Hassan told the assembled delegates that Deutsche Bank keeps Islamic investors’ assets isolated from haram assets, something that is demonstrated in the regular Shariah audits carried out on the bank.

In the specific mechanism outlined in the white paper issued by Deutsche Bank last year, the wa’ad swap is an agreement between the bank and the investor to swap the returns from two baskets of performing assets, which are kept entirely separate and do not interfere with each other. When the assets are deposited with the bank, it agrees with the investor to hand over the return from the basket of haram assets at the due date, in return for the return from the basket of Shariah compliant assets. The Islamic investor therefore takes the risk that the Shariah compliant assets he deposited with the bank could outperform the haram returns he will receive when the swap is conducted. For this reason, two agreements need to be signed to ensure that both sides carry out their obligations on the due date.

Deutsche Bank is confident that the transactions it conducts are entirely compliant with Shariah law, regardless of what assets make up the haram side of the swap.

“We had discussions with Shariah scholars to discuss if we need to change anything we do,” said Dr Hassan. “They explained we don’t need to resort to blocking the means.”

He said that he expected a greater range of benchmarks to be available to the Islamic finance industry in future, making it easier to create Shariah compliant investment products that are linked to other assets.

Alka Banerjee, chairperson of Standard & Poor’s index committee, also argued that more Islamic benchmarks were necessary to develop the industry.

“Commodities is one that’s really crying out for indices,” she said. “That’s a no-brainer. They are a big source of revenue for most Islamic countries and we do not have a commodities index right now. All commodities indices are based on futures pricing and futures are not Shariah complaint, so until the scholars come up with an acceptable form of pricing that index, it’s waiting to happen.”

Banerjee added: “We are working with Islamic scholars to find a way, but we don’t have anything yet.”

She predicted that Islamic ETFs (exchange traded funds) would take off in the next two years, and called for more breadth and depth in the Islamic funds industry, something that was echoed by other participants.

Mohammad Shoaib, CEO of Al Meezan Investment Management in Pakistan said that the high levels of liquidity in the region meant that there was not necessarily an incentive for the industry to come up with innovative types of funds.

“There is lots of liquidity in the system, so it is very easy to come up with plain vanilla products and bring in a lot of money,” he said.

Syed Tariq Husain, CEO of Pakistan’s Emirates Global Islamic Bank, agreed. “We’re growing rapidly, but in terms of value rather than product diversification,” he told the audience. “We probably need to do more in terms of funds and Islamic investment opportunities available.

“In the GCC we have an excessive amount of liquidity chasing too few assets. The rate at which liquidity is coming into the system is so great that assets can’t keep up with it.”

He said that, having used negative screening to rule out assets that are not Shariah compliant, there may now be a case for fund managers to apply positive Shariah screening to assets.

However, other participants argued that product innovation should not come at the cost of customer relations.

Umer Majid, director, Halal Investment Bank in the UK, said that British Muslim investors were becoming distrustful of Shariah compliant investment products. “They feel they’re being conned,” he said. “They feel they are being given conventional products with Islamic labels.”

He added: “There was one sukuk fund very well promoted as halal by certain investment funds, but if you looked closely at the small print it promised a guaranteed return and that is haram,” said Majid.

“This has created a lot of mistrust and what I’m worried about is that the Islamic finance experiment might fail before it’s begun because people are trying to mimic conventional products.

“There needs to be something done about the legal documentation – it needs to be standardised.”

Majid called for an Islamic ombudsman which could authenticate even Islamic investment products that had already been approved by a Shariah board, and which could handle complaints from the public.

Generally, though, the outlook for the Islamic funds industry seemed to be bright, as long as the supply of new products is able to keep up with demand from a huge Muslim investor base.

Oliver Agha, global head of Islamic finance, DLA Piper Middle East, gave some perspective of the Shariah compliant investment opportunities that will be available. “There are $690 bn of projects expected in KSA in the next decade, most of which will be Islamically financed,” he told delegates.

Rationale for the Prohibition of Riba: Answered by Sheikh Yusuf Talal DeLorenzo

Rationale for the Prohibition of Riba: Answered by Sheikh Yusuf Talal DeLorenzo

Question: While I understand that the shariah is strongly opposed to riba in all its forms, I was considering what the rationale for this is. The Quranic text and prophetic tradition are clear in prohibiting it but I haven’t yet seen a clear explanation of why it is problematic. I also fail to see WHY asset-backed ownership is the only permissible type in Islam and exactly what the problem is with other purely financial instruments. Are there any other readings you could recommend to help answer these questions?

Answer: Please keep in mind that the prohibition is very much a moral issue, and that it is closely related to the concept of khilafah or stewardship. The Islamic concept of monotheism views the Almighty as the Fashioner and Possessor of all creation.

His is all that is in the heavens and on earth. Everything submits to Him (2:116).

When the earth and everything in it belong to the Almighty, the role of humankind is no more thanthat of caretakers. Even so, humankind has been granted an awesome responsibility, one which, in the poetic language of the Qur’an, even the mountains dared not accept.

The terms of this stewardship are that the Almighty allows humankind the use of the physical universe, hopefully for good (though possibly for evil, because humans have the ability to choose), and in return humankind agrees to be accountable for how the physical universe is used.

This agreement is the foundation of all worldly justice, and this leads to the Shariah orreligious law which includes guidelines for using the Almighty’s property for profit and acceptable gain. Unjust enrichment, according to the Shariah, may take many forms; but the most iniquitous of all is enrichment at the expense of others, and this includes lending for profit.

Money lending and financing belong to two entirely different spheres; one is charity, pure and simple, and the other is business. The repercussions of this bifurcation range far and wide, and shape much of what is unique about Islamic notions concerning economy and society.

Equity investing offers Muslims the opportunity to profit, not by lending at a guaranteed rate of return, but by sharing in ownership, and thus commiting to share in the risks associated with ownership. Such a commitment is clearly in consonance with the concept of stewardship, and this, more than anything else, explains how the Islamic prohibition against interest is as much a moral matter as it is a legal one.