Islamic Finance July12

8/12/2019 Islamic Finance July12

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It is in Indias strategic interest to adopt Islamic Finance with the

right safeguards, says Sanjay BankaIslamic Finance?

Islamic Finance (IF) began its jour-ney ve decades ago and is one ofthe fastest growing and evolvingsectors in global finance. This

system is based on the principlesof Islamic law (the Sharia), and it hasseveral innovative and unique prod-ucts that are in line with the religiouslaws oering investment and bankingopportunities. The estimated fundswith Islamic Financial Institutions(IFIs) along with their associates havegrown from a meager USD 100 bil-lion in 2000, to over USD 1.3 trillion

by 2010. Some international bankswith strategic interests in the Gulfregion like Citigroup, HSBC, Standard

Chartered Bank, and Deutsche Bankhave also ventured into the Islamicbanking business. It is estimated thatthere are over 300 IFIs scaered over75 countries.

Its stupendous growth was madepossible by unstinted support fromthe enormous, untapped wealth inthe Gulf countries, the growing in-tegration of the GCC countries withthe world economy, and its regula-tory evolution. Despite this, IF assets

with certain exceptions (Ijarah, Baial Salaam,andIstisna). Money is justa medium of exchange and hencemaking money from money is not

permied; Discourages businesses which dealin unethical goods and services(Haram);

Promotion of profit-sharing andrisk-sharing by Musharakah and

Mudharabah; Introduces an Islamic tax (Zakat).

All IFIs are required to make col-lections in this benevolent fund anddistribute it to the poor and needyeither directly or through religiousinstitutions amounting to about

2.5 per cent of the total income ofbanks, and it may increase up to 10per cent in the case of certain assets.In order to ensure Shariacompli-

ance, IFIs are required to constitutea Sharia Supervisory Board (SSB)consisting of Sharia experts; or theycan hire independent experts to advisethem on Islamic banking products.The Bahrain-based Accounting andAuditing Organisation for IslamicFinancial Institutions (AAOIFI) laysdown important tenets of Islamicfinance. Among other Islamic or-ganisations which also prescribestandards are the Islamic FinancialServices Board (IFSB), Fiqh Academyof Organisation of Islamic Countries(OIC), and the International IslamicFinancial Markets (IIFM).

Islamic banking productsIslamic banking operates on the

principle of Shirakh(partnership) andMudharabah(prot sharing). Based onsuch principles, IFIs may decide thenature of the project, the pre-agreed

Should India Embrace

represent below 2 per cent of globalbanking assets and it remains an un-derpenetrated market across manyasset classes and geographies.

It has aracted the interest of policymakers and central bankers havingcrossed boundaries into the US, UK,and Japan. There are signs of thisactivity in India as well, despite stiarguments against adopting this sys-tem due to its non-standardised law,individual interpretation, and dier-ences in rulings between scholars. Itwill be in Indias favour to adopt thissystem in a calibrated fashion, to serveits strategic interests; by building insafeguards that will mitigate any risks

and pitfalls associated with it.

Key tenets of Islamic FinanceIslamic Finance and Banking are

based on some key tenets of the Shariaand IFIs have to ensure that their busi-ness activities are compliant with thereligious laws (See Chart 1).

Some key tenets that it has adoptedare the following: Prohibits payment of interest (Riba)

and excessive risk-taking (Gharar),

Chart 1: Islamic Banking Framework

Islamic Finance & Banking

Banking, Trade & Project Finance & Insurance

Shirakah (Partnership) and Mudharabah (Profit Sharing)

Profit Sharing

Non Profit Sharing

Musharakah Mudarbah

Murabaha Ijarah

SalaamIstisnaBanon"Riba"

(Interest)

Banon"Gharar"

(ExcessiveRisk)

Promotionof"Zakat"

Banon"Haram"

(Business)

"Sharia" principles, Guidelines of AAOIFI, IFSB etc and Sharia Boards

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rate of return, and even the locationof the project. The following tablegives an insight into various Islamic

banking products, while there maybe slight variations in terminologiesbetween markets.

Among the key profit-sharingproducts (See Chart 2) in Islamic bank-

Chart 2: Islamic banking products

Genre Product(s) Key Features

Profit-sharing Musharkah A Joint Venture between IFI and a customer. It envisages profit-sharing in a pre-agreed (Joint Venture, Profit ratio, but loss sharing in proport ion to equity contribution.Musharakahmay take 2 forms

& Loss sharing ) Shirkat-ul-milkand Shirkat-ul-adq. Mudharabah (Sleeping Partnership, A sleeping partnership between IFI as sleeping partner (Rabb-ul-maal) and the customer Profit sharing) (Mudharib). IFI contributes capital while the customer invests expertise and effort. Profit-

sharing is done in a pre-agreed ratio, but loss, if any, is fully borne by the bank. Due to thehigh risk, this is not a popular product.

Non-profit sharing Murabaha (Mark-up or AMurabahacontract either involves (i) the sale-repurchase agreement of a borrower-held cost-plus finance) asset (negative short sale) or (ii) the lenders purchase of a tangible asset from a third party

on behalf of the borrower (back to-back sale). The re-sale price is based on original cost(i.e., purchase price) plus a pre-specified profit markup imposed by the lender so that theborrowers repurchase of the asset amounts to a loss-generating contract. This is done in2 stages. In the first stage, the bank purchases the assets at customers request (non-legallybinding); and in second stage the Bank sells the assets to customer on deferred paymentbasis. The Bank is obliged to inform the buyer its cost price and estimated profit. The bankbears risk of loss in case customer reneges on his promise.

Ijarah The bank (the lessor ormujir) procures the desired assets and leases them to the (lease finance) customers (the lessee ormustajir). The customers thus fund their project finance through the

lease route. The lessor retains the liability for repairs and maintenance of the assets, whileoperating expenses are borne by the lessee.

Forward Contracts Bai al Salaamor Salaam Used for working capital finance, whereby the bank (acting as the buyer) enters into a forward (advance payment ) contract with the borrower to purchase the asset at a discounted price and pays the purchase

price in advance (effectively working capital loan). The discount compensates the bank forthe interest. Under normal circumstances, a sale cannot be affected unless the goods are inexistence at the time of the bargain. However, this exception is permitted provided the goods(tangible) are defined as to quantity, quality and workmanship and the date of delivery is fixed.

Bai muajjal A contract for sale of good on deferred payment basis either in one transaction or multipleinstallments. The date of payment must be certain and not contingent on some event(s).

Istisna Istisnais a purchase contract for an asset, whereby the bank (acting as the buyer) places (future assets) an order with the seller (customer), to purchase the asset to be constructed or delivered on

a fixed date in the future. The purchase price can be paid later or in a deferred manner asagainstBai al salaamwhere it is payable in advance. These contracts are executed in case oftechnology and real estate transactions.

Bank Accounts Current Account Operated underal-wadiahprinciples and hence no interest is paid by the IFI. The fundsreceived are used only for liquidity adjustment.

Savings Account Operated underal-wadiahprinciples. The customer is not given an assured interest rate as inconventional banking. Insteadhiba(or premium) is paid.

Investment Account These accounts also called Profit Sharing Investment Accounts (PSIA) received underMudharabah al-mutalkaprinciples and referred as Displaced Commercial Risk (DCR). Heredepositor bears the risk of losing capital, while also being entitled to earn voluntary profits(tabarru) instead of absolute commitment of interest. These funds may be deployed by IFI inequity, Ijarah, commodity, or Murabahah fund.

Other Products Zakat All customers are required to contribute from 2.5 per cent to 10 per cent of their net assetsdepending on the assets.

Qard Al Hasanah A benevolent interest-free bank loan to the poor and needy, either directly or through Islamic

charity institutions. Takaful Since commercial insurance goes against the principle of interest payment (riba),al-maisir

(gambling), and al-gharar (risk taking), hence customers contribute tabarru(donation) to acommon fund and the persons suffering losses are paid from the common pool. The balanceleft, if any, is payable back to members at agreed schedules.

ing are Musharakah and Mudharabah.The Musharakah form of nancing is

being used increasingly by Islamicbanks to nance domestic trade andimports, as well as to issue leers ofcredit. There are two main forms of

Musharakah, namely, permanent anddiminishing. In the rst, the contract

period is not specied, and hence itcan continue as long as the parties in-volved remain interested. This modelis suitable for nancing projects thathave a longer gestation period. In thesecond form, the banks equity in theproject keeps diminishing till it be-comes zero, and nally, ownership of

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project assets stands fully transferredto the customers. A diminishingMush-arakahprovides for payment over andabove the banks share in the prots.

In aMudharabahcontract, the bank

does not have the right to interferein the management which is the soleresponsibility of the entrepreneur.However, the bank has every rightto specify conditions that will ensure

beer management of its funds. Inpractice, however, Mudharabah hasnot made much progress on the assetside of the balance sheet due to thehuge risk involved; nonetheless onthe liability side, Islamic banks acceptfunds based onMudharabahin invest-ment accounts.

The non-profit or loss-sharingproducts includeMurabaha, Ijarah, andSalam.Murabahahis the most popularmode. IF also permits forward con-tracts, with some variants like Bai alsalaam, and Istisna. A unique featureof forward contracts in IF requiresthat the seller of the forward contractmust own the underlying asset at thetime of making the contract and mustreceive full payment in advance, orin a deferred arrangement as agreed.

Sukuk bonds The mostfavourite productSukuk bonds have emerged as the

most popular mode of fund raising inIF. Sukuk reects an ownership inter-est in an underlying asset, transaction,or project with undivided, propor-tionate ownership. These bonds aredesigned innovatively in accordancewith the Sharia, whereby the underly-ing assets are transferred to a specialpurpose vehicle (SPV). The SPV actsas Trustee (Wakalah) and raises funds

against the asset by issuing the bonds.Since these bonds have real under-lying assets, they are listed, freelytradable, and the pricing is based onmarket performance of their portfolio.They have become increasingly popu-lar and in 2010, the total issuance wasUSD 45 billion per annum (See Chart3). Sukuk issuances during 2001-2010were primarily by corporates (63per cent), followed by sovereign (34per cent), and quasi sovereign (3 percent). During this period, the GCC

has seen the largest issuance (83 percent) followed by others includingMalaysia, Indonesia, Pakistan, Sudan,and Brunei. The annual returns on the

bonds ranged from 3.75 per cent to 6.5

per cent, but in some cases, the returnswere as high as 10.75 per cent. In termsof tenor, it ranged from 12 months to480 months with an average tenor of 60months. Sukuk is structured primar-ily as Sukuk al Murabaha, but there areother structures like Sukuk al Ijarah, Su-kuk al Salam, Sukuk al istithmar, Sukuk alIstisna, Sukuk al Wakalah, and Sukuk al

Musharakah. The most notable Sukukissuance was by Cagamas BerhadMalaysia, in June, 2007, raising USD5.79 billion with a tenor of 480 months.

Sukuk issuances from non-Islamiccountries were a meagre 2 per cent.Some non-Islamic Sukuk issues in-clude Nomura Holding Plc, Japan(July 2010, USD 100 million), andGeneral Electric, USA (November2009, USD 500 million). Both adoptedthe Sukuk Ijarah route which offersthe highest exibility in the case ofthe CDR. Sovereign Sukuk issuanceprovides more depth to the marketencouraging corporates and othergovernment-owned entities to enter.

Sukuk has also faced defaults andrestructuring and in the last threeyears, defaults have occurred in sev-eral, high-prole Sukuk bonds includ-ing Kuwait-based Investment Dar andInternational Investment Group andthe US energy rm East Cameron. Inthe event of default, a debt restruc-turing is a lile complex as againstthe conventional CDR. The status ofSukuk holders is to be determined assecured creditors, unsecured creditors,or preferential creditors depending

on the Sukuk model adopted. Thispriority is determined with referenceto terms and conditions of the Sukukcerticates, the trust deed, and relateddocumentation; and above all, the

Sharia Boards interpretation.

Legal hurdles for IslamicFinance in India

IF protagonists have been makingregular representations to the IndianGovernment to adopt Islamic Bank-ing and the RBI had constituted acommiee under the chairmanshipof Anand Mohan Sinha (presentlyDeputy Governor, RBI) in 2006. Thecommiee submied its report in 2007,recommending that under the current

legal framework, Islamic Bankingproducts cannot be permied as theseare against the basic principles of theBanking Regulation Act, 1949 (BRAct). Some major incongruities thatthe committee pointed out are thefollowing: Risk-sharing and participating in

the business of customers forms thecore of Islamic Banking which is notin accordance with the BR Act;

Deposits placed by customersunder conventional banking are

guaranteed as to capital protectionand agreed interest rate. However,in Islamic Banking the depositor

bears considerable risk in certainbank accounts as to capital andreturn;

Equity participation which formsthe basis of several Islamic Bankingproducts likeMusharakahwill haveto be examined on a case-by-case

basis as per restrictions imposedunder the BR Act.

India will also have to analyse

(Source: International Islamic Financial Market-IIFM Sukuk Report- Second Edition, May 11)

Chart 3: Sukuk issuance 2001-2010

60000 Size (mm)

Year

30 336

1990

1,172 1,3716,410

8,140

12,180

30,034

48,887

18,59725,727

45,123

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

40000

20000

0

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whether IF will dilute the role ofthe Reserve Bank of India (RBI) andthe Securities and Exchange Boardof India (SEBI), and if so, how tomitigate the associated risks;

The BR Act disallows productswhere the bank can invest themoney in equity funds (in India,equity exposure is determined bya separate set of rules);

In view of asset ownership inher-ent in Islamic bonds and sale ofsuch bonds from one customer toanother there may be issues onstamp duty, central sales tax, andstate tax laws which will open upa Pandoras Box requiring severalchanges across all states. India be-

ing a federal state will have dif-culty in implementing a coherenttaxation structure across all statesto ensure compliance to IslamicFinance products. We are alreadyfacing huge challenges in imple-menting the Goods and ServicesTax (GST) despite having a generalconsensus;

Islamic Finance regulators arefacing challenges in introducingstandards to ensure compliancewith capital adequacy norms as

required by Basel III norms; and. Approval of the ShariaBoard for

every new product to be introducedhas created a unique regulatorychallenge and hence it requires amore mature governance regime.However, Islamic banking prod-

ucts are slowly being ushered intoIndia. Tata AMC, belonging to therespected Indian business house theTata Group, has already launched aSharia-compliant mutual fund calledthe Tata Ethical Fund, to aract global

investment in India. So has Bajaj Alli-anz. These funds have collected overRs 500 crore and they invest in equi-ties of Sharia-compliant companiesand other instruments permied bythe Sharia.

In 2010, the state-owned KeralaState Industrial Development Corpo-ration (KSIDC) had planned to start aninstitution based on Islamic bankingprinciples named Al-Baraka FinancialServices, which was stayed by theKerala High Court, but withdrawnrecently. More recently, the RBI has

cancelled the NBFC licence of Kerala-based Alternative Investments andCredits (AICL), which had started anIslamic Banking product in violationof RBI guidelines. This ruling has clari-

ed that NBFCs cannot oer Islamicbanking products in deance of RBIjurisdiction.

Indias policy interest in IFIndia has set up an ambitious tar-

get of USD 1 trillion investments inthe infrastructure sector which callsfor radical policy changes and initia-tives to aract global funds, and thismay require us to reconsider IslamicFinancing as an alternate source offunding to meet our strategic interests.

However, given our legal frameworkand social sensitivities, the follow-ing would be some real challengesfor India: Constitution of ShariaAdvisory

Boards in the RBI and at bankslevel may be tantamount to grant-ing legal sanction to Sharialaws inour polity;

There may be need to changethe Indian accounting standardsas well. India is already facing achallenge in implementing Ind-AS

(Indias variant of IFRS), and thiswill create another roadblock in oureort to harmonise our accountingstandards with IFRS;

Our political parties have usedpriority sector and minority sec-tor lending as a political tool forvote bank politics ignoring basiceconomics. There is a concern thatthe ruling parties may grant highsubsidies and equity funds to suchIFIs. Certain groups in India havealready started clamouring for

interest-free nance to the micronance sector and students underthe umbrella of Islamic Finance.This clearly indicates the risk ofdefaults and NPAs which we areexposed to, arising from loanswaivers to such groups; and

The spectre of illegal funds enteringthe Indian markets, especially fromcountries which have become terrorhavens is alarming. In case the RBIapproves a limited Sukuk strategy,it will have to ban countries whichsupport anti-Indian activities.

It is evident that the nature of Is-lamic Banking diers signicantly toconventional banking and structuralchanges will be required to the BRAct and other laws to accommodate

this in India.

The roadmap aheadIndia needs to adopt a selective

and staggered approach towardsIslamic Finance. First, the RBI willneed to cross the rubicon by permit-ting Indian corporates to issue Sukuk

bonds globally. The Sukuk strategywill help the country to meet its tar-get of infrastructure development byaracting low-cost funds. Second, inline with the strategy pursued by oc-

cidental banks, the RBI may considerpermiing branches of Indian banks inGCC countries to start Islamic bank-ing and create an additional channelof funding for India. But permiingIF in India in full scale will require anextremely cautious strategy, given theevolution of our social and bankingframework since independence in aquintessential secular manner. Thefund inow into IFIs in India espe-cially from GCC countries will need to

be monitored forensically, regarding

money laundering and legality, evenas we try to avoid any stereotyping.The case study of China, Hong Kong,or Japan as cited by some quarters isnot applicable to India due to dier-ences in our demographic paerns,social fabric, and historical experience.The perception that Islamic banking ismore resilient to nancial crises thanconventional finance has also beenproven wrong, in view of the highprole Sukuk defaults. Clearly, Indiawill need to adopt a multi-pronged

strategy in the national interest whichwill enhance our understanding andexperience of IF and enable us to takea right decision at an opportune mo-

ment in future.

The author is Sanjay Banka

FCA, FCS, MCSI (UK), MIMA,

MICA, Additional

Vice President, Finance, at

Viom Networks Limited. He can be

contacted at [email protected].

The views expressed in this article are hispersonal views and the author retainscopyright to this article.

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Islamic Finance July12