Growth of Islamic Banking in the UK in the Context of Financing Techniques - Case Study Example

Running head: ISLAMIC GROWTH OF ISLAMIC BANKING IN UK IN THE CONTEXT OF FINANCING TECHNIQUES ___________ ________________________ ________________ Growth of Islamic Banking in UK in the context of financing techniques Introduction This paper has the primary objective to trace the impact of economics on products and services, in terms of their development and growth, offered by Islamic banking in UK.The paper covers the competition faced by Islamic banks from conventional banks and the level of ethical compliance ensured by Islamic banks. Write up also envelops the failure of Islamic banking institutions in some countries. Through the quoted literature, an attempt would be made to trace the growth of Islamic banking in UK finance, the bottlenecks faced by it and what it could learn from case studies of failures to ensure steady growth. An important part of the paper is the approach of main regulator in UK to supervision and regulation of Islamic banking. Paper also specifically focuses on specific Islamic mortgage products and their development in UK market. Growth of Islamic Banking Products in UK Global size of Islamic finance has been long estimated between $200 and $500 billion with an estimated growth rate of 10-15% annually.A precise estimate escapes though.In comparison the sterling assets of UK banking sector alone amount to 2.5 trillion (around $4 trillion).Thus Islamic banking has some distance to cover . But that is just another way of emphasising the scale of the opportunity(Howard,2003). In the UK, with the exception of one purely Islamic bank there are only Islamic products on offer by Islamic arms of commercial banks(HSBC, Llyods TSB,UBS for example).A large and well-developed Islamic financial structure has not come about thus far. But there is already a significant amount of business of various kinds focussed around relatively wealthy individuals or large institutions. Some London banks use the London Metal Exchange for Murabaha. The customer buys and sells forward a metal on the London Metal Exchange and earns a profit(Howard,2003).The first service provider for islamic banking products Halal Financial Services has been set up in 2005 as full fledged company. This is first in Islamic banking space. It is actively marketing products of Ahli Bank and HSBC Amanah and propagating the concept of halal mortgage. Its Chief Executive Officer reported," At the moment it is halal mortgages but we are only looking at a matter of weeks before we see Takaful coming to the market in the UK in the middle of July(2005). Of course HSBC Amanah has also launched the UK's first Sharia compliant pension plan as well. In the same context we tend to get involved in halal commercial finance, Murabaha based commodity benchmarked transactions and so on. We will continue to diversify our product range as and when we can" (Paul, 2005).Thus a vibrant Islamic banking products' market is round the corner in UK financial markets. However strategic conditionalities as stated below must be met before this happens. Competition with conventional banks Warren Edwardes says that "Given a choice between a pure Islamic bank and a highly rated reputable international bank providing the same service, a client would rather go to the one that has a brand name than the one that provides Islamic-only services, without the brand name - so special purpose Islamic Banks will just have to keep innovating to stay in business just like the old British Merchant Banks"(Warren, 2002). To begin with renaming the Arabic terminology, such as "Ijara" with "leasing" or "Musharakah" with "equity participation", will lead to a greater understanding of the Islamic banking system. If products are structured in islamically acceptable way then Islamic banks would address a niche market. In a system where both parties to a contract have to have their Sharia compliance status verified, and where a fault at any subsequent stage of the deal can void it entirely, having a standardized set of Sharia rulings and therefore knowing where you stand is all the more pressing. In 2004 first purely Islamic bank viz.Islamic Bank of Britain was authorized by FSA. Jon Boone wrote about the prospects of new Islamic bank as below: "However, the outlook for the new Islamic Bank of Britain is not as rosy as such a calculation would suggest. Conventional banks are not about to let it monopolize the UK's 1.8m Muslims. Citibank, HSBC and UBS are just three of the large banks that have launched products aimed specifically at Muslims. Experts say the Islamic Bank of Britain will also have to deal with the problems that Islamic banks confront around the world, rooted in the challenge of offering services similar to conventional banking but which conform to Islamic law"(Jon,2004). Thus while regulator has more or less provided level playing field for Islamic banks and conventional banks; Islamic banks will have to do an efficient and strategic definition of Sharia compliant products to capture the Islamic operations of competing large sized banking companies. Ethical Compliance by Islamic Banks Islamic banking shuns riba as per sharia laws. They have therefore developed other techniques for performing financial intermediation (Iqbal, 2002). As Warren Edwardes put it, "the basic aspect of Islamic banking is, thus, the absence of interest but there are other social and ethical features claimed by the more "pure" or "zealous" such as there is more to Islamic banking, such as aiding a more equitable distribution of income and wealth and avoiding undesirable areas. Some argue that the prohibition of Riba is akin to the usury laws in many Western countries or a ban on excessive interest. Thus a lax view of Islamic banking would only exclude back-street money-lenders and pawn brokers and include modern bank lending. A distinction has also been made between interest earned on passive investments such as bonds and bank deposits and interest earned on productive industrial loans. For all practical purposes, there is now no distinction between different forms or sources of interest. All interest, whether deemed usurious or not in Western eyes is Haram" (Warren, 1999).In practice, Sharia means that Islamic finance is asset backed, so the foundation of Islamic banking is asset management. Once the basic tenet of Islamic finance (i.e., the prohibition of riba, or interest) is understood, the most common activities are no different to those undertaken by many conventional banks (Gordon, 2002). The distinguishing ethical features of Islamic Finance can be seen as: (a) Making Money from Money is not permissible (b)Prohibition of Interest (c) Profit and Loss Sharing (d)Gharar (Uncertainty or Speculation) is Prohibited (e)Investments Should only Support Halal Activities In Islam, Muslims are prohibited to deal with interest (riba), give it, receive it or even witness it. As a result Islamic banks cannot pay interest to depositors nor receive interest from burrowers. They cannot even witness or keep accounts that include interest-charging transactions. The Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole and considers any charging of interest as usurious as it is not given for any fruitful labor. The only time lending money is not prohibited in Islam is when value is being created (hence backed by assets). If money is borrowed for a venture, the lender and borrower will have to share the profits and losses fairly according to Sharia Law--this is known as mudaraba. If the venture is profitable then both share in the profits. If the venture fails then both share the loss in the same way. In conventional finance this is not the case. The borrower has to pay a fixed rate of interest as well as the principal whether or not the venture is profitable. If the venture makes a profit then the lender only gets a fixed percentage, which is governed by supply and demand and not on the actual profits produced from the venture. This rate of return might not be a reasonable portion for the lender, which is a form of injustice. If the venture fails then the borrower has to pay interest to the lender as well as the principal, which means the interest of the lender is guaranteed at the price of the destructive loss of the borrower, which again is a gross injustice. As a result financing a business on the basis of interest causes an unbalanced atmosphere and brings injustice to either party depending on the success or failure of the venture. On a large-scale interest based economies create a debt-oriented economy. Here is an opinion from an Islamic investor's point of view. Interest is not healthy for an economy. For once interest is allowed, and advancing loans, in itself, becomes a form of profitable trade, the whole economy turns into a debt-oriented economy, which not only dominates over the real economic activities and disturbs its natural functions by creating frequent shocks, but also puts the whole mankind under the slavery of debt. It is no secret that all the nations of the world, including the developed countries, are drowned in national and foreign debts to the extent that the amount of payable debts, in a large number of countries, exceeds their total income. Just to take one example of UK, the household debt in 1963 was less than 30% of total annual income. In 1997, however, the percentage of household debt rose up to more than 100% of the total income. It means that the household debt throughout the country, embracing rich and poor alike, represents more than the entire gross annual incomes of the country. Consumers have borrowed, and made purchases against their future earnings, equivalent to more than the entirety of their annual incomes. Peter Warburton has commented on this situation as follows: "The credit and capital markets have grown too rapidly, with too little transparency and accountability. Prepare for an explosion that will rock the western financial system to its foundation"(Peter, Islamic Bnkg). It is tedious to verify ethical compliance by Islamic banks. Top UK regulators have stated that while supervision and regulation of Islamic banks would be akin to that of their conventional counterparts, Sharia compliance is seen entirely as an internal matter of these banks. How do these banks view their compliance to Sharia laws An illustrative example could illustrate the matter. Islamic Development Bank (IDB) has the following information on its web page: "What is Sharia Which are the principles of Sharia that apply to Islamic Banking Sharia is the set of rules derived from both the Holy Quran and the authentic traditions (Sunnah) of the Prophet (peace be upon him) and the scholarly opinions (Ijtehad) based on Quran and Sunnah. The principles of Sharia that govern Islamic banking are the following: prohibition of interest (riba) in all financial transactions, such as: riba in debts; riba in sales, particularly in the forward currency exchange. entitlement to return is due to liability of loss and vice versa. How does the Bank ensure that its operations conform to Sharia In order to ensure that its operations conform to Sharia, the Bank seeks guidance from the OIC Fiqh Academy comprising scholars from member countries. It also constitutes Ad hoc Committees of Sharia Jurists, whenever required, to study Sharia-related issues and give opinion. What is service fee How does it defer from interest charges The Bank charges service fee on Loan financing to cover actual administrative expenses related to the project. It differs from interest in that the service fee is the actual expense incurred by the Bank, while interest is payment for the use of the funds. What is mark-up How is it different from interest The mark-up is the margin added as a profit in addition to the real cost of the commodity sold. In IDB the practice of mark-up is applied to murabaha and installment sale. The mark-up in the case of murabaha, is the profit, which is agreed upon between the concerned parties. As for installment sale, the mark-up is the amount to be included in the re-payment installments to be paid by the beneficiary. The mark-up rate is used to calculate the lease rental in the case of lease financing. Mark-up is different from interest in that it is related to machinery, equipment, etc., in case of installment sale or a commodity in case of murabaha, whereas interest is related to money. "(www.isdb.org). Thus ethical compliance is more of a matter of interpretation than standardization as it stands now. However as a strategic position even Sharia interpretations need to unambiguous and clear and even standardized so that Islamic banking has at least a clear conscience in developing newer Islamic banking products through financial engineering. This is urgently required to enable Islamic banks to develop competitive new product ranges within robust business plans. It is stated that there is acute global shortage of Sharia scholars who could confidently dovetail banking with Sharia.As an intended strategy Islamic banking sponsors must work to increase the population of such scholars. It is pertinent to note here that International Islamic Rating Agency (IIRA), Bahrain not only provides financial rating of Islamic banks but also includes therein the level of Sharia compliance by such banks. More such rating institutions can resolve ethical compliance professionally. In 2002 a favorable vote of 21-1 was taken by the Islamic theological research committee of Al-Azhar, based in Cairo, and one of Islam's most important universities, on the question of fixed interest rates.(BBC,2002) This was presumed to be the ethical clearance for development of host of Islamic products now in the market. Financial engineering has been mentioned elsewhere as an important purveyor of Islamic banking product development. It is interesting to note that some scholars believe that products of financial engineering and derivatives such as, futures (and forwards), option and swaps provide certain benefits to market participants exposed to certain kinds of risky situations and the maslahah seems to be real and substantial. However, in forming the basis of legislation, maslahah such as above is to be given a lower priority than the Quran, or the Sunnah, or Ijma. Among the various Sharia norms the ones that are the most important are freedom from riba, gharar and qimar or maysir. While a small amount of gharar is even tolerable, the prohibition is the strongest on the issue of riba and qimar.(Ariff,1990).Thus one has the basis for generic ethical compliance of all derivative products. Failure of Islamic Banking in some countries-Reasons Islamic banking in Brunei has only been in the country for the last 12 years and is still very new compared to conventional banking (Izam, 1999).The failures of such banks in Brunei had as much to do with underlying economics of the nation as with the newness of banking industry and loose internal controls. An economic shock to the Bruneian banking system took place in 1998 with the collapse of Amedo Development Corporation which is estimated to have cost upwards of 50 percent of Brunei's foreign exchange reserves (bankintro). Oil dependent Brunei was so much involved with oil economics that it had lost sight of the dealings within the largest non-oil conglomerate which collapsed in 1998, leaving behind foreign liabilities worth billions of dollars and several frozen bank accounts. The prime reason for this was the control over such business by the royal family run Ministry of Finance which loosely ran with obscure distinction between corporate and personal investments. In banking language such personal investments are called "diversion of funds" from stated corporate purpose(s). When such diversion takes place in illiquid investments on a mammoth scale and turn non performing too then "collapse" is the only outcome of the concerned corporate. This set in motion the government to wipe out the mess and restructure the banking system of the country. As of present the small Islamic banking industry is facing growth challenges and trying to expand horizons to"non-muslims" constituents, developing investment and fee earning products and integrate the local banking system globally(Izam, 1999). Brunei is also making an effort to distinguish "development banking" from normal "retail/trading banking" .Inability to arrive at such distinction and use it for decision making had partly caused the banking crisis earlier on. Thus a robust internal control system with only acceptable amount of executive discretion and clear cut identification of "long-short" deployments is necessary for any Islamic bank to stay above par. This is evidently a good lesson for Islamic banks having ambitions to spread out in UK markets. Islamic Banking regulation & supervision in UK Islamic banking regulation and supervision runs along parallel lines to such regulation and supervision of other banking entities in UK. The FSA is well established as a single regulator for the whole of the UK's financial system.UK parliament had set supervisory and regulatory objectives for FSA in 500 clauses of the Financial Services and Markets Act,2000.Briefly these objectives require four main tasks of FSA. First, FSA is required to work to maintain confidence in the UK's financial markets. Second principal task is to promote public understanding of the financial system. Third task is to protect consumers of financial services, but bearing in mind their own responsibilities. In other words FSA is not meant to protect people from any mistaken saving or investment decision they may make on their enlightened volition. The "buyer beware" principle certainly still applies. Fourth task is to work to reduce financial crime. The main concerns in the last task is about money laundering activities of drug dealers,terrorist(s) or other organized crimes . All supervision and regulation centres around these four tasks.These when translated to the arrangements for supervising banks,it is required that new applicants meets five threshold conditions for authorisation as an institution entitled to take deposits in the UK. Some of those conditions, such as the legal status of a bank, its location etc, are entirely straightforward and no bank has difficulty meeting them. The other two key conditions are that a bank must have adequate resources and must have reasonable systems and controls to manage the type of business it wishes to undertake in a reasonably sound and prudent way. That will include systems to guard against money laundering.Legislation obligates to treat applications from Islamic institutions no differently from any other. Any successful Islamic bank would only gain by passing the entry standards set out for large sized banking companies and it would be able to market itself as a company with sound capital and healthy management practices.FSA however recognizes that requirements will need to be shaped to suit the particular demands of an Islamic bank. Islamic banks differ from conventional banks in four main ways. They offer a rather different range of types of Islamic finance, from Murabaha through Ijarah and Salam to Istisna. It is recognized that the risk sharing characteristics of these Islamic contracts are rather different from those in place in a conventional bank. For example, there is typically a mix of contracts on the liability side. In particular, unrestricted Islamic investment account holders share in the risks of the bank, since their deposits have some of the characteristics of equity stakes. It is entirely reasonable to take some of these defined features into account when looking at the capital structure of the bank. If customers genuinely share risks, and understand that they are doing so, that may reduce the amount of capital required.However FSA considers these differences in the nature of Islamic banks less important than the similarities between Islamic and other banks. Therefore what FSA is really looking for when it authorizes a bank is an organisation which abides by sound principles of corporate governance, which has adequate capital for the risks it plans to take on, and which has a capacity for managing those risks through robust systems. Compliance with Sharia law, is left to several self regulatory organisations and associations and is primarily treated as an internal matter of the concerned Islamic bank.Even the UK direct tax amendments of 2005 have sought to place sharia compliant islamic banking products on par with their traditional counterparts.This applies to both deposit taking and lending activities of Islamic banks.Profit share return on Mudaraba deposits are treated as payment of interest and banks are expected to deduct tax at source.Regarding islamic mortgages, tax amendments have been discussed below.Thus it has been ensured that there is level playing regulation and supervision of Islamic banks and other banks.Ensuring Basel II compliance by Islamic banks may be cited as an example of major regulator concern as of date given varying risk profiles of such banks. Mortgage Finance in Islamic Banking According to some estimates the Islamic mortgage market is set to grow by 47% a year and could be worth 1.4bn by 2009. The current value is estimated at just 164m. There is increasing demand from the UK's 1.8 million Muslims for mortgages that comply with Sharia law. Another estimate assesses the UK mortgage market as: "There is somewhere in the region of 400,000 Muslim households in the UK. We break that down into about 255,000 that have conventional mortgages. This doesn't include those who hold investment properties. Typically a mortgage is about $225,000. We believe that as much as 50% would opt for an Islamic mortgage if one was available and it was competitive. As you can see the market is absolutely huge"(Paul, 2005). The Sharia law forbids interest payments; in Islamic mortgages an intermediary buys the property for an interim period, and receives rent and other payments. Commercial banks like HSBC and Lloyds TSB have begun offering Islamic mortgages. The entry of these two banks' into this market has made it far easier for consumers to access Islamic mortgages because HSBC and Lloyds TSB enjoy extensive branch networks. While 5 banks offered Islamic mortgages by the end of 2005 including the Islamic Bank of Britain; there was only one in 2003(BBC, 2005).Further growth is probably a direct function of amount of regulation this market faces. Whiles Ijara mortgages (lease prototype mortgages, with the crucial difference that at the end of the lease the tenant owns the property, not the freeholder) are not regulated by FSA; Murabaha mortgages are under full regulation of FSA.Though it is expected that even Ijara mortgages may be brought under FSA regulation sooner than later; its unregulated nature had prevented mainstream lenders from offering such mortgage structure to clients. As for Murabaha based mortgages, the removal of double stamp duty in 2003(Stamp Duty Land Tax-SDLT) has boosted the market. Without this legislation mortgages of UK land which were structured either as Murabaha or Ijara would be taxed twice, once on acquisition of the property by the financial institution and again on the sale, or lease, to the customer(or even three times in case of remortgages).SDLT extends such relief to Scottish mortgages and covers diminishing Mushakara forms of Ijara mortgages(Norton,2005).Such relief would be substantial as stamp duty rates can be as high as 5%.Application of such rates would have turned Islamic mortgages quite uncompetitive. The Finance Act 2005 further provided for equivalent treatment of direct taxes, in legislation and practice, both for banks and customers in Sharia compliant deposits and loan products (including mortgages).The unambiguous tax treatment of mortgages both for banks and customers has further given boost to the market for Islamic mortgages and enabled several large sized banks to offer such products. The new provisions equate the Murabaha transactions to their traditional counterpart for the purposes of corporation and personal taxation. Any effective return on Murabaha is to be treated as if they are payment of interest. In addition purchase price payable under Murabaha is treated equivalent to as principal amount of a loan. In the earlier tax regime there was a disincentive for non-UK-residents into entering Murabaha kind of transactions with UK banks as they would have been deemed to carry on trading activities in UK through a permanent address and/or agent and would be liable to pay UK tax on profits. The new law negates this position and works to encourage Islamic mortgages by non-UK-residents clients. Another difficulty facing Ijara mortgages under Basel I was that such transactions attracted 100% risk weight whereas traditional mortgages had a risk weight of only 50%.The Basel II accord will set right this differential in as much as under it, risk weights will be related to borrower rating(under standardized method) and according to rating migration under IRB.This would also work to fillip this market. Future of Islamic Banking Repeal of Glass-Steagall Act (1933) in USA that separated commercial banking from investment banking was not encouraging news for Islamic banking. The new rule, implicitly allowed the conventional banks in USA to take up some Islamic banking activities as well and hence leaving little justification for the establishment of separate "Islamic banks" in USA. The big banking corporations are now in a position not to leave any room for Islamic banks to compete with them in USA. They already had this privilege abroad (and they utilized it) as Glass-Steagall Act did not apply on US banks abroad. A strategy for Islamic banks for 21st century would be to join hands with conventional banks to pursue with the regulators such financial modernization that will equally benefit the conventional banks and Islamic banks to enhance their business.(Fahim, Vol. 1 No.3).In UK though there is substantial scope for standalone and purely Islamic banks given the substantial minority resident and tourist population and their demand for Islamic banking products it would be a better strategy if such banks synergized their energies through collaborations and partnerships with large sized banking companies to offer their products. Particularly in developing new products through financial engineering the contribution of large sized banking companies can be substantial. These companies have large capital bases and risk taking capacities and can be major partners in risk assumptions in businesses like takaful.They also have necessary expertise to custom make sharia compliant derivative and investment products. It is beyond any doubt that in consultancy and advisory areas these big banking corporations can help their junior partners viz.purely Islamic banks. As Warren Edwardes stated," The successful purveyors of Islamic Financial products, they may be Western ones, will be those which are the first to identify the emerging and evolving needs of the Islamic consumer and to offer product improvements which satisfy those needs. Banks should seek out buyers with the most difficult needs - they will become part of the firm's Research and Development programme"(Warren, 1995). References Howard Davies.(March,2003).Islamic Finance and the UK Financial Services Authority.Speech.Conference On Islamic Banking and Finance. Bahrain. 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