The Implementation of Islamic Finance and Portfolio Theory in National Commercial Bank - Case Study Example

The implementation of Islamic finance and portfolio theory in National Commercial Bank (NCB) Name Course Name and Code Instructor’s Name Date Islamic finance To understand on the best way to implement Islamic finance in National Commercial Bank (NCB, we first explored the history of Islamic finance. From, research we found that Islamic finance dates back to 1975 when Bank of Faisal was established in Egypt as noted by Hassan & Lewis (2007).  In addition we learned that just like NCB other financial institutions are interested in introduction of Islamic finance in their institution. Due to this demand, I learnt that the Islamic finance industry has been developing very strongly since its first establishment. As at the time we were making this research on the history of Islamic finance, I found out that the Islamic finance market has an estimated growth rate of between 15% and 20% per annum (El-Gamal, 2006). I also learned that the Islamic assets account for approximately 1% of global banking assets (Kettell, 2010). From the analysis that we made we found that the demand for Islamic products is expected to increase substantially. From the statistics that we accessed, it is estimated that over 300 Islamic financial institutions operate worldwide in some 75 countries (Usmani, 2002). I also found out that the leading Islamic finance centers in the world are Bahrain, Dubai, Kuala Lumpur and London. One thing that motivated us is that Islamic banks are not confined to Muslim countries but are instead spread over Europe, United States, the Far East and the Middle East as established by El-Gamal (2006). Having established the history of Islamic finance, we sought to establish the principles of Islamic economics. We found out that these principles are guided by Quran as a primary source in addition to other secondary sources. From our studies we found out that there are four main principles which guide Islamic finance. Accoding to Visser & Visser (2009), the first principle that we found out was the prohibition of RIBA (interest). This principle requires that no person ought to charge or receive interest. The second principle that we found out was the prohibition of activities with elements of GHARAR (uncertainty). According to Hassan & Lewis (2007), this principle prohibits financial institutions or individuals from excessive speculation, gambling and derivatives. The third principle that we found out was the one that prohibits individuals or financial institutions from investing in certain sectors or “haram” items such as alcohol/drugs, weapons/defense, adult entertainment, pig related industry or conventional financial services offered by banks or insurance companies. The fourth principle that we found out was the one that requires all transactions to be backed by a tangible asset (Visser & Visser, 2009). Thus we learned that in order for NCB to implement Islamic finance, the products that they intent to offer need to uphold these principles in their development and application. Introduction of Islamic system at NCB will of the institution various advantages. From our discussion we realized that the profit sharing principles will ensure that investible funds are channeled to the projects with the highest expected profitability as opposed to the interest based system where funds go to the most creditworthy borrowers whose projects may not necessarily be the most profitable ones (Visser & Visser, 2009). Another advantage that NCB will incur by introducing Islamic financial system is that profit sharing will be more conducive to economic growth as this would increase the supply of risk capital for investment and greater incentives for undertaking such risks due to expected profitability as mentioned by El-Gamal (2006). Our discussion also found out that Islamic financial system will promote an integrated economic development at NCB since it encourages the use of money for facilitating trade in goods and investment in productive capacity instead of money creation for the sake of money as supported by Hassan & Lewis (2007). Thus, we concluded that introduction of Islamic financial system at NCB would likely be more stable and less vulnerable to financial crisis that can be caused by speculative activities as suggested by Kettell (2010). Having been convinced that the system is of advantage to the NCB, we sought to find out financial products that conform to Islamic financial system that could be introduced at NCB. We discovered that the major contracts/products used in Islamic banking are divided into four major categories. These are profit sharing financial products; advance purchase financial products; deposit products; and insurance products. Our discussion and research found that profit sharing financial products includes Musharakah, mudarabah, wakalah, hawalah and Qard Hasan. According to Usmani (2002), Musharakah is a contract where all partners participate in terms of equity, investment, management and profit sharing based on pre-agreed ratio and loss based on equity contributions. Thus, we recommended that if NCB need to introduce this product, it ought to formulate contracts that will guide such contracts. On the other hand we found out that mudarabah entails investors providing the financial institutions with capital to fund a specified enterprise (Rajesh). Under this arrangement, the financial institution does not contribute capital but investment management capabilities only. Thus the investors contribute capital while the financial institutions provide entrepreneurship and profit is shared on pre-agreed ratio (Saunders & Cornett, 2003). This is similar to discretionary asset management in the conventional financial institutions. From our discussion we realized this is one of the easiest products that can be introduced at NCB since it requires little modification of the discretionary asset management at the firm to conform to Islamic financial principles (Visser & Visser, 2009). Wakalah on the other hand is where the bank acts as an agency and is therefore authorized to conduct business on behalf of the customers. our discussion also concluded that this product can be easily introduced at NCB since the firm has been acting an agency for managing investors funds for long. From our discussion we recommended that the firm ought to tailor its present fund management to conform to Islamic financial principles. Abdullah & Chee (2010) defines Qard Hasan as charitable loans free of interest and profit sharing margins where repayment is done via installments and modest service charge is permitted. Even though my colleagues argued that this product can also be easily introduced at NCb, I was of the contrary opinion given that NCB is a profit oriented institution. I argued that such a product could be used in funding non profit making organizations involved provision of social welfare to the communities in which NCB operates as highlighted by Saunders & Cornett (2003). I argued that NCB could loan such funds to these organizations at no profit or interest as its way of promoting its corporate social responsibility. Hawallah is an agreement by the bank to undertake some of the liabilities of the customer in return for a service fee (Ayub, 2009). Under this arrangement, the customer pays back the bank when the liabilities mature. This product is also tricky to introduce and from our discussion it emerged that for NCB to be able to introduce Hawalah it ought to have sufficient capital base as noted by Usmani (2002). From our research we found out that advance purchase financial products include murabahah, istithna, mu’ajjal and ijarah. We found out that Murabahah is a contract between the bank and its client for the sale of goods at a price that includes a profit margin agreed by both parties. Our discussion concluded that NCB can transact this product easily since the only investment it has to make is drafting the contract and finding the market for the said product on behalf of the client. Our investigation found out that Istithna is a contract for acquiring goods by order or specification where the price is paid progressively in accordance with the progress of job completion (Ayub, 2009). Our discussion realized that this product is closely related to mortgage products provided by NCB and thus the product can easily be introduced at the firm by tailoring mortgage products to comply with Sharia law. Our investigation also found out that Mu’ajjal is a sales contract that allows purchase with deferred delivery (Ayub, 2009). Ijara on the other hand is a sale and leaseback transaction which is employed to generate income that can be classified as rent rather than as interest (Ilias, 2009). From our discussion we agreed that NCB can easily introduce the two products in its portfolio. Our research found out that deposit products include wadi’ah, mudarabah and Qard al-Hasanah. Wadi’ah in Islamic finance refers to deposits including current accounts (giro wadi’ah). Since NCB currently has a related product (current account) we agreed that NCB can easily introduce wadi’ah by tailoring current accounts to conform to ilamic financial principles. As discussed by (Archer & Karim, 2007), Qard al-Hasanah is unremunerated deposit products which are often meant for charitable purposes. We realized from our discussion that this product is closely related to the corporate responsibility that NCB is involved in and therefore we argued that such funds can be used in similar way by incorporating Islamic financial principles in their execution (Saunders & Cornett, 2003). Finally, we realized that takaful is an example of insurance products offered by Islamic financing. According to Iqbal, et al. (2010), takaful is an Islamic insurance which involves joint risk sharing. Since NCB does not currently offer insurance products we argued that this product does not need to be introduced at the firm. Sharia supervisory board and their role in Islamic finance From our investigation we realized that Modern Islamic banking has a distinctive feature from other conventional financial institutions in that it has a role of the Sharia boards. This implies that NCB needs to establish a Sharia board. From our findings, the boards will be made up of Islamic scholars available to NCB for guidance and supervision in the development of Sharia compliant products, which will have to approve all transactions (Ilias, 2009). Generally, Sharia supervisory board will play various roles and will have various obligations at NCB. The roles of the board will need incorporated in the NCB’s articles of association. This we realized will be a bit challenging since the article of association of NCB will need to be realized to accommodate such transactions. Even though we realized that the functions of the board vary from firm to firm, we recommended that the board to be formed at NCB need play the following roles. First, we agreed that the board need to be involved in purification of investments of NCB for them to be Sharia compliant. Thus we recommended that the board need to be involved in cleansing off any elements in the products offered which are impure as supported by Ilias (2009). Our discussion found out that, Muslims are supposed to cleanse their accounts by donating interests earned to charitable organizations since Riba is prohibited under Sharia law as highlighted by (Abdullah & Chee, 2010). Thus the Islamic supervisory board at NCB is expected to quantify interests earned on mutual funds (which are against Sharia law) invested by Islamic corporations and purify them. The purification will be in form of fiscal purification and moral purification. The supervisory board will also be responsible for the purification of the investors’ income which will be done in accordance to the principles of Sharia law even though the investors can do the cleansing themselves. Islamic supervisory board will also offer counsel and advice to the management on how to distribute these accumulated funds to various suitable charitable organizations as indicated by Ilias (2009). This purification concerning money constitutes the fiscal purification and will be advantageous to the investor since it will save them from the responsibility of performing the cleansing and the time involved. From our discussion we also found out that the board will be involved in moral purifications. This will entail involve voicing of investors concerns to the management during annual general meetings of the bank (Iqbal, et al., 2010). Thus the board will be representing issues which pertains the investor which are important from the perspective of Islam. Apart from purification we recommended that the Sharia board at NCB need to be involved in the selection of portfolio or investment. It is the board that will be expected to scrutinize the equities and any other investments based on Sharia law and establish whether they comply with Islamic law as noted by Abdullah & Chee (2010). From our arguments we concluded that such screening should be quantitative, ethical and social screening guided by the Sharia law. This will ensure that all financial products offered by NCB are ethical to the firm and are in accordance to Sharia and socially responsible as suggested by Ilias (2009). Our discussion also agreed that Sharia supervisory board at NCB will be involved the monitoring of investment and portfolio. Thus the board will need to ensure that the equity of NCB or investors are not overstated or understated in the NCB’s financial statements. The board will also need to ensure that the funds holdings of NCB are within the acceptable limits set by Islamic principles. Our discussion also agreed that the board will be involved in Another monitoring the NCB’s management. The board will be tasked with ensuring that any action undertaken by the management concerning the investment of Islamic investors’ funds is within the statutes of the Islamic principles. For instance, the board will need to ensure that the fund managers do not engage in margin purchasing of stocks. The Islamic supervisory board at NCB will also be expected to monitor fees charged by the bank to its Muslim clients and investors. They will be expected to inform the clients and investors of the existence of such fees. Thus the board will act as a consumer advocate in such circumstances. We also agreed that the Sharia supervisory board at NCB will also be responsible for monitoring the documentation of various funds of the firm. The preparation of these documents will be interpreted by the board members in accordance to Islamic principles. The board will be involved in reviewing all the documents which are drafted. This will ensure that they are in accordance to Sharia law (El-Gamal, 2006). From our exploration of Islamic financial products, we realized that their development is a daunting task and thus the board will be involved in the development of Islamic financial products at NCB. Thus the board is expected to be innovative and creative to come up with profitable products which are compliance to Sharia law. Portfolio theory Our investigations found out that the modern portfolio theory was devised by Harry Markowitz in 1952 (Elton, et al., 2009). We learnt that Markowitz was one of the first people to attempt quantification of risk and to demonstrate quantitatively why and how portfolio diversification works to reduce risk for investors. From our research we learned that portfolio theory explores how risk averse investors construct portfolios in order to optimize expected returns for a given level of market risk (Rajesh). The theory tries to quantify the benefits of diversification. It assumes that out of a universe of risky assets, an efficient frontier of optimal portfolios can be constructed. The theory states that each portfolio on the efficient frontier offers the maximum possible expected return for a given risk level (Fernholz, 2002). Here an efficient frontier refers to a set of portfolios that each maximizes expected return for a given level of risk. Under this theory investors are expected to hold one of the optimal portfolios on the efficient frontier and adjust their total market risk by leveraging or deleveraging that particular portfolio with positions in the risk free asset (Berghe & Verweire, 1998). Under the portfolio theory, a broad context for understanding the interactions of systematic risk and reward are provided. We realized that the theory has shaped the way institutional portfolios are managed and it has motivated the employment of passive investment management techniques (Elton, et al., 2009). Our discussion concluded that mutual funds in conjunction with modern computing power have provided avenues for smaller investor to benefit from sophisticated analysis as well. We realized that mutual funds allow individual investors to diversify their portfolio investments in specific asset categories. Our investigation found out that portfolio equity include net inflows from equity securities other than those recorded as direct investment and including shares, stocks, depository receipts (American or global), and direct purchases of shares in local stock markets by foreign investors. Bonds are securities issued with a fixed rate of interest for a period of more than one year as defined by Amenc & Sourd (2003). They include net flows through cross-border public and publicly guaranteed and private nonguaranteed bond issues. We found out that Sukuk are structured to generate the same economic effects as conventional bonds, but in a Sharia compliant manner (Iqbal, 2002). This is attained through the use of assets and various contractual techniques acceptable under Sharia. In Islamic finance, sukuk essentially amounts to commercial paper that provides the subscriber with ownership in the underlying asset, that is, asset backed note. This is similar to securitization in conventional finance (Elton & Gruber, 1999). According to Iqbal (2002), Sukuk is a financial instrument that serve much the same purpose as debt but which is structured in such a way to avoid the payment of interest. From our discussion we agreed that the Sharia supervisory board will be involved in development and choice of equities and bonds that are Sharia compliant at NCB. From our analysis we found that the challenges that a Sharia compliant portfolio faces are not different from other portfolio managers. We learned however that management of assets in accordance with Islamic precepts is a bit more unique in that the practice is a form of socially responsible investing with the unique specification of avoiding interest bearing investments of any kind (Elton, et al., 2009). From this knowledge we agreed that NCB need to tailor its portfolio products to comply with Sharia law. In spite this we realized that it is challenging for portfolio managers to be completely invested all times and at the same time comply with the Islamic financial principles. Another challenge that portfolio managers face is remaining faithful to Islamic law in the stock selection when the realities of corporate finance dictate the need for companies both to borrow and to find a principal protected respository for excess cash as discussed by Berghe & Verweire (1998). In spite these challenges, we learned that once a private client portfolio management is armed with Sharia permissible products, an investment committee at an Islamic private wealth firm face the same issues as any other portfolio manager (Archer & Karim, 2007). Thus even though the Sharia boards will be involved in choice of Sharia permissible products at NCB, it will face same issues such as how to develop, implement and monitor an investment policy consistent with a client’s objectives. Conclusion From the exercise I have learned that there are various Islamic financial products that NCB can introduce. The products I learnt that need to comply with the Islamic financial principles. From my analysis I realized that for such products to be compliant with Sharia law, they need to be devised by Sharia board which ought to be formulated at NCB for it to effectively implement Islamic financial products and portfolio. This is because Islam is against numerous traditions that are practiced by conventional banks (commercial). Thus, NCB should devise their strategies ensuring that the requirements of consumer are fulfilled. Moreover, utilization of portfolio theory has shown that the Islamic banks and Islamic finance illustrates both religious linking and other societal requirements that can be molded to ensure successful financial strategies. References Abdullah, D.V., & Chee, K. 2010. Islamic Finance: Why It Makes Sense. Riyadh: Marshall Cavendish Corp. 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