Features of Islamic Finance - Research Paper Example

 Research Paper Islamic finance: Comparison with conventional finance, its impact on mortgage finance products, and protective capacity during financial crises Contents Introduction 4 Features of Islamic finance 4 Comparison with conventional finance 6 Impact on mortgage finance products 7 Murabahah home financing 7 Ijara wa iqtina 8 Musharakah Mutanaqisah 9 Istisna 10 Other Islamic property financing arrangements 11 Legislative support 12 Impact of Islamic financing arrangements 12 Protective capacity during financial crises 13 Concluding discussion 14 References 15 Additional bibliography 17 Tables and Figures Table 1: Comparison between conventional and Islamic finance 7 Figure 1: Musharakah within the shirkah structure (Source: Taqi Usmani, 2002) 5 Figure 2: Ijara in property finance (Source: Schoon, 2009, p. 102) 8 Figure 3: Musharakah mutanaqisah in property finance (Source: Noreeta, 2008) 9 Figure 4: Istisna in property finance (Source: Schoon, 2009, p. 105) 10 Figure 5: Tawarruq in property finance (Source: Schoon, 2009: 107) 11 Abbreviations and Terminology CSR – Corporate Social Responsibility IFI – Islamic Financial Institution SDLT – Stamp Duty Land Tax ‘Adl Justice ‘Aqar Immovable (property) Gharar Uncertainty; risk; deceit Ijara wa Iqtina From lease to purchase Istisna A contract of exchange with deferred delivery; literally exception or exemption Manqul Movable (property) Mudárabah Partnership in which one partner (rabb ul-maal) gives the other (mudarib) money for investing. Murábahah A sale in which the seller discloses the cost incurred and adds the mark-up, i.e. reselling on profit Mushárakah Co-partnership; equity participation; joint enterprise Musharakah Mutanaqisah Diminishing partnership Qimar Speculation; gambling Rabb ul-Maal Owner of the capital Riba Interest; usury Salam Advance payment for deferred delivery of goods Shariah Islamic law; literally pathway Shirakah Sharing; joint participation Sukuk Islamic bond; literally deed or financial certificate Tawarruq Reverse murabahah; monetisation; buying goods with a delayed payment Wakalah Agency Islamic finance: Comparison with conventional finance, its impact on mortgage finance products, and protective capacity during financial crises Introduction This research paper examines the characteristics of Islamic finance through highlighting its key features and comparing with conventional finance. It then makes a detailed study of the impact of Islamic finance on mortgage finance products. The following section then considers the protective capacity of Islamic finance during times of financial crises, in particular whether Islamic finance can help to avoid a future global financial crisis altogether. Features of Islamic finance Under the shariah (Islamic law), the charging, rather handling of riba (interest) is strictly prohibited. The Holy Quran (2:275) states, “Allah has allowed the sale and has prohibited interest”. As such, the giver and the taker, i.e. both, are blameworthy if any transaction or venture involves any interest. Interest is seen as an evil tool that perpetuates manipulation and exploitation of the masses. In addition, Islamic finance also prohibits gharar, which is uncertainty and qimar, which is speculation. The notable features of Islamic finance are therefore the complete absence of interest and speculation and reduction in uncertainty. All shariah compliant financial products and services conform to this ruling and ideals. In the absence of the aforementioned is found the application of the basic principle of shirakah (or shirkah) instead, which is a form of sharing or partnership (‘Abdur Rahman, 1984). The term literally means involvement or participation, i.e. from both sides. The Islamic system is based on both parties forming a close relationship and sharing in the risks and rewards from all financial ventures that ensue. In the context of a bank, this relationship is between the bank and its customers, and it is potential profit sharing that guides the relationships. In Islamic finance therefore, the rate of interest is replaced with “the rate of return of real activities as a mechanism for allocating financial resources” (Iqbal & Mirakhor, 1987: 29). In principle, this leads to financial and real rates of return correspond more closely and resources to be allocated more efficiently. Furthermore, at the heart of this Islamic framework for forging financial and business relationships, are in general, “ethical, fair and just practices” (Bank AlFalah, 2007). Islamic financial institutions (IFIs) and other service providers are therefore inherently ethically and socially responsible. In fact, the entire Islamic banking and financial system is designed to be an integral part of the greater universal Islamic system based on brotherhood and justice (‘adl). Providers of Islamic finance use three key instruments that epitomise the central philosophy of riba-free dealing and shirakah (sharing) in practice (to a varying degree). These are murábahah, mushárakah and mudárabah. Under murabahah, when a commodity is sold, there is allowance for the commodity to be bought back with a predetermined price differential (Glasse, 1989). Murabahah is used to sell a commodity acquired, such as property for example, wherein a mark-up or profit is applied and also disclosed to the purchaser (Albaraka, 2009). Ascertaining the exact cost is therefore essential in marabahah. Under musharakah, the depositor that is treated as a partner, shares in the profits as well as the losses after setting aside remuneration for management (Glasse, 1989). The share of any loss however, is in proportion to the ratio of investment, whereas the profit sharing can be in a different ratio as mutually agreed. Mudarabah involves “putting up financial backing for operations entrusted to someone else, and profit sharing in the profits of these operations” (Glasse, 1989). The first instrument (murabahah) is a form of fiduciary sale and is non-participatory for the buyer, but the other two allow for greater participation through partnership. The following diagram shows how musharakah fits into the traditional shirkah, or participatory scheme for financing. It concerns partnership in trade and services where there is a joint enterprise. Several other instruments have also been devised but they all share the same basic features. Figure 1: Musharakah within the shirkah structure (Source: Taqi Usmani, 2002) Comparison with conventional finance There are fundamental differences between Islamic and conventional or non-Islamic finance. Significantly, in conventional finance, interest is paid on money deposited at banks and levied on loans provided by banks, whereas in contrast, under Islamic finance, no interest is added to money deposited in banks or incurred on banks loans (Hassan & Aldayel, 1993). Conventional banks thus provide debt-based financial products and services based on charging interest on assets and liabilities, which in Islamic finance are strictly prohibited and therefore not to be found. What is found instead in Islamic finance, besides trade and lease based arrangements, is the characteristic equity based financing, Whereas in Islamic finance, both parties share both the risks and the rewards, the conventional system is geared to benefit the lender at the expense of the borrower. Only providers stand to benefit from gains while borrowers have to bear the entire risk. Thus, while the financier stands to gain under either system, whether in the form of interest or a share of the profits, there is also the theoretical possibility that he or she will have to share in any losses under Islamic finance. A financier under conventional finance cannot therefore suffer a loss under any circumstances. In regard to loans, the difference between conventional finance and Islamic finance, as exemplified by the instrument of musharakah, can be further clarified as follows. In conventional finance, there is normally a fixed rate of return on the loan, determined by the rate of interest on that loan. On the other hand, in a musharakah arrangement, this return is dependent on the actual profit earned through the joint venture. In case of the debtor incurring a loss, it is considered unjust in Islam for the creditor to still claim a fixed rate of return, and likewise, if a very high rate of profit is earned, it is considered unjust for the creditor to only gain a small proportion of the profit (Taqi Usmani, n.d.). Clearly, the Islamic system is built upon fairness, justice and social responsibility. The concept of Corporate Social Responsibility (CSR) for example, is a relatively new introduction in the non-Islamic world, but still, conventional finance is designed to advantage lenders in all situations not borrowers. Moreover, the interest-based system is fundamentally exploitative whereas Islamic finance is designed to prevent and eliminate exploitation and injustice, and sustain greater equality of wealth. Islamic principles therefore promote the well being of society. Another fundamental difference is in terms of how financing is backed. In Islamic finance, the financing is strictly backed by non-liquid assets (Taqi Usmani, 2002). On the other hand, conventional finance pays little regard to the amount of its fixed assets in issuing credit. The creating and lending of money without backing by assets or beyond the bank’s cash reserves (credit creation) is purely a feature of the capitalist monetary system, and which leads to its instabilities discussed further on. In short, Islamic finance denominates monetary exchanges into assets with intrinsic utility (such as gold) and restricts treating money as a commodity. The important differences between the two systems are summarised in the table below. Conventional finance Islamic finance Interest Interest based Interest free Debt-based financing Debt based financing is common Debt based financing is prohibited Risk Borrowers bear entire risk Both parties share risk Gains Providers benefit from gains Both parties benefit from gains Return on loan Fixed rate determined by interest rate Dependent on actual profit earned in joint venture Lender responsibility Little if any Corporate and social responsibility Backing of finance Not necessarily backed by fixed assets Strictly backed by fixed assets Table 1: Comparison between conventional and Islamic finance Impact on mortgage finance products The natural aversion to interest poses a problem to devout Muslims, especially when they want to buy a house on loan. Many have therefore resorted to accepting interest-based finance packages for homeowners out of necessity. The impact of Islamic Finance on mortgage finance products has therefore seen the eventual introduction of mortgage finance products based on Islamic modes of financing, espcially suitable for Muslim homebuyers in non-Muslim countries. The availability of shariah-compliant financing though is relatively recent in the modern era and not without its problems. Islamic home finance or mortgage products, aka home purchase plans, are mainly available in the following four forms: Murabahah (Reselling at profit) Ijara wa Iqtina (Lease to purchase) Musharakah Mutanaqisah (Diminishing partnership) Istisna (Deferred) Murabahah home financing Adhering to the description of this instrument given earlier, in the context of home financing, this involves the buyer finding a home and approaching the financier, requesting it to buy the house and then promising to buy the house from the financier instead. It is referred to as reselling at a profit or a deferred payment sale. This kind of resale before taking possession is permitted as real estate is classified as ‘aqar (immovable) property, as opposed to manqul (movable) property. Murabahah based mortgage financing tends to be very cost-effective, especially for banks located far away from the property being financed (Gamal, 2006: 38). However, customers are not necessarily better off than they would have been under conventional finance. The financier or bank’s purchase price plus the mark-up for murabahah is usually paid in fixed monthly installments. This is essentially similar to a conventional mortgage where the mark-up takes the place of the interest payments. However, this scheme can be costlier because two transfers of property take place against one in conventional finance. It is also cost prohibitive in case of desiring to sell before the end of the loan period, does not allow the loan period to be lengthened, and the finance cannot be securitised (Visser, 2009: 107-9). The latter makes debt only tradable at par otherwise riba becomes involved. Another disadvantage occurs in places where only interest payments on home finance can be deducted for income tax purposes (ibid). The issue of two transfers taking place results in double stamp duty, registry and other fees being payable such as solicitor or public notary fees. For the second sale, the marked up price of the house compounds the problem. In the UK at least, it is in recognition of this problem that double stamp duty was removed in 2003 by the Finance Act, by allowing the two sales to be regarded as part of a single financing agreement (BBC News, 2005; Masood et al., 2009). The new Stamp Duty Land Tax (SDLT) allows ownership of property to transfer from the financier to the buyer in stages as long as the temporary ownership is with a third party trust. Nonetheless, due to these issues and the other potential disadvantages, a number of alternative modes of Islamic home financing products have emerged, which are now discussed in turn. Ijara wa iqtina In ijara wa iqtina, which has some similarities with a conventional leasing arrangement, when a home is found and the financier buys it, it is resold against deferred payment. Moreover, the financier retains the title until the final payment is made. In addition to the purchase agreement, both parties enter into a lease agreement whereby a monthly payment is agreed, which includes rent and amortisation of the principle amount (Visser, 2009: 109). Schoon (2009: 102) depicts the process as follows: Figure 2: Ijara in property finance (Source: Schoon, 2009, p. 102) The rental levels are usually revised yearly, so it is argued by the likes of El Diwany (2003) that this introduces gharar (uncertainty). A problem also arises if the house price falls or the house buyer is no longer able to keep up with the payments. Moreover, the issue of double stamp duty and other fees remains as there are still two sales transactions involved. The main advantage of this product over murabahah however is that securitisation is possible and therefore such loans are not illiquid (Visser, 2009: 110). In Islamic finance, securitisation transforms the risk-sharing of the transaction into market-based refinancing (Jobst, 2007: 15). Musharakah Mutanaqisah Under this special diminishing musharakah (partnership) arrangement, the house buyer and financier both jointly own the property, but the latter’s share gradually diminishes over time while that of the house buyer increases. The financier is paid a periodic rental for using the property, which may have either a fixed or floating rate, and the buying of units of the property at a time is governed by the agreement (Schoon, 2009: 65). The process of musharakah mutanaqisah is depicted below where the customer is the ultimate house buyer and the financier is the bank. For the purpose of illustration, the initial ownership between the customer and the bank is in the ratio 20% to 80%. Figure 3: Musharakah mutanaqisah in property finance (Source: Noreeta, 2008) In practice however, this arrangement is usually combined with ijara, thus making it a diminishing musharakah lease structure. The need to combine is usually due to regulatory and tax issues (Schoon, 2009: 66). Also, some financiers, such as HSBC Amanah in the UK, only transfer ownership at the end of the period (Visser, 2009: 111). The musharakah mutanaqisah arrangement alone also has practical issues related to the rental rate, redemption, defaults, asset value appreciation, and contract termination, as found in a study by Ahamed & Dzuljastri (2009). They showed for example, that an increase in the rental rate tends to reduce the additional share the customer has to acquire in subsequent years, which leads to the need for revaluation of the property. They also compared rental yields with market interest rates between 1984-2005 in Kuala Lumpur, and found that the former generally tend to be lower. Therefore, banks usually favour musharakah mutanaqisah arrangements only if there is potential for high rental. Their recommendation was implementing musharakah mutanaqisah through cooperatives in case of rental rates below prevailing interest rates for the sake of promoting social well being. Osmani & Abdullah (2010) found similar shortcomings in the application of musharakah mutanaqisah for home financing. The issues concern ownership, liabilities, shares, transfer of ownership, rentals, ijarah, etc., so they also recommended modifications to make it more practical. Istisna In istisna, the delivery is deferred, so it is also referred to as long-term production finance. It has similarities to what is known as a salam contract but it is for a longer term and is more flexible. The exemption implied by its name refers to the ownership and existence of the asset. It is not necessary for the payment to be made in full to the property developer in advance, and it is usually made in installments as the development progresses (Schoon, 2009: 104). The process of istisna can be depicted, as in the diagram below, in which the relationship between the three entities and the flow of payments can be seen. Unlike in the ijara wa iqtina arrangement, the initial seller, in this case the developer has a more involved role. Figure 4: Istisna in property finance (Source: Schoon, 2009, p. 105) In practice, the developer of the property is made to pay forward lease payments during construction from the sales proceeds for the bank’s convenience. The ultimate buyer could also be the bank’s own client of course. Other Islamic property financing arrangements Besides the above four, some other property financing arrangements have also been devised in compliance with the shariah. Among these is bai bithaman ‘ajil, which was popular in Southeast Asian countries like Malaysia and Indonesia, bai ina, salam, which was mentioned above in comparison with istisna, and tawarruq, which is a variant of murabahah financing. Bai bithaman ‘ajil and tawarruq are based on the murabahah concept but their deviation is significant enough to make their validity as shariah compliant dubious in the eyes of some. The first is a deferred type arrangement. However, the bank functions strictly as a financier rather than owning initial ownership of the property, and the ultimate house buyer ends up having almost immediate title to the property (Noreeta, 2008). As such, the house buyer is indebted to the bank from the very outset, so there is hardly any risk sharing involved, which is the basis of Islamic modes of financing. Tawarruq attempts to do away with the double elements in the previously described home financing arrangements. This avoids the problems associated with VAT, stamp duty and other related issues. A single agreement simultaneously handles both sales. Tawarruq is graphically depicted in Figure 5 below. Figure 5: Tawarruq in property finance (Source: Schoon, 2009: 107) Due to the combined sale and purchase, and appointment of the bank as the agent, all together, it can become difficult to ascertain who actually owns the property at any point in time during the transaction. The disadvantage is obvious in the event that the transaction fails during this period. However, tawarruq is criticised mainly on theological grounds because “the intention behind the purchase of the commodity is not to own and use the commodity, but solely to generate a cash flow” (Schoon, 2009: 107). The approval of tawarruq however, is usually granted provided the property is transferred through auditable ownership and the sale and purchase arrangements are separated. Legislative support No doubt, the success of Islamic finance mortgage products would not be possible if the legislative framework in which they operate do not support them or treat them on a par with conventional finance. Fortunately, the situation in the UK at least, is promising as the government has been keen to allow UK financial institutions offer Islamic finance to help them compete with IFIs in other countries of the world. The introduction of the SDLT was a significant step in this direction. There have also been more recent changes in legislation expressly implemented for the sake of facilitating Islamic finance in the UK. Notable changes were made for example, in the Finance Act 2006, which amended tax laws “to remove the tax impediments to Shariah-compliant Islamic finance products” (Ahmad, 2010: 256). The 2006 and 2007 budgets saw further changes in incorporating more ‘alternative finance arrangements’ such as wakalah (agency), musharaka mutaniqisa and ijara wa iqtina. The situation also highlights the need for Islamic financial services to be not only Shariah compliant, but also take into account existing tax regulations. Tax relief for alternative property finance arrangements is covered by sections 71A to 73 of the SDLT (Humphrey & Freedman, 2007: 197). Impact of Islamic financing arrangements The reliance of Islamic finance on backing with fixed assets instead of interest suggests difficulties in providing loans, especially on short-term basis. However, Islamic banks have now become well established globally and have acquired sufficient scale to be able to offer not only mortgage finance products but also satisfy other shorter term funding requirements. According to the 2010 ‘Islamic Funds & Investment Report’ (EY, 2010), although fund assets remained fairly stagnant during 2009, there was a 20% growth in the wealth pool of the Islamic funds industry, estimated at $480 billion. The impact of Islamic finance on the market for mortgage finance products has seen the promotion, especially of equity based financing models. The impact on profit is typically positive with higher returns in the longer term than debt based. From the economic perspective, Islamic finance helps to put the focus on making profit because the risk sharing principle makes lenders more responsible to ensure profitability. It avoids the undue barriers to success caused by constant negotiations over lending rates and repayment schedules under conventional debt financing. Borrowers thus tend to gain automatically from the greater effort to make the enterprise succeed. If applied on a wide scale, this can only have positive consequences for enterprising people with good ideas but insufficient capital, for innovation, and for the economy in general. The social impact is also positive as an outcome of the positive economic conditions. The social repercussions under contrary conditions due to the evil of interest is evident and acutely demonstrated during times of personal, local and global financial crises. Protective capacity during financial crises “The most important lesson [of the recent global financial crisis] is that interest-based monetary management stands discredited and invalidated” (Karim, 2010). The recent global financial crisis during the latter part of the 2000s has heated the discussion about whether the Islamic finance model is a viable alternative to conventional finance, and whether the crisis could be avoided in future. The global financial crisis could be the ‘dire consequences’ that Allah refers to in the Holy Quran (2:279), which results upon those nations that indulge with interest. One of the principle causes of such destabilising economic cycles in general is the erroneous practice of creating money out of nothing through its impact on inflation, as pointed out by John Tomlinson (1993: 51) in his book ‘Honest Money’. The subprime mortgage debt, which led to the recent crisis, involved the heavy trading of money that had no backing by assets. This would not be possible under Islamic finance. The sub-prime mortgage crisis in the US housing market could therefore have been avoided. In fact, this crisis has been described by many as unthinkable under Islamic finance, precisely because the shariah principles never allow to “sell a debt against a debt” (Sinnakkannu & Bhatt, 2008). This alone does not let the financial markets “be stretched beyond what the real economy can bear” (OIC, 2009). Moreover, under Islamic finance, greed would not be allowed to reign free as in the capitalist system. In short, the crisis would not have happened if all the various preventive measures in Islamic finance were adopted against greed, speculation, risky trading, etc. (Kates, 2010: 178). Together with the substantial minimisation of uncertainty in general, the regulations on money creation, and so on, Islamic finance promotes much greater economic stability. As the sharing of gains and losses puts the onus on investors to invest wisely, banks engaged in Islamic finance tend to minimise risk by accumulating loss compensating balances during periods of high profit. This also becomes useful for deposit insurance, diversification of assets, and monitoring projects (Iqbal & Mirakhor, 1987: 29). The concept of sharing risk alone can therefore make a huge difference if it were made compulsory. This would make banks more responsible for the performance of projects as it would determine the actual returns. That is, the value of their liabilities would be tied to the performance of their assets. Hassan & Aldayel (1993) conducted an empirical examination of stability in the demand for money under the conventional and Islamic financial systems across fifteen countries. It was found that “the velocity of money and its variance are lower for interest-free banking system than for interest-bearing banking system”. The study aimed to duplicate the findings of an earlier study by Darrat (1988) conducted in Tunisia in which it was concluded that interest-free money tends to be more stable than interest-bearing money. The findings thus supported the same hypothesis, i.e. that interest-free money exhibits greater stability than interest-bearing money. A study by Hasan (2010) for the IMF showed that during the global financial crisis that did occur, Islamic banks displayed stronger resilience. The study examined the performance of 120 different banks during the period 2007 to 2010. Before the crisis, Islamic banks were more profitable, and when the crisis began, they only experienced a minor impact on profitability while their growth remained strong for assets and credit. However, there was a steep decline in profitability in 2009. The explanation deserves the attention of further study, suffice to say, Islamic banks were less affected than conventional banks and demonstrated greater stability. However, the capacity for Islamic finance to prevent a future global crisis will require the practice of risk sharing to become more widely adopted than it is today. This is because it creates “a tangible economic purpose, ensuring sound liquidity management” (Seetharaman, ). The greater risk sharing will be better facilitated by further advances in information technology besides further institutional and legal developments to support Islamic financing (Iqbal, 2009: viii). Institutional level changes would require minimisation of the regulatory and legal risks posed to IFIs to allow Islamic finance to flourish (Ahmed, 2009). The prevention of a future crisis also hinges on increasing trust, which besides managing risks more effectively, also means there is a need for greater transparency in all financial dealings. Concluding discussion The important distinctions between conventional and Islamic finance were highlighted and this was followed by a survey of Islamic mortgage finance products. This revealed an array of existing arrangements designed to assist homebuyers wishing to comply with the shariah. However, they have to face a number of problems, such as stamp duty and securitisation, which continue to be dealt with in order to allow the Islamic framework to become established. Islamic finance can also prove to be a panacea for wider financial issues. The solution to prevent future financial crises is in completing replacing the interest-based system with an equity-based system that is fair and favourable to both parties. Islamic finance is inherently an equity-based system (Khan & Bhatti, 2008) that can fulfill this need. In practice however, the degree of adoption of the Islamic finance model around the world varies considerably even among Muslim countries. Moreover, many attempts are fundamentally flawed because they are still in many respects modelled on the conventional interest based model, for example in terms of the institutional structure and material goals. 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Visser, Hans. (2009). Islamic finance: principles and practice. Edward Elgar Publishing. Additional bibliography Calyon. (N.d.). Glossary of terms used in Islamic banking. Calyon Credit Agricole CIB. Available at http://mediacommun.ca-cib.com/sitegenic/medias/DOC/29461/glossaire_islamicbanking_en.pdf. Islamic Finance. (2010). http://www.islamic-finance.com. Islamic Mortgages. (2010). http://www.islamicmortgages.co.uk. Read More