Saturday, 18 October 2014

Islamic Banking shows growth

Chancellor guide to Legal and Shari'a  Aspects of Islamic finance

The Rise of Islamic Banking Finance
A very helpful 40 minute overview

Online training

To maintain their independance the Sudanese have borne with much patience 22 years of western sanctions and war across a country the size of Western Europe.  US and UN Sanctions go back to close Sudanese-Iraqi ties and the first Gulf war in 1990.   

With access to conventional banking restricted by Sanctions Islamic Banking has become a particular success story in Sudan as it has across the Muslim world.

The growth and popularity of the use of Islamic finance has been exceptional since the Central Bank of Bahrain issued the first sovereign sukuk bonds in 2001. It is estimated that by the end of 2012 Islamic financial assets will have exceeded $1,600bn, which is around 1–2% of global financial assets worldwide.

KPMG Global Islamic Finance Guide

KPMG Islamic finance reporting through IFRS
http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/pol-afb-gabc.pdf

ACCA
Introduction - Syllabus
http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012/introIsFinance.pdf


From 2013, Islamic finance becomes part of the Paper P4 syllabus, following its introduction to Paper F9 two years ago. This article looks at Islamic finance as a growing and important source of finance, including the success and failure of the use
The growth and popularity of the use of Islamic finance has been exceptional since the Central Bank of Bahrain issued the first sovereign sukuk bonds in 2001. It is estimated that by the end of 2012 Islamic financial assets will have exceeded $1,600bn, which is around 1–2% of global financial assets worldwide.
ACCA recognised the importance of Islamic finance and introduced it in the Paper F9 syllabus two years ago. The ACCA syllabus states students should be able to: ‘Identify and briefly discuss a range of short- and long-term Islamic financial instruments available to businesses.’
From this year, Islamic finance becomes part of the Paper P4 syllabus, but at a different level to that which is tested at Paper F9. A successful Paper P4 student must: ‘Demonstrate an understanding of the role of, and developments in, Islamic financing as a growing source of finance for organisations; explaining the rationale for its use, and identifying its benefits and deficiencies.’
This article is focused on Islamic finance as a growing and important source of finance. In particular, it looks at the success and failure of the use of sukuk bonds to finance the purchase of assets. However, for the purpose of reference, the attached appendix explains the basic principles of Islamic finance.


SUKUK FINANCE

What is sukuk finance? The official definition provided by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Bahrain-based Islamic financial standard setter, is ‘certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity.’
Sukuk is about the finance provider having ownership of real assets and earning a return sourced from those assets. This contrasts with conventional bonds where the investor has a debt instrument earning the return predominately via the payment of interest (riba). Riba or excess is not allowed under Sharia law.
There has been considerable debate as to whether sukuk instruments are akin to conventional debt or equity finance. This is because there are two types of sukuk:
  • Asset based – raising finance where the principal is covered by the capital value of the asset but the returns and repayments to sukuk holders are not directly financed by these assets.
  • Asset backed – raising finance where the principal is covered by the capital value of the asset but the returns and repayments to sukuk holders are directly financed by these assets.

There are fundamental differences between these. The diagrams set out below explain the mechanics of how each sukuk operates.


ASSET-BASED SUKUK

Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease back.


sa_feb13_p4_islamic-2
  1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company.
  2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
  3. The SPV uses the funds raised and purchases the asset from the obligor (seller).
  4. In return, legal ownership is passed to the SPV.
  5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah agreement.
  6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the asset.
  7. The SPV then make periodic distributions (rental and capital) to the sukuk holders.


ASSET-BACKED SUKUK

Sukuk: Securitisation of Leasing Portfolio


sa_feb13_p4_islamic-3
  1. Sukuk holders subscribe by paying an issue price to a SPV company.
  2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
  3. The SPV will then purchase a portfolio of assets, which are already generating an income stream.
  4. In return, the SPV obtains the title deeds to the leasing portfolio.
  5. The leased assets will be earning positive returns, which are now paid to the SPV company.
  6. The SPV then makes periodic distributions (rental and capital) to the sukuk holders.
  7. With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the SPV. Hence, they would have to maintain and insure the asset. The payment of rentals provides the return and the final redemption of the sukuk is at a pre-agreed value. As the obligor is the lessee, the sukuk holders have recourse to him if default occurs. This makes this type of sukuk more akin to debt or bonds.

Asset-backed sukuk certainly have the attributes of equity finance – the asset is owned by the SPV. All of the risks and rewards of ownership passes to the SPV. Hence, should the returns fail to arise the sukuk holders suffer the losses. In addition, redemption for the sukuk holders is at open market value, which could be nil.


SUKUK FINANCE CASE STUDIES

For Emirates airline, the use of sukuk finance has been a huge success. The company issued its first sukuk (Islamic Bond), with a seven-year term, in 2005, which was listed on the Luxembourg Stock Exchange. The $550m was repaid in full in June 2012.
‘The repayment of our first ever sukuk bond is part of Emirates’ varied financing strategy and reflects our robust financial position,’ said Sheikh Ahmed bin Saeed Al Maktoum, chairman of the Emirates Group and chief executive of Emirates airline.
Emirates’ initial injection of equity finance at the time of its creation 24 years ago has been supplemented by a variety of financing options, including operating leases, EU/US export credits, commercial asset-backed debt, Islamic financing, conventional bonds, as well as sukuk.
Tim Clark, Emirates’ president, recently stated that the airline had traditionally used European debt to finance purchase of its fast-growing Boeing and Airbus fleet. The French banks were particularly forthcoming with finance solutions.
However, since the global debt crisis in 2008, the traditional debt markets have taken a risk averse position – even with a business like Emirates, which has an unbroken profit-making record.
Clark outlined that obtaining funding for new planes using sukuk could be tricky because Islamic finance, in addition to forbidding payment of interest, prohibits pure monetary speculation and requires deals to involve concrete assets. It would be harder to win a seal of approval from Islamic finance scholars for a sukuk that was based on assets, which the airline did not yet own.
For new aircraft, it is not impossible but it is much more complicated as the cash would have to go from investors through a special purpose vehicle to the manufacturer before a lease-back arrangement is put in place. Hence, using existing assets to obtain sukuk finance is far easier.
Emirates currently has two aircraft-based sukuk instruments that have been issued globally, and is backed by existing aircraft: a $500m issue from GE Capital in November 2009, and a $100m deal for Nomura in July 2010.
Emirates is not the only success story when it comes to the use of sukuk finance. Dubai shopping mall developer Majid Al Futtaim decided against issuing a conventional bond because of pricing concerns. It mandated its banks to set up a separate sukuk programme. Turkish Airlines has followed suit and will finance the purchase of its expanding fleet with Islamic bonds.
The sukuk market has been relatively resilient during the instability in global financial markets, which has made it more difficult for even highly rated companies around the world to issue conventional bonds. That is partly because Islamic investors in the Gulf remain cash-rich, partly due to the limited supply of sukuk, and partly since sukuk investors tend to hold the bonds until maturity. If these bonds are not being sold on to other investors, there is little or no chance of the bond value fluctuating.
Recent events have shown the same is not true for conventional bonds. The influence of the credit rating agencies with their regular reassessment of government and corporate credit ratings has caused downward movement in prices. As one commentator recently stated: ‘Equities are the only game in town – bonds carry more risk.’
However, the story of Dubai World, the sovereign investment fund of the Dubai royal family, gives the other side of the story when it comes to the use of Islamic finance. On 25 November 2009, the financial world was shocked when Dubai World requested a restructuring of $26bn in debts. The main concern was the delay in the repayment of the $4bn sukuk, or Islamic bond, of Dubai World’s developer Nakheel, which was especially known for construction of the Dubai Palm Islands.
The Nakheel sukuk was quite a complicated instrument. It was broadly based on the aforementioned Ijarah structure. In theory, the SPV has legal ownership over the asset in this sale and leaseback arrangement. However, in this case the SPV only had a long leasehold interest for a period of 50 years. The issue is that leasehold right is not seen as a real right or property right under UAE law as applicable in Dubai. What may have seemed secure was not.
Nevertheless, the Nakheel sukuk was backed by a few additional guarantees that should have provided sukuk investors with some recourse. As such, these guarantees gave investors the confidence to invest in the sukuk. A guarantee from the state-owned parent company, which implicitly provides a government guarantee for the sukuk (despite the fact that the prospectus clearly stated otherwise), had reassured investors. This misplaced assumption misled investors in their risk–return decision on the investment.
The issue, however, did not end there; the complications worsened when the parent company that acted as guarantor found itself in a situation that made it no better placed than Nakheel to repay the sukuk. Dubai World is also just a holding company for a number of other companies beside Nakheel. However, all of Dubai World’s subsidiaries have their own creditors and their own debts to service, and the important thing for Nakheel sukuk-holders is that the creditors of Dubai World, through the guarantee, are subordinated to the creditors of the subsidiaries of Dubai World.
A public statement on 30 November 2009 by the Dubai Finance Department director-general, that the Dubai World debts are ‘not guaranteed by the government’, appears to correctly reflect the legal position, as the Dubai government was not required by the lenders, and nor did it provide, any contractual guarantees in respect of the Dubai World debt.
As history tells us, Nakheel did not default on its Islamic bond. The well reported $10bn bailout, including providing $4.1bn to assist Nakheel directly from Dubai’s rich neighbours Abu Dhabi, calmed the markets. But this was only part of the solution. Nakheel also issued new sukuk bonds to some of its creditors in lieu of amounts due to them. This was a key part of the company's restructuring.
In a prospectus attached to the new sukuk, Nakheel revealed that it wrote down the value of its property and project portfolio by almost Dh74bn (US$20.14bn) in 2009 as its fortunes flagged. The company also said it changed tactics in response to the financial crisis, forging ahead with a selection of its projects and putting others on hold.


CONCLUSION

The global debt crisis sent shockwaves through the financial markets and, at the time of writing this article, the western banks remain reluctant to loan cash to the business community. Islamic finance, and in particular sukuk, has to some extent filled the gap left by the traditional debt markets.
The Sharia principle on which it is based is fundamentally important and should ensure it is a safe and sensible finance option for both the company needing the finance as well as the sukuk holder. Clearly, companies like Emirates have shown the way on how to make sukuk one part of their finance portfolio.
However, the Nakheel story paints a different picture. A complicated Ijarah structure and a lack of legal clarity as to ownership of the underlying asset have clouded the water. If the Abu Dhabi bailout failed to materialize, then the story may have been significantly different.
Sunil Bhandari is a freelance Paper P4 tutor (www.SunilBhandari.com)

APPENDIX – THE BASIC PRINCIPLES OF ISLAMIC FINANCE
The Islamic economic model has developed over time based on the rulings of Sharia on commercial and financial transactions. The Islamic finance framework is based on:
  • equity, such that all parties involved in a transaction can make informed decisions without being misled or cheated
  • pursuing personal economic gain but without entering into those transactions that are forbidden (for example, transactions involving alcohol, pork-related products, armaments, gambling and other socially detrimental activities). Also, speculation is also prohibited (so options and futures are ruled out)
  • the strict prohibition of interest (riba = excess).

As stated above, earning interest (riba) is not allowed.
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channeled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.
A typical illustration would be how an Islamic bank may purchase a property from a seller and resell it to a buyer at a profit. The buyer will be allowed to pay in instalments. Compare this to a typical mortgage where the bank lends money to the buyer and charges interest.
Hence, returns are made from cash returns from a productive source – for example, profits from selling assets or allowing the use of an asset (rent).
In Islamic banking there are broadly two categories of financing techniques:
  • ‘fixed Income’ modes of finance – murabaha, ijara, sukuk
  • equity modes of finance – mudaraba, musharaka.


FIXED INCOME MODES

(a) Murabaha Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan is that, with a murabaha, the bank will take actual constructive or physical ownership of the asset. The asset is then sold to the ‘borrower’ or ‘buyer’ for a profit but they are allowed to pay the bank over a set number of instalments.
The period of the repayments could be extended, but no penalities or additional mark-up may be added by the bank. Early payment discounts are not within the contract.

(b) Ijara Ijara is the equivalent of lease finance. It is defined as when the use of the underlying asset or service is transferred for consideration. Under this concept, the bank makes available to the customer the use of assets or equipment such as plant or motor vehicles for a fixed period and price. Some of the specifications of an Ijara contact include:
  • the use of the leased asset must be specified in the contract
  • the lessor (the bank) is responsible for the major maintenance of the underlying assets (ownership costs)
  • the lessee is held for maintaining the asset in proper order.

An Islamic lease is more like an operating lease, but the redemption features may be structured to make it similar to a finance lease.
(c) SukukCompanies often issue bonds to enable them to raise debt finance. The bond holder receives interest and this is paid before dividends. 
This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukuk holder is a partial owner in the underlying assets and profit is linked to the performance of the underlying asset. So, for example, a sukuk holder will participate in the ownership of the company issuing the sukuk and has a right to profits (but will equally bear their share of any losses).


EQUITY MODES 

(a) MudarabaMudaraba is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner (who is called ‘rab ul mal’), while the management and work is an exclusive responsibility of the other (who is called ‘mudarib’).
The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. In a Mudaraba only the lender of the money has to take losses.
This arrangement is therefore most closely aligned with equity finance.
(b) MusharakaMusharaka is a relationship between two or more parties that contribute capital to a business, and divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital. All providers of capital are entitled to participate in management, but are not required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to their respective capital.

This article aims to continue to develop the understanding of Islamic finance and follows the first article on this subject, 'Islamic finance – theory and practical use of sukuk bonds', published in February 2013 (see 'Related links'). The first article focused on Sukuk finance and case studies where Sukuk finance was utilised. This article is more general and considers different aspects, issues and developments of Islamic finance. It also extends the explanations provided in the appendix to the first article.
Islamic finance has been a recent addition to the Paper P4 syllabus. It is expected that future questions in this area will focus on developments and understanding of Islamic finance. However, questions could also focus on the application of Islamic finance as an additional source of finance, and assessing its benefits and drawbacks, in different business scenarios and situations.


OVERVIEW

Islamic virtues and tenets specify the need for ethical behaviour and fair treatment. Within a business context, this means that organisations should maintain high ethical standards in all business dealings. Specifically, business and enterprise should be conducted with honesty and integrity, maintaining truthfulness and morality in all dealings. In particular, such business and enterprise should not capitalise on the misfortune of others or take unfair advantage. For example, higher prices should not be charged to an individual because they lack knowledge and information about the fair price of a product that they are purchasing. Profit creation should be the result of business activity that benefits society at large.
Within this context, the Islamic finance framework is based on certain prohibitions. In particular, money (and money substitute products such as gold and silver) should not be viewed as commodities, but rather as means of exchange. Therefore, interest (or riba) cannot be paid or received on loans. Furthermore, although it is fully acceptable to engage in profitable business activities, such business should be ethical. In particular dealing in alcohol, pork-related products, armaments, gambling and other socially detrimental activities is not acceptable. Engaging in activities involving speculation is also not allowed, limiting the use of derivative instruments and money markets, which are based on interest.


OPERATIONALISING ISLAMIC FINANCE

Organisations need access to short-term and long-term sources of finance. The basic, fundamental function of banks is to provide a channel that enables the flow of financial resources from investors to borrowers, and thereby provides a source of finance for organisations. Investors invest their excess funds to earn interest, and borrowers use the funds in business activity to generate profits, some of which are then used to pay interest on the borrowings. Among other sources of finance that involve the payment and receipt of interest are corporate and government bonds.
The question that could be asked is how could finance flow between investors and borrowers without involving interest. The answer provided by Islamic finance, in its basic form, is through profit-sharing arrangements or partnerships. The article on Islamic finance published in February 2013 explained it as follows:
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channeled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.
Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and Musharaka equity-type contracts through multi-partnership contracts (see below). Here, investors (known as rub-ul-mal) would invest funds with the IFI (known as the mudareb or investment manager). The funds are then pooled and used in profit-making projects while also keeping within Sharia rules. Therefore, the IFI would effectively become the rub-ul-mal and the corporation that uses the funds for investment purposes becomes the mudareb. In each case, the emphasis is on partnerships, and the profits earned are shared between the corporation, the bank and the investors. It is possible that all three parties share the losses as well, if the business venture is not successful.
However, with corporations requiring different modes of finance and IFIs keen on providing these, different types of Islamic financial products have been developed. The challenge for IFIs is to ensure that the products comply with Sharia rulings, as well as normal financial regulations and law.


COMMON ISLAMIC FINANCIAL PRODUCTS

IFIs offer two broad categories of financial products: equity-based and fixed income-based. The appendix to the February 2013 article on Islamic finance explained many of these financial products and it is recommended that this article is read in conjunction with the first article for further detail.
Equity-based financial products
Equity-based financial products consist of Mudaraba and Musharaka contracts. With these contracts, the investor or IFI (rub-ul-mal) and the investment manager or corporation (mudareb) share the profits from the business venture, in which the funds are invested, in a pre-arranged agreement. The key differences between the two contracts are two-fold.
With a Mudaraba contract:
  • all losses are borne solely by the investor (IFI), although provisions can be set up to carry forward these losses against future profits, and
  • the mudareb, as the expert in the business venture takes the sole responsibility for running the business.

With a Musharaka contract:
  • losses are shared between the two parties in proportion to their monetary investment or investment-in-kind, and
  • both parties would participate in managing and running the venture jointly.

Diminishing Musharaka contracts are a recent innovation where not only are the profits shared between rub-ul-mal and the mudareb, but the mudareb would pay greater amounts to the rub-ul-mal. In this way the mudareb owns greater and greater proportion of the asset, until eventually the ownership of the asset is passed to the mudareb entirely.
Fixed-income based financial products
With Murabaha contracts, the IFI purchases the asset and then sells it to the business or individual at cost plus a fair profit. The business or individual pays for the asset in pre-agreed instalments and over a pre-agreed time period.
Ijara contracts are similar to operating leases where the IFI purchases an asset for the business or individual to use. The lease payments, the lease period and payment terms are agreed at the start of the contract. The lessor is responsible for the maintenance and insurance of the asset. Provisions can be made to allow the lessee to purchase the asset for a nominal fee at the end of the contract.
Sukuk bonds were covered in some detail in the February 2013 article on Islamic finance and it is recommended that you study that article in detail. Sukuk bonds have been based on underlying securitised Islamic contracts such as Ijara and Mudaraba, as well on individual or groups of physical assets. Some Sukuk bonds have been based on securitised Murabaha contracts, but there is some debate on whether these comply with Sharia rulings, as they may be viewed as debt on debt and therefore attracting riba. Some Sharia rulings have allowed minor proportions of Murabaha and Istisna contracts within the securitised asset portfolio, used as the underlying asset portfolio.
Salam contracts are similar to forward contracts, where a commodity (or service) is sold today for future delivery. Cash is received immediately from the IFI and the quantity, quality, and the future date and time of delivery are determined immediately. The sale will probably be at a discount so that the IFI can make a profit. In turn, the IFI would probably sell the contract to another buyer for immediate cash and profit, in a parallel Salam arrangement. Salam contracts are prohibited for commodities such as gold, silver and other money-type assets.
Istisna contracts are often used for long-term, large construction projects of property and machinery. Here, the IFI funds the construction project for a client that is delivered on completion to the IFI’s client. The client pays an initial deposit, followed by instalments, to the IFI, the amount and frequency of which are determined at the start of the contract.


SHARIA BOARDS

Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant with the principles of Sharia rules. They review and oversee all new product offerings made by the IFI and make judgments on an individual case-by-case basis, regarding their acceptability with Sharia rulings. Additionally, SBs often oversee Sharia compliant training programmes for an IFI’s employees and participate in the preparation and approval of the IFI’s annual reports.
SBs are normally made up of a mixture of Islamic scholars and finance experts to ensure that fair and reasonable judgments are made. Where necessary, the finance experts can explain the products to the Islamic scholars. The Islamic scholars often sit on several SBs of a number of different IFIs. SBs are in-turn supervised by the International Association of Islamic Bankers (IAIB).
SBs face several challenges when making judgments. Sharia law can be open to different interpretations, leading to different outcomes on the acceptability of the same products by different SBs and Islamic scholars. Furthermore, precedents set by SBs are not binding, and changes in SB’s personnel over time may shift the balance of the SB’s collective opinions and judgments on the acceptability of existing and new products.
SBs need considerable resources to operate effectively, especially where Sukuk finance is concerned. IFIs need to ensure that their SB members are well informed about the developments and trends in global financial markets.


BENEFITS, DRAWBACKS AND CHALLENGES

Benefits
Corporations, individuals and IFIs engaged in raising and issuing funding based on Islamic finance virtues may be viewed as belonging in stakeholder-type partnerships that are engaged in deriving benefits from ethical, fair business activity. The result of these partnerships is one of mutual interest, trust and co-operation. The ethical stance and fair dealing of Islamic finance virtues means that partnerships, business activity and profit creation comes from benefiting the community as a whole.
Since the virtues of Islamic finance and enterprise prohibit speculation and short-term opportunism, it encourages all parties to take a longer term view of success from the partnership. It focuses all the parties’ attention on creating a successful outcome to the venture. This should result in a more stable financial environment. Indeed, literature in this area suggests that had banks and other financial institutions conducted their business activity based on Islamic finance principles, the negative impact of the banking and sovereign debt financial crises would have been much reduced.
IFIs or conventional financial institutions with products based on Islamic finance principles gain access to Muslim funds across the world and provide finance for organisations and individuals who need them. As the February 2013 article stated, it is estimated that Islamic financial assets have exceeded $1,600bn worldwide. As the world emerges from the global financial crisis and business activity increases, this should increase. Furthermore, access to Islamic finance is not restricted to Muslim communities only. The wider business community could have access to new sources of finance. This may be particularly attractive to corporations focused on ethical investments that Islamic finance virtues stipulate.
Drawbacks and challenges
Because of the prohibitions of riba and on speculation, IFIs may be slower to react to market demand and changes. They may lack sufficient flexibility in their product offering when compared to conventional financial institutions and may be less able to take advantage of short-term opportunities.
Moral hazard and principal-agent issues may be more pronounced between IFIs and organisations and individuals to whom they lend funds. This is because Islamic finance virtues stipulate close relationships from partnership-like arrangements. However, information asymmetry between the IFI and the borrower of funds will always exist. Therefore, costs related to increased level of due diligence and negotiating are probably higher for IFIs.
Costs related to developing new financial products may also be higher for IFIs because not only will the products have to comply with normal financial laws and regulations but also with Sharia rules. As stated above, the resources required by SBs can be considerable.
Added to this, because these financial products need to go through stages of compliance and layers of complications before they are approved, the approval process can take time. The pace of innovation of new Islamic financial products may be considerably slower than that of conventional products. This may make the IFI less able to compete with conventional financial institutions and may make it restrict its activities to smaller, niche markets.
Some Islamic financial products may not be compatible with international financial regulation – for example, a diminishing Musharaka contract may not be an acceptable mortgage instrument in law, although it could be constructed as such. The need to ensure that such products comply with regulations may increase legal and insurance costs.
The interpretation of Sharia rulings may allow certain Islamic finance products to be acceptable in some markets, but not in others. This has led to some Islamic scholars, who are experts in Sharia and finance, to criticise a number of product offerings. For example, some Murabaha contracts have been criticised because their repayments have been based on prevailing interest rates rather than on economic or profit conditions within which the asset will be used. Some Sukuk bonds have faced similar criticisms in that their repayments have been based on prevailing interest rates, they have been credit-rated and their redemption value is based on a nominal value rather than on a market value, and thereby, perhaps, making them too close to conventional bonds and their repayments too similar to riba. On the other hand, the opposite argument could be that in order to make Islamic financial products competitive in all markets, their valuations need to be comparable. Therefore, benchmarking them using conventional means is necessary.
So far the discussion on drawbacks and challenges has focused on IFIs, as providers of Islamic finance. It is also important to consider the drawbacks and challenges that corporations may face when using Islamic finance.
From the above discussion, the costs related to developing and gaining approval for Islamic financial products is likely to be passed down to customers and possibly make these products more expensive. In addition to this, access to new products and flexibility within existing products may be limited, due to the more complicated approval process that is necessary. These more expensive and less flexible sources of finance may make the corporation using them less competitive when compared to rivals who have access to cheaper, more flexible sources of finance.
The partnership nature of Islamic finance contracts may also cause agency type issues within corporations. These may be more prevalent in joint venture type situations or where the diverse range of stakeholders may make it more difficult for corporations to determine and act upon the importance of various stakeholder groups. For example, in the case of a Musharaka contract, where the IFI and the organisation are both involved in the management of a project, dealing with other stakeholder groups may be more challenging.
Before the financial crisis, trading in asset backed and securitised Sukuk products, issued by corporations, has been limited (a notable exception was Sukuk products denominated in Malaysian ringgits). Furthermore, since the financial crisis, issuance in new Sukuk products has reduced somewhat.
Using Islamic finance may also increase the cost of capital for a corporation. For example, it may be more difficult to demonstrate that repayments for Mudaraba, Musharaka and Sukuk contracts are like debt, and therefore they may not attract a tax-shield. However, an equivalent organisation which raises the same finance using conventional debt finance may be able to lower its cost of capital due to tax-shields and therefore increase the value of its investment.


CONCLUSION

The increasing global interest in and use of Islamic finance means that this is an important source of finance which organisations need to consider. Its many attributes that are common to ethical investment and finance would make it an attractive source of finance particularly to organisations that place importance on ethical issues. The innovations in Islamic financial products by IFIs, such as Sukuk and diminishing Musharaka, have meant new and innovative Islamic finance products are being developed and are coming into the market. This is likely to continue as the impact of the financial crisis recedes.
However, IFIs face a number of challenges such as agency-related issues, increased costs, lack of flexibility, difficulties with complying with Sharia rulings, and also normal regulations and law. The IFIs (and the wider Islamic finance regulatory bodies) need to put into place mechanisms and strategies that will help to overcome these challenges, and thereby ensure that Islamic finance-based products compete and compare with conventional riba-based financial products.

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