GLOBALISATION AND ISLAMIC FINANCE

GLOBALISATION AND ISLAMIC FINANCE Session 1 Academic Training Programme - 2018 Dr. Salah Alhammadi Assistant Professor (Lecturer) in Islamic Economics and Finance s.alhammadi@almcollege.org.uk OUTLINE What is Globalization Islamic Finance? Whether the globalization of Islamic finance as a system is even possible, and if so how can it take place? What would globalization do for Islamic Finance? Islamic Banking Concept Background on the Islamic Financial Services Industry Sector Types of Islamic Financial Institution Reason for Islamic banking existence Major Islamic Contracts Used in Islamic Finance Islamic Banks Infrastructural Issues Benefits & Opportunities Specific Globalization Issues in Islamic Finance Group discussion 2 1

ESSENTIAL READING Askari, H., et al. (2010). Globalization and Islamic finance: convergence, prospects and challenges, John Wiley & Sons. MANSOOR KHAN, M. & ISHAQ BHATTI, M. 2008. Islamic banking and finance: on its way to globalization. Managerial Finance, 34, 708-725. Archer, S. & Karim, R. A. A. (2013). Islamic Finance: The New Regulatory Challenge. Second Edition ed.: Wiley. MIRAKHOR, A. 2007. Globalization and Islamic finance. ISLAMIC ECONOMICS AND FINANCE, 19. Iqbal, Z. & Mirakhor, A. (2011). An Introduction to Islamic Finance: Theory and Practice. John Wiley & Sons. PERRY, F. V. & REHMAN, S. S. 2011. Globalization of Islamic finance: Myth or reality. International Journal of Humanities and Social Science, 1, 107-119. Kettell, B. (2011). Introduction to Islamic Banking and Finance. John Wiley & Sons. Kureshi, H. & Hayat, M. (2015). Contracts and Deals in Islamic Finance: A Users Guide to Cash Flows, Balance Sheets, and Capital Structures. John Wiley & Sons. 3 THE STORY Chronic and systemic failures in the banking and financial system Leading to macroeconomics imbalances Search for alternative systems/ institutions/practices Wall Street Protests 4 2

GLOBALIZATION The process that enhances the flow of goods, services, capital, people, technology and ideas across national borders. Exchange of products and services. Reduce the transactional cost. However it might also increase unemployment rate. It is a method of achieving company expansion to address new markets and access cheaper funds. 5 GLOBALIZATION Globalization for a particular country is shaped by its culture, history, and religion. Abu-Tapanjeh (2009) argued that Islamic principles are entirely compatible with the global principles and guidelines, but the processes and practice may be different. i.e different business transaction. Organizational activities in different countries are characterized by different dimensions such as education, traditions, and religion which in turn affect their decisions on their cultural background and ethical perspectives. GCC which are mostly Muslim countries consider cultural and religious dimensions when they adopt globalization framework. Shariah law significantly affects the aspects of the globalization in the Islamic financial institutions. 6 3

ISLAMIC FINANCE A system of finance that prohibit debt-based financing (no interest) Has a different business model, the value of money under Islamic system is different. Paper money has no intrinsic value and it is only a medium of exchange, the real value lies under the fixed assets (no cash loan) Also Islamic institutions are prohibited in dealing with any profit from alcohol, gambling pork product, etc. Therefore we will look at how globalization affect Islamic finance? Will Islamic finance continue to grow? 7 BACKGROUND ON THE ISLAMIC BANKING AND FINANCE Mainly developed over past 40 years Stimulated by petrodollars in the 1970s Over 500 institutions in 70+ countries Mainly in Middle east, Malaysia & Pakistan Rapid growth (10-15% annually) since 1975 8 4

BACKGROUND ON THE ISLAMIC BANKING AND FINANCE Many Muslim countries were colonized in the 19 th century. After independence in the 20 th century, most adopted Western economic/legal systems. There was an urge to introduce Islamic economic system. Establishment of Organization of Islamic Conference (OIC) in 1973. OIC established Islamic Development Bank in1975, based in Jeddah, Saudi Arabia. 9 ISLAMIC FINANCIAL INDUSTRY SECTOR In UAE, a businessman (Saeed Ahmed Lootah) established the first Islamic commercial bank in1975 Dubai Islamic Bank. One of the foremost Islamic financial institutions in the world. In Kuwait, the government established Shari ah Compliant Bank called Kuwait Finance House (KFH) in 1977. KFH has Independent banks in Turkey, Bahrain, and Malaysia 10 5

EARLY DEVELOPMENT OF ISLAMIC BANKING Egypt In 1963, Ahmed al Najjar established savings/investment houses (social welfare institution) in small towns in Northern Egypt, called Mit Ghamr Provided financing on profit-loss sharing basis to small entrepreneurs and poor farmers Closed and liquidated in 1967 by the national bank of Egypt. In 1971, the government established Nasser Social Bank used Islamic principles (interest-free financing and distribution of Zakah-obligatory) Malaysia Tabung Haji: In 1963, Pilgrims Management and Fund Board established To help people save money to go for hajj (pilgrimage) Funds used to invest in industrial and agricultural projects 11 THE GLOBALIZATION PERIOD OF THE ISLAMIC FINANCE Real establishment first period October 1975 IDB was establish by 22 Islamic countries in Jeddah Dubai Islamic bank 1975 Second period from 1977 2002 More than 100 IBs were opened across the world Conventional banks started to provide Shari ah compliant products and services through Islamic windows Full transformation of banking system in Iran 1983, Sudan 1984, Pakistan 1985 Islamic capital market in the form of Islamic funds (Sukuk) and Islamic insurance (Takaful) Third period from 2003 2009 Global acceptance of Shari ah compliant financial solutions by the regulatory authorities in western Europe and USA Fourth period from mid-2009 to present Bankers and regulators are evaluating the fact that IB were the least affected by credit crunch due to its asset-based nature UK sovereign Sukuk were issued in June 2014 12 6

TYPES OF ISLAMIC FINANCIAL INSTITUTION Banks & other finance providers Islamic banks/finance houses Islamic windows in conventional banks Islamic leasing companies Islamic insurance undertakings (Takaful) Direct Takaful Retakaful Takaful windows of conventional insurers Capital market institutions Freestanding Islamic investment funds (mutual funds, etc.) Sukuk (Islamic bonds ) International Islamic Financial Market (IIFM) (Bahrain) International Islamic Liquidity Management (IILM) (Kuala Lumpur) 13 THE SIZE OF THE ISLAMIC FINANCE MARKET Global Islamic banking assets expected to hit USD 1.66 trillion by 2018 Based on $1.66 Trillion, Islamic Finance assets represented 1% of the global financial market of $127 Trillion in assets. As a comparison, $1.66 Trillion is about the size of the balance sheet assets of HSBC in the annual report of 2013. If Islamic banking wishes to be an important alternative or globalized, it must appeal to people outside Muslim countries Ernst & Young, and the Malaysia Islamic Financial Centre predict the size of the Islamic market to hit $3.4 Trillion by end of 2018. 14 7

ORGANIZATIONAL REGULATORY BODIES NEEDED TO SUPPORT GLOBALIZATION Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) Founded in 1991 in Bahrain by a consortium mainly of Islamic banks Issues financial reporting & auditing standards + some Shari'ah standards 27 + Financial Accounting Standards issued: i.e. FAS 25 Investment in Sukuk, shares and similar instruments, FAS 26 Investment in Real Estate, FAS 27 Investment Accounts Islamic Financial Services Board (IFSB) Founded in 2002 in Kuala Lumpur, Malaysia by a consortium mainly of central banks of countries having Islamic financial institutions. Now also has Insurance and Capital Market Supervisors as members, plus market players as Associate members. Has issued guidelines on Risk Management, Capital Adequacy, Corporate Governance, the Supervisory Review Process and Transparency & Market Discipline, etc. 15 INFLUENCES SHAPING ISLAMIC FINANCE Shari ah as a body of religious law, which has two primary sources, the Qur an and the Sunnah Other secondary sources come from Islamic jurisprudence and human interpretation of the laws, such as Fiqh, Fatwa, Ijma. Fiqh al Muamalat Shari ah Commercial Jurisprudence especially as developed during the classical period by the 4 Schools The Nominate Contracts such as Musharakah, Ijarah 16 8

ISLAMIC FINANCE CONCEPT IBs are based on Shari'ah compliant 1. The absence of interest (Riba) Islam has strictly prohibited of Riba Lender cannot receive interest and the borrower cannot pay it Shari'ah does not prohibit trade or making return on capital. 2. The potential for unethical concerns in the investment mix Prohibition in dealing with Alcohol, Gambling, Pornography, Tobacco Ancillary Activity Any business though not directly engaged in the above, derives greater than 5% of its income from the above. 3. The nature of the contract between the parties involved ensuring that all terms and conditions of the investment contract are detailed in a manner. price, subject matter, delivery date, (lemon problem) etc. AL-MAKTOUM COLLEGE OF HIGHER EDUCATION 2017 17 ISLAMIC FINANCE CONCEPT What does it mean Riba prohibition to IB? Interest-free banking Emphasis on using profit-loss sharing (PLS) modes of financing - equity modes Risk sharing principle Entitlement to return associated with the liability of risk (Al Ghunm bil Ghurm) which means there is risk in earning income. Does prohibition of Riba reduce the investment return or Globalization opportunity? AL-MAKTOUM COLLEGE OF HIGHER EDUCATION 2017 18 9

ISLAMIC FINANCE CONCEPT Prohibition of Gharar Risk, uncertainty, or hazard Conditions of sale are unknown or uncertain Types of Gharar Gharar Yasir (minor or slight) Tolerated and will not invalidate a contract Sale and purchase of all fruits on a tree Gharar Fahish: (major or excessive): not tolerated and may result in contract voidability: 1. Arises due to the non-existence of, or the inability of the parties to control, the exchanged. i.e. Sale of an unborn animal while it is still in its mother's womb or sale of fish still in the sea. 2. Also arises due to lack or inaccuracy of information disclosure of material information on the subject matter. AL-MAKTOUM COLLEGE OF HIGHER EDUCATION 2017 19 REASON FOR ISLAMIC FINANCE EXISTENCE Conventional financial services do not adapt to the requirements of Islamic Shari ah, which forbids Interest (Riba) Speculation (Maysir) e.g. short positions Uncertainty of contract of or contractual outcomes (Gharar) e.g. contingent liabilities or contingent assets such as guarantees & insurance contracts Gharar may be mitigated. Riba & Maysir may not. Guarantees may not be sold (may be given mutually) Islamic financial services are designed to be Shari ahcompliant Avoidance of interest by Islamic financial institutions Particular form of mutual insurance (Takaful to avoid Maysir & mitigate Gharar) 20 10

ISLAMIC BANKS The most developed sector and account as the majority of existing Islamic financial institutions. Prohibition of Riba, make IBs do not accept interestbearing deposits Instead, IBs offer Profit Sharing and Loss Bearing Investment Accounts (PSIA) to Investment Account Holders (IAH) IBs do not offer commercial loans Instead, IBs offer credit sale (Murabahah) or leasing (Ijarah) facilities, or specialised forms of working capital finance (Salam, Istisna a), or (more rarely) financing on a profit and loss sharing basis (Musharakah) or profit sharing and loss bearing basis (Mudarabah). Also Tawarruq 21 MAJOR ISLAMIC CONTRACTS USED IN ISLAMIC FINANCE Key features of Islamic financing Islam does not permit a pure return on money, financing must be either Asset based Credit sales or sale based with mark-up (Murabahah) Working capital financing via a pre-purchase agreement (Salam, Istisna a & parallel Istisna a) Leasing (Ijarah or Ijarah Muntahia Bittamleek) Equity based Mudarabah, Musharakah 22 11

MURABAHAH CONTRACT Financing Mode in Islamic Banks - Debt The financial institution buys and then sells a good to the client at a mark-up Price paid at a later date The bank must own and posses the good The profit rate and other terms should be clearly specified in the contract The bank can ask for guarantees or collateral 23 THE STRUCTURE OF A MURABAHA CONTRACT Transfer of title to bank Transfer of title to customer VENDOR ISLAMIC BANK CUSTOMER Payment of purchase price (P) Payment of marked up price (P + X) 24 12

IJARAH CONTRACT Financing Mode in Islamic Banks - Leasing A hire-purchase leasing contract Ownership is transferred to lessee at the end of the contract period Banks give away the asset at nominal value or as a gift at the end of the lease period Why Ijarah is preferred at IB? Transfer of title to bank Assets leased to customer Title does pass at end of lease term VENDOR ISLAMIC BANK CUSTOMER (Lessee) Payment of purchase price Ijarah Installment 25 MUDARABAH CONTRACT Financing Mode in Islamic Banks - Equity Partnership between bank and clients Used on the liability and asset sides Profit shared among parties at an agreed upon ratio Loss borne by financier only (Rub Almal) Financier cannot ask for a guarantee of capital or return 26 13

THE STRUCTURE OF A MUSHARAKA CONTRACT Financing Mode in Islamic Banks - Equity A partnership contract in which bank contributes capital and managerial services Like a Mudarabah, but all partners manage the project ISLAMIC BANK PARTNER (Customer) The profit share among the partners at an agreed upon ratio Loss shared according to share of capital 60% Ownership MUSHARAKA 40% Ownership 27 SPECIFIC GLOBALIZATION ISSUES IN ISLAMIC FINANCE Credit risk of profit-sharing assets (Musharakah & Mudarabah financing) Forms of risk not faced by conventional banks (losses on investment due to market or credit risk are carried by IAH) Price risk on Salam, Ijarah, etc. Performance risk on (parallel) Salam, Istisna a Lack of risk mitigants (Shari ah restrictions on use of futures and derivatives generally) Operational risk Shari ah non-compliance (e.g. Sukuk) IT systems (those designed for conventional banks don t fit) 28 14

SPECIFIC GLOBALIZATION ISSUES IN ISLAMIC FINANCE Liquidity risk Islamic banks tend to have weaker liquidity Limited interbank market & LOLR facilities Shortage of Shari ah compliant liquid assets Legal infrastructure Debt recovery Effectiveness/enforceability of collateral and ownership claims Court system (trained judges) 29 SPECIFIC GLOBALIZATION ISSUES IN ISLAMIC FINANCE Accounting & financial reporting (Transparency) Weak accounting and disclosure framework Impact on Capital Adequacy IFRS not adequate & AAOIFI standards applied in few countries (arguably out of date in parts in light of new IFRSs) Market discipline & info. environment Weak! (predominantly emerging markets?) lack of a secondary market for Shari ah compliant financial instruments. Human resources Shortcomings of labour markets & HR policies in emerging market countries There is the lack of trained Islamic legal scholars with knowledge of the world of finance to set on banks Shari ah boards. 30 15

CHALLENGES FACING THE GLOBALIZATION OF ISLAMIC FINANCE? Shari ah compliance Need for Shari ah rulings & compliance regime (country laws) UK does not have Islamic banking system, however it have hybrid system, i.e. Stamp duty. Corporate governance Shari ah compliance & variations in Fiqhi interpretations (unified system). One of the major stumbling blocks to the development of an internationally accepted Islamic banking industry is a lack of broadly accepted standards. For example, the Shari ah board of a banking institution in Malaysia may approve a financial product as being Shari ah compliant, but that same product may not be acceptable or approved in a country within the Gulf Cooperation Counsel GCC. 31 CONCLUSIONS Islamic financial instruments can be used to provide a wide range of products in the fields of Retail: consumer credit, retail mortgages Business: working capital and project finance However there are some challenges: Risk identification, measurement & mitigation Lack of Shari ah compliant tools for managing: Liquidity risk (interbank market & LOLR facility) Credit & market risk (insurance & hedging) Shari ah non-compliance risk AL-MAKTOUM COLLEGE OF HIGHER EDUCATION 2017 32 16

THE QUESTION TO ALL Some people doubt that Islamic financial system would reach globalization. Whether the Islamic Finance and banking industry are actually becoming a global phenomenon? can it be adjusted to be called ethical finance instead of Islamic finance? Do you think that Islamic finance is an authentic finance or is it a myth? 33 17