Islamic Capital Markets

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fm JWBK508-Hassan February 2, 2011 19:23 Printer: Yet to come

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Islamic Capital Markets

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For other titles in the Wiley Finance Seriesplease see www.wiley.com/finance

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Islamic Capital Markets

Products and Strategies

M. Kabir HassanMichael Mahlknecht

A John Wiley and Sons, Ltd., Publication

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This edition first published 2011© 2011 John Wiley & Sons, Ltd

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Library of Congress Cataloging-in-Publication Data

Hassan, M. Kabir.Islamic capital markets : products and strategies / M. Kabir Hassan, Michael Mahlknecht.

p. cm. — (The wiley finance series)Includes bibliographical references and index.

ISBN 978-0-470-68957-81. Banks and banking—Islamic countries. 2. Capital market—Islamic countries. 3. Finance—Islamic countries. I.Mahlknecht, Michael. II. Title.

HG3368.A6M36 2011332′.0415091767—dc22

2010050394

A catalogue record for this book is available from the British Library.

ISBN 978-0-470-68957-8 (hardback), ISBN 978-1-119-99137-3 (ebk),ISBN 978-1-119-97081-1 (ebk), ISBN 978-1-119-97082-8 (ebk)

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Contents

About the Contributors xv

Preface xxv

PART I GENERAL CONCEPTS AND LEGAL ISSUES 1

1 Rahn Concepts in Saudi Arabia: Formalization and a Registration andPrioritization System 3Michael J.T. McMillen1.1 Introduction 31.2 The Mortgage Law 4

1.2.1 General Observations 41.2.2 Specific Provisions 6

1.3 Conclusion 13Notes 13

2 The Shariah Process in Product Development and Approval in ICM 23Ahcene Lahsasna and M. Kabir Hassan2.1 Introduction 232.2 Product Development, Financial Engineering, and Innovation in

Islamic Finance 232.2.1 Principles to be Considered in Product Development,

Innovation, and Financial Engineering 242.2.2 Area of Product Development, Innovation, and Financial Engineering 252.2.3 Failure of Innovation and Financial Engineering 25

2.3 The Shariah Framework in Product Development and Approval 262.3.1 Sources of Shariah Law 262.3.2 Maqasid al Shariah 312.3.3 Legal Maxims 332.3.4 Regulators and Standard-Setting Organizations: Regulations,

Standards, and Parameters for Islamic Finance (AAOIFI, IFSB,and Others: Shariah Standards, Corporate Governance, andPrudential Regulations) 34

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2.4 The Types of Product in Islamic Finance 372.4.1 Shariah-Based Products 372.4.2 Shariah-Compliant Products 39

2.5 Process of Product Development in Shariah-Based Products 392.5.1 Example of Product Development in Shariah-Based Product:

Ijarah Muntahiah Bittamlik (Leasing Ending with Ownership) 402.6 Process of Product Development in Shariah-Compliant Products 412.7 The Framework and Process Flow of Product Approval in

Islamic Finance 432.7.1 The Flow of the Process of Approval of the New Product:

From the Product Owner to the Market Place 432.7.2 Mechanism for Obtaining Rulings 462.7.3 Position of the IFI with Regard to the Resolutions of SSB and

IFSB Principles Governing the SSB 472.8 The Methodology Used in the Approval Process 49

2.8.1 The General Rules and Standards Governing the ProductApproval in Islamic Finance 50

2.8.2 Methodology and Standards of fatawa in Islamic FinancePrior to Issuing a fatwa and Resolutions 50

2.8.3 Methodology of fatawa in Islamic Finance in Issuing theIslamic Ruling 50

2.8.4 Methodology of Presenting fatawa in Islamic Finance 512.8.5 Methodology of Empowering the fatwa in Islamic Finance 52

2.9 Product Approval in Securities in Islamic Capital Markets 522.9.1 Shariah Criteria for Listed Securities 532.9.2 Primary Activities Criteria 532.9.3 The Product Approval of Securities in Mixed Companies 542.9.4 Image as Criteria for Listed Securities 562.9.5 Quantitative and Qualitative Approach in Screening Process

in Capital Market 562.9.6 Image with Benchmark 572.9.7 Image without Benchmark 572.9.8 Fundamentals of Shariah Assessment on Image Analysis 572.9.9 Relationship of Image and Principle of Shariah 57

2.10 Applying the Shariah Advisory Council Methodology 602.10.1 Case 1: Wawasan Holding 602.10.2 Case 2: Gemada Berhad 61

2.11 Other Methodology of Shariah Screening Process for Securities 622.11.1 FTSE Shariah Index Screening Methodology 622.11.2 Yasaar Shariah Index Screening Methodology 632.11.3 DJIM Shariah Screening Process 63


3 Integration of Social Responsibility in Financial Communities 69Sayd Farook and Rafi-Uddin Shikoh

3.1 Introduction 69

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Contents vii

3.2 The Conflicting Ideologues within Islamic Finance 703.3 Core Motivations of Conventional Business Models and Their Social

Responsibility Mandates 713.4 Islam, Business, and Social Responsibility 73

3.4.1 “Taqwa-Centricity” (God Consciousness) and Human Beingsas Vicegerents on Earth 73

3.4.2 Primary Responsibilities: To Educate and Establish Justice 743.4.3 Ability-Based Focus 753.4.4 Individual vs. Institutional Responsibility 753.4.5 Existing Paradigms of Social Responsibility Discourse in Islam 76

3.5 Case for Broader Social Responsibility Mandate 763.5.1 IFIs’ Special Obligation 773.5.2 Religious and Financial Obligations 783.5.3 New Realities 783.5.4 Different from Charities 79

3.6 Current Challenges and Recommended Approach to IslamicSocial Responsibility 793.6.1 Regularize a Framework of Mandatory and Recommended

Social Responsibilities 793.6.2 Mandatory Forms of Social Responsibility 803.6.3 Recommended Forms 81

3.7 Disclosure as a Means of Accountability 843.8 Lessons from Current Socially Responsible Business Practices 85

3.8.1 Key Lessons from Current Practices 853.9 Concluding Thoughts 86

Notes 86References 88Further Reading 89

4 The Dispute Resolution Framework for the Islamic Capital Marketin Malaysia: Legal Obstacles and Options 91Umar A. Oseni and M. Kabir Hassan

4.1 Introduction 914.2 The Legal Framework of the Islamic Capital Market in Malaysia 92

4.2.1 Relevant Legislations Regulating ICM in Malaysia 924.2.2 Guidelines and Practice Notes 95

4.3 The Nature of Disputes Among Market Players 964.4 Constraints and Concerns Over the Current Legal Framework 97

4.4.1 Jurisdiction of the High Court vs Shariah Court of Appeal 974.4.2 Shariah Dispute Resolution in the Malaysian ICM 984.4.3 Inadequacy of the Existing Legal Reforms 101

4.5 Dispute Resolution Models for the Capital Markets 1024.5.1 The Saudi Arabian Model 1024.5.2 United Arab Emirates Dispute Resolution Framework for the

Capital Market 1044.5.3 A Hybrid Model for the Malaysian Islamic Capital Market 105

4.6 Conclusion 106

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Case Studies 107Notes 113References 113

5 The Small World of Islamic Finance: How Good Governance can Assistin Taking the Islamic Finance Industry to the Next Level 115Murat Unal

5.1 Introduction 1155.2 Shariah Scholars in the GCC – A Network Analytic Perspective 1165.3 Good Governance-Related Points 1185.4 Summary 123

References 124

6 The Alpha and Omega of Abrahamic Finance 125Mufti Talha Ahmad Azami and Shahzad Siddiqui

6.1 Introduction 1256.2 Jewish Funds 1266.3 Catholic Funds 1276.4 Socially Responsible Investing (SRI) Funds 1276.5 Islamic Funds Redux 1286.6 Alpha: Quantitative Results of Abrahamic Funds 1326.7 Amana and the Benchmarks 1356.8 Conclusion 136

Appendix: The Abrahamic Family Tree 137Notes 137References 142

PART II GLOBAL ISLAMIC CAPITAL MARKET TRENDS 145

7 Islamic Derivatives: Past, Present, and Future 147Priya Uberoi and Ali Rod Khadem

7.1 Introduction 1477.2 Formal Shariah Objections and Solutions 148

7.2.1 Forwards and Futures 1487.2.2 Options 1497.2.3 Swaps and Currency Transactions 151

7.3 Substantive Shariah Objections and Resolutions 1537.3.1 Existence, Ownership, Possession 1547.3.2 Speculation, gharar, and maysir 1557.3.3 Trading Obligation for Obligation 158

7.4 Islamic Swaps and Currency Transactions 1587.4.1 Cross-currency Swap 1587.4.2 Profit Rate Swap 1617.4.3 FX Option 1637.4.4 Total Return Swap 164

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7.5 ISDA/IIFM Tahawwut Master Agreement, Published 1 March 2010 1667.6 Conclusion 167

Notes 167

8 Overcoming Incentive Problems in Securitization: IslamicStructured Finance 171Andreas A. Jobst

8.1 Introduction 1718.2 Incentive Problems of Conventional Securitization 1728.3 The Rise of Islamic Finance 1758.4 The Case of Islamic Securitization 176

8.4.1 Definition of Islamic Securitization 1768.4.2 Current Market Situation 1778.4.3 Sukuk – The Good Side of Securitization? 1798.4.4 Economic Challenges 1818.4.5 Legal Challenges – Regulatory Consolidation and

Supervisory Harmonization 1818.5 Conclusion 182

Notes 182References 183

9 The Evolution of Takaful Products 185Mervyn K. Lewis

9.1 Insurance under Islam 1859.2 Organizational Structures and Operational Models 188

9.2.1 Mudaraba Model 1909.2.2 Wakala Model 1919.2.3 Hybrid Model 1929.2.4 Waqf Model 192

9.3 Product Development and Prospects 1939.3.1 Products 1939.3.2 Prospects 195

Notes 198References 198

10 A New Model for Options in Islamic Law 201Valentino Cattelan10.1 Looking for Islamic Derivatives: A Legal Oxymoron? 20110.2 Options, Western Law, and Islamic Justice 20310.3 Khiyar ash-shart. and al-’urbun as Islamic Analogues to Options:

Critical Elements 20410.4 In Search of a Shariah-Based Substitute: The ijara wa-hiba

Structure 20610.5 Trading ijara wa-hiba Options? Clearing House, Issuance of S. ukuk

al-manfa‘a, and Lack of Speculation 211

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10.6 Pricing S. ukuk al-manfa‘a in Relation to the Rental Rateof Return 213

10.7 ijara wa-hiba Options and the Path towards Legitimacy 215References 215

PART III NATIONAL AND REGIONAL EXPERIENCES 219

11 Building up an Islamic Capital Market: The Malaysian Example 221A. Usama DeLorenzo11.1 Introduction 22111.2 The Beginnings of Shariah-Based Finance in Malaysia 222

11.2.1 The Securities Commission Malaysia 22211.2.2 The Shariah Advisory Council (SAC) 223

11.3 The Islamic Capital Market in Malaysia 22511.3.1 The Capital Market Master Plan 22511.3.2 The Current State 22611.3.3 Malaysian Sukuk 22611.3.4 Malaysian Shariah-Compliant Equities and Fund Management 22711.3.5 Government, Regulation, and Taxation 22911.3.6 Promoting International Linkages 23011.3.7 Development of Skills in the Islamic Capital Market 231


12 Islamic Finance in Germany: Trends, Opportunities, and Potential 235Azadeh Farhoush and Nicolas Schmidt12.1 Introduction and Background 235

12.1.1 Brief Background on Islamic Finance 23512.1.2 Development and Market Potential of Islamic Finance 23612.1.3 Economic Relevance of Germany 23812.1.4 Immigrants and the Muslim Community in Germany 23812.1.5 Products and Services Focused on the Muslim Community

in Germany 23912.1.6 Status Quo of Islamic Finance and Shariah-Compliant

Products in Germany 24012.1.7 One Clear Objective is to Attract Major Muslim Investors 241

12.2 Research and Studies on the Muslim Population in Germany 24212.2.1 Research and Studies on Financial Services and Islamic

Finance 24412.3 Analysis of the Attitudes and Preferences of the Muslim Population

in Germany Towards Financial Products 24612.3.1 Research Questions and Assumptions 24612.3.2 Methodology and Approach 24612.3.3 Description of the Dataset 24712.3.4 Quantitative Results 248

12.4 Conclusion and Practical Implications for Financial Institutionsin Germany 26012.4.1 An Offer of Shariah-Compliant Products According

to Needs 262

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12.4.2 Improvement of Financial Education and Consultancy 26212.4.3 Elaboration of Marketing Activities 262Notes 263References 265

13 Islamic Finance in France: An Emerging Market? 267Ibrahim-Zeyyad Cekici and Laurent Weill13.1 Legal Aspects 267

13.1.1 The Positions of Public Authorities 26813.1.2 The Trends 271

13.2 Economic Dimensions 27213.2.1 The Demand Side 27313.2.2 The Supply Side 275Notes 277References 277

14 Islamic Finance in the United States 279Blake Goud and M. Kabir Hassan

14.1 Introduction 27914.2 The United States as a Destination for Shariah-Compliant Investment 280

14.2.1 The Development of an Ijara-Istisna’a Contract for RealEstate Construction 280

14.2.2 The First Entrants 28214.2.3 The Entry of Private Equity 28314.2.4 Growth Accelerates 28614.2.5 Conclusion 290

14.3 Wholesale Islamic Finance within the United States 29114.4 Mutual Funds and Exchange Traded Funds 29514.5 Legal, Tax, and Regulatory Issues in Islamic Finance 29714.6 Sukuk Issued by US-Based Companies 30014.7 Conclusion 302

Notes 303

15 An Analysis of Global Trends and Regional Pockets in the Applicationof Islamic Financial Contracts in Malaysia and the GulfCooperation Council 307Anne-Sophie Gintzburger

15.1 Regional Pockets and Global Trends 30915.2 The Influence of the Shariah Framework 31015.3 The Function of Shariah Boards 31115.4 The Role of Shariah Boards in Malaysia 31415.5 The Role and Function of Shariah Boards in the GCC 31615.6 Convergence Between the GCC and Malaysia 31715.7 Slight Divergence in Interpretations 31815.8 The Impact of the Regulatory Dimensions of the Jurisdictions 31915.9 The Role of the Creation of International Hubs in Harmonizing Views 327


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16 Developments in Islamic Finance Practice: The Experience of Australia 341Abu Umar Faruq Ahmad and M. Kabir Hassan16.1 Introduction 34116.2 State of the Australian Economy in the World 342

16.2.1 The Australian Economy 34216.3 Potential Problems in the Development of Islamic Finance in

Australian Market 34316.3.1 The Acceptance of Interest 34416.3.2 A Wait-and-See Approach 34416.3.3 The Size of the Muslim Community 34416.3.4 Doubt Concerning Shariah-Compliant Finance and

Investment Products 34416.3.5 Lack of Understanding on Islamic Finance 34516.3.6 Risk Analysis and Balance Sheet Management 34516.3.7 Absence of a Standard Rate of Return 34516.3.8 Difficulty in Classifying Risk Sharing Funds 34616.3.9 Problem of Accounting Standards 346

16.3.10 International Perspective 34616.4 Prospects of Islamic Finance in Australia 347

16.4.1 Opportunities for Introducing Islamic Banking 34916.4.2 Prospects of Islamic Banking and Finance in the

Academic Sphere 34916.5 Summary, Findings, and Recommendations 355

16.5.1 Summary and Findings of the Study 35516.5.2 Suggestions and Policy Recommendations for the Study 355

References 356

PART IV LEARNING FROM ISLAMIC FINANCE AFTER THE GLOBALFINANCIAL CRISIS 359

17 The Current Financial Market Crisis: Lessons Learned, Risksand Strengths of Islamic Capital Markets Compared to theConventional System 361Rasem N. Kayed, Michael Mahlknecht, and M. Kabir Hassan17.1 Introduction 36117.2 Causes of the Global Financial Crisis 36217.3 Some Implications of the Global Financial Crisis 365

17.3.1 Implications for the Global Economy 36517.3.2 Implications for Islamic Finance 366

17.4 Can Such Crises Occur Under an Islamic Financial System? 36717.4.1 Islamic Theory of Finance and the Global Financial Crisis 36717.4.2 The Current Financial Crisis Would not have Occurred

Under an Islamic Financial System 37017.4.3 A Systemic Trade-off Between Risks and Returns 373

17.5 The Prohibition of “Bad” Risks in Islamic Finance 37517.5.1 Types of “Bad” Risks 37517.5.2 Individual vs. Systemic Effects of “Bad” Risks 377

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17.6 Lessons Learned 37817.6.1 Reputational Risk and the Recreation of Trust 37817.6.2 Real vs. Virtual Transactions: sukuk and the Escape from

the Debt Trap 37917.6.3 The Need for Clearing Houses 380

17.7 Conclusions and Outlook 38017.7.1 Main Challenges for Real-life Islamic Finance 38117.7.2 Convergence Between Conventional and Islamic

Financial Industry 381Notes 382References 383

18 An Islamic Perspective of Financial Engineering 385Sami Al-Suwailem and M. Kabir Hassan

18.1 Introduction 38518.1.1 Financial Engineering and Financial Innovation 385

18.2 Financial Engineering: Definition and Concept 38618.2.1 Value of Innovation 38618.2.2 Shariah and Creativity 38718.2.3 Regulatory Arbitrage 38718.2.4 State of Financial Innovation 388

18.3 Principles of Islamic Financial Engineering 38818.3.1 Principle of Balance 38918.3.2 Principle of Acceptability 39018.3.3 Principle of Integration 39218.3.4 Principle of Consistency 393

18.4 Strategies for Product Development 39418.4.1 Imitation 39518.4.2 Mutation 39618.4.3 Satisfaction 397

18.5 Challenges in Financial Engineering in Islamic Finance 39818.5.1 Fragmented Approach to Shariah 39818.5.2 Product Development Process in Islamic Financial

Institutions 39918.5.3 Specialized Institutions and Advanced Markets 399

18.6 Concluding Remarks 399Note 399References 399

19 Shariah-compliant Portfolio Management: Processes, Methodologies,and Performances 401Shehab Marzban

19.1 Introduction 40119.2 Shariah-compliant Portfolio Management Process 402

19.2.1 Shariah Issues in Investment Policy Analysis 40219.2.2 Shariah Issues in Financial Analysis 40419.2.3 Shariah Issues in Portfolio Construction 404

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19.2.4 Shariah Issues in Performance Analysis andPortfolio Revision 405

19.3 Shariah Guidelines 40519.3.1 Shariah Compliance of Asset Classes 40519.3.2 Shariah Screening 40719.3.3 Purification 410

19.4 Fund Performance 412Notes 413References 414

20 Islamic Microfinance: The Way Forward 415Mohammed Obaidullah20.1 Modes of Islamic Microfinance 415

20.1.1 Replication of Conventional Models 41620.1.2 Indigenous Models 416

20.2 Instruments of Islamic Microfinance 41720.2.1 Instruments for Mobilization of Funds 41720.2.2 Instruments of Financing 41820.2.3 Instruments of Risk Management 418

20.3 Islamic Microfinance Projects Across the Globe 41820.3.1 Middle East North Africa (Mena) 41920.3.2 South Asia 41920.3.3 South East Asia 42020.3.4 Rest of the World 420

20.4 Product Development in Islamic Microfinance Sector 42020.4.1 Shariah Compliance 42020.4.2 Divergent Perceptions 42220.4.3 Agency Problems 422

20.5 Meeting Funding Requirements of Islamic Microfinance Sector 42420.5.1 Linkage with Banks 42420.5.2 Rating Services 42520.5.3 Islamic Microfinance Fund 42520.5.4 Securitization 425

Notes 427References 427Further Reading 427

Index 429

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About the Contributors

Dr Abu Umar Faruq Ahmad is an Islamic legal expert in Shariah advising, research andteaching and with experience in Islamic banking, finance, microfinance, comparative jurispru-dence, Islamic studies and case studies of Islamic financial services providers. Dr Ahmadreceived his LLM (Honours) in Islamic banking and PhD in Islamic finance at the Univer-sity of Western Sydney, Australia, with two prestigious university-wide research scholarshipsfor his doctoral study in which he earned an ‘A’ (high distinction) for the quality of hisresearch. Currently he is an Assistant Professor of Islamic Finance at Hamdan BinMohammed e-University, Dubai. He has published over 12 research articles in academicrefereed journals. He is author of Theory and Practice of Modern Islamic Finance: The CaseAnalysis from Australia (ISBN: 1599425173, pp. 322) and Developments in Islamic Bank-ing Practice: The Experience of Bangladesh (ISBN: 1599428288, pp. 228). Besides, he haspublished book chapters and conference proceedings, and presented papers at over 30 profes-sional forums held in Asia, Australia, America, Europe and Africa. Dr Ahmad has been onthe Editorial Advisory Board of International Journal of Islamic and Middle Eastern Financeand Management, Journal of Islamic Accounting and Business Research and The Open LawJournal. In addition, he acts as an ad hoc reviewer of American Journal of Islamic SocialSciences, Thunderbird International Business Review, Review of Islamic Economics, IslamicEconomic Studies and African Journal of Business Management.

Dr Sami Al-Swailem was educated in the USA, earning his MA in Economics from SouthernIllinois University, Carbondale, in 1990 and his PhD in Economics from Washington Universityin 1995. He was a Chief Consultant and subsequently Research and Development Manager inAl-Rajhi Bank during 1995–2004. Since 2004, he has been a Senior Economist at the IslamicResearch and Training Institute (IRTI), IDB Group. He has published several papers on IslamicEconomics and Finance

Mufti Talha Ahmad Azami is a Principal at BMB Islamic. A seasoned and dynamic UK-basedShariah scholar with a specialization in Islamic Commercial Law, Mufti Talha serves as thein-house Shariah scholar for BMB Islamic and plays an instrumental role in the managementof the firm’s Shariah advisory services. Mufti Talha is responsible for Shariah structuring,screening and monitoring, research, and publications. Prior to BMB Islamic, he worked inIslamic Academia with prominent scholars from India for more than ten years. Mufti Talhaholds a BA in Arabic and Quranic Sciences and an MA in Islamic Law from Nadwa Universityin Lucknow, where he studied under a number of leading Islamic jurists and Muslim thinkers.

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xvi About the Contributors

He also has an MA in Hadith Sciences from Islamic University in Deoband and an MA inIslamic Banking and Finance Management from Loughborough University in the UK. He is thegeneral editor of the Global Islamic Finance Report 2010 published by BMB Islamic, Shari’a-Compliant Private Equity: A Primer for the Executive, forthcoming for Euromoney Booksand a co-author with Shahzad Siddiqui of SS Law Corporation on several works including“Fruits” of the Orchard: Endowments for Mosques and Islamic Charitable Organizations inWestern and Muslim Lands, also published by Euromoney.

Dr Valentino Cattelan, LLM, MSc, holds a PhD in Banking and Financial Law from theUniversity of Siena and he is currently Post-Doctoral Research Fellow at the School ofEconomics of the University of Rome Tor Vergata. He is qualified as a lawyer in the EU, andhe actively contributes to seminars, workshops and conferences in Islamic law and finance.His major fields of research are comparative law methodology, Islamic law of contracts, and itsapplication to structure innovative financial instruments, especially in the derivatives market.In relation to his expertise, he has been awarded by the European Commission a grant fora teaching module on “Integrating Islamic finance in the EU market”, to be developed overthe next three years (September 2010–August 2013). Among his recent publications: IslamicFinance and Ethical Investments. Some Points of Reconsideration, in Khan, M.F., and Porzio,M. (eds) (2010) Islamic Banking and Finance in the European Union. A Challenge, EdwardElgar, pp. 76–87 and “From the Concept of h. aqq to the Prohibitions of riba, gharar andmaysir in Islamic finance”, in International Journal of Monetary Economics and Finance(2009) 2(3/4), 384–97.

Ibrahim-Zeyyad Cekici is a teacher and researcher in the Business School EM Strasbourg,University of Strasbourg. He is in charge of the Master’s Degree Islamic Finance and theresearch programme on Islamic Banking and Finance. He is at present a PhD candidateand his topic is the Islamic credit operation in French law. He has two Master’s degrees:one on European Comparative Law on Religion and another on Banking and Finance Law.He has written a number of papers on the compatibility of Islamic finance and French law.He has launched a review named Les Cahiers de la Finance Islamique.

A. Usama DeLorenzo is currently serving as Project Leader in the office of the executivedirector for Strategy and Development for the Securities Commission Malaysia. Prior toworking with the Securities Commission, DeLorenzo helped with the launch of the firstShariah-compliant exchange traded fund to be listed on the New York Stock Exchange.DeLorenzo has worked with Shape Financial as a consulting analyst, with Oppenheimer andCo. as a trader, and with Saturna Capital, investment advisor to the Amana Mutual FundTrust, as an investment manager. Prior to his work in finance, DeLorenzo worked in theinformation technology sector with work ranging from software development to cartographicanalysis. He has spoken about Islamic finance and investments at many industry conferencesand universities, as well as at many educational panels for the communities in which he haslived. He also served as Treasurer on the board of directors for the Council for AmericanIslamic Relations in New York City.

Azadeh Farhoush is presently working for BNP Paribas Lease Group S.A., a subsidiaryof BNP Paribas, as an Underwriter in the Wholesale Finance Department. She was bornin Teheran, Iran, and emigrated to Germany in 1984. Ms Farhoush studied Economics andBusiness Information Systems at the University of Cologne where she earned a Masters Degree.Additionally, she successfully completed a semester in Indonesia. Her diploma thesis focused

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About the Contributors xvii

on Islamic Leasing (Ijarah), comparing the banking and financial systems of Iran, Dubai, andGermany. Ms Farhoush recently completed a two and a half year course in Islamic Studiesand she is a prospective PhD student in the field of Islamic Banking and Finance. AzadehFarhoush has published the article “Leasing as a Sharia compliant Financial Instrument”.

Dr Sayd Farook is mandated with the responsibility to lead the development of the nextgeneration Islamic capital markets transactions platform at Thomson Reuters. As GlobalHead, Islamic Capital Markets, Dr Farook is the principal architect of Thomson Reuters’vision of a global interconnected and diversified Islamic finance and capital markets withoutborders. Dr Farook joins Thomson Reuters from Dar Al Istithmar where he was responsible forStructuring and Legal compliance as a Senior Consultant. Prior to his time at Dar Al Istithmar,Dr Farook worked in a number of roles at the Centre for Islamic Finance - Bahrain Instituteof Banking and Finance (BIBF), Accounting and Auditing Organisation for Islamic FinancialInstitutions (AAOIFI), Hong Kong Shanghai Banking Corporation (HSBC) and lectured onBusiness Analysis, Valuations and Islamic Finance at several prominent universities andinstitutes globally. He holds a Phd in Islamic Finance, Business and Law degrees from theUniversity of Technology Sydney, and is a Certified Islamic Professional Accountant (CIPA)from AAOIFI. Sayd’s papers are widely published in peer-reviewed journals, magazines, andas chapters in edited books, while he has also been invited to present his research and views at anumber of renowned international gatherings on Islamic Finance. Sayd is on the internationaleditorial board of the Journal of Islamic Accounting and Business Research (Emerald Insight).

Anne-Sophie Gintzburger was awarded an MPhil at the Australian National University inMarch 2010 on the topic of Islamic finance. Her chapter is a snapshot of her research onregional contractual differences in the Gulf Cooperation Council (GCC) states and Malaysia.Her research, based on fieldwork in Malaysia and the UAE, is the subject of her forthcomingbook to be published by Edward Elgar Publishing. Of both French and Australian citizenship,Anne-Sophie Gintzburger is currently a doctoral candidate in France at the Ecole NormaleSuperieure, is working at Altran CIS financial services, and is project manager for the newedition of Failaka Advisor’s Shariah Report.

Blake Goud is the founder of SharingRisk.org, a think tank on Islamic finance based inPortland, Oregon. He is also the Chief Compliance Officer for Marquam Capital, a registeredinvestment advisor, and is a registered representative at HP Securities, Inc. He graduatedfrom Reed College with a BA in Economics in 2003 and has several years’ experience in thefinancial industry. In April 2008, he co-authored a paper, “The development of Shari’ah-basedmicrofinance using the Grameen group financing methodology” which he presented at thepre-forum workshop on Islamic microfinance at the 8th Harvard University Forum on IslamicFinance. A similar paper was published in 2009 in the Journal of Islamic Banking, Economicsand Finance. He writes regularly for several Islamic finance publications and has been involvedin an advisory role with two Islamic microfinance development projects. He also serves as theEditor of Publications for the Usury Free Association of North America (UFANA).

Dr M. Kabir Hassan is a financial economist with consulting, research, and teaching experi-ence in development finance, money and capital markets, Islamic finance, corporate finance,investments, monetary economics, macroeconomics, and international trade and finance. Hehas provided consulting services to the various governments and multilateral developmentagencies. Dr Hassan received his BA in Economics and Mathematics (Phi Beta Kappa) fromGustavus Adolphus College, Minnesota, USA, and his MA in Economics and PhD in Finance

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xviii About the Contributors

from the University of Nebraska-Lincoln, USA, respectively. He is now a tenured Professorin the Department of Economics and Finance at the University of New Orleans, Louisiana,USA. He has more than 100 papers published in refereed academic journals to his credit.Dr Hassan has supervised 27 doctoral theses, and many of his students are now well placedin academic, government, and private sectors. He is editor of Journal of Islamic Economics,Banking and Finance, and co-editor of Journal of Economic Cooperation and Development.Dr Hassan has edited and published many books along with articles in refereed academic jour-nals. Dr Hassan is co-editor (with M.K. Lewis) of Handbook of Islamic Banking and IslamicFinance, The International Library of Critical Writings in Economics (Edward Elgar, 2007),and co-editor (with Michael Mahlknecht) of Islamic Capital Market: Products and Strategies(John Wiley and Sons Ltd, forthcoming 2010). He is co-author of Islamic Entrepreneur-ship (Routledge UK, forthcoming 2010). A frequent traveller, Dr Hassan gives lectures andworkshops in the US and abroad, and has presented over 100 research papers at professionalconferences.

Rasem N. Kayed is currently head of the Business Administration and Marketing Depart-ments – Faculty of Administrative and Financial Sciences at the Arab American Universityin Palestine. Prior to his recent appointment at the AAUJ, he was a lecturer in InternationalBusiness at the College of Business at Massey University, and an adjunct senior lecturer atthe New Zealand School of Export – New Zealand. Dr Kayed received his both undergraduatedegrees as well as his MBA degree from Jacksonville State University – USA, and his PhDin Development Studies from Massey University – New Zealand. His doctoral thesis exploredthe entrepreneurial phenomenon from an Islamic perspective and argued for Profit and LossSharing (PLS) contracts as viable alternatives to the conventional interest-based financinginstruments. Dr Kayed is co-author of Islamic Entrepreneurship (Routledge UK, 2010). Hehas published a number of peer reviewed papers in preferred academic journals and chaptersin edited books. He also participated in several seminars, forums and workshops and presentedvarious academic as well as research-based papers at several high profile international confer-ences. Dr Kayed’s research activities are currently twofold: while the first research activity isset to explore the developmental role that entrepreneurship could play in advancing the well-being of the Muslim ummah; the second major research theme that he is pursing is focused onthe current global financial crisis and the resilience of the Islamic financial services industry,and its ability to present itself as a more reliable alternative to the conventional financialsystem.

Ali Rod Khadem is the founder of New Orient Advisors, where he provides consulting servicesrelated to Islamic finance, Islamic law and politics, and the China-Middle East investmentcorridor. Ali Rod is currently a PhD candidate in Islamic Law at Harvard University. AliRod launched his career at Andersen Consulting in 1999, prior to accepting a role in SiliconValley as a business development and strategy manager for two companies in the Idealab,Inc. portfolio. From 2004 to 2009, Ali Rod worked as an Islamic finance and private equitylawyer for King & Spalding LLP and DLA Piper LLP. Since founding New Orient Advisorsin 2009, Ali Rod has consulted with clients such as a Shanghai-based placement agent seekingto build a China-GCC investment platform, a Dubai-based financial services company seekingto structure a Shariah-compliant exchange traded gold fund, and an East Asian governmentregulatory body seeking to revise its domestic securities and tax regulations in order to allow forcorporate sukuk issuances. Ali Rod received his Bachelor’s degree with Honors in 1999 fromthe University of California at Berkeley, where he double-majored in International Relations

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About the Contributors xix

and Environmental Biology. In 2004, Ali Rod earned two further degrees from UC Berkeley: aJuris Doctor (JD) and a Master’s Degree in Islamic Law. While in law school, Ali Rod was aneditor of the California Law Review, and subsequently, he clerked for the Honorable CeciliaM. Altonaga of the United States District Court. Ali Rod has given numerous presentationsand has published on the topics of Islamic finance, Islamic law and politics, and comparativelaw. His article, “The Doctrine of Separation in Islamic Jurisprudence”, was published in theUCLA Journal of Near Eastern and Islamic Law (2005). Ali Rod is fluent in formal Arabic,Farsi, and English, is proficient in French, and knows Mandarin.

Andreas (Andy) Jobst is a mid-career economist at the Monetary and Capital MarketsDepartment (MCM) of the International Monetary Fund (IMF) in Washington, DC. His workfocuses on structured finance, risk management, sovereign debt management, financial regu-lation, and Islamic finance. As a member of IMF Article IV missions, he has been responsiblefor the financial sector coverage of several large mature and emerging market economies. Herecently completed the stress test of the US financial sector for the IMF’s Financial StabilityAssessment Programme (FSAP), and he will lead the upcoming stress tests for Germany andthe United Kingdom. Mr Jobst is one of the main authors of the Global Financial StabilityReport (GFSR) published by the Monetary and Capital Markets Department. He also con-tributes to both the early warning and vulnerability exercises (for both advanced and emergingeconomies) in collaboration with the Financial Stability Board (FSB) and teaches courseson banking regulation, risk management, derivatives, and systemic risk analysis at the IMFInstitute. He holds a PhD in Finance from the London School of Economics (LSE).

Dr Ahcene Lahsasna is currently a lecturer at the Shariah and Legal Studies department atthe International Centre for Education in Islamic Finance (INCEIF) and the Graduate StudiesAcademic advisor at the same university. He received his Bachelor’s degrees in Islamiclaw and Islamic Jurisprudence from Algeria, and his Master’s and PhD degrees in IslamicLaw & Islamic Jurisprudence (Fiqh and Usul Fiqh) from IIUM (Malaysia). He lecturedat several universities in Malaysia including the Islamic Science University of Malaysia,Faculty of Business and Accountancy at University of Malaya (MBA and BBA), School ofInternational Business and Finance at the University of Malaysia Sabah, Labuan, and the OpenUniversity Malaysia on Islamic finance courses for MBA. He was attached to the industry andworked for several years at the Manufacturer and Exporter group of companies in Malaysiaas International Marketing Manager, and head of the documentation department. Currently heis a Shariah Advisory Board member at Maybank Islamic and Etiqa Takaful in Malaysia, andShariah advisory member for the Malaysian Financial Planning Council (MFPC. Malaysia). Hepublished books and articles in Arabic and English in Qatar, Egypt and Malaysia. In additionhe is actively participating in presenting papers and conducting workshops and training in thearea of Islamic banking and finance locally and internationally.

Mervyn K. Lewis is Professor of Banking and Finance in the School of Commerce at theUniversity of South Australia. Previously he was Midland Bank Professor of Money andBanking at the University of Nottingham, and Course Director of the MBA in FinancialStudies. He was also a Consultant to the Australian Financial System Inquiry, Visiting Scholarat the Bank of England, inaugural Securities Commission-University of Malaya, VisitingScholar in Islamic finance, and has been visiting professor at the Universities of Cambridge,Melbourne, Vienna, Wuhan, Mauritius, Goettingen, and Euromed Marseilles. In 1986 he waselected a Fellow of the Academy of the Social Sciences in Australia.

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xx About the Contributors

Professor Lewis has authored or co-authored 21 books, 65 articles, and 75 chapters. Recentvolumes are The Economics of Public Private Partnerships (2005), Reforming China’s State-owned Enterprises and Banks (2006), Handbook of Islamic Banking (2007), Islamic Finance(2007), and Untangling the U.S. Deficit: Evaluating Causes, Cures and Global Imbalances(2007). His book, Public Private Partnerships: The Worldwide Revolution in InfrastructureProvision and Project Finance (2004), co-authored with Darrin Grimsey, won the 2005 BlakeDawson Waldron Prize for Business Literature. The latest volume is An Islamic Perspectiveon Governance (2009), written with Zafar Iqbal. In addition, Professor Lewis is Series Editorof New Horizons in Money and Finance and Studies in Islamic Finance, Accounting andGovernance.

Michael Mahlknecht is a consultant in the areas of risk management, capital markets, andIslamic finance. He regularly holds presentations and gives university lectures about Islamicfinance, for instance in the Islamic finance programme at institutions, such as the Ecole deManagement Strasbourg, the Philipps-Universitat of Marburg (Germany), and others. He cur-rently lives in Hamburg, Germany. Michael has written several papers about Islamic banking,insurance, and capital markets, as well as on issues as diverse as graphical analysis methods,financial hedging, structured products, and credit risk management, which have been publishedin various national and international magazines, such as the Capco Journal of Financial Trans-formation, Islamic Business & Finance, Banker Middle East, and Private Equity and HedgeFunds Middle East. Michael Mahlknecht is the author of the introductory German handbookIslamic Finance: Einfuhrung in Theorie und Praxis (Wiley, 2008) and of the Executive ReportIslamic Capital Markets and Risk Management (Incisive Media/RISK Books, 2009). Michaelis co-editor (with Prof. M. Kabir Hassan) of Islamic Capital Markets: Products and Strategies(Wiley, 2010). He may be reached via his private e-mail address: [email protected].

Dr Shehab Marzban is an expert in computer-based financial services with consulting,research, and teaching experience in finance, Islamic finance, Operations Research andDecision Support Systems. As the domain expert in Islamic Fund Management and Screening,Dr Marzban joined IdealRatings, the market leader in screening Islamic equities, as ProductDevelopment Director and Head of Research in August 2008. Prior joining IdealRatings hereceived his PhD – magna cum laude – entitled “Strategies, Paradigms and Systems for Shariah-compliant Portfolio Management” from the University of Cologne in Germany where he alsoworked as researcher and project manager for global research and partnership programmes.His extensive research in Islamic Fund Management, Shariah Screening, and Purificationresulted in some innovative results presented in international conferences and published ina number of papers and articles that appeared in highly ranked international journals andmagazines, such as the Journal of Banking and Finance, Harvard Islamic Finance ForumProceedings, International Journal of Islamic and Middle Eastern Finance and Management,as well as the Islamic Banking and Finance magazine. Dr Marzban is in parallel a VisitingFellow at Durham University in the UK and a guest lecturer in various European Islamicfinance programmes as well as a frequent speaker at international Islamic finance events andconferences.

Michael J.T. McMillen is a member of the bar of the State of New York and works in theareas of Islamic finance (since 1996) and project finance and structured finance (since 1983).He has been a partner of major international law firms. He teaches Islamic Finance at theUniversity of Pennsylvania Law School and the Wharton School of Business. Dr McMillen

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About the Contributors xxi

has twice served as Chairman of the American Bar Association Islamic Finance Section, wasthe founding Chairman of that Section, and currently serves as Senior Adviser to that Section.He has twice received Euromoney’s award for Best Legal Advisor in Islamic Finance (Global)and has also received the Sheikh Mohammed Bin Rashid Al Maktoum Award for Best IslamicFinance Legal Advisor for North America. Euromoney Magazine featured him as one of the12 pioneers of Islamic finance. He has worked on transactions in over 25 countries and hasdeveloped many of the Islamic finance structures currently used in North America, Europe, theMiddle East, and South East Asia. Michael received his Doctor of Medicine from the AlbertEinstein College of Medicine in 1983, his Juris Doctor from the University of WisconsinSchool of Law in 1976, and his Bachelor of Business Administration from the University ofWisconsin in 1972.

Dr Mohammed Obaidullah is the Founder of IBF Net: The Islamic Business and FinanceNetwork and the International Institute of Islamic Business and Finance (IIIBF), India. Hecurrently serves the Jeddah-based Islamic Development Bank as a Senior Economist spe-cializing in microfinance and poverty alleviation. Dr Obaidullah has also served the IslamicEconomics Research Center, King Abdulaziz University, Jeddah, Saudi Arabia, and taughtat the International Islamic University Malaysia, the Xavier Institute of Management, India,as an Associate Professsor. He has also served the International Association for Islamic Eco-nomics as its Secretary General. He is the author of Islamic Financial Services (ScientificPublishing Centre, King Abdulaziz University, Jeddah, 2005); Teaching Corporate Financefrom an Islamic Perspective (Scientific Publishing Centre, King Abdulaziz University, Jeddah,2006); Role of Microfinance in Poverty Alleviation: Lessons from Experiences in Selected IDBMember Countries (IRTI, IDB, 2008); Islamic Microfinance Development: Challenges andInitiatives (IRTI, IDB, 2008) and over thirty research papers in the field of Islamic Finance,Financial Markets, and Development Finance.

Mr Umar Oseni is a Solicitor and Advocate of the Supreme Court of Nigeria. He completedthe Bachelor of Laws programme in 2005 and proceeded to the Nigerian Law School. Hesuccessfully completed the Bar Part II programme in 2007 and was called to the NigerianBar on 11 May 2007. He had a one-year stint in legal practice as an attorney and was alsoinvolved in corporate practice before he proceeded to postgraduate studies in Malaysia. He is amember of the following professional bodies: Peace and Collaborative Development Networksince 2009; Young International Arbitration Group (YIAG), London Court of InternationalArbitration, since 2008; Nigerian Bar Association, since 2007; and Association of ProfessionalNegotiators and Mediators since 2007. Mr Umar Oseni has written up to 15 academic papers, 10of which have been published in academic journals and books. He has also presented papersin international conferences on Islamic banking and finance. In December 2009, he was aresource person on Islamic microfinance at the UN-Habitat Workshop on Land Developmentin Islam organized by the United Nations, International Islamic University Malaysia (IIUM)and the University of East London. Mr Umar Oseni was also invited as a resource person ata Pre-Conference workshop organized by the Asia Business Forum on 22 March 2010 wherehe spoke on “Islamic Microfinance and Waqf in Land Development” at JW Marriott Hotel,Kuala Lumpur, Malaysia. The young scholar won the Best Student Award for Masters ofComparative Laws, during the 25th Convocation Ceremony of IIUM in 2009. He is currentlya PhD research scholar and part-time lecturer at the Faculty of Law, IIUM. His areas ofresearch include Islamic banking and finance, Alternative Dispute Resolution, ContemporaryApplication of Islamic Law, and International Trade Law.

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xxii About the Contributors

Nicolas Schmidt works as business consultant and project manager within the EuropeanCorporate Development of a large global asset management firm. Before that, he workedfor a management strategy consultancy and in several positions for different asset managersand private banks. He holds a graduate degree as “Diplom-Kaufmann” from the Universityof Frankfurt, majoring in Finance and Politics. In his diploma thesis, he critically analysedthe development of Dubai as an international financial centre. Nicolas Schmidt is currentlyenrolled as an external doctoral candidate at the WHU – Otto Beisheim School of Management,Vallendar. His research focuses on investment preferences and characteristics of private clientsand implications for the retail asset management industry in Germany.

Rafi-uddin Shikoh, Managing Partner/Founder, DinarStandardTM, is leading the developmentof DinarStandardTM – a growth strategy and market intelligence consultancy, focused on theOIC markets (The Organization of the Islamic Conference) and the global Muslim LifestyleMarketTM. DinarStandard’s vision is to empower businesses in Muslim markets to becomeglobal leaders with recognized brands and services while leveraging their unique identity.Rafi-uddin has led the research, analysis, and writing of the DS100TM ranking of Top 100Businesses in the Muslim World, Leading Brands of the Muslim World, Top 10 OpportunityTrends, and various Muslim Lifestyle MarketTM reports and features.

As an emerging expert on Muslim markets, he is regularly quoted in media such as TheEconomist, Forbes, LA Times, BrandChannel, Arab News (Saudi Arabia), Khaleej Times, Sabah(Turkey), The Star (Malaysia), Geo TV (Pakistan), and many more. Rafi-uddin has 12+ yearsof marketing strategy, e-business strategy consulting and technology management experiencewith small to Fortune 500 sized companies in the US such as Marsh & McLennan, Hartford,Sun Microsystems, Acxiom and Thomson Reuters. He has an MBA from UNC-Charlotte,North Carolina, USA, and a BSc in Marketing from Southwest State University, Minnesota,USA. He was born in Pakistan and spent 14 years of his early schooling in the Sultanateof Oman.

Shahzad Siddiqui is a Toronto-based lawyer. A graduate of the University of Toronto andOsgoode Hall Law School, he worked at the Bay Street law firm of Fraser Milner CasgrainLLP before teaching the law of international business transactions at Southwest Universityin China. He subsequently spearheaded the entry of a Chinese conglomerate into the IslamicRepublic of Pakistan. He currently advises organizations as diverse as the Islamic Foundationof Toronto, which is one of the largest mosque and school facilities in Canada; the ChineseMuslim Association of Canada; and Islamic wealth management teams at HSBC Securitiesand Macquarie Capital Advisors, a top-tier investment bank. He is the author of Shari’a-Compliant Private Equity: A Primer for the Executive, forthcoming for Euromoney Booksand a co-author with Mufti Talha Ahmad Azami of BMB Islamic on several works including“Fruits” of the Orchard: Endowments for Mosques and Islamic Charitable Organizations inWestern and Muslim Lands, also published by Euromoney.

Priya Uberoi is the Director of Islamic Derivatives and Islamic Structured Products at Clif-ford Chance. Over the past 12 years Priya has advised on a number of complex structuredfinance and OTC derivative transactions mainly in Emerging Markets (Middle East, Russia,Kazakhstan, and North Africa) that blend conventional debt and derivative instruments withlocal law particularities. Priya’s practice specializes in developing OTC derivatives technol-ogy in the world of Islamic finance using halal Islamic products (e.g. murabaha, wa’ad,salam and arbun) to generate similar economic profiles to conventional derivatives, but in a

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Shariah-compliant manner. Priya has advised a number of major banks on establishing cutting-edge OTC Shariah-compliant derivative platforms that trade cross-currency swaps, profit rateswaps, and wa’ad-based products. She has also advised a number of banks on Islamic Struc-tured Note Programmes. Priya has worked extensively in helping to develop the ISDA/IIFMTahawwut Master Agreement and is a regular speaker at industry events on this subject. Shehas also been involved in a number of discussion fora with respect to the establishment ofShariah-compliant long funds and Shariah-compliant hedge funds with emphasis being placedon Shariah-compliant shorting techniques, repos, custodian arrangements, and issues relatingto rehypothecation and synthetic CLO structures. Priya has a BA Hons in Jurisprudence fromOxford and is the author of a number of publications and articles.

Murat Unal studied Business Administration and graduated from the University of Ade-laide/Australia with a BCom degree. He worked for an international management consultingfirm after his studies and joined the investment industry in 1998 acting as a ManagementCommittee member for a local asset manager where he was mainly responsible for inte-grated marketing, sales and PR. As Head of Investment Marketing and Sales within CitibankNorthern Europe (focusing on Belgium and France) in Brussels he managed the third partyfund business (CitiChoice) and brokerage activities. Before Murat founded Funds@Work AG,which he now represents as the responsible board member, he took over the bank marketingbusiness at Fidelity Investments for a short period of time. Murat has an MBA degree fromthe Kellogg School of Management/USA in joint cooperation with WHU/Germany and itsnetwork programmes at Tel Aviv University/Israel and Hong Kong University of Science andTechnology/China). Murat also holds an LLM degree from the School of Law at NorthwesternUniversity (NLaw) in Chicago. Murat is also a doctoral candidate and about to complete hisDoctorate at IE Business School (Instituto de Empresa, www.ie.edu). He has published andcontributed to more than 1000 articles in leading international dailies and practitioner maga-zines. The leading German economic daily Handelsblatt recently positioned him as one sixinternationally acknowledged masterminds within the investment industry and the FT AssetManagement’s DPN publication singled out his work (a network analysis he carried out amonginstitutional investors and their links to the SRI industry) as ingenious. At Funds@Work AGhe has been involved in more than 150 projects in 14 countries. In this context he has developednew solutions and organizations and has been involved in numerous market entry as well asexpansion projects but has also assisted in take-over activities within the investment industry.

Laurent Weill is Full Professor of Economics at EM Strasbourg Business School, Universityof Strasbourg. He has been visiting researcher at Bank of Finland and at Universite Libre deBruxelles. His research focuses on banking in emerging markets. His current fields of interestare Islamic finance and banking in Russia. He has published 50 papers in journals and books,including World Development, European Financial Management, Economics of Transition,Applied Economics, and European Journal of Political Economy.

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Preface

Islamic finance is the only financial system in the world today that is based on the teachingsof a major religion, and it proves to be increasingly attractive for secular Muslims and non-Muslims as well. While the conventional financial industry has been suffering a tremendousloss of reputation, due to its obvious shortcomings and its harmful impact on economiesworldwide, a Shariah-compliant financial system appears to be profitable, viable, fair, and aclear survivor of the recent global debacle.

Islamic finance represents a fundamental departure from conventional interest-based andspeculative practices, as it relies completely on real economic transactions, such as trade,investment based on profit-sharing, and other solidary ways of doing business. Rather thantreating money as a commodity (as in capitalism), in Islam, money is no more than a measureof value.

Many of the features of Islamic finance are also found in other religions and ethical systems.For instance, the prohibition of interest is present in all Abrahamic faiths: Christianity, Islam,and Judaism. Interest was limited in Hindu law, the Code of Hammurabi, the Magna Carta, andRoman law, as well as in many US States until 1981. The rejection of financial speculation,which is detached from real economies, is shared by many observers and consumers innon-Islamic, Western countries. There is a significant overlap between Islamic principlesand socially responsible investment (SRI), given that Islam preaches social justice, ecology,kindness, and what is called nowadays sustainability. All this makes Islamic finance a topic oftruly global interest and relevance, as there is the potential for introducing a financial systemwhich is both ethical and stable at the same time.

It must however be noted that the reality of Islamic financial systems nowadays is not yetclose enough to those noble ideals. In several cases, the basic rules, such as the prohibition ofriba (interest), have been circumvented, and pseudo-Islamic financial products were created,which were actually mere imitations of conventional financial products. By way of example,in the past there had been some types of sukuk (Islamic bonds), which exactly mimickedconventional interest-based bonds, and even instruments that resembled financial derivativesin an undesirable way. Pseudo-Islamic financial products strike at the foundations of Islamicfinance, and in fact there is a growing standardization of financial instruments and practices,which will avoid such a misuse of traditional Islamic contracts.

Moreover, most existing Islamic financial institutions are Shariah-compliant in form, butfew of them have aimed to achieve the higher objectives of Shariah, i.e. to add explicit “ethical”objectives and features to their financial products. For example, while modern microfinance

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has been devised significantly by Muslims, such as Muhammad Yunus, Islamic microfinancefunds only account for a very small share of Islamic fund products currently. Likewise, socialresponsibility has been integrated so far by very few Islamic fund managers and financial insti-tutions. Other challenges include education and the creation of awareness, the development ofsuitable Islamic benchmarks for pricing of goods and services, the creation of efficient liquiditymanagement tools, and the unification of Shariah-compliant risk management products.

To help bring discussion on the most imminent issues to a higher level, this book focuses onShariah, regulatory, legal issues affecting the evolution of Islamic capital markets, economictheory and policy, as well as on major current market trends. It focuses on imminent real-lifeissues from various perspectives, which should make it a comprehensive reference materialon the subject.

It is structured in four major parts: general concepts and legal issues; global Islamic capitalmarket trends; national and regional experiences; and learning from Islamic finance after theglobal financial crisis.

In Part I, relevant legal aspects of Islamic capital markets are being analysed. MichaelMcMillen provides a cutting-edge and up-to-date analysis of trust laws in Islamic jurisdictionsand explains the concept of Rahn in Saudi Arabia. Ahcene Lahsasna and M. Kabir Hassanfocus on the Shariah process in product development, while Sayd Farook and Rafi-uddinShikoh discuss the need for a broader ethical and social foundation of Islamic finance. Lookingat the highly developed Islamic capital market of Malaysia, Umar A. Oseni and M. KabirHassan provide a discussion of the dispute resolution framework existing there, while MuratUnal focuses on the world of Shariah Boards, and Mufti Talha Ahmad Azami and ShahzadSiddiqui look at the successes and failures of Abrahamic, faith-based funds.

In Part II, current practices of Islamic hedging and derivatives products are discussedfrom a legal perspective by Priya Uberoi and Ali Rod Khadem. Andreas Jobst shows howIslamic structured finance may help overcome some incentive problems in securitization, whileMervyn Lewis gives an overview of Takaful (Islamic insurance), its basic structural types,Shariah issues, and the further evolution of Takaful insurance products. Finally, ValentinoCattelan discusses a new model for options in Islamic law.

Part III contains various chapters that focus on relevant national experiences, situations,and potential with regard to Islamic finance. It is commenced by Antonio Usama DeLorenzowho explains in detail how the Malaysian Islamic capital market was built up. Malaysia isstill the largest single national Shariah-compliant capital market in the world, and it providesa very inspiring example for the development of Islamic capital markets. The situation ofIslamic finance in Germany is then described by Azadeh Farhoush and Nicolas Schmidt,while the case of France is explained in legal detail by Laurent Weill and Ibrahim Cekici.Both countries share several characteristics, which make an analysis of them interesting: theyhave the largest Muslim populations in the European Union, there are both French and Germanglobal banks acting in Islamic banking and capital markets abroad, but there is virtually noIslamic financial industry in place so far. This is in contrast to the USA and Australia, which areboth non-Muslim countries, but with a longer tradition of Islamic financial institutions. BlakeGoud and M. Kabir Hassan give an excellent, detailed, and highly comprehensive overviewof Islamic finance in the USA, while Anne-Sophie Gintzburger takes a closer look at thecomparative study of Malaysia and the GCC. Developments in Islamic finance in Australiaare also described by Abu Umar Faruq Ahmad and M. Kabir Hassan.

Part IV discusses possible learning effects, which can be derived from Islamic finance inthe light of the recent global financial market turbulences. Rasem Kayed, M. Kabir Hassan,

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and Michael Mahlknecht search for lessons learned, analyse specific risks of the Islamicfinancial system, and compare its strengths and weaknesses with the prevailing conventionalfinancial system. Sami al-Suwailem and M. Kabir Hassan analyse the specifics of Islamicfinancial engineering, again comparing it to its conventional counterpart. Shehab Marzbanthen studies the most important properties of Shariah-based investment, and again comparesit to the conventional financial industry. Finally, Mohammed Obaidullah takes a closer lookat Islamic microfinance, which still needs to be developed further.

We sincerely hope that this book, and the effort of all our esteemed contributors, will dothe Islamic and ethical financial industry a good service.

19 August 2010M. Kabir Hassan, Philadelphia, USA

Michael Mahlknecht, Hamburg, Germany

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c01 JWBK508-Hassan January 8, 2011 9:30 Printer: Yet to come

Part I

General Concepts and Legal Issues

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1

Rahn Concepts in Saudi Arabia:Formalization and a Registration and

Prioritization System

Michael J.T. McMillen*

1.1 INTRODUCTION

The first limited recourse project financing in the Kingdom of Saudi Arabia, the Saudi Chevronpetrochemical project, commenced in 1996.1 Conventional interest-based financing was pro-vided by a group of international, regional, and local lenders to a special purpose entityestablished to construct, own, and operate the project. As recourse was limited to the assetscomprising the project and cash flows generated by the project, the collateral security structureprovided to those lenders was critical.2 A primary difficulty in creating an effective collateralsecurity structure in 1996, and at all times up to and including the present, is the fact thatmortgages, pledges, and other security interests may not be registered in Saudi Arabia.3 Whichis not to say that mortgages and pledges are unavailable as part of a collateral security packagein Saudi Arabia. They are available pursuant to the principles and precepts of Islamic Shariah(the “Shariah”) as enforced in Saudi Arabia, most particularly those applicable to rahn (mort-gage and pledge) arrangements.4 The Shariah is the paramount law of the land in the Kingdomof Saudi Arabia and is enforced in the courts of Saudi Arabia.5

The absence of recordation capability, and the uncertainties resulting from the absence ofstare decisis principles and reliance on de novo case-by-case enforcement in the Saudi Arabiancourts,6 have hindered certain aspects of development in Saudi Arabia. Those factors have alsoincreased the need for involvement by the Saudi Arabian government in terms of additionalgovernment support undertakings, as would be the case in any jurisdiction subject to suchfactors. A couple of examples may give a flavour of those hindrances. Each example seemsindependent of the factors that have emerged in the post-2007 economic crisis. Developmentof infrastructure, real estate, industrial, and other projects in Saudi Arabia has remained robustthroughout this economic crisis. However, the participation of international banks and financialinstitutions in the provision of financing may be characterized as modest, at best, due in largepart to these systemic infirmities. Financing is provided primarily through local banks andfinancial institutions, a pattern that is apparent in many sectors of the Saudi Arabian economy.From a risk diversification perspective, this is not the ideal situation for the Saudi Arabianfinancial sector. Another example is the limited availability of home purchase financing in SaudiArabia due to the reluctance of banks and financial institutions to provide financing because

Islamic Capital Markets: Products and Strategies M. Kabir Hassan and Michael MahlknechtC© 2011 John Wiley & Sons, Ltd

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4 Islamic Capital Markets

of the aforementioned factors. Home financing structures have been developed, and there hasbeen some expansion of available credit for these purposes. However, given the uncertaintieswith respect to collateral security, current levels of credit availability seem insufficient andpricing may be suboptimal for home purchasers.

The dramatic growth of Islamic banking and finance, internationally and within SaudiArabia, the lack of participation of international banks and financial institutions in financ-ings, and the pressing needs for home purchase financing, among other factors, haveresulted in intensive consideration of formalization of collateral security concepts within SaudiArabia. Specifically, drafts of different bills pertaining to rahn (mortgage and pledge) prin-ciples, including recordation systems and enforcement processes, have been prepared andwere approved by the Shura Council of Saudi Arabia in mid-February 2010. These long-discussed pieces of “legislation” have taken concrete form, although their ultimate form is as yetuncertain and there is no defined timetable for formal adoption. The primary substantive rahnbill is the “Bill of Registered Real Estate Mortgage Law” (the “Mortgage Law”). There arefour other related bills, although it is uncertain whether all will be adopted together with theMortgage Law: (a) the Real Estate Funding Project (the “RE Funding Project”); (b) the Bill ofFinancial Leasing Definition; (c) a Bill of Finance Companies Control Law; and (d) a Bill ofExecution Law (the “Execution Law”). For convenience, the five laws are collectively referredto as the “Financing Laws”.7

This chapter considers the Mortgage Law and limited aspects of the other Financing Laws.The focus is on the correlations and divergences between the Mortgage Law and substantiveprinciples of classical rahn formulations, as embodied in the “Majelle”8 and discussed in“Al-Zuhaylı ”9 and “Ibn Rushd”.10 The Finance Laws, as finally effective, are likely to varyfrom the current drafts. However, given that the current drafts of the Finance Laws have beendiscussed and reworked for a considerable period, and received Shura Council approval, itseems appropriate, even prior to finalization, to consider the principles adopted by the newcollateral security structure that appears likely to emerge.

1.2 THE MORTGAGE LAW

1.2.1 General Observations

As a general statement, the substantive Mortgage Law, and to some extent the Execution Law,embodies classical Shariah principles of rahn but does not appear to be wholly consistent withthe classical formulations of those principles. Embodiment of those principles is consistentwith the paramount position of the Shariah in Saudi Arabian law and is important given thatthe Mortgage Law will likely be enforced by the Board of Grievances (Qiwan Al-Mazali’im)or a similar court or body, each of which applies Shariah principles.11 The Mortgage Lawand the Execution Law contemplate local jurisdictional enforcement, rather than enforcementby the Banking Disputes Settlement Committee of the Saudi Arabian Monetary Agency (the“SAMA Committee”) (which has jurisdiction over disputes between a bank and its customers)or the Office for the Settlement of Negotiable Instruments Disputes (the “NIO”). Thus, it canbe surmised that, even if the SAMA Committee or the NIO has jurisdiction over the financingagreements for a transaction, enforcement of the mortgage will be within the jurisdiction ofa separate Shariah court. That said, the jurisdictional ambits are not clearly delineated in theMortgage Law, the Execution Law, or the other Financing Laws.

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Rahn Concepts in Saudi Arabia: Formalization and a Registration and Prioritization System 5

That raises a critical question of whether a local Shariah court will enforce a mortgage orpledge if the obligation secured by the mortgage is interest-based or otherwise violative of theShariah. That issue, of course, is what has precluded registration of mortgages and pledges upto the present. And that issue is not specifically addressed in the Financing Laws.

The Mortgage Law applies to real estate and certain other movable assets that have a“regular record” (other than “securities”). It does not specifically address other property, suchas movable property that does not have a regular record. Specifically, the Mortgage Law andthe other Financing Laws do not preclude, by their express terms, rahn arrangements underthe Shariah in respect of such other property. The RE Funding Project is clearly directed,in part, at residential housing initiatives. The Mortgage Law is not so addressed and seemsto have a broader application, although popular press discussions of the Mortgage Law havefocused primarily on its application to residential housing matters. It is conceivable that the REFunding Project also has a broader application to commercial properties and to securitizations,but that is not discussed in this chapter.

The Mortgage Law contemplates registration of security interests and addresses the rightsof registered and unregistered holders of security interests, including the priorities of interests.A registered mortgage becomes effective as against third parties upon registration, subjectto certain third party proprietary rights predating registration.12 The mortgagee’s priority isdetermined by the entry number and registration date of the mortgage, a “race to the counter”system that is shared with numerous other jurisdictions within the Gulf Cooperation Council.13

The concept of priority is accepted under classical rahn principles, including in the bankruptcyof the debtor mortgagor.14 Registration seems to be an extension of traditional “possessionby the mortgagee” concepts to something more akin to “constructive possession” concepts.The Mortgage Law applies classical Shariah principles in the context of a modern registrationsystem. This is a welcome development, but is certain to give rise to the need for further clarifi-cation and refinement, quite possibly in the litigation and dispute resolution context. As notedabove, the de novo case-by-case process, unrestricted by stare decisis doctrines, in the SaudiArabian system makes it difficult to predict the nature of the clarifications and refinements.

It is helpful to consider ten primary consequences of a valid contractual arrangement underclassical rahn principles as an analytical framework for assessing the extent to which theMortgage Law gives effect to rahn principles:15

1. Association of the underlying debt with the mortgaged property.2. The right of the mortgagee to hold and keep the mortgaged property.3. The obligation to safeguard and maintain the mortgaged property.4. The obligation to pay the expenses associated with the mortgaged property.5. Forbidding the mortgagor debtor or the mortgagee creditor from dealing with (selling,

lending, leasing, mortgaging, pledging, gifting, or placing in trust) the mortgaged propertyduring the term of the mortgage.

6. Forbidding the mortgagee creditor from using the mortgaged property.7. Guarantee of the mortgaged property, which pertains to the relationship between the value

of the mortgaged property and the underlying debt.8. Selling the mortgaged property, or demanding that the creditor sell the mortgaged property,

to pay the secured debt.9. Giving the mortgagee creditor in possession of the mortgaged property priority in payment

over other creditors.10. The obligation to return the mortgaged property if the debt is repaid.

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1.2.2 Specific Provisions

1.2.2.1 Asset Application

As suggested by its full title, the Mortgage Law pertains to real estate.16 However, by its terms,it also applies to certain other movable assets that have a regular record, such as automobilesand other vehicles, airplanes, and the like, but expressly excluding securities.17 The implicationis that the Mortgage Law will not apply to movable assets where there is no “regular record”.Classical rahn concepts cover both mortgages and pledges, and pertain to any mortgagedproperty, movable or fixed, that meets the sale and other applicable requirements of the Shariah.Given the paramount status of the Shariah in Saudi Arabia, the Mortgage Law will presumablynot preclude the practice of obtaining a valid rahn on other assets, including movable assets notsubject to registration, and enforcement of that rahn in the relevant Saudi Arabian courts andadjudicative bodies. Thus, a rahn, enforceable outside the Mortgage Law under the Shariah,should be available with respect to assets that are not the subject of the Mortgage Law.

It appears that certain assets, such as proceeds from the operation of mortgaged property(marhun) that are subject to the Mortgage Law, are within the ambit of the Mortgage Law,which is consistent with the majority position of the four orthodox Sunni madhahib (schools ofIslamic jurisprudence) regarding classical rahn principles.18 The mortgage gives the creditormortgagee a proprietary right in the registered property and an established priority over othercreditors with respect to the proceeds of the sale of the mortgaged property, which is alsoconsistent with classical rahn principles.19 Successive mortgagees of the same mortgagedproperty are contemplated.20 The customary statement of the classical rahn principle is thatthe provision of a rahn over the marhun by the mortgagor to a third party, with the consentof the mortgagee, renders the first rahn void and the second rahn to be the sole valid rahn.21

The granting by the mortgagor of such a third party rahn without the consent of the mortgageewould be void under classical principles.22 Thus, the Mortgage Law effects a position that issomewhat divergent from classical principles.

1.2.2.2 Registration and Possession

The Mortgage Law focuses on “registration” concepts, and specifically links the validity of themortgage and the determination of relative priority to the registration process (and, under theMortgage Law, a mortgage is not effective vis-a-vis third parties unless it is registered).23 Thisis an extension of the relevant Shariah principles that speak of the necessity of “receipt andpossession” of the marhun by the mortgagee.24 Specifically, it is an adoption of “constructivepossession” concepts (in modern parlance), at least in the context of the mortgage registrationprocess.25 There is a basis in classical rahn formulations for acceptance of constructive posses-sion formulations.26 Specifically, various madhahib have long defined “receipt” of the marhunas either actual receipt or the removal of impediments to such receipt (for example, provisionof access). Other classical rahn principles are also supportive of the concept of continuingpossession, for rahn purposes, by the creditor mortgagee in situations where physical posses-sion and use are retained by the debtor mortgagor. These include the provisions hereinafterdiscussed with respect to use of the marhun by the debtor and certain termination principles.

Two types of registration are addressed in the Mortgage Law: (a) registration pursuant tothe provisions of the system of real estate registration, with registration being effected inaccordance with such law; and (b) registrations that are not made pursuant to the provisions ofthat system, which must be made by way of countersignature on the record of the property at

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the relevant court or notary public.27 Given that there is currently no central registry of propertythat coordinates registrations with courts and notaries public, careful attention must be paidto the relevant requirements of applicable law, and due diligence efforts must be extensivewith respect to many types of movable property, in particular. If mortgaged property is notregistered pursuant to that system, the mortgagor may not dispose of the property during theterm of the mortgage, unless the mortgagor and the mortgagee shall have otherwise agreed.28

Registration and renewal expenses are for the account of the mortgagor and are considered tobe part of the mortgage debt secured by the mortgage, absent agreement to the contrary.29

1.2.2.3 The Mortgaged Property

Pursuant to the Mortgage Law, a mortgagor must be the owner of the mortgaged property,with full power, authority, and entitlement to dispose of that property.30 If the mortgagor isnot the owner of the mortgaged property, the relevant mortgage becomes effective only fromthe date upon which the mortgagor obtains a deed of ownership with respect to the mortgagedproperty.31 This implies that a mortgage may be granted with respect to property to be acquiredin the future. This implication is supported by other provisions of the Mortgage Law, suchas the provision that makes the mortgage effective against all annexures to the mortgagedproperty (such as buildings, plants, services, constructions, and modifications), expresslyincluding those coming into being subsequent to the mortgage deed, unless the mortgagorand the mortgagee otherwise agree.32 This is largely consistent with classical rahn principles,which usually include in the marhun both annexures and contiguous increases and separategrowths of the marhun.33 Under the Mortgage Law, the mortgagor may, but need not, be thedebtor on the debt secured by the mortgage: the mortgagor may be a guarantor, including aguarantor that provides a mortgage without the consent of the debtor.34 Another implicationof the ownership requirement is that mortgages of borrowed or previously mortgaged propertyare impermissible. Interpreted literally, this is somewhat contrary to the classical formulationwhich allows a rahn of borrowed property with the consent of the ultimate owner.35 The clas-sical rules pertaining to mortgages of previously mortgaged property involve issues pertainingto the comprehensiveness or restricted nature of the initial mortgage, consents and permissionswith respect to subsequent mortgages, and the extent to which the two mortgages contradictone another, among others. However, the classical formulation under the Majelle indicates thatthe original mortgage pertaining to the mortgaged property that is subsequently mortgagedagain is rendered void by the second mortgage.36

The mortgaged property must be of a tangible or contingent nature and capable of beingsold, which is consistent with classical Shariah principles.37 Thus, the mortgaged propertymust (a) be in existence at the time of the grant of the rahn, (b) have a quantifiable value,and (c) be saleable and deliverable.38 The mortgaged property must be accurately describedin the mortgage deed itself or in a supplemental contract.39 While the supplemental contractconcept in the Mortgage Law allows for some privacy as among the contracting parties, it alsointroduces an element of uncertainty and ambiguity that will have to be further clarified as thesystem is effectuated. Given the lack of centralization of the registration system, this provisionmay result in difficulties in effective due diligence and related opaqueness. As noted above,the mortgaged property will include annexures constituting “after acquired” or future propertyunless otherwise agreed by the mortgagor and the mortgagee.

Under the Mortgage Law, each part of the mortgaged property is security for the entiretyof the debt secured by the mortgage, and each part of the debt is guaranteed by the mortgaged

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property, unless otherwise agreed by the mortgagor and the mortgagee.40 These principles arecongruent with classical rahn principles relating to “association of the underlying debt” whichprovide that the underlying secured debt is associated with the entirety of the mortgagedproperty and the mortgaged property is associated with the entirety of the debt.41 Thus,repayment or forgiveness of part of the debt leaves the remaining outstanding unpaid debtassociated with the entirety of the mortgaged property and no portion of the mortgagedproperty is released until payment in full of the debt even if there are multiple debts ormultiple items of mortgaged property.

If the property is registered pursuant to a system of real estate registration, leases issued bythe mortgagor to third parties may not be enforced in favour of the mortgagee, provided thatthe property was registered prior to the registration of the mortgage deed, unless the periodof the lease is less than five years.42 If the property is not registered pursuant to that law,the mortgagor must disclose, in the mortgage deed, all in-kind original and accessory rightsrelating to the mortgaged property, and the mortgagor is liable to the mortgagee for any failureto disclose if any such rights affect the right of the mortgagee.43 If a failure to disclose is in badfaith, the mortgagor is subject to criminal actions pursuant to the laws pertaining to forgery.

1.2.2.4 The Secured Debt

Pursuant to the Mortgage Law, the debt secured by the mortgage must be (a) of a financialnature, (b) a specific amount to be acquired in the future, (c) a secured asset, or (d) a debt tobe repaid, such as a conditioned debt or a debt to be established in the future or a potentialdebt. It is difficult to determine the distinctions between and among the foregoing categories,which are listed as summary statements, without further explication, in the Mortgage Law.Further elucidation will likely be forthcoming only in the litigation context and interpretivesources may then include classical rahn principles.44 In each case, however, the mortgagesecures only debt that is specified in the mortgage deed, including as to its amount and themaximum period for repayment.45 Although not addressed in the Mortgage Law, cautiondictates careful specification of the nature of the debt, including contemplated future advancesand other similar matters. Conventional rahn principles allow increases in debt subsequent tothe grant of the rahn.46 Thus, it seems that conventional rahn principles will support most of thecategories of permissible debt that are listed in the Mortgage Law. However, some madhahibhave not permitted a rahn in respect of debt that has not yet arisen.47 It is difficult to predictwhether courts and adjudicative bodies in Saudi Arabia, when considering the Mortgage Lawcategories in the litigation context, will define those categories in a manner that is consistentwith classical Shariah principles or adopt a more expansive interpretation of the MortgageLaw categories.

Under the Mortgage Law, the debt obligation, and the related mortgage, may be transferredby the mortgagee to a third party, unless the relevant documentation otherwise limits thisright.48 The Mortgage Law here strives for flexibility and responsiveness to modern financingarrangements and is permissively broad in its conception of debt that may be secured by aregistered mortgage. It seems that the Mortgage Law, on its face, will easily apply to multipledraw, revolving and term credit facilities, so long as the amounts and tenors are specificallydeterminable and stated. It would also seem to be applicable to more creative financingarrangements, including those pertaining to some uncertain future events. This will likely bewarmly received by banks and other providers of financing. The absence of outside constraints

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and limits, however, will require that debtors carefully consider and negotiate the designatedterms, including amounts and tenors. And questions remain as to whether the courts will giveeffect to the intention that seems to be embodied in the Mortgage Law.

The Mortgage Law provides that the mortgage is subordinate to the debt, and thus terminatesupon payment of the debt.49 This provision is consistent with classical rahn formulations,including the consequence of the “right of the mortgagee to hold and keep the mortgagedobject” until payment in full of the debt.50 Corollaries of this principle, and of the consequences,under classical rahn principles, of “dealing in and sales of the mortgaged property”, are that(a) the debtor mortgagor may not deal in (sell, lend, lease, mortgage, pledge, gift, or placein trust) the mortgaged property without the consent of the creditor mortgagee, and (b) thecreditor mortgagee may not deal in the mortgaged property without the consent of the debtormortgagor.51 Pursuant to the Mortgage Law, the debt may be prepaid prior to its maturity datein accordance with the agreement of the parties to the debt and mortgage documents.52 This isconsistent with the Shariah principle that allows a debtor to prepay his, her, or its debt at anytime, even if the financing arrangement expressly precludes early payment.

1.2.2.5 Operation, Safety, and Expenses of the Mortgaged Property

Under the Mortgage Law, the mortgagor is entitled to manage the mortgaged property duringthe term of the mortgage so long as such management does not prejudice the mortgagee’srights, and the mortgagor is entitled to receive the proceeds from operation of the mortgagedproperty and pay expenses relating to the operation of such property.53 This is consistentwith the classical rahn principles of some of the orthodox Sunni madhahib, most notably theShafi’ı madhhab, which allow debtor use so long as the use does not harm the mortgagedproperty,54 and of the general classical principles of the Hanbalı, Shafi’ı, and Malikı madhahibto the effect that the creditor mortgagee is not permitted to use the mortgaged property in anyway.55 The Hanafı and Hanbalı madhahib allow the debtor mortgagor to use the mortgagedproperty only with the consent of the creditor mortgagee, which forms the basis for covenantrestrictions on use in transactional documentation.56 The Malikı madhhab does not permit anyuse of the mortgaged property by the debtor mortgagor, and any such use is said to invalidatethe rahn.57 The classical formulation of the Hanbalı principle regarding creditor mortgageeuse of the mortgaged property is that creditor mortgagee use is impermissible absent debtormortgagor consent.58 This position is based upon a number of different rationales: that themortgaged property, and its usufruct, is the property of the debtor mortgagor and may not betaken without consent; that the debtor’s property may not be taken without the payment ofcompensation, even with debtor consent; and that any benefit to the creditor may constituteriba on the underlying secured debt obligation. Thus, the Mortgage Law seems to adopt andgive effect to the classical Hanbalı doctrines in the area of debtor and creditor use of themortgaged property.

The general classical Hanafı rahn principle is that the debtor mortgagor is responsiblefor the expenses relating to the benefit and upkeep of the mortgaged property without creditfor such expenses against the outstanding debt, while the creditor mortgagee is responsible forsafeguarding the mortgaged property with the limit of the creditor’s liability being the amountof the underlying secured debt.59 The other three orthodox Sunni madhahib took a somewhatdifferent view, which seems to underlie the view of the Mortgage Law: the debtor mortgagoris responsible for all expenses relating to the benefit and upkeep of the mortgaged property

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and also for the expenses relating to safeguarding the mortgaged property.60 The basis for thisposition is that the debtor mortgagor is the owner of the mortgaged property and is entitled toits output and is correspondingly responsible for its expenses.

The Mortgage Law provides that the mortgagee may be authorized to collect and receivethe proceeds from operation of the mortgaged property prior to foreclosure, but is not allowedto retain those proceeds.61 Any provision authorizing the retention of those proceeds bythe mortgagee is null and void as a matter of law, although the mortgage deed itself willremain valid and binding.62 These provisions should permit the use of lockbox collateralsecurity structures, especially if considered together with Shariah principles pertaining to adlstructures.63 This should also permit the use and enforceability of reserve account provisionsso long as the funds in those accounts are not applied to the debt except in accordance withthe enforcement provisions set forth in the Mortgage Law and the Execution Law. Thesearrangements are consistent with classical rahn formulations.64 Under those formulations,the mortgagee cannot take any benefit from the mortgaged property during the term of themortgage absent the consent of the mortgagor. However, if the mortgagor’s consent is obtained,the benefits of the mortgaged property, to the extent of the consent, are retained by themortgagee and do not constitute a reduction in the secured debt. The Mortgage Law appears toprohibit this mortgagor consent arrangement (note the Mortgage Law provision that makes anysuch arrangement, even with consent, is null and void),65 although it does allow for consentto collection, without mortgagee retention, by the mortgagee.

Under the Mortgage Law, the mortgagor remains obligated to guarantee the safety and valueof the mortgaged property until repayment of the secured debt obligation.66 This obligationextends to all matters that might result in a decrease in the value of the mortgaged propertyor prevent the mortgagee from recovering due to destruction or defect of the mortgagedproperty.67 The mortgagee may object to all matters that would result in such a decreasein value or make the mortgaged property subject to loss or defect and may take necessarymeasures to ensure the safety of the mortgaged property, with the mortgagees’ costs beingfor the account of the mortgagor.68 The extent of this right in the mortgagee, and how far itextends into the “self-help” domain, remain unclear, but the bare language of the MortgageLaw is favourable to a strong position in favour of the mortgagee. That language also supportsthe use of strong preservation and use covenants in the related financing agreements. In anyevent, the mortgagee is permitted to seek a court injunction against actions that might havethe effect of exposing the mortgaged property to destruction or damage or that might render itinsufficient as collateral for the debt.69

Under the Mortgage Law, if a decrease in value or a loss or defect occurs with respect to themortgaged property or the rights or interests of the mortgagee in such property, there are threesituations that must be considered, each of which bears defined consequences.70 With respectto the first situation, if the decrease, loss, or defect is the result of the mortgagor’s negligenceof wilful misconduct, the mortgagee may require immediate payment of the debt or demandsecurity that is adequate to that provided by the mortgage. This should be compared with theclassical rahn principle that requires the mortgagor to pay an amount of compensation equalto the amount of the loss or defect.71 A second situation addressed under the Mortgage Lawprovides that, if the decrease, loss, or defect is not the result of the mortgagor’s negligence orwilful misconduct, the mortgagor is obligated to either provide a sufficient guarantee of thedebt or pay the debt. The third situation addressed under the Mortgage Law is particularlyconfusing, including in the original Arabic text, and provides that the mortgagee may accept anew or substitute mortgage that is equal in value to the decreased, lost, or defective mortgage,

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unless the mortgagee has an interest in the decreased, lost, or defective mortgage, in whichcase a mortgagee may request immediate payment of the debt.72 And upon any damage toor decrease in the value of the mortgaged property, the mortgagee’s rights attach to anymoney that is substituted for the mortgaged property without the consent of the mortgageeand the mortgagee shall have rights, and the mortgage’s priority, against such money, whichis consistent with classical rahn concepts.73

Under classical rahn principles, decrease, loss, or defect resulting from third party actsthat are not attributable to the mortgagor must be compensated by the third party and thatcompensation then becomes subject to the mortgage.74 If the decrease, loss, or defect resultsfrom acts or omissions of the mortgagee, the amount of the decrease, loss, or defect is struckfrom the secured debt as it is compensable by the mortgagee.75 The different orthodox Sunnimadhahib treat the guarantee or assurance with respect to the mortgaged property somewhatdifferently.76 The Hanafı position, which characterizes the creditor mortgagee’s possession asa possession of trust, allows for a reduction in the amount of the underlying secured debt if themortgaged property perishes, with the mortgaged property being protected in an amount equalto the lesser of its value and the amount of the underlying secured debt. Various conditionsattach in order to make a diminution, loss, or defect compensable while in the possession ofthe creditor mortgagee: (a) existence of the underlying secured debt at the time of the relevantevent; (b) possession by the creditor mortgagee (and not the debtor mortgagor) at the timeof the event; and (c) that the affected mortgaged property is part of the original underlyingmortgaged property, and not an increase to or output of that property.77 The other orthodoxSunni madhahib view the creditor mortgagee’s possession as one of guarantee, such thatperishing of the mortgaged collateral gives rise to a reduction in the underlying debt unlessthe creditor mortgagee is responsible by way of transgression or negligence. The MortgageLaw conception extends somewhat further than the classical rahn conception.

The second and third situations addressed by the Mortgage Law are not entirely inconsistentwith classical rahn principles, although they do place the burden on the debtor to pursue thecompensation from the non-debtor offender, which is an element of the classical Hanbalıposition based upon the position that the debtor mortgagor is the owner of the mortgagedproperty.78 Thus, under classical principles, the debtor would provide adequate security, equalto the value of the decrease, loss, or defect, and thus to the full amount of the debt, for thebenefit of the mortgagee and separately pursue an action against the third party or mortgagee,as relevant, for the amount of such value.

1.2.2.6 Defaults and Remedies

Under the Mortgage Law, provisions in a mortgage deed or related documents that allow themortgagee to take ownership of the mortgaged property upon non-payment of the secured debtare null and void, although the mortgage itself will remain valid.79 This is entirely consistentwith classical rahn principles and an oft-quoted hadith, although some Hanbalı jurists havesometimes allowed the transfer of ownership of the mortgaged property upon non-payment.80

The mortgage is cancelled upon payment of the secured debt under the Mortgage Law.Defaults other than payment defaults, such as covenant defaults, allow the mortgagee toforeclose upon the mortgaged property.81 A default entitles the mortgagee to request sale ofthe mortgaged property pursuant upon adequate notice and compliance with the provisions ofthe Execution Law,82 with the mortgagee having the designated priority with respect to theproceeds of such a sale.83 If those proceeds are insufficient to pay the secured debt in full, the

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mortgagee becomes an unsecured pari passu creditor with respect to the unpaid balance of thesecured debt.84

These provisions of the Mortgage Law are largely consistent with classical rahn principles.For example, classical principles favour sale of the mortgaged property in default scenarios,including pursuant to judicially ordered sale.85 However, the classical formulations permit thedebtor mortgagor to sell the mortgaged property in some situations (this rule is often stated asthe preferred rule in light of the debtor mortgagor’s retention of ownership)86 and permit themortgagor to appoint the mortgagee or another person as attorney for the sale of the mortgagedproperty.87 The Mortgage Law and the Execution Law do not make provision for sales by themortgagor or by the mortgagee as attorney for the mortgagor.

The mortgage lien, and rights of the mortgagee, survive any transfer of ownership orpossession of the mortgaged property.88 A holder of the mortgaged property or certain rights inthe mortgaged property is deemed to be in possession of the mortgaged property for purposesof the Mortgage Law if that holder came into possession after the mortgage or acquired amortgaged proprietary right without personal liability for the debt secured by the mortgage.89

At any time prior to the sale of the mortgaged property in accordance with the ExecutionLaw (and as otherwise provided by law), possessors of the mortgaged property have a right tomake payment of the secured debt upon receipt of notice of default and foreclosure, and, uponany such payment, such possessors succeed to the position of the mortgagee and are entitledto reimbursement of expenses from the mortgagor.90 This effects a “right of redemption” inpossessors “until the gavel falls” upon foreclosure sale. Possessors of the mortgaged property,which presumably include the owner mortgagor if a possessor, may participate in the auctionsale of a mortgaged property in foreclosure, and may purchase the mortgaged property at anysuch sale, free of the lien of the mortgage.91 The purchaser in foreclosure will acquire themortgaged property free of the mortgage lien.

Upon a foreclosure sale, a portion of the sale proceeds, equal to instalments due and unpaidat the time of the foreclosure sale, is paid to the creditor and the remainder of the proceedsare placed in a bank account (and can be released upon the agreement of the creditor if abank guarantee is obtained with respect to the payment of future debt payments).92 Theseprovisions of the Mortgage Law give effect to classical rahn principles that are based upon thetheory that the proceeds obtained by sale of the mortgaged property substitute for the originalmortgaged property, with continuation of the original transaction arrangements in respectof the underlying debt until maturity of the debt.93 Of course, an arrangement such as thisintroduces issues pertaining to a previously unconsidered credit, that of the bank holding thefunds until maturity. The identity of the owner of the bank account is not clear in the MortgageLaw, whatever the strictures of the release provisions pertaining to that account. Under mostclassical rahn formulations, the debtor mortgagor continues to own the proceeds as mortgagedproperty as it is substituted for the original collateral. That arrangement, of course, wouldexpose the amounts in the bank account to the subsequent bankruptcy of the debtor mortgagor(although it is likely that the creditor mortgagee’s priority in those amounts would continueduring the bankruptcy).

Foreclosure sale terminates the mortgage upon the mortgaged property, as does (a) repay-ment of the debt (previously discussed), (b) expiration of the stated term of the mortgage,(c) a unification of the mortgage and ownership in a single person, (d) a waiver by themortgagee creditor during the term of the debt,94 and (e) pursuant to mortgagor request,expiration of the statute of limitations on the underlying secured debt.95 Presumably, the mort-gaged property must then be returned to the debtor mortgagor if it is held by the creditor

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mortgagee at the time of mortgage termination. The registration concept, with possession foruse being retained by the debtor mortgagor during the term of the mortgage, should minimizethe issues that arise under classical principles with respect to retention of possession by thecreditor mortgagee.96 The terminations upon foreclosure and in the cases in clauses (a) and(d) find explicit support in compilations of the classical rahn principles, and the terminationsprovided in clauses (b) and (c) find implicit support from classical principles.97 Statute oflimitations provisions are an example of more modern conceptions of the orderly conductof business.

1.3 CONCLUSION

Saudi Arabia is in the process of taking the critical first step to the establishment of a collateralsecurity regime based upon a registration system and prioritization principles. This is to belauded. The regime will enhance the confidence of current and potential market participants. Itwill expand the range and number of market participants, particularly financiers. The regimewill encourage broader and more penetrating participation in Saudi Arabian financings bylocal, regional, and international financiers. It will do much to encourage greater creativityand product range in the Saudi Arabian markets.

The proposed regime embodies existing rahn principles in the statutory framework. Asindicated in this chapter, much remains to be done and much remains to be clarified. The basicprinciples set forth in the Mortgage Law will need to be elucidated in greater detail, hopefullyto the end that the entire regime is internally consistent. At present, it is difficult to discerndoctrinal consistency in the choice of principles, and the current draft of the Mortgage Lawis selective and quite summary in nature in terms of the principles that have been chosen forinclusion. The elucidation and development process will be challenging in any case. If thatprocess is left to the courts and other adjudicatory authorities, the process may not result incoherency and consistency for many years due to the lack of reporting of decisions and theabsence of a stare decisis framework. And the implementation of that process may becomeintertwined with the reorganization of the judiciary and quasi-judiciary system, adding yetfurther complexity.

The review presented in this chapter is intended as one of optimism; it is intended tofocus discussion, constructive analysis and criticism so that the collateral security regime thatemerges in Saudi Arabia best serves the markets and the needs of the full range of marketparticipants.

NOTES

* Member of the bar of the state of New York and lecturer in Islamic finance at the Universityof Pennsylvania Law School and the Wharton School of Business. Dr McMillen’s primaryareas of practice are Islamic finance and project finance. Dr McMillen has practised lawin the Kingdom of Saudi Arabia, the United Arab Emirates, and other Middle Easternjurisdictions since 1996 and lived in Saudi Arabia from 1996 to 2000 and in the UnitedArab Emirates from 2009 to the present. Copyright C© 2010, Michael J.T. McMillen; allintellectual property rights reserved to Michael J.T. McMillen.

1. The development and implementation of the project, including the then unique collateralsecurity structure developed for and implemented in the Saudi Chevron financing, isdescribed in Michael J.T. McMillen (2001) “Islamic Shari’ah-Compliant Project Finance:

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Collateral Security and Financing Structure Case Studies”, Fordham International LawJournal 24, 1184 (“McMillen: 2001”), at pp. 1184–232.

2. The transaction also involved limited technology and completion recourse. For a dis-cussion of the definition and historical development of project financing, see MichaelJ.T. McMillen (2009) Islamic Project Finance: An Introduction to Principles and Struc-tures, III Global Infrastructure, Fulbright & Jaworski LLP, entire issue (“McMillen:2009”), and sources cited therein, particularly, with respect to historical considerations;Stuart E. Rauner, “Project Finance: A Risk Spreading Approach to Commercial Financ-ing of Economic Development” (1983) Harvard International Law Journal 24(145), at146–156. Michael J.T. McMillen, “Shari’ah-Compliant Project Finance” and Michael J.T.McMillen, “Islamic project finance” in M. Kabir Hassan and Mervyn K. Lewis (eds)(2007) Handbook of Islamic Banking, also discuss Shariah-compliant structures that areused in infrastucture, real estate, electricity, petrochemical, mining, industrial, and otherproject financings, virtually all of which have evolved since 1996.

3. See McMillen: 2001, above n. 1, at pp. 1184–232. In orthodox jurisprudence of the Shariah,no distinction is made between a mortgage and a pledge as those concepts are known tocontemporary Western legal practitioners: the term “rahn” encompasses both of thoseconcepts. Many government officials, lawyers, and financiers in Saudi Arabia believe, andhave long believed, that the unwillingness to register mortgages and pledges derives fromthe assumption that they secured, and continue to secure, interest-bearing obligations thatare contrary to the Shariah. That set of beliefs was frequently asserted to the author duringthe period in which the author lived and practised law in Saudi Arabia (1996–2000 and2008–2010). At that time, Shariah-compliant financing transactions were uncommon inSaudi Arabia. As an aside, those beliefs, and the unwillingness to register rahn interests,also influenced the formation and powers of the SAMA Committee (see, for example, thediscussion at McMillen: 2001, above n. 1, at pp. 1193–203). Recent discussions with SaudiArabian government officials, lawyers, and financiers support the assertion that the growthof Islamic banking and finance throughout the world, and particularly in Saudi Arabia,has had a marked impact on thinking with respect to the appropriateness of registeringrahn interests and may be one impetus to consideration of the legislation discussed inthis chapter. Shariah-compliant financings are now commonplace in Saudi Arabia, as areinterest-based financings. Rahn arrangements supporting Shariah-compliant financingsare entirely consistent with ancient Shariah-compliant practices in the fields of commerceand finance.

4. See McMillen: 2001, above n. 1, at pp. 1184–232, with rahn principles being discussedat pp. 1219–26. As discussed in McMillen: 2001, a collateral security structure that iscompliant with the Shariah as enforced in Saudi Arabia was developed for the SaudiChevron petrochemical project. That structure has been, and continues to be, widely usedin Saudi Arabia. For definitions of rahn as adopted by each of the four orthodox Sunnimadhahib, see Al-Zuhaylı, below note 9, at pp. 79–80.

5. Article 48 of the Constitution of the Kingdom of Saudi Arabia.6. See McMillen: 2001, above n. 1, at 1193–203, Michael J.T. McMillen (2008) Asset

Securitization Sukuk and Islamic Capital Markets: Structural Issues in the FormativeYears, Wisconsin International Law Journal 25, p. 703, and Michael J.T. McMillen (2007)Contractual Enforceability Issues: Sukuk and Capital Markets Development, ChicagoJournal of International Law 7, p. 427, for discussions of some of the enforceability,enforcement, and other uncertainties, and their genesis, under Saudi Arabian law.

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7. The translation of the Mortgage Law used for this chapter was prepared by Fulbright &Jaworksi LLP. The author expresses particular gratitude to his former partners, Hassan El-Sayed and David Silver, and to other Arabic language scholars whom we have consulted,for their thoughts and observations on the original Arabic text of the Mortgage Law, someof which is particularly unclear in the original Arabic text. A single set of the translationsof the other Financing Laws (and a separate translation of the Mortgage Law) have beenprovided to the author from various different sources (the same translations came fromeach source); the original source is unknown. Only select sections of those translationswere checked by Fulbright & Jaworski LLP and it is to be noted that the Fulbright &Jaworski translations are materially different from the other set of translations. It is alsoto be noted that the Arabic version of the Mortgage Law is itself difficult, confusing,and somewhat internally inconsistent, even to skilled legal professionals whose nativelanguage is Arabic and who work in the Arabic language.

8. Two versions of the “Majelle” have been used for the preparation of this chapter: MajalatAl-Ahkam Al-Adliyah (an English language translation prepared by Judge C.A. Hooperas The Civil Law of Palestine and Trans-Jordan, Vols I and II (1933), and reprinted invarious issues of 4 Arab Law Quarterly, 1968) (“Hooper 1933”), and C.R. Tyser, D.G.Demetriades, and Ismail Haqqi Effendi (2001) The Majelle: Being an English Translationof Majallah El-Ahkaml-Adliya and a Complete Code on Islamic Civil Law. These versionsare essentially identical; the minor differences between them are irrelevant for purposes ofthis chapter. Thus, “Majelle” refers to both translations or either translation. The Majelleis an unfinished digest of principles and rules of the Shariah under the Hanafı madhhab asapplied in civil law transactions (muamalat). It was prepared by a committee of OttomanHanafı scholars during the period from 1869 to 1888, was published between 1870 and1877, and was codified as law in the Ottoman Empire as applicable to matters outside thecommercial code. See S.S. Onar (1955) “The Majalla” in Majid Khadduri and Herbert J.Liebesny (eds), Law in the Middle East. Although the Majelle reflects the position of theHanafı School (madhhab) of Islamic jurisprudence, the differences between the Hanafımadhhab and the Hanbalı madhhab, which is predominant in Saudi Arabia, are relativelyminor as to most matters referred to in this chapter.

9. Wahbah Al-Zuhaylı (Mahmoud El-Gamal, translator, and Muhammad S. Eisaa, revi-sor), Al-Fiqh Al-Islami wa-Adillatuh (Islamic Jurisprudence and its Proofs), Wahbahal-Zuhaylı, Financial Transactions in Islamic Jurisprudence, which is a translation ofVolume 5 of Al-Fiqh Al-‘Islami wa ‘Adillatuh, fourth edition (1997) and appears in twovolumes (“Al-Zuhaylı ”). Al-rahn concepts are discussed in part X, chapters 69–74, vol. II,at pp. 79–194. All references in the chapter are to vol. II, unless otherwise specificallyindicated. A short summary of a few rahn principles is contained in Wael B. Hallaq,Shari’a: Theory, Practice, Transformations (2010), at pp. 267–68, a book constituting anexcellent introduction to Shariah concepts and the development of the Shariah.

Al-Zuhaylı provides the following introduction to rahn concepts, at p. 79.The Arabic term “rahn” may refer either to constancy, or to holding and bindingness.

In this regard, the verse “every soul will be held (rahınah) in pledge for its deeds” [74:38]refers to the binding aspect of the term. Of the two opinions, the holding aspect is themore physical one, and hence we deem it to be the primary linguistic meaning, while thepermanency meaning is derived from that primary one. The juristic meaning of the termis closely associated with its linguistic meaning. Oftentimes, one uses the term rahn torefer to the object that was pawned to ensure a debt.

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10. Ibn Rushd, The Distinguished Jurists’ Primer, Volume II, Bidayat Al-Mujtahid Wa NihayatAl-Muqtasid (Imran Ahsan Khan Nyazee, translator, and Mohammad Abdul Rauf, revisor)(“Ibn Rushd”).

11. For a discussion of the Board of Grievances and other adjudicative bodies in Saudi Arabia,see McMillen: 2001, above n. 1, at pp. 1195–203. Saudi Arabia is currently contemplatinga reorganization and rationalization of its judicial and quasi-judicial organization. It isnot possible, at this stage, to surmise on the nature of that reorganization and the effect itmight have on enforcement of collateral security interests.

12. Article (22), Mortgage Law.13. Article (23), Mortgage Law.14. Al-Zuhaylı, above n. 9, at p. 175. With respect to Shariah principles in the bankruptcy

context, see Michael J.T. McMillen, “Shari’ah Considerations in the Bankruptcy Contextand the First Bankruptcy (East Cameron)” (2010) (“McMillan: 2010”), forthcoming articlebeing published by the Islamic Financial Services Board.

15. Al-Zuhaylı, above n. 9, at pp. 143–82, discusses each of these consequences and the posi-tions and rulings of each of the four orthodox madhahib with respect to each consequence.

16. Article (1)(a), Mortgage Law, and full title of the Mortgage Law: “Bill of Registered RealEstate Mortgage Law”.

17. Article (48), Mortgage Law. To the extent of inconsistencies, the Mortgage Law supersedesthe Commercial Mortgage Law.

18. Consider, for example, Articles (12) and (20)(a), Mortgage Law, Ibn Rushd, above n. 10,at pp. 330–1. See, also, McMillen: 2001, above n. 1, at p. 1220, discussing the prohibitionon the pledging of rent and other proceeds of operation of the mortgaged property withouta mortgage or pledge of the underlying asset generating the rent or other proceeds.

19. Articles (1)(a) and (27), Mortgage Law. And see the discussion of priority at nn. 12–14and 48, below, and accompanying text.

20. Article (27), Mortgage Law, providing for collection by successive mortgagees of theirrespective debts in the order of their respective priorities.

21. Article 744, Majelle.22. Article 743, Majelle.23. Article (1)(d), Mortgage Law.24. See e.g. Articles 718, 722, and 751, Majelle, and Al-Zuhaylı, above n. 9, at pp. 106–22.25. See McMillen: 2001, above n. 1, at 1203–32, Al-Zuhaylı, above n. 9, at p. 80 (which notes

that the rahn is a voluntary charitable contract (tabarru’) because the mortgaged propertyis given without financial consideration and involves non-fungibles, and, as such, is notconsidered totally binding until the object of the contract is delivered and received bythe mortgagee) and p. 82 (with respect to Hanafı delivery requirements), and Ibn Rushd,above n. 10, at pp. 328–9. Proofs of the legality of the rahn from the Qur’an and the Sunnaare summarized at Al-Zuhaylı, at pp. 80–1, and Ibn Rushd, at p. 325.

26. Al-Zuhaylı, above n. 9, at pp. 106–22, discusses a wide range or receipt-related issuesunder the four primary orthodox Sunni madhahib. It is also common, under the classicalformulations, for the debtor to be permitted to hold and operate the mortgaged propertyduring the term of the mortgage (with an obligation to produce the mortgaged propertyfor confirmation upon demand by the mortgagee in certain circumstances, such as at thetime of repayment; see, Al-Zuhaylı, at pp. 148–9). See, also, Al-Zuhaylı, at pp. 187–8.

27. Articles (1)(c) and (1)(d), Mortgage Law, respectively.28. Article (11), Mortgage Law.

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29. Article (1)(d), Mortgage Law.30. Separate rules apply to grants of mortgages by multiple owners of mortgaged property. See

Article (7), Mortgage Law. The Mortgage Law does not explicitly address the possibilityof grants of a mortgage by an individual or entity that is not the owner of the mortgagedproperty, and it is unclear whether such grants are prohibited by the Mortgage Law, atleast in the context of mortgages that can be registered. The Majelle specifically addressesmortgages by entities or persons that are not the owner of the mortgaged property. Seee.g. Articles 710, 726–728, and 732, Majelle. Al-Zuhaylı, above n. 9, at pp. 104–5 and128–38, and Ibn Rushd, above n. 10, at p. 326, discuss the granting of a rahn in respectof borrowed property (which is said to be permitted by all madhahib), the granting arahn on the property of others, including mortgaged property, and various permissionrequirements pertaining to mortgaging non-owned property.

31. Articles (2)(a) and (3), Mortgage Law.32. Article (5), Mortgage Law. Notably, in the case of subsequent annexures, the rights of

third parties in and to such annexures are protected. The application of third party rightsprovisions is straightforward in some circumstances; it will undoubtedly give rise todisputes in other cases.

33. Article 711, Majelle. See Al-Zuhaylı, above n. 9, at pp. 183–5. As noted in Al-Zuhaylı,different madhahib have somewhat different interpretations of these principles, with theMalikı being the most restrictive and the Hanbalı being quite comprehensive and generalas to which annexures, increases, and growths constitute part of the mortgaged property.

34. Article (2), Mortgage Law. If the mortgagor is a guarantor or the mortgaged property iswithout a debtor [is mortgaged by another person who is not the debtor], enforcementmay only be made against the assets constituting the mortgaged property who is not thedebtor [i.e., and not against the non-debtor mortgagor]. Bracketed language indicates thepresumed intention of the Article.

35. See e.g. Articles 726 (rahn musta’ar), pp. 735, 736, 737, 765 and 823, Majelle.36. See e.g. Al-Zuhaylı, above n. 9, at pp. 134–6. Article 745, Majelle, provides that a

mortgage by the creditor mortgagee of previously mortgaged property with the consent ofthe mortgagor debtor renders the first mortgage (by the mortgagor debtor to the mortgageecreditor) void, with the second mortgage being treated as valid and akin to the mortgageof lent property. Article 743, Majelle, provides that if either the mortgagor debtor or themortgagee creditor mortgage the previously mortgaged property to a third party withoutthe consent of the other, the second mortgage to the third party is void. This provision doesnot address effects on bona fide third parties without knowledge of the original mortgage.Article 744, Majelle, provides that a mortgage of the previously mortgaged property to athird party by the original mortgagor with the consent of the mortgagee renders the initialmortgage void and the second mortgage as the sole valid mortgage. Rather precise ruleshave been developed for some specific types of mortgage arrangements and specific typesof mortgaged property. See e.g. Al-Zuhaylı, at pp. 136–9, which addresses mortgages ofindebted estates, perishables, fruit juices, and religious books.

37. Articles 709 and 715, Majelle. See, also, Al-Zuhaylı, above n. 9, at pp. 101–6, and IbnRushd, above n. 10, at p. 326. The ability of the marhun to be sold is said to be necessaryboth at the time of the grant of the rahn and upon termination of the rahn.

38. Article 709, Majelle. See, also, Al-Zuhaylı, above n. 9, at pp. 101–6, and Ibn Rushd,above n. 10, at p. 326. Mortgages of claims for a debt are not permitted. The issueof “after acquired” property, or property added to the rahn after the execution of the

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mortgage deed, is discussed in McMillen: 2001, above n. 1, at pp. 1220. With respect tothe “existence” requirement and the requirement of Article (4), Mortgage Law, regardingaccurate description of the mortgaged property, it is important to note that Article 713,Majelle, specifically permits the post-execution addition of collateral to the mortgage andpledge. The safest course, particularly in light of the description requirements set forthin Article (4), Mortgage Law, even in the face of invocation of Article (10), MortgageLaw, and Article 711, Majelle, is supplementation of the mortgage deed to additionallylist critical after-acquired property. With regard to the nature and many conditions andrequirements pertaining to saleability and deliverability and sales transactions, see Al-Zuhaylı, above n. 9, vol. I, at pp. 1–366, and Articles 197–299, Majelle.

39. Article (4), Mortgage Law. See the next preceding note with respect to post-executionadditions of collateral to the coverage of the mortgage deed. Consider, Al-Zuhaylı, aboven. 9, at pp. 123–5, with respect to grants of rahn with respect to unidentified propertyshares, at pp. 125–7, with respect to connected and occupied properties and fungibleliabilities, and at pp. 127–8i, with respect to leased or lent non-fungibles.

40. Article (10), Mortgage Law.41. Al-Zuhaylı, above n. 9, at pp. 144–6, with discussion of the Hanbalı principles being at

p. 145, and Ibn Rushd, above n. 10, at pp. 329–30. As summarized by Al-Zuhaylı and IbnRushd, there are circumstances in which the orthodox Sunni madhahib modify the unitaryrahn contract principles, such as where there are multiple debtors and multiple creditorsand, in some cases, where the underlying debt is multiple. See, also, Articles 713, 714,and 729–732, Majelle.

42. Article (21)(a), Mortgage Law. The original Arabic version of this Article of the MortgageLaw is particularly unclear and confusing. Different native Arabic speaking lawyers andacademicians have been unable to agree on the meaning of the original Arabic version, anddifferent readings are feasible. The statement in the text must thus be further investigatedand treated with caution.

43. Article (21)(b), Mortgage Law.44. Al-Zuhaylı, above n. 9, at p. 83, observes that there are three forms of mortgages: (a) a

mortgage required pursuant to the debt-generating contract, such as a condition in a saleagreement that a mortgage be provided to secure payment of the sale price; (b) a mortgageoriginating after the establishment of the relevant secured debt; and (c) a mortgage priorto the establishment of the relevant secured debt, such as a mortgage of property prior toincurring of any indebtedness. With respect to the last category, Al-Zuhaylı notes that theShafi‘ıs and most Hanbalıs (whose doctrines predominate in Saudi Arabia) ruled that sucha mortgage is not valid. The Shafi‘ı’s and the Hanbalıs established a number of conditionsrelating to the liability underlying the mortgage, including the requirement that liabilitymust be an established and matured fungible debt. See, Al-Zuhaylı, at pp. 99–100. TheHanafıs also set forth a number of conditions for the underlying secured debt, includingthat the underlying right in respect of which an object is mortgaged must be binding andmatured. See, Al-Zuhaylı, at pp. 93–9. The Malikı conditions are discussed at Al-Zuhaylı,pp. 100–1.

45. Articles (23) and (9), Mortgage Law.46. Article 714, Majelle. See, also, Al-Zuhaylı, above n. 9, at pp. 185 and 93–8.47. Al-Zuhaylı, above n. 9, at p. 83, notes that the Shafi‘ı and Hanbalı madhahib have disap-

proved on the grounds that insurance of a legal right may not precede the establishmentof the legal right, characterizing a rahn as a derivative of a legal right. See n. 44, above.

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See, also, Al-Zuhaylı, at pp. 93–8, in respect of the positions of different madhahib withrespect to the maturity of the secured debt, including distinctions as to “finally established”loans and those that are not “finally established”, and pp. 98–101, with respect to otherunderlying debt conditions.

48. Articles (18), (24) and (26), Mortgage Law, with Article (18) subjecting such trans-fers to the Disposition of Debt Provisions and Article (24) requiring registration of thetransfer. The Arabic language of Article (24) is particularly unclear as to what rightsof third parties are being discussed and the circumstances in which that Article willbe applicable. Considerable care should be taken in investigating and interpreting theimplications of Article (24). Article (26) allows certain waivers of priority by a mort-gagee in favour of another mortgagee. Article (26) does not provide any indication ofthe consequences of any permitted waiver: consider, for example, the consequences of awaiver by a first priority mortgagee creditor of an SAR 500 million mortgagee positionin favour of a second mortgagee in a situation where there are three priority credi-tors. Does the waiving first priority mortgagee then become second, or third, priority inrespect of the waived priority? What if the waiver is for less than all of the total se-cured mortgage claim of the waiving mortgagee (e.g., the total mortgage in favour of thewaiving first priority mortgagee is SAR 1 billion, but the waiver pertains to only SAR500 million)?

49. Article (40), Mortgage Law, and Al-Zuhaylı, above n. 9, at p. 187 (among many otherreferences). The mortgage is automatically reinstated, subject to intervening rights ofbona fide third parties, if the debt is lifted and subsequently re-effected. It is unclear howthis provision will operate in the case of revolving credit concepts, but it can be surmisedthat they will be unaffected and that this provision operates to a complete termination andreinstatement of the debt rather than a period in which no debt is actually outstanding (see,for example, Articles (23) and (9), Mortgage Law). See, also, Al-Zuhaylı, at pp. 111–12,as it pertains to payment of the debt and reinstatement of the rahn.

50. Articles 729, 739, 740 and, in the case of placement of the mortgaged property with anadl, 751, Majelle. See, also, Articles 730 and 731, Majelle. See, also, Al-Zuhaylı, aboven. 9, at pp. 146–8, which explains the association of the “right of the mortgagee to hold themortgaged object” with the consequence of the “association of the underlying debt withthe mortgaged property” and also discusses the rationales adopted by the four orthodoxSunni madhahib.

51. Al-Zuhaylı, above n. 9, at pp. 159–65. Note that the Hanbalı position is that (i) any suchdealing in the mortgaged property by the debtor mortgagor without the consent of thecreditor mortgagee is invalid ab initio, but is permissible with the consent of the creditormortgagee, and (ii) any such dealing in the mortgaged property by the creditor mortgageewithout the consent of the debtor mortgagor is invalid ab initio, but is permissible withthe consent of the debtor mortgagor. See, also, Al-Zuhaylı, at p. 189, pertaining to thetermination of a mortgage or pledge upon permitted leasing, gifting, or sale of the mort-gaged property by the debtor or the creditor and noting that the mortgaged property maythereafter be held pursuant to different principles (such as those pertaining to a lease, agift, or a sale).

52. Article (41), Mortgage Law. This Article is particularly unclear, including in the originalArabic language text. Caution should be exercised in the interpretation and application ofthis Article.

53. Article (12), Mortgage Law.

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54. See the discussion of the Shafi‘ı position at Al-Zuhaylı, above n. 9, at pp. 147, 152,and 154, which most clearly states the principle. Most formulations of the classical rahnprinciples require the creditor mortgagee to safeguard the mortgaged property, and toassume responsibility for at least some of the expenses relating to such activities. See,also, Al-Zuhaylı, at pp. 149–50, and Ibn Rushd, above n. 10, at pp. 330–1.

55. Al-Zuhaylı, above n. 9, at pp. 154–8.56. Ibid., at pp. 152–3.57. Ibid., at pp. 153–4.58. Ibid., at pp. 158–9. There are limited exceptions, such as for animals that require feeding.59. Ibid., at pp. 150–2.60. Ibid., at p. 151.61. Articles (12) and (20)(a), Mortgage Law, Al-Zuhaylı, above n. 9, at p. 151, and Ibn Rushd,

above n. 10, at pp. 330–1.62. Article (20)(a), Mortgage Law. See, also, the discussion of conditions included in a

mortgage or pledge transaction under classical rahn principles at Al-Zuhaylı, above n. 9,at pp. 90–101, and Ibn Rushd, above n. 10, at p. 329.

63. McMillen: 2001, above n. 1, at pp. 1213–16 and 1219–26.64. Article 750, Majelle.65. Article (20)(b), Mortgage Law.66. Articles (13) and (14), Mortgage Law, and Al-Zuhaylı, above n. 9, at pp. 165–71.67. Article (14), Mortgage Law.68. Article (13), Mortgage Law.69. Article (16), Mortgage Law.70. Article (14), Mortgage Law.71. Article 741, Majelle.72. Virtually every lawyer and academician that has examined Article (14), particularly Article

(14)(c), of the Mortgage Law has discerned a different meaning and expressed concernwith both the original Arabic language drafting and the inconsistency with other provisionsof the Mortgage Law (including Article (14)(b)).

73. Article (17), Mortgage Law.74. Article 742, Majelle.75. Article 741, Majelle.76. Al-Zuhaylı, above n. 9, at pp. 166–71, and Ibn Rushd, above n. 10, at pp. 331–2. As noted

in the Al-Zuhaylı discussion, there are separate rules pertaining to consumption of themortgaged property.

77. Al-Zuhaylı, above n. 9, at pp. 167–9, and Ibn Rushd, above n. 10, at p. 333. Note alsothat the time of valuation of the mortgaged property is an important consideration, andrulings vary as to whether the relevant value is the value at inception of the mortgageor at the time of the diminution or loss event. Insurance proceeds are not addressed inthe Mortgage Law, although they would presumably substitute for the lost or destroyedmortgaged property.

78. Al-Zuhaylı, above n. 9, at pp. 170–1. The Mortgage Law position varies slightly from theclassical Hanbalı principle in that the Mortgage Law seems to allow the debtor mortgagorto retain proceeds obtained from the party that is liable, a position that is internallyconsistent given the requirements that the debtor mortgagor provide increased assurancesdirectly to the creditor mortgagee, including during the pendency of the action against theliable party.

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79. Article (20)(b), Mortgage Law. See, also, n. 62, above, with respect to conditions includedin a mortgage or pledge transaction under classical rahn principles.

80. Al-Zuhaylı, above n. 9, at pp. 175–6; the hadith is referenced at 175, footnote 62 andaccompanying text.

81. Articles (30) and (41)(c), Mortgage Law.82. Article (30), Mortgage Law.83. Article (19), Mortgage Law.84. Article (19), Mortgage Law.85. Article 757, Majelle. See, also, Al-Zuhaylı, above n. 9, at pp. 171–80, and Ibn Rushd,

above n. 10, at p. 329. A similar sale preference is evident in Shariah principles applicablein the bankruptcy context, where marshaling of assets and asset sale is preferred; seeMcMillen: 2010, above n. 14.

86. Articles 757 and 758, Majelle; Al-Zuhaylı, above n. 9, at pp. 173–4. The “normal” rule ofdebtor sale quickly gives way to judicially mandated sale if the debtor refuses to sell or isrecalcitrant in effecting a sale of the mortgaged property.

87. Articles 760 and 761, Majelle. See, also, Article 759, Majelle, pertaining to sales of assetsthat can spoil or otherwise lose value.

88. Article (28), Mortgage Law.89. Article (29), Mortgage Law.90. Articles (31) and (32), Mortgage Law.91. Articles (34) and (35), Mortgage Law. The original Arabic text of certain related articles,

such as Articles (36) to (39), is somewhat confusing as to whose rights and obligationsare being addressed with respect to related matters.

92. Article (41)(c), Mortgage Law.93. Al-Zuhaylı, above n. 9, at pp. 175 and 187–8.94. Al-Zuhaylı, above n. 9, at p. 188, discusses this principle as adopted by all four orthodox

Sunni madhahib.95. Articles (44), (45), and (46), Mortgage Law.96. See e.g. Al-Zuhaylı, above n. 9, at 178–80.97. It is noteworthy that classical rahn principles indicate a termination of the rahn arrange-

ment if either the debtor or the creditor leases, gifts, or sells the mortgaged property withthe permission of the other. See, for example, Al-Zuhaylı, above n. 9, at p. 189.

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22

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2

The Shariah Process in ProductDevelopment and Approval in ICM

Ahcene Lahsasna and M. Kabir Hassan

2.1 INTRODUCTION

Product innovation and enhancement in business and finance is an important aspect for thedevelopment and growth of the Islamic finance industry. However the flexibility provided byShariah in product development should be understood within the norms of Shariah rules,principles and framework. The following discussion will encompass two major dimensions,namely product development and product approval in Islamic Capital Market.

2.2 PRODUCT DEVELOPMENT, FINANCIAL ENGINEERINGAND INNOVATION IN ISLAMIC FINANCE

There are three related terms which stand in close correlation with one another, namely productdevelopment, financial engineering and innovation. They constitute a family which leads tochange and invention. Financial engineering and innovation together form the main driversof Islamic finance globally whilst playing a major role in attracting international players, in-vestors and business opportunities. Innovation itself fosters the progressive development of theIslamic finance industry whilst reflecting a healthy growth sign for the business environment.Therefore product development and innovation, together with financial engineering, can createniche markets, expand the market place, and create business opportunity and tolerance in thecompetition, enabling Islamic financial institutions to offer more products to a wider rangeof customers, for both individual and corporate customers, and providing multiple options tothe market place. We will highlight below the important aspects of innovation and financialengineering to give a proper perspective of the issues.

Invention is defined as a focused application of the human mind to the world that yields anoriginal creation which has practical use. Inventions are typically patentable, but patents do notnecessarily make an invention. Innovation is defined here as the practice of bringing inventionsinto widespread use through creative thinking, investment and marketing. That is why basicinvention is typically needed to spur innovative activity.1 On the other hand innovation is achange in the thought process for doing something or it creates new things such as instrumentsand tools that will be useful. It can be understood both as a revolution in thought and aschanges in thinking, products, processes or organizations.


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Table 2.1 20 largest countries by GDP

Rank County OverallInnovation

inputsInnovation

performance

1 South Korea 2.26 1.75 2.552 United States 1.80 1.28 2.163 Japan 1.79 1.16 2.254 Sweden 1.64 1.25 1.885 Netherlands 1.55 1.40 1.556 Canada 1.42 1.39 1.327 UK 1.42 1.33 1.378 Germany 1.12 1.05 1.099 France 1.12 1.17 0.96

10 Australia 1.02 0.89 1.05

The objective of innovation is to bring about positive change in order to make things betterfor shareholders and other stakeholders alike. The innovation in Islamic finance leads toincreased productivity and value which are the main fundamental sources of increasing wealthand prosperity in the economy.

Innovation is thus considered a major driver of the Islamic economy especially when itleads to the design of new product categories or increasing productivity in the banking sector.The strong connection or linkage of innovation with financial engineering and product designor development makes it a suitable tool for advancement as well as reflecting on the maturityof the market.

One of the latest indices was published in March 2009. This index ranks various countriesin the measure of both the innovation inputs and outputs. The innovations that are listedinclude technology, business performance and economic growth. Table 2.1 shows a list of thetwenty largest countries as measured by GDP by the International Innovation Index.2

The innovation and product development in Islamic finance clearly represents the coreengine of financial engineering which is a multidisciplinary field involving financial theoryusing tools of mathematics, computation and the practice of programming to achieve thedesired end results. It results in a sophisticated product channeled to a niche market place. Inthe Islamic finance context, innovation, product development and financial engineering are verymuch needed to maintain the productivity and growth of the Islamic finance market. Howeversuch innovation and financial engineering should be within the rules and principles of Shariah.

2.2.1 Principles to be considered in Product Development, Innovationand Financial Engineering

In order to ensure a proper process of financial engineering the following principles should beconsidered:

• The consistency and continuance in product innovation in the entire Islamic finance regimewhich includes banking, takaful and capital markets.

• The careful design of the product by avoiding the substantial risk exposure of the Islamicfinancial institutions or the investors.

• Maintaining Shariah compliance throughout the procedure which includes all stages of thefinancial engineering process and avoiding compromising on Shariah rules and principlesin any circumstances.

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The Shariah Process in Product Development and Approval in ICM 25

• Minimizing the duplication of conventional products and promoting innovation based onIslamic finance principles.

• Linking financial engineering to R&D at the Islamic financial institution, or to any otherR&D specializing in Islamic finance.

2.2.2 Area of Product Development, Innovation and Financial Engineering

Islamic finance has witnessed a major development in product innovations:

• Example: Ijarah, which has been developed into a typical financial contract or financialleasing instrument known as Ijara Muntahia Bittamleek, or AITAB as known in Malaysia,has a slightly different model of transferring the ownership according to AAOIFI StandardNo. 9.3 The said financial instrument is used in different types of banking facilities suchas care financing and home financing; in addition to that it has also been implemented insukuk issuance, whereby the contract of ijarah is the base financial contract in sukuk.

• The salam contract has been developed from a typical contract into a sophisticated contractused in banking, stock markets and capital markets.

• In banking, salam has been developed into a product known as parallel salam, wherebythe Islamic bank positions itself to facilitate the financing of the commodities. The gooddesign of the parallel salam gave a wider opportunity to Islamic banks to engage themselvesactively in the business of commodity.

• Salam has also been introduced as a potential contract in the futures market and stockexchange in the Bursa Malaysia (Bursa Suq Al-Sila).

• The istisna contract has been developed into a product known as parallel istisna wherebythe Islamic bank can take part in the process cycle of this financial transaction related tothe production, manufacturing and contracting sectors.

• The contract of musharakah has been developed from a typical contract to a sophisticatedproduct used in banking and capital markets. Islamic finance has introduced musharakahmutanaqisah used in home financing. The same contract is the basis for sukuk issuance inequity based sukuk.

The above innovative structuring are just a few examples showing that innovation throughfinancial engineering and product development can drive Islamic banking to create more so-phisticated products and expanding the market place by providing a wider business opportunityand attracting more investors and funds. However there are many other areas awaiting furtherinnovation and development by using financial engineering as a tool to develop and create newproducts. Areas such as the money markets, Islamic capital markets, hedging and derivatives,takaful investment link and structured products are fresh fields for exploring further innova-tion. There are some other pertinent areas in the Islamic finance industry which need to belooked afresh or requiring innovation to become part of the business activities such as zakatand waqf , especially cash waqf .

2.2.3 Failures of Innovation and Financial Engineering

Despite the importance of product development and innovation in Islamic finance, there maybe a failure to maintain invention in Islamic finance due to various factors. A product may bewell designed and have innovative features but sometimes it is rejected or postponed becauseof a Shariah compliance risk issue, high cost or high risk exposure. This may be due to cost and

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budgetary constraints, lack of skills in developing the product or poor fit with major objectivesof Islamic finance. In order to avoid failures in innovation, the parties involved in this particularprocess should have an open discussion, engage in team work, and encourage consultancy tocombine different skills, expertise and professional background to ensure the full success ofthe product innovated. There are internal and external factors which may contribute towardsthe failure of the institution to influence the process and effectiveness of the innovation. Butwe shall highlight the internal factors only, due to their paramount importance, and becausethey can be controlled.

As to the internal causes of failure they can be divided into two (2) types: one is associatedwith the cultural infrastructure and the second with the innovation process itself.

Failure in the cultural infrastructure varies between organizations but the following arecommon across all organizations at some stage in their life cycle (O’Sullivan, 2002):

1. Poor organization2. Poor communication3. Poor empowerment4. Poor knowledge management

Common causes of failure within the innovation process in most organizations can bedistilled into five (5) types:

1. Poor goal definition2. Poor alignment of actions to goals3. Poor participation in teams4. Poor monitoring of results5. Poor communication and access to information

Islamic finance should consider the above reasons that may be responsible for the failure ofinnovations, to ensure a consistent productivity of the Islamic finance market.4

2.3 THE SHARIAH FRAMEWORK IN PRODUCTDEVELOPMENT AND APPROVAL

The Shariah framework in Islamic finance refers to the overall scope that governs the processof product development and approval. The Shariah framework comprises the Shariah sources,Maqasid al Shariah, legal maxims, AAOIFI standards, and IFSB guidelines. All these ele-ments complement each other and together play a significant role in the process of productdevelopment and approval.

2.3.1 Sources of Shariah Law

Shariah is the apex source and point of reference for product development and approval. Bothdevelopment and approval are very much interrelated, because the development of the productwill finally result in a product offered to the market place. However before moving to thatstage, a prior Shariah approval should first take place to validate the product. Therefore, inorder for a Shariah scholar to issue a resolution pertaining to product approval in Islamicfinance, he or she is bound to refer to the sources of Shariah to justify the position taken, byproviding the necessary evidence that supports that position, because the resolution representsa Shariah position and carries a religious value which has an impact on the legitimacy of the

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product. It should be noted that the sources of Shariah are divided into two major categories:the first category is known as the primary sources and the second category as the secondarysources. In all circumstances, Shariah Board members are bound to refer to these sourcesduring the exercise of ijtihad. The scholars are not allowed to overrule these sources becausethey represent the soundest Shariah references that will enable them to produce a fatwa orIslamic ruling pertaining to any product in Islamic finance.

2.3.1.1 The Major Criteria of the Primary and Secondary Sources

In order to have a better understanding of the sources of Shariah, it is important to highlightthe following criteria:

• The primary sources are those sources unanimously agreed upon by the majority of scholarsand therefore they have to be accepted and recognized in fatwa and ijtihad. The debaterecorded in this category is not vital and has no impact on the validity of the sources; forexample the scholars did not take into account the arguments of Ibn Hazm in rejectinganalogy as a source of ijtihad.

• The secondary sources are subject to debate. Some of the schools of law accept them andothers reject them depending on various arguments, such as istihsan (juristic preference)and amal ahl al madina (the practice of the people of the city of Madina). On the other hand,in relation to the other sources which are accepted, the scholars have different positionsand interpretation on their implementation by imposing additional terms and conditions fortheir validation in ijtihad (such as maslaha mursala (public interest)).

• The primary sources provided are definitive knowledge, if we exclude the analogy becauseit is only a probable source. However Shariah accepts building a ruling based on probability.

• The law discovered through the primary sources can be extended through the rationalsources or the secondary sources, while law discovered through secondary sources cannotbe further extended.5

• The categorization or the grouping of the sources from the transmitted perspective willinclude the Quran, Sunnah, Ijma, Urf, Shar man Qablana, and the opinion of the companionsand exclude the other sources. The categorization or the grouping of the sources from arational perspective will include analogy, public interest, Istihsan, Istishab, and Sad alDarai and exclude the other sources.

• The categorization or the grouping of the sources based on independent sources willinclude the Quran, Sunnah, and Ijma and the other relevant sources. The categorizationor the grouping of the sources based on non-independent sources will include analogy andexclude the other sources, because in order to derive an Islamic ruling by way of analogy, itneeds and depends on the original case and the underlying cause in the Quran and Sunnahin order to have an effective function of Qiyas. So Qiyas is not an independent source but itrelies upon other factors and elements and traces back its origin to the Quran and Sunnah.

2.3.1.2 Classification of the Sources

The scholars of Islamic jurisprudence view the sources of Shariah from various perspectives;therefore, they structure the relevant sources according to that particular classification. Despitethe various classifications by the scholars, we refer here only to the popular and acceptedclassification of the sources which are as follows.

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2.3.1.3 Primary Sources (Agreed Upon Sources)

There are four primary sources in Islamic jurisprudence: the Quran, Sunnah, consensus, andanalogy. The main Shariah sources are the first two considered as divine law: the Holy textfrom the law giver the Quran which is the word of God (meaning and word) and Sunnah whichis the word of his Messenger. The other following two sources namely ijma and analogy areincluded in the primary sources respectively due to their importance and because they havebeen accepted as a major source by way of consensus, which gives them more credibility infatwa and ijtihad. Based on this justification and argument, scholars of Islamic jurisprudencelist them as primary sources. However there is no implication on the validity and importancein ijtihad and fatwa by putting consensus and analogy in the primary sources or even in thesecondary sources. It is a matter of classification only.

Therefore the following are the primary sources of fatwa in Islamic finance: the noble Quran(Al Kitab), the Sunnah (Tradition of the Prophet), the consensus of legal opinion for Muslimjurists (al-Ijma’), and the analogy. These sources are the most accurate and sound referencesthat the Shariah Board members refer to them in order to provide a Shariah opinion. Thesesources should be understood in order to be used in the exercise of ijtihad in a proper manner;the lack of knowledge of these sources will result in committing mistakes in fatwa and maylead the Shariah member to a failure in his ijtihad.6

2.3.1.3.1 Example of Ruling Derived from the Primary Sources

A. Kafalah contract: The contract of guarantee is a permissible base for the followingprimary sources:

• Quran: The act of Prophet Yusuf who feigned the loss of the King’s measure and stoodguarantor for a reward to whoever could retrieve it gives validity to the contract underthe Islamic law. They said: “We have lost the (golden) bowl of the king and for him whoproduces it is (the reward of) a camel load; and I will be bound by it” Quran (12: 72).

• The word za’im used in the verse has been interpreted by Ibn Abbas to mean Kafil, thatis, guarantor. Imam Al-Razi in his exegeses of al-Qur’an also interpreted the verse as abasis for the kafalah contract especially as it was confirmed by the Quranic verse andsaying of the Prophet (pbuh).

• Sunnah: It was narrated by Salamah bin al-Akwa that the Prophet (pbuh) was reportedto have gone for the funeral of a man to pray for his soul. He asked those who werepresent at the funeral: “Did he leave any wealth?” They replied “No.” He asked further,“Did he die with any debts outstanding?” They replied, “Yes, he owed two Dinars” (insome narrations three). The Prophet (pbuh) was about to leave when he said: “Thenperform prayers on your companion.” Abu Qatadah interceded and said: “I guaranteehis debt, Oh Messenger of Allah” and the Prophet (pbuh) then prayed for his soul.

• In another tradition, the Prophet (pbuh) was reported to have said: “The guarantor(al-za’im) is responsible.”

• Consensus: Jurists unanimously agree on the validity of a contract of guarantee.B. The contract of Ijarah (leasing): The legality of ijara is derived from the Quran, Sunnah,and the consensus as primary sources:

• Qur’an: There are several verses from Quran as evidence for the permissibility of theleasing, these verses are:

• Allah says: And said one of them (the two women): “O my father! Hire him!Verily, the best of men for you to hire is the strong, the trustworthy.” He said: “I

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intend to wed one of these two daughters of mine to you, on condition that youserve me for eight years, but if you complete ten years, it will be (a favour) fromyou. But I intend not to place you under a difficulty. If Allah will, you will findme one of the righteous.” (Al-Qasas: 26–7). “. . . Then if they give suck to thechildren for you, give them their due payment, . . .” (Al-Talaq: 6).

• The above verses show that the contract of al-ijara is a lawful and permissibletransaction.

• The verse is reporting the story of the Prophet Musa being hired by his father-in-law for a certain period of time; these verses are always quoted by scholars toprove the permissibility of Ijarah.

• Sunnah: The evidences from the Sunnah are as follows:• The Prophet (pbuh) said: “Pay the hired worker his wages before his sweat dries

off.” Narrated by Ibn Majah. The order to pay wages (ajr) as instructed by theProphet (pbuh) in this Hadith is clearly an indication of the validity of hiring theworker’s labour for a specific period of time.

• The Prophet (pbuh) is reported to have said: “He who hires a person should informhim of his fee.” Narrated by al-Baihaqi.

• Ibn Abbas reports that the Prophet (pbuh) had cupping performed on him and gavethe cupper his fee. Narrated by Malik in Muwata.

• The Prophet (pbuh) said, “Allah said, ‘I will be an opponent to three types ofpeople on the Day of Resurrection: One who makes a covenant in My Name, butproves treacherous; One who sells a free person and eats his price; and One whoemploys a labourer and takes full work from him but does not pay him for hislabour.”’ Narrated by al Bukari.

• Abdullah ibn Umar narrates, “Allah’s Apostle gave the land of Khaibar to the Jewsto work on and cultivate and take half of its yield.” Ibn ‘Umar added, “The landused to be rented for a certain portion (of its yield).” Al Bukari.

• All the above-mentioned Hadiths provide evidence on the permissibility of theijara contract.

• Consensus: Scholars unanimously approve the permissibility of Ijarah contract.

2.3.1.3.2 Example of Ruling Derived by Using Analogy as Primary Sources

Qiyas is defined as the extension of a Shariah value from the original case, or asl, to a newcase, because the latter has the same effective cause (illah) as the former. The assignment ofthe hukm of an existing case found in the text of the Quran, the sunnah or ijma, to a new casewhose hukm is not found in these sources on the basis of a common underlying attribute calledthe illah of the hukm. The qiyas has four pillars which are as follows:

1. Asl (original case, set of facts, on which a ruling has been given)2. Hukm (ruling on the original case)3. Illah (underlying cause of ruling in the original case)4. Far’ (new case on which ruling is to be given).

Allah says in the Quran: “O ye who believe! When the call is proclaimed to prayer on Friday(the Day of Assembly), hasten earnestly to the Remembrance of God, and leave off business(and traffic): That is best for you if you but knew.” (Al Juma: 9). By using the analogy thisprohibition is extended to all kinds of transactions and activities such as agriculture activities

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and others. The reason is because the underlying cause that is diversion from Friday prayer iscommon to all. Therefore the ruling will be extended from the original case mentioned in theQuran (which is related to Friday prayer) to the new case which is the business transactionsuch as leasing if it is conducted during the same time where the prohibitions applied.

2.3.1.4 Secondary Sources (Disputed Sources)

Besides the primary sources mentioned above, there are other secondary sources that playa crucial role as sources of Shariah. This category is a back-up and supplements the firstcategory, and supports the exercise of ijtihad when the first category is not applicable. TheShariah Board member should refer to this category of Shariah sources in order to providean Islamic ruling for the cases presented or for the validation of the product. Of course thisstage takes place if the Shariah Board could not resolve the issue from the first category. Thesesources must be understood and comprehended by the scholars in order to ensure their properusage and implementation in the exercise of ijtihad.

This category includes a wider range of sources belonging to different schools of law.The most popular secondary sources are: Istihsan (juristic preference), Muslahah Mursalah(public interest), Urf (custom), Qawl al sahabi (the opinion of the companion), Sad Al darai(blocking the law full), and Istishab (presumption of continuity). These sources are subject tosome different interpretations, terms, and conditions that should be observed by the ShariahBoard when they refer to them.

It is difficult to cover the entire category of the secondary sources in this brief description;however I will give just one example from the list mentioned above.

2.3.1.4.1 Some Resolutions Based on Maslahah as Secondary Sources

Maslahah is one of the prominent sources of Islamic law. It means “benefit” or “interest” andit is the opposite of the mafsadah or evil. According to Ibn Ashur maslahah mean utmostrighteousness and goodness.7 Scholars refer to maslahah to issue Islamic rulings when thesource is applicable for ijtihad. Maslahah has been implemented largely in contemporaryIslamic finance. Below are some of the resolutions based on maslahah:

Dallah al Baraka, Fatwa no. 19/8• In relation to investment in stock of companies who capitalize on loans from conventional

banks. If the stocks rise and create profit for the investor, how shall the return be dealt with?The committee stated: “And the opinion that we undertake to realize both Maslahah andjustice (‘adl), is by viewing the return as raised out of the loan and the effort exhausted bythe company and therefore he is to dispose half (50%) of the return realized out of the loan.Thus, he is entitled to benefit from the works done, which constitute half of the total returnand he is obliged to dispose the other half due to the illegitimacy of the loan transactioneven if the loan is considered as guarantee.”8

Dallah al Baraka, Fatwa no. 19/4 (1) (8) 371• “It is permissible for specific official authority to regulate/organize a stock exchange so that

it shall not be conducted by other than specilaized brokers who possess licences to performsuch work, in order to realize masalih masyru’ah (legitimate interests).9

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2.3.2 Maqasid al Shariah

Maqasid al Shariah is one of the important pillars that should be considered for the improve-ment of the Islamic financial system. Besides the Shariah rules and the regulator, Maqasidal Shariah or the objectives of Islamic law represent the most comprehensive instrument thatcan enhance contemporary Islamic finance and banking today. However understanding theconcept of Maqasid al Shariah and its underlying principles is very important before applyingit in the current business scenario. It is very important to understand that maslaha (publicinterest) is the core of the theory of Maqasid al Shariah itself. This strong link leads us to havea specific focus and concern in relation to maslaha – or interest or benefit or utility – all thesewords are treated synonymously – and thus, these terms are used interchangeably in theoryof maslaha. Al Gazali says in the definition of maslaha: “It is seeking of benefit or repellingof harm.”10 Accordingly the general objective of Shariah is to preserve the society order ofthe community and ensure the continuity of its healthy progress.11 Allah says: “I desire nomore than to set things to right in so far as it lies within my power, but achievement of myaim depends on God alone” (11:88). And he said also: “. . . and do not act wickedly on earthby spreading corruption” (7:74). The above provisions and other provisions mentioned in theholy text confirm that the objective of Shariah is to set things right and remove the corruptionin all types of activity in the society and business community as well.

2.3.2.1 Concept of Maqasid al Shariah

According to Ibn Ashur the definition of Maqasid al Shariah is based on two aspects, thegeneral aspect which is the purpose and wisdom behind the enactment of all or most ofthe Shariah ruling.12 This definition is more related to the general objective of Shariah,those overall principles that guide the enactment of Islamic law in their totality. The seconddefinition of Maqasid al Shariah is very specific; it is related to those specific objectivesthat are designed to achieve specific benefits to people in their daily activities, such as theimportance of validation of contracts.13 The other definition is provided by Alal al-Fasi whodefined Maqasid al Shariah as “the end sought behind the enactment of each of the ruling ofShariah and the secret involved”.14 This definition is more comprehensive because it coversthe public Maqasid (ama) and the private Maqasid (khasa). The above definition focuses onthe end sought behind the enactment of each of the rulings of Islamic law, and the secret ofthese rulings. The secret of the Islamic rulings means the goals intended by Allah in the law.As part of the comprehensive concept of Maqasid al Shariah it includes various aspects ofbenefit, public interest, private interest, and protection from various types of harm and vices.So Maqasid al Shariah aims to protect the interest of mankind and keep them from evil, andit is meant to realize public benefit for society, and encourage virtues and avoid vices.

2.3.2.2 Importance of Implementation of Maqasid al Shariah in Developing IslamicFinance Products

The importance of the Maqasid al Shariah in developing Islamic finance products comesfrom the position of the wealth itself in Islamic law and Maqasid al Shariah as well. Thisimportance refers also to the objectives of Islamic law in finance and business transaction andto the overall goals of Shariah in wealth. The preservation and protection of wealth is classifiedunder the category of necessary (daruriyyar). The meanings of daruriyyar are “those without

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the protection of which there would be anarchy and chaos in society. The absence of protectionfor these interests would mean loss of everything that we hold dear.”15 This infrastructure andclassification of Maqasid al Shariah shows the primary position of wealth and the importanceof finance in Islamic law. Thus, it is clearly mentioned that finance is recognized by Maqasidal Shariah as a valuable aspect in life. Furthermore finance is protected by Islamic law inthe form of Islamic legal rulings and regulation. It is strongly recommended to emphasize theimplementation of Maqasid al Shariah and be part of the framework that governs the currentbusiness transaction for the following reasons:

• The proper matching and smooth relationship between Maqasid al Shariah and the objec-tives of the business transaction can be observed from the position of wealth in Maqasid alShariah; as mentioned there is a clear indication from Shariah text and rules emphasizingthe protection of finance and wealth in all types of business activities. Therefore disregard-ing the objectives/Maqasid al Shariah in business transactions may lead to hardship anddisorder.

• The business transactions in domestic and international trade should be based on theprinciples of Islamic law; the main objectives of Maqasid al Shariah in finance and businessshall be taken as a guideline in executing all types of financial transactions.

• The particular objectives of Maqasid al Shariah in business transactions are a continuationof the general objectives of Maqasid al Shariah; this linkage makes the relationship betweenthe two categories much stronger.

• The rules of business transaction should be understood within the regulations and therequirement of Maqasid al Shariah and Islamic law.

• Maqasid al Shariah governs and regulates the Shariah principle of the Islamic finance.• Maqasid al Shariah facilitates the product development and improvement by looking at the

main objectives of Shariah in business and finance and the need of the market.

2.3.2.3 Maqasid al Shariah in Business Transactions

The conventional financial system focuses primarily on the economic and financial aspects oftransactions; it is normally driven by profit maximization, whereas the philosophical foundationof the Islamic financial system goes beyond that. According to the principles of Maqasid alShariah the Islamic system places equal emphasis on the ethical, moral, social, and religiousdimensions in order to enhance equality and fairness for the good of the society as a whole.Maqasid al Shariah aims to achieve various objectives in a business transaction, which are asfollows:

• The circulation of wealth in the business transaction• Preservation and protection of wealth• Transparency in wealth and finance• Development and investment of wealth• Prevention of harm and hardship in wealth and finance• Ensuring justice in circulation of wealth.16

It should be understood that Maqasid al Shariah is an important aspect in the framework ofIslamic finance that can play a crucial role in economics, finance, and business transactions to-day. The consideration of Maqasid al Shariah in finance and economic activities gives the wayto achievement of the noble objectives of the Shariah. These objectives give value to finance,

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banking, trade, and all business transactions. The implementation of Maqasid al Shariah willenhance the performance of finance and trade and establish justice in the business commu-nity and society at large. Furthermore the achievements of Shariah objectives in businesstransactions create happiness and satisfaction and fulfil the economic needs of the society.

2.3.2.4 Maqasid al Shariah Principles

There are important principles which play a significant role in understanding Maqasid alShariah, helping the regulators, and making for easy implementation of decisions in theIslamic finance industry. The following are some guidelines:

1. Maqasid al Shariah has noble objectives in economics, finance, and business transactions.2. The objectives of Maqasid al Shariah in business transactions create communal prosperity

and happiness and satisfaction in society.3. The concept of Maqasid al Shariah and its noble objectives are considered universal goals.4. Maqasid al Shariah creates balance between the private interest, by meeting the demands

of the individual according to their self-interest, and the public interest, by catering to theneeds of society and leading to welfare programmes.

5. The duty of implementation of Maqasid al Shariah in economics and finance is not thesole responsibility of scholars, but is the responsibility of all members involved in finance,business, and economic activities.

6. There is a mechanism and process that has to be taken into account in order to implementMaqasid al Shariah in finance, banking, and business transactions.

7. It is very important to address Maqasid al Shariah in the current business scenario andapply it in all types of business activities.

8. Maqasid al Shariah helps to enhance the financial market and banking system by makingsignificant progress in the domestic market and international trade.

9. Maqasid al Shariah helps to overcome the current issues in finance, banking and businesstransactions because Maqasid al Shariah is about essences and real attributes rather thannames and forms.

10. It is recommended to promote Maqasid al Shariah as additional tools to understandfinance and banking and to enhance the applications of business transactions and supportand assist the rapid development of the Islamic banking and finance.

11. Maqasid al Shariah is a solid platform for the Shariah advisor to understand the currentShariah issues in finance and banking; furthermore it helps them in dealing with thecurrent issues through a true examination and provides alternative solutions within thenoble objective of Shariah.

12. There must be full and comprehensive understanding of the Maqasid al Shariah beforethe stage at which they are implemented in economics and finance.

2.3.3 Legal Maxims

Legal maxims represent sayings by competent scholars from different Schools of Law whichhave been established from time to time and have then been refined by other jurists throughoutthe ages. Legal maxims play an important role in ijtihad and fatwa – they help scholars toencapsulate and understand the details of Islamic law very quickly. They also help to derive

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Islamic rulings and offer very fast access to the Islamic law where no explicit provision existsin the sources. The five leading legal maxims are:

• Acts are judged by their goals and purposes. (Al Umuru Bimakasidiha)• Certainty is not to be overruled by doubt. (Al yaqin la yuzal Bi al-shaq)• Harm must be eliminated. (Al Darar Yuzal)• Hardship begets facility. (Al Mashaqqah Tajlib Al Taysir)• Custom is the basis of judgments. (Al-Adah Muhakkamah)

Besides the above five leading legal maxims, there are other legal maxims very relevant tobusiness and finance such as al ghunm bil ghurm and al kharaj bil daman which mean that theentitlement to revenue depends on a corresponding liability for loss, and other relevant legalmaxims. It should be understood that each of the above leading five legal maxims comprisesrules and principles that must be observed during the exercise of product approval by a Shariahadvisor in order to ensure the soundness of the resolution. On the other hand, Shariah advisorsshould use these legal maxims carefully, because every legal maxim has an exception.

2.3.3.1 Example of Resolution Based on a Legal Maxim (Permissibility of Ta’widh)

According to a Bank Negara resolution Ta’widh in general means giving compensation onlosses incurred resulting from harmful occurrences. Majma’ Fiqh defines Ta’widh as paymentof financial compensation or counter-value which is obligatory as a result of harm causedto other parties. Ta’widh is more specific than compensation for losses (dhaman) which isstipulated by Shariah sources like yad dhaman.

The resolution of the Bank Negara Shariah Advisory Council was based on the Hadith ofprophet (SAW) who said: “The rich (solvent) who delay the payment of a debt are committingtyranny.” Another Hadith supports the same position. This Hadith takes the form of a maxim,and is used by scholars as a prominent legal maxim: “Neither harming nor reciprocating harm(in Islam).”

Based on this Hadith, the debtor’s act of delaying payment is a loss (harmful) to the creditor.This situation has to be avoided so that businesses are conducted according to the principle ofistiqrar ta’amul, that is the smooth running of the market.

Besides the above evidence other legal maxims have been used and implemented thatrepresent a solid ground to support the same Shariah position. This legal maxim supports thepermissibility of Ta’widh: “Whatever loss should be removed.”

As a result of the above evidence the SAC resolved that in the context of this discussion,losses which are borne by a creditor must be removed by the provision of a suitable approach.Imposing Ta’widh on a delayed payment of debt is a suitable approach for covering the lossborne by the creditor and it encourages the debtor to settle the debt within the stipulated timeframe.17

2.3.4 Regulators and Standard-Setting Organizations: Regulations, Standards, andParameters for Islamic Finance (AAOIFI, IFSB, and Others: Shariah Standards,Corporate Governance, and Prudential Regulations)

The regulations, standards, and parameters provide guidance and proper direction to Islamicfinance. The future shape of the Islamic finance industry is subject to the regulations, standards,guidelines, and principles set by the official regulators such as the central bank and the

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Securities Commissions, and the major players of Islamic finance such as AAOIFI, IFSB, andothers.

The responsibility of the official and non-official regulators is crucial due to the implicationsof the set of rules and standards produced, whether they be Shariah standards, corporategovernance, or prudential regulations.

The set of rules and standards will decide the future of the Islamic finance industry anddesign its shape and structure. Therefore establishing a global vision and global picture,and addressing the issues from a global perspective is essential to ensure effectiveness andefficiency of the rules and the standards.

Principles to be considered by the regulators in setting the standards: There are someimportant principles which should be considered by the regulators in setting the standards andthe parameters as follows:

• Standardization and harmonization of the standards and the set of rules issued.• Comprehensiveness and global vision in setting the standards.• Recognition of the different Islamic finance practices in different jurisdictions.• Recognition of the diversity of Shariah opinions which result in a dual set of standards

recognized globally.• The possibilities for double standards to co-exist and be practised globally.

Principles to be considered by the players: There are some principles which should beconsidered by the players in Islamic finance, including the decision makers in the respectiveIslamic financial institution, and their respected Shariah Boards:

• Toleration and acceptance of other standards which are based on different Shariah opinionsand different business practices.

• Collaboration and coordination between the different jurisdictions to move from a regionalperspective and position to a global one.

The above will foster and strengthen the Islamic finance position globally and present theIslamic finance industry as a dynamic and flexible financial system that functions and worksglobally.

2.3.4.1 AAOIFI Standards and AAOIFI Accounting Standards

The Shariah standards in Islamic finance have a very important role in regulating the financialsystem. The appropriate standards, regulations, and supervision protect the financial systemand safeguard the market at large. In addition to that the effectiveness and adequate regulatorystandards ensure the stability of the financial system. In this context, the Shariah Board shouldobserve the standards that have been established by industry players, especially AAOIFI whichacts as a regulation setting body in the Islamic finance industry. A careful observation of thesaid standards in Shariah and accounting ensures the consistency of the resolution and takesinto account the best practices in the market. The AAOIFI aims to facilitate the functioningof Islamic financial institutions by providing various standards related to the Islamic bankingindustry. These standards can be considered as a custom of the market and best practices forIslamic banks and Islamic financial institutions as well. By adopting this approach, the Islamicfinance industry can achieve in the future one unique and universal Shariah standard withglobal features for the Islamic financial institution. Shariah Board members can play a crucial

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role in the harmonization process by bridging the gap between the various Shariah opinionsand limiting the room for argument in Islamic finance. The standards of the regulators andfatwa should complement each other to achieve this.

The AAOIFI includes Shariah standards, accounting standards, auditing standards, gover-nance standards, and ethics.

The objectives of the AAOIFI are as follows:

1. To develop accounting and auditing ideas relevant to Islamic financial institutions;2. To disseminate accounting and auditing ideas relevant to Islamic financial institutions

and their application through training, seminars, publication of periodical newsletters,commissioning and carrying out of research, and other means;

3. To prepare, promulgate, and interpret accounting and auditing standards for Islamic finan-cial institutions; and

4. To review and amend accounting and auditing standards for Islamic financial institutions.

The AAOIFI carries out these objectives in accordance with the precepts of Islamic Shariahwhich represent a comprehensive system for all aspects of life in conformity with the environ-ment in which Islamic financial institutions have developed. This activity is intended both toenhance the confidence of users of the financial statements of Islamic financial institutions inthe information that is produced about these institutions and to encourage these users to investor deposit their funds in Islamic financial institutions and to use their services.18

2.3.4.2 IFSB Standards

The Islamic Financial Services Board, IFSB, serves as an international standard-setting bodyfor regulatory and supervisory agencies that have a vested interest in ensuring the soundnessand stability of the Islamic financial services industry, which is defined broadly to includebanking, capital markets, and insurance. IFSB promotes the development of a prudent andtransparent Islamic financial services industry through introducing new, or adapting existing,international standards consistent with Islamic Shariah principles and recommending them foradoption. IFSB complement the work done by the Basel Committee on Banking Supervision,the International Organization of Securities Commissions, and the International Associationof Insurance Supervisors. Malaysia is the host country of the IFSB.19

The objectives of the IFSB are:

1. To promote the development of a prudent and transparent Islamic financial services industryby introducing new standards or adapting existing international standards consistent withShariah principles and recommending these for adoption.

2. To provide guidance on the effective supervision and regulation of institutions offeringIslamic financial products, and to develop for the Islamic financial services industry thecriteria for identifying, measuring, managing and disclosing risks, taking into accountinternational standards for valuation, income and expense calculation, and disclosure.

3. To liaise and cooperate with relevant organizations currently setting standards for thestability and the soundness of the international monetary and financial systems and thoseof the member countries.

4. To enhance and coordinate initiatives to develop instruments and procedures for efficientoperations and risk management.

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5. To encourage cooperation amongst member countries in developing the Islamic financialservices industry.

6. To facilitate training and personnel development and their skills in areas relevant to theeffective regulation of the Islamic financial services industry and related markets.

7. To undertake research into and publish studies and surveys on the Islamic financial servicesindustry.

8. To establish a database of Islamic banks, financial institutions, and industry experts.20

In light of the sound objectives of the two regulators of the Islamic finance industry, Shariahopinion on product development and Shariah approval can add more value by adopting theseguidelines to ensure consistency of the resolutions. However, the adoption of the standardsdoes not mean that the Shariah advisor is not allowed to adopt a different Shariah opinion.

The most important IFSB publications are:

• Guiding Principles on Corporate Governance for Institutions Offering Only IslamicFinancial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mu-tual Funds)

• Capital Adequacy Standard for Institutions (other than Insurance Institutions) offering onlyIslamic Financial Services (IIFS)

• Guiding Principles of Risk Management for Institutions (other than Insurance Institutions)offering only Islamic Financial Services (IIFS).

The Guiding Principles are designed to facilitate institutions offering Islamic FinancialServices (IIFS) to identify areas where appropriate governance structures and processes arerequired and to adopt best practices in addressing these issues. It also aims to empowerstakeholders, in particular investment account holders (IAH), with sound knowledge.

2.4 THE TYPES OF PRODUCT IN ISLAMIC FINANCE

The most popular products offered in Islamic finance are listed in Table 2.2 according tomarket place.

The above-mentioned products are either Shariah-based products or Shariah-compliantproducts. Both products are acceptable from a Shariah perspective to be used in the Islamicmarket place if they fulfil Shariah requirements and conditions.

2.4.1 Shariah-Based Products

Shariah-based products are those products that have been produced by Shariah on the basis ofconcepts and rules based on the Quran and Sunnah and other sources of Islamic commerciallaw such as mudarabah, musharaka, salam, ijarah, hawalah, etc. The lists of those productshave been deliberated by the Muslim jurist through the ages. Their concepts, meanings, rulesand conditions are clearly spelt out in the books of Islamic law of the various Schools ofLaw. The development of some of these contracts will not change their nature and criteria.The same contract rules apply regardless of the development of the contract in the differentapplications in Islamic finance. For example the contract of salam has been developed intoparallel salam and used in banking and Islamic capital markets, but the said development inthe salam contract will not release it from the basic rules that govern the contract of salam. The

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Table 2.2 Most popular Islamic finance products

A. Islamic financing product

Products Principles of Shariah

1. House Financing (asset financing) MurabahahIstisna’ (parallel istisna’)Ijarah Muntahiya BittamleekForward IjarahMusharakah Mutanaqisah

2. Vehicle Financing (asset financing) MurabahahIjarah Muntahiya Bittamleek/ijarah Thumma al-Bay’

3. Working Capital Financing (asset orcash financing)

MurabahahIjarah Muntahiya Bittamleek/ijarah Thumma al-Bay’TawarruqSalamSale and Lease Back

4. Project Financing Istisna’ and Parallel Istisna’MudarabahMusharakahSale and Lease BackMurabahahTawarruq

5. Trade Financing LC based on WakalahLC based on MurabahahLC based on Musharakah

6. Debit Card Set-off (Muqasah)7. Charge Card Tawarruq/’Inah

Kafalah8. Overdraft Tawarruq/’Inah9. Factoring Bay’ al-Dayn10. Letter of guarantee Kafalah11. Personal financing Tawarruq/‘Inah12. Services financing Ijarah (sub-lease)

B. Takaful product

Products Contract Among Participants

1. General Takaful 1. Tabarru’ (donation)2. Waqf (endowment)

2. Family Takaful 1. One portion for Tabarru’ and another portion forinvestment

2. All portions for Tabarru’

C. Equity based product


Shares/Equity MusharakahMutual Funds/Unit Trust Musharakah (amongst the investor) and Wakalah

(between the investor and the fund manager)Private Equity Fund Musharakah and Wakalah (as above)REITs Musharakah and Wakalah (as above)Specific funds, e.g. aircraft leasing fund Musharakah and Wakalah (as above)

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Table 2.2 Most popular Islamic finance products (Continued)

D. Fixed income securities based on securitization


BBA/Murabahah Bonds/notes BBA/Murabahah and Bay’ al-DaynSukuk Ijarah Sale and Lease-BackSukuk Mudarabah Mudarabah with purchase undertaking to purchase

the Sukuk assetsSukuk Musharakah Musharakah with purchase undertaking to purchase

the Sukuk asset

E. Islamic derivative products


Forward Currency Wa’d (unilateral binding promise)Murabahah Currency swap

Option Urbun/earnest moneyProfit rate swap Murabahah (both fixed and floating)

same rules are applicable to the other financial contracts developed such as financial leasing,ijarah munthiah bi tamlik, commodity murabahah, parallel istisna, and others.

2.4.2 Shariah-Compliant Products

Shariah-compliant products are those products that have been imported from conventionalfinance and converted into Islamic products. In principle they are conventionally based productsproduced and used by conventional finance with a specific structure and mechanism, but theIslamic financial institution implement them in their banking business due to their importance.However their rules and conditions have been amended and modified to suit the Shariah rules,which will result in a Shariah-compliant product that can be used by the Islamic financeinstitutions.

2.5 PROCESS OF PRODUCT DEVELOPMENT INSHARIAH-BASED PRODUCTS

The development of Shariah-based products should be governed by the following parametersin order to ensure proper development and improvement before placing the product in themarket place.

• Identifying the Islamic commercial contract: Before making any development on theproduct it is important to identify the underlying contracts that govern that product; thereason behind this step is to understand the norm of the product in the first place and whattype of rules and conditions should be observed in the development of the product.

• Understanding the rules governing the contract: The identification of the nature of thecontract will enable the Shariah advisor to have a proper understanding of the product, andwill help to design a proper structure to develop the product. It should be understood that

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each contract has principles, rules, and conditions that must be preserved and protectedfrom any potential violation during the development of the product.

• Maintaining the existing Islamic rules of the underlying contract when applying thecontract in a new application: The contract that governs the application must maintainits rules, conditions, and nature, even though the application has changed from its originalform, and takes different shapes and serves different purposes and applications.

For example the development of a leasing contract from its typical format to the financialleasing ending with the transfer of the ownership of the asset, which is used by the Islamicfinancial institutions in car financing and home financing, will not allow the financial leasingto depart from the basic rules and conditions of a leasing contract.

The above parameter should be applied in all types of contracts that have developed fromtheir typical format to new applications, depending on the need of the market. For examplesalam has been developed from a typical salam contract to parallel salam, istisna has beendeveloped from a typical istisna contract to parallel istisna, etc.

• Maintaining the underlying contract and upgrading the application by designing anew feature according to market demand: The development of the product is driven bymarket demand to fulfil the need of the market place, the customer in the retail market, andthe corporate as well, whereby some institutions request the bank to customize a particularproduct to suit their need, e.g. a takaful operator in product-linked investment. Thereforethe contract maintains its basic rules and the applications will be developed to suit particularneeds.

• Ensuring that the final product developed is in line with Shariah rules and principles:The flexibility of Shariah in product development and innovation cannot be extended tooverrule Shariah principles. The freedom of innovation is accommodated and encouragedwithin the norm of Shariah and its rules in business and finance. The developed productmust be designed by taking into account the Shariah rules of the contract that govern theoriginal product: at the end of the process development the product should be in accordancewith Shariah rules and principles. The force of Shariah rules and principles will trigger theShariah non-compliance risk.

2.5.1 Example of Product Development in Shariah-Based Product: Ijarah MuntahiahBittamlik (Leasing Ending with Ownership)

Financial leasing is a form of contract that has been developed from the typical format of ijarah.It has been designed to fulfil the need of the market. Financial leasing or ijarah muntahiahbittamlik is a form of contract based on leasing and ending with the transfer of ownership. Theobjective of the contract developed is transfer of the legal title of the leased asset to the lessee.Otherwise they would be considered an operating lease contract. The mode of financing usedto achieve the said objective is ijara muntahiah bittamlik.

This type of financing based on the contract of ijarah is becoming one of the most populartypes of financing offered by Islamic banks. Financial leasing has many forms of the contractto facilitate the transfer of ownership as described below:

• Ijara Muntahia Bittamlik through Gift (Transfer of Legal Title for No Consideration)• Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale at the End of Lease Period

for a Token Consideration)

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• Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale at the End of Lease Periodfor an Amount Specified in the Lease)

• Ijara Muntahia Bittamlik through Transfer of Legal Title (Sale) Prior to End of Lease Termfor a Price Equivalent to Remaining Ijara Instalments

• Ijara Muntahia Bittamlik through Gradual Transfer of Legal Title of Leased Asset.21

The above modes of transfer of ownership should be consistent with the contract of leasing,and Shariah rules and principles in business and trade.

2.6 PROCESS OF PRODUCT DEVELOPMENT INSHARIAH-COMPLIANT PRODUCTS

The Shariah-compliant product normally consists of a combination of features from the con-ventional product, and from Shariah rules and principles. The Shariah part will normally bein the form of a contract that replaces the conventional mechanism based on lending andborrowing, and therefore the product development process in a Shariah-compliant product ismore challenging and complicated compared to the development of a Shariah-based product.The following are the most important parameters that should be considered in the developmentprocess:

◦ Selection of niche product and niche market: The development process in productcompliance starts by selecting an appropriate product for a niche market. The process ofselection and design is easier for Islamic banks that are subsidiaries of conventional banks,whereby the Islamic bank will leverage on the mother bank for designing and developingproducts. In some cases the product development department in the bank will share the newproduct developed in order to produce a conventional version and an Islamic version at thesame time. In some cases other financial institutions approach the Islamic bank to design aproduct for some particular need such as a product investment link for a takaful operator ora structured product for some investment bank.

◦ Understanding the product in its conventional framework: The starting point and initialstage in the product development of a Shariah-compliant product starts from understandingthe product in its conventional framework. The understanding of the product includes theconcept of the product, features, functions, applications, the parties involved, the mechanismof generating profit, the type of risk that exists in the product, etc.

◦ Analysis and examination of the product: The understanding of the product in its conven-tional environment will be followed by a process of analysis: the product will be dismantledto its basic components. The process of examination is a very important stage in productdevelopment; the examination will include the following:• Identify the process flow of the product.• Identify the parties involved in the transactions.• Understand how the profit is generated and calculated.• Identify if there is a loan transaction in the product.• Trace the flow of funds in lending and borrowing.• Identify the nature of the transaction and norm of the deal whether it is investment,

financing, deposit, etc.• Identify the purpose of the product and its objective – this will help to select the potential

Islamic contract to serve the same purpose.• List the prohibited elements that may exist in the product.

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◦ Elimination of prohibited elements in Shariah: In building a new product it is a primaryrequirement to eliminate the prohibited elements that have been identified in the product inorder to ensure its Shariah compliance. The prohibited elements are:• Riba• Maisir• Gharar• Ghubn• Deception• Inequality• Duress

◦ Reassembly of the product based on underlying contract in Shariah: The process ofreassembling the product again takes place upon completion of the analysis and eliminationof the prohibited elements, whereby the product is assumed to be free from potential Shariahnon-compliance risk. This particular stage is a process of switching the product from itsoriginal format based on loan interest to a new format by structuring it on the suitable Islamiccommercial contract. The product may have a flow of transactions involving few parties;the proper design of the flow at this stage will ensure the Shariah compliance of the product.Careful procedure should be observed here especially when selecting a suitable contract.

◦ Careful observation in using contract combination: It is known that most of the facilityconsists of a series of transactions, which means a series of contracts. This is a verycrucial stage in product structuring and development; there is no issue of having a masterdocument which governs the entire product process, including the different transactionsand contracts pertaining to the product. However in the implementation and executionof the product the separation of the contracts and their sequence is very important toensure Shariah compliance. Each contract should stand on its own, and has its obligations,conditions, and rules. The combination of the contracts in product development withoutcareful consideration of the conditions of the contract will lead to the risk of Shariahnon-compliance.

According to AAOIFI there are certain rules to be considered in combining the contract:• Contract combining should not include those cases that are explicitly banned by the

Shariah, such as combining sale and lending in one contract.• It should not be used as a trick for committing riba, such as an agreement between two

parties to practise riba al fadhl.• It should not be used as an excuse for practising riba. The two parties could, for

example, misuse contract combining when they conclude a lending contract which, atthe same time, facilitates some other compensatory gains to them. For example, theycould stipulate in the contract that the borrower should offer accommodation in his houseto the lender, or should grant him a present. Contract combining could also be misusedby imposing excess repayment in terms of quantity or quality on the borrower.

Combined contracts should not reveal disparity or contradiction with regard to their under-lying rulings and ultimate goals. Examples of contradictory contracts include granting an assetto somebody as a gift and selling/leasing it to him simultaneously, or combining mudarabawith lending the mudaraba capital to the mudarib, or currency exchange with jua’la, or salamwith jua’la for the same contract value, or leasing with selling.22

◦ Consideration of the terms and conditions of the contract: The terms and conditionsof the contract are rules governing the contract, therefore the parties must always respect

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these terms and conditions. No party is allowed, from a Shariah perspective, to violate anyclause without prior consent of the counterparties. In product development two types ofconditions should be distinguished. Conditions that have been imposed by Shariah mustbe implemented in such a way that the contracting parties have no choice but to adhere tothem. On the other hand Shariah allows contracting parties to stipulate additional conditionswhereby they have the freedom to include any condition that serves their purpose on thecondition that the stipulated condition in the contract agreement does not contradict thenorm and nature of the contract and does not violate the Shariah rules and principles.

◦ Consideration of the risk exposure in the product: Consideration of the risk exposureis an important part of product development. There is no valid reason to expend financialengineering effort on products that have a high risk level, and do not attract investors. Inaddition to this it is prohibited to expose the capital to high risk that may damage the assetand lead to a financial crisis as a result of that product. Allah says: “Spend your wealthfor the cause of Allah, and be not cast by your own hands to ruin; and do good. Lo! Allahloveth the beneficent” (Al Baqara: 195).

Consideration of high risk is obviously observed by the Islamic financial institutionsand the regulator, whereby the regulator, e.g. the central bank, will sometimes reject orhold back some products if they are associated with a high risk, where the regulator feelsthat the Islamic financial institution is unable to control or mitigate the risk due to lack ofexperience.

◦ Consideration of the commercial value of the product in the market and its profitabilityand its contribution to the economy and finance (public interest of the ummah):Shariah is given equal consideration concerning the product developed. The first concernis the Shariah aspect, whereby the product is to be free from all the elements prohibitedby Shariah. This aspect represents the interest of the religion. The second aspect is thecommercial value of the product in the form of its profitability and its benefit (manfa) tothe growth of the economy and prosperity to the ummah. This check and balance ares anelement integrated into the process of Shariah approval.

2.7 THE FRAMEWORK AND PROCESS FLOW OF PRODUCTAPPROVAL IN ISLAMIC FINANCE

The above deliberation was on product development. The following discussion will be on theprocess of approval. Every product developed will be subject to the decision of the ShariahBoard either to validate it or to reject it.

2.7.1 The Flow of the Process of Approval of the New Product: From the ProductOwner to the Market Place

Figure 2.1 shows the process flow of product development and approval in Islamic finance,which includes banking, takaful, and Islamic capital market products. Before the product islaunched in the market place, prior approval must be obtained from the Shariah Board ofthe Islamic finance institutions in order to ensure that the product has been reviewed andexamined, and is in accordance with Shariah rules and principles. This process of approvalprovides insurance to the stakeholder of the Islamic financial institution such as shareholders,depositors and investors that the product is permissible to use, and therefore that the profitgenerated is halal.

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The process of product approval has two layers: the first is an internal process at the levelof the Islamic financial institutions and the second is an external process at the level of theofficial authorities such as the central bank or the Securities Commission. The product mustobtain both approvals in order to be placed in the market place and marketed by the Islamicfinancial institution to the public, regardless of the type of product – whether it is a deposit,investment, retail financing, corporate financing, or securities.

2.7.1.1 The First Layer: The Internal Product Approval Process

The internal product approval is processed internally by the Islamic finance institution wherebytwo major organs will have the responsibility for securing this internal process with the supportof another stakeholder in the Islamic financial institution such as the relevant department. Thisis the Shariah department/unit/division, which is an internal committee, and the Shariah Board,which is an external committee. Both committees play a crucial role in the approval of theproduct, and ensure its Shariah compliance before the product moves out to the next layer.

2.7.1.2 The Second Layer: The External Product Approval Process

The external product approval takes place only upon completion of the internal approvalprocess. The official authorities such as the central bank or the Securities Commission willnot accommodate the product and engage in the external approval process unless the ShariahBoard has endorsed the product and shows that the first layer process has been completedsuccessfully. The completion of the first layer process is evidence that the product has takenthe appropriate route and procedure for product approval; furthermore it shows that the productis Shariah-compliant according to Shariah rules and principles.

The external process conducted by the official authorities is another process of examinationand review of the decision of the Shariah Board, to ensure that the internal Shariah approvalof the product has been obtained according to the Shariah compliance manual of the Islamicfinancial institution that has been submitted to the official authorities (central bank). This is acautionary process to provide advice or clarification when applicable by the official authorities.However it should be noted that sometimes the official authorities reject the product not becauseof the issue of Shariah compliance but due to other concerns related to the risk of the productor the policy of the regulators towards specific matters, especially if the product is designedfor global investment or for exchange currency, or for some international commodities inthe global market or global stock exchange, whereby the regulators feel that the financialinstitution is not ready to embark upon that type of business and manage the potential risk.

Figure 2.1 shows the full process including the internal and external process of Shariahapproval of the product.

• Stage 1: Product design and development: The product is usually designed at the levelof the department/unit/division of the Islamic financial institution, whereby the treasury orwealth management department – or other unit or division in the IFI – designs, structures,or produces a particular product according to the needs of the client or market demand. Theproduct can target the retail or corporate market.

• Stage 2: Submission of the developed product to Shariah department/division (secre-tariat): The owner of the product such as the treasury or wealth management departmentsubmits the new product in the form of a business proposal to the Shariah committee throughthe Shariah department (secretariat).

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Process flow of products approval by SC

Wealth management Dept.

Treasury Dept.

Investment Dept.

Any other Dept.

Shariah Dept.

Submission of proposals

Administration of the proposals

ShariahCommittee

Submission of the proposals

Decision and resolutions of the SC

Deliberation on the proposals

Shariah Dept.

Bank Negara

ApprovedRejectedAmendment

To the department for amendment and resubmission

To BNM for final approval

•Shariah Committee •Board members •Product owner for presentation

Back to IFI

Market space

Islamic Financial Institution

Resolutions documented by SD

Figure 2.1 Process flow of product approval by SC

The objective of product submission is as follows:

• To obtain the approval from the Shariah Committee before placing the product in the marketplace.

• To ensure that the product is Shariah-compliant.• To seek feedback and advice on the product.• To evaluate and examine the product.• To identify any possible prohibited elements in the product.• To seek amendment or an alternative solution for any Shariah non-compliant element in the

product.

On the other hand the product proposal submitted by the product owner should include thefollowing:

• The title, including the name of the product, application, or facility.• The objective of the submitted proposal, whether the submission is for obtaining the

approval of the Shariah Committee, or getting advice, or is only for notification andinformation.

• The background of the product.• The concept of the product.• The chart to show the flow of the product and the type of contracts involved.• The parties involved in the operation and their rights and obligations.• The issues to be deliberated in the Shariah Committee meeting.• The recommendation of the product owner on the submitted proposal.• Appendix (if any).

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• Stage 3: Administration and coordination: The Shariah department is responsible foradministration or coordination; the members of Shariah department/unit/division representthe secretariat of the Shariah committee. According to the GPS1 guidelines of the CentralBank of Malaysia: “[A]n Islamic financial institution is required to have a minimum of oneofficer, preferably a person with knowledge in Shariah who will serve as the secretariat tothe Shariah committee.”23 The secretariat of the Shariah committee or the internal Shariahdepartment plays a coordinating role to facilitate the smooth functioning of the ShariahBoard. The Shariah department compiles and administers the proposals and relevant docu-ments from different departments in the Islamic financial institution, arranges a convenientmeeting for the Shariah Board and proposes the items to be discussed in the agenda.

• Stage 4: Discussion and deliberation: The Shariah Board meeting will be held to discussand deliberate the matters according to the meeting agenda that has been prepared bythe secretariat. The product owner presents the product in the meeting, and explains itsconcept, features, structure, and the underlying contracts governing the product and howthey have been used in the product presented. The product owner should elaborate on thesubmitted proposal at the level of detail needed in order to provide a comprehensive pictureof the matter under discussion. The Shariah committee deliberate actively on the cases, andengage with the presentation to ensure that the product is fully understood and a suitableresolution is issued accordingly.

• Stage 5: Decision and resolution: After deliberation and discussion the decision willbe made by the Shariah Board. The outcome of the discussion will be in the form ofa resolution, either approving the product, or rejecting or modifying it in order to be inaccordance with Shariah.

• Stage 6: Shariah endorsement on the product: Upon approval of the product the en-dorsement of the Shariah Board will follow, whereby all the members of the Shariah Boardwill certify that the product is Shariah-compliant in accordance with the Shariah rules andprinciples.

• Stage 7: Follow-up: After the resolution is concluded, and the endorsement of the productsis obtained by the Shariah Board, the secretariat will then do the follow-up. If the productis approved by the Shariah Board the Shariah department will further process the productto the relevant official regulator (the central bank) to obtain final approval. In cases wherethe product is accepted subject to some modifications or adjustments the product goes backto the product owner to effect the necessary amendments according to the advice of theShariah Board.

• Stage 8: Launching the product in the market place: After obtaining the final approvalfrom the official authority the product will be ready to be launched in the market place.

• Stage 9: Closing the case in the minutes: The decision of the Shariah Board will berecorded and documented; the endorsement of the product will be confirmed at the followingmeeting by the Shariah Board and the case will be closed accordingly.

2.7.2 Mechanism for Obtaining Rulings

According to Shariah law the Islamic financial institutions must operate their financial trans-actions within the Shariah rules. In order to ensure that the IFI is fulfilling this obligation,the regulators placed the Shariah Board in the banking structure as part of their compositionwith the responsibility to ensure that the business activities of the IFI are carried out in amanner that is consistent with Shariah. The Shariah Board provides consultancy and advice

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when it is needed; in addition to that they assist in designing the banking products and thevarious transactions in accordance with the principles of Shariah. The function of the ShariahSupervisory Board is meant to abide strictly by Islamic principles.

According to the IFSB:

The mechanism for obtaining rulings from Shariah scholars, applying fatawa and monitoringShariah compliance shall cover:

� Both ex ante and ex post aspects of all financial transactions carried out by the IIFS – that is, toensure Shariah compliance of the contracts and, later, the performance of obligations under thecontracts; and

� Operations of the IIFS, including aspects such as Shariah compliance review, investmentpolicies, disposal of non-Shariah-compliant income, charitable activities, etc.24

The above recommendations can be used as an appropriate mechanism for obtaining Shariahopinions from the respective SSB. The above mentioned are part of their coverage.

In addition to the above mentioned, the IFSB stated: “Where appropriate, the IIFS shallinform the supervisory authorities about their mechanics of obtaining rulings from Shariahscholars, applying fatawa and monitoring Shariah compliance, and make available the sameinformation to the public.”25 This clause refers to the Shariah manual that every Islamicfinancial institution produces; the Shariah manual should be endorsed and adopted by the SSBand provided to the official authority.

2.7.3 Position of the IFI with Regard to the Resolutions of SSB and IFSB PrinciplesGoverning the SSB

According to the IFSB, the Islamic financial institutions should comply with the resolutionsof the Shariah Supervisory Board (SSB). According to IFSB corporate governance principle3.2: “IIFS shall comply with the Shariah rules and principles as expressed in the rulings of theIIFS’s Shariah scholars. The IIFS shall make these rulings available to the public.”

The IFI cannot manipulate the resolution of the SSB and overrule them and adopt differentresolutions from different IFIs. According to the IFSB:

Although the diversity of Shariah opinions might tempt an IIFS to adhere to the fatawa of otherShariah scholars at the expense of differing fatawa issued by the IIFS’s Shariah scholars, theIIFS shall not change their allegiance and obedience to fatawa to suit their convenience. Such apractice could impair the independence of Shariah scholars and have a damaging impact on theintegrity and credibility of the individual IIFS, in particular, and on the Islamic financial servicesindustry as a whole. The adverse effect of such a practice on the reputation of the IIFS and theIslamic financial industry would be immense and difficult to repair. Therefore, the IIFS shall betransparent in the adoption and application of Shariah rules and principles issued by the IIFS’sShariah scholars.26

There are two important IFSB principles governing the SSB:

A. Principle 3.1: The IIFS shall have in place an appropriate mechanism for obtainingrulings from Shariah scholars, applying fatawa and monitoring Shariah compliance in allaspects of their products, operations and activities.

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Structure and Process

Inevitably, the diversity of Shariah opinions will be a permanent feature of the Islamicfinancial services industry. It has been widely acknowledged within the industry that thereare major requirements for new fatwa as the industry progresses and faces contemporarychallenges. Shariah scholars in each locality should arrive at their own opinions that canaddress appropriately and effectively the specific problems of the ummah within theirrespective localities.

Initiatives on harmonization of fatawa should continue to be pursued and applauded, asthe industry in particular, and the ummah in general, can benefit from common understand-ing and cooperation amongst Shariah scholars.

Recommended Best Practices

As Shariah compliance is central in assuring the integrity and credibility of IIFS, and isone of the ultimate responsibilities of the BOD, the Board needs to establish a mechanismthat can be mobilized swiftly and efficiently, as and when required, to obtain rulings fromShariah scholars and monitor Shariah compliance. The Shariah scholars may be externalor internal, depending on the requirements of the IIFS’s business model.

The mechanism for obtaining rulings from Shariah scholars, applying fatawa and mon-itoring Shariah compliance shall cover:

(i) both ex ante and ex post aspects of all financial transactions carried out by the IIFS –that is, to ensure Shariah compliance of the contracts and, later, the performance ofobligations under the contracts; and

(ii) Operations of the IIFS, including aspects such as Shariah compliance review, invest-ment policies, disposal of non-Shariah-compliant income, charitable activities, etc.

Where appropriate, the IIFS shall inform the supervisory authorities about their mechan-ics of obtaining rulings from Shariah scholars, applying fatawa, and monitoring Shariahcompliance, and make available the same information to the public.

For internal Shariah compliance reviews, the SSB or Shariah scholars of IIFS shallwork together with either a separate Shariah control department or the designated internalauditors/Shariah reviewers. This would enable the SSB or Shariah scholars to advise theShariah control department or designated internal auditor/Shariah reviewers on the scopeof audit/reviews required. As the Shariah control department or designated internal audi-tors/Shariah reviewers shall be responsible for producing the internal Shariah compliancereports, they shall acquire the relevant and appropriate training to enhance their Shariahcompliance review skills.

For external Shariah compliance reviews, the Audit Committee shall ensure as far aspossible that the external auditors are capable of conducting, and do conduct, ex postShariah compliance reviews within their terms of reference.

To enhance public confidence in the Shariah scholars sitting in the SSB, the supervisoryauthorities may wish to consider steering the initiatives towards the establishment of aprofessional organization or an industry association for Shariah scholars serving the IIFSwithin their respective jurisdictions.

Alternatively, supervisory authorities may establish a “fit and proper” test that clearlyand carefully sets out the criteria required prior to an IIFS appointing a Shariah scholar

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into its SSB. Again, the “fit and proper” criteria shall take into account factors that canstrengthen public confidence in the SSB, such as academic qualifications, professionaltraining, recognition by local and international peers of Shariah scholars, etc.27

B. In principle 3.2 it was stated that: IIFS shall comply with the Shariah rules andprinciples as expressed in the rulings of the IIFS’s Shariah scholars. The IIFS shall makethese rulings available to the public.

Structure and Process

Although the diversity of Shariah opinions might tempt an IIFS to adhere to the fatawaof other Shariah scholars at the expense of differing fatawa issued by the IIFS’s Shariahscholars, the IIFS shall not change their allegiance and obedience to fatawa to suit theirconvenience. Such a practice could impair the independence of Shariah scholars and havea damaging impact on the integrity and credibility of the individual IIFS, in particular, andon the Islamic financial services industry as a whole. The adverse effect of such a practiceon the reputation of the IIFS and the Islamic financial industry would be immense anddifficult to repair. Therefore, the IIFS shall be transparent in the adoption and applicationof Shariah rules and principles issued by the IIFS’s Shariah scholars.

Recommended Best Practices

An IIFS shall comply with the rules and principles issued by their Shariah scholars. Theserules and principles shall be made publicly available through appropriate publication andcommunication channels.

An IIFS shall make available to the public, upon request, an explanation of any decision toadopt a fatwa issued by its Shariah scholars, whereby such explanation should be preparedin consultation with the Shariah scholars. Similarly, an IIFS should be prepared to providea transparent clarification to the public should they decide to abandon a fatwa issued by itsShariah scholars.

Shariah scholars serving the IIFS are encouraged to expose their fatawa to the scrutinyof fellow Shariah scholars by publishing their detailed opinions. The IIFS can also promotebetter awareness on the part of the public by publishing information on the fatawa of theirShariah scholars on their websites. The IIFS may also allow customers to access the fatawaissued by their Shariah scholars as part of their customer services.28

2.8 THE METHODOLOGY USED IN THE APPROVAL PROCESS

There are some rules of engagement in fatawa that should be considered. These rules representan appropriate methodology for issuing resolutions and providing the Shariah position fordifferent products in Islamic banking and finance. The methodology should be taken intoconsideration during product approval whereby the Shariah Board adopts it as standard toensure the appropriate procedure of fatwa and resolution issuance. This methodology is a verycomprehensive Shariah process in fatawa which takes place before issuing the resolution andgives a final decision on the product. The methodology is implemented during the process ofissuing the resolution, and thereafter. The standards which represent this methodology in theexercise of ijtihad in the Shariah Board are set out below.

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2.8.1 The General Rules and Standards Governing the Product Approvalin Islamic Finance

Before beginning the exercise of ijtihad which ends with the issue of a fatwa or resolutionpertaining to the permissibility of the product, Shariah Board members should comprehendand understand the following rules in order to expend their effort in the right context. Theserules are:

• Having a clear method for providing fatawa.• Follow the easy path is issuing fatwa by accommodating the conditions and circumstances

of the case which is the subject matter of the fatwa.• Avoiding weak Shariah opinions.• Moderating problems by careful use of licences.• Benefiting from the established school of law opinions and the Islamic literature in Islamic

law.• Supporting the collective ijtihad in issuing fatawa.• Ensuring seriousness of fatawa.• Understanding the consequence of the financial implication of the fatawa.• Understanding the implications of fatawa on the IFI stakeholder.

The above-mentioned rules are guidelines in governing the overall process of the exerciseof the Shariah Board.

2.8.2 Methodology and Standards of fatawa in Islamic Finance Prior to Issuing afatwa and Resolutions

In addition to the above rules that govern ijtihad, there some other standards to be observedprior to issuing the resolution pertaining to the Shariah position on a product. These standardsare the following:

• Complete understanding of the case raised by al mustafti.• Full understanding of the mustafti’s conditions and circumstances.• Requesting further information if the illustration of al mustafti is not clear.

The above standards help the Shariah Board to have a full understanding of the product andaccordingly provide a sound resolution pertaining to the product. These standards are observedprior to issuing any position on the product.

2.8.3 Methodology of fatawa in Islamic Finance in Issuing the Islamic Ruling

This methodology is implemented during the process of issuing the fatwa or resolution pertain-ing to the product approval, whereby the Shariah Board should adopt the following standardsduring the process of providing a Shariah position on the permissibility of the product. Thesestandards are the following:

• Consideration of the Islamic primary sources and secondary sources in issuing fatawa.• Issuing fatawa through a valid examination of the legal Islamic sources.• Processing fatawa according to the requirement of ijtihad in Islamic jurisprudence.• Ensuring that the fatwa is fully complied with in the case that has been raised by al mustafti.• Mainstreaming the opinion of the majority of the Muslim jurists.

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• Consideration of the arguments of the minority of Muslims jurists.• Consideration of the various Shariah opinions which enhance Islamic finance.• Postponing issuing fatawa in the future when the case presented needs further research.• Maintaining the middle way in fatawa and apply justice and fairness.• Applying maqasid al Shariah in fatawa.• Referring to legal maxims in supporting the Shariah ruling.• Special consideration of the objectives of Shariah in business transactions in the fatwa.• Observation of the Shariah principles in Islamic finance.• Observation of the prohibited elements in Islamic finance in issuing a fatwa.• Adequate knowledge of Islamic finance.• Consideration of the special features of trade in Islam, business ethics, and norms of Islamic

finance.• Consideration of Islamic finance custom and best practices in the Islamic market.• Consideration of Shariah standards in Islamic finance (AAOIFI).• Consideration of IFSB Guideline in Islamic finance.• Consideration of the international conventional standards in finance which are consistent

with Shariah rules and principles.• Restriction of fatawa.• Fatwa does not end at issuing the ruling but it also provides solutions and proposals.• Accommodation of the Parallel Practice of the Shariah rules in the same banking industry.• Consideration of the principles of al Darurah.29

The above-mentioned standards represent a safety process to ensure the accuracy of theresolutions issued by the Shariah Board.

2.8.4 Methodology of Presenting fatawa in Islamic Finance

The position of the Shariah Board carries a Shariah value which has an impact on the permis-sibility of the product; therefore it should be documented in the proper manner. This process isrelated to the methodology of presenting the resolution which can be observed in the followingstandards:

• Providing an introduction• Documentation of the fatwa• The fatwa should be clear in its statement• Providing evidence of the fatwa• Providing justification for the fatwa• Issuing the fatwa without saying this is the rule of Allah or this is the rule of his Prophet.• The fatwa should be comprehensive covering the whole issue raised by al mustafti.• Conciseness of the fatwa• Consideration of the conditions of the fatwa• The order of the issues in presenting the fatwa• Reference to Schools of Law.30

The above standards should be considered especially during onward processing of theproduct to the regulators for final and official approval. The regulator’s request for the decisionon the product by the Shariah Board should be documented and presented in the proper

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manner for the record. The final decision of the regulator to approve the product is based onthe documented resolution by the Shariah Board which contains the above elements.

2.8.5 Methodology of Empowering the fatwa in Islamic Finance

The following are the final standards to be considered in order to have a comprehensivemethodology in issuing a resolution on an Islamic finance product. These standards play animportant role in clarifying the resolution and the Shariah position on the product under review.This methodology will create confidence in the shareholder and also the official regulators andthe investors about the credibility and soundness of the decision taken by the Shariah Board.These standards are as follows:

• Referring to al dalil (evidence).• Connecting the various Shariah opinions to the Islamic jurisprudence rules.• Linking the investigation in fiqh for the fatwa issued to the ahadith.• Referring to reasoning as additional evidence.• Consideration of the social and business dimensions in issuing the fatwa.

The above standards are the final stage of consideration by the Shariah Board in themethodology in implementing product approval.

2.9 PRODUCT APPROVAL IN SECURITIES IN ISLAMICCAPITAL MARKETS

The scholars invented the screening process in order to distinguish between the non-permissiblesecurities and Shariah compliance securities, so the approach became very significant in thedual banking system where there is the potential to have some degree of non-permissibleactivities which may render the securities listed non-Shariah-compliant. The purpose of settingup the screening process is to identify the elements prohibited by Shariah and advise theinvestors on how to invest and generate profit and increase wealth through permissible means.Therefore the role of the scholars who are behind the establishment of the screening approachis to help and assist in cleansing the stock market from impurities. The Shariah decision onthe securities is usually published and disclosed to the public in order to enable them to takea decision and invest in the right stock.

There are different approaches in the Shariah screening process due to the emergence ofseveral Islamic indexes such as the Dow Jones, the FTSE and others, as we shall highlight.For the Securities Commission in Malaysia for example, the primary criteria for excludingcompanies from Shariah stock according to the Shariah Advisory Council of Malaysia are asfollows:

• Financial services based on riba• Gambling and gaming• Manufacturing or sale of non-halal products or related products• Conventional insurance• Entertainment activities that are non-permissible according to Shariah• Manufacture or sale of tobacco-based products or related products• Stock broking or share trading in non-Shariah-compliant securities• Other activities deemed non-permissible according to Shariah.31

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Besides the above primary criteria which represent the first stage of screening, there isanother stage of screening based on additional criteria to finalize the process of Shariahcompliance in stock. These criteria are as follows:

• Total outstanding debt not exceeding 33%.• Accounts receivable of less than 33%.• Interest income should be less than 5%.32

Thus there is a special methodology and approach regarding product approval of securitiesin Islamic capital markets which will lead to an outcome decision and result. The result andoutcome of this particular process will disclose the Shariah position on the securities as towhether they are Shariah-compliant or not. The methodology of product approval in securitiesis described below.

2.9.1 Shariah Criteria for Listed Securities

The Kuala Lumpur Shariah stock index was established in 1999 to provide Shariah-compliantsecurities to the investors in Bursa Malaysia. The criteria for the Shariah screening process areset by the Shariah Advisory Council of Malaysia; therefore the fund management companieshave no authority to set their criteria for Shariah stock. The screening process is conducted inMalaysia twice a year; the list of stock is published and listed for the public.

According to the Securities Commission of Malaysia the focus of the examination will bebased on the primary activities of a company with regard to the goods and services offered.This is because these primary activities bring returns for the companies that are subsequentlydistributed to their shareholders. Such activities need to be identified to see whether theyare contrary to Shariah principles. If they are, then that particular company’s securities areexcluded from the list of Shariah-compliant securities.33

2.9.2 Primary Activities Criteria

• The criteria can be used to analyse whether securities of a particular company can bedeemed Shariah-compliant or not.

• The decision was made on four basic primary criteria to analyse listed securities.• These criteria were established after referring to the sources of Shariah and general Shariah

principles.• The criteria were formulated according to the activities of a particular company.

2.9.2.1 First Criterion: Riba as the Primary Activity of the Company

The primary activity of the company is based on riba as practised by conventional financialinstitutions, including commercial banks, merchant banks, and finance companies. This cri-terion is based on the Quranic verses 275–276 in Surah al-Baqarah: “Those who devour ribawill not stand except as one whom the evil one by his touch hath driven to madness. That isbecause they say: ‘Trade is like riba,’ but God hath permitted trade and forbidden riba. Thosewho after receiving direction from their Lord, desist, shall be pardoned for the past; their caseis for God to judge; but those who repeat (the offence) are Companions of Fire: they willabide therein (forever). God will deprive riba of all blessing, but will give increase for deedsof charity: for He loveth not creatures ungrateful and wicked.”

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2.9.2.2 Second Criterion: A Company Whose Primary Activity is Gambling

Such as companies running casinos, gaming, and others. This criterion is based on the Quranicverses: “O you who believe! Intoxicants, and gambling, (dedication of) stones, and (divinationby) arrows, are an abomination of Satan’s handiwork: eschew such (abomination) that ye mayprosper.”

2.9.2.3 Third Criterion: The Primary Activity of a Company is the Production and Saleof Goods and Services that are Prohibited in Islam

This will include the following:

• Processing, producing, and marketing alcoholic drinks;• Supplying non-halal meat like pork, etc.; and• Providing immoral services like prostitution, pubs, discos, etc.

This criterion is based on the following verses of the Quran:

• “O ye people! Eat of that which is on earth, lawful and good; and do not follow the footstepsof the evil one for, he is to you an avowed enemy.” (Surah al-Baqarah: 168)

• And “Forbidden to you (food) are dead meat, blood, the flesh of swine, and that on whichhas been invoked other than Allah’s name, that which has been killed by strangling, or by aviolent blow, or by a headlong fall, or by being gored to death, that which has been eaten bya wild animal, unless you are able to slaughter it (in due form), and that which is sacrificedon stone altars.” (Surah al-Maidah: 3)

• And “O you who believe! Intoxicants and gambling, and (dedication of) stones, and (div-ination by) arrows, are an abomination of Satan’s handiwork. So avoid such abominationthat you may prosper.” (Surah al-Maidah: 90)

• And “Nor come high to adultery: for it is a shameful (deed) and an evil, opening the road(to other evils).” (Surah al-Isra’: 32)

2.9.2.4 Fourth Criterion: gharar (Uncertainty)

The primary activity of the company is gharar (uncertainty) such as conventional insurancetrading. The basis of the prohibition on gharar is a hadith of the Prophet s.a.w.: “Verily, theProphet s.a.w. prohibits gharar transactions.”34

2.9.3 The Product Approval of Securities in Mixed Companies

The methodology used in the approval of mixed securities is based on setting a specificbenchmark to measure a certain degree of prohibited elements. This Shariah position takesinto consideration umum al balwa and gharar yasir as positions to justify listing a companywith a mix of permissible and prohibited elements. According to the Securities CommissionShariah Advisory Council, companies with a certain level of prohibited elements, which donot exceed the benchmark set by the SAC, can be included in the list of Shariah-compliantsecurities.

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2.9.3.1 Definition of the Mixed Company

A mixed company is one whose core business activities are Shariah-compliant, but whichinvolves some other prohibited activities.35 Consideration is given to including this type ofcompany in the list of Shariah-compliant securities subject to some conditions as follows:

• The core activities of the company must be activities which are not against the Shariahprinciples as outlined in the four primary criteria (explained earlier). Furthermore theharam element must be very small compared to the main activities;

• Public perception of the image of the company must be good; and• The core activities of the company have importance and maslahah (benefit in general) to the

Muslim ummah and the country, and the haram element is very small and involves matterssuch as ‘umum balwa (common plight), ‘urf (custom), and the rights of the non-Muslimcommunity which are accepted by Islam.36

2.9.3.2 Basis for Establishing the Benchmark

According to SC the purpose of specific benchmarks is to ensure that prohibited elementsare minimal. The use of benchmarks as a basis can be considered as ihtiyat (precautionarymeasure) providing a degree of caution in classifying a mixed company under the permissiblecategory. The argument is based on some traditional elements like maslahah, ‘umum balwa,‘urf khas min asalib iqtisodiyah, fasad al-zaman, and huquq ghair muslimin. An example ofbenchmarking used in a fatwa, such as the wearing of silk cloth by men, provides that the ratioof silk thread mixed with the common thread should not exceed 50%.

Benchmark of one third• The Prophet s.a.w.’s condition of one third (33.33%) is a very generous limit which can

also be considered for use as the benchmark for mixed companies. This statement can besupported by the legacy of Sa’ad Ibn Abi Waqas who wanted to leave his assets as alms asin the following hadith: “One day, the Prophet s.a.w. visited Sa‘ad bin Abi Waqas who wasill. Sa‘ad expressed to the Prophet s.a.w. his feelings that his illness was entering the lastphase and that death was near. He asked for the Prophet s.a.w.’s opinion on giving his assetsaway as alms for he had only one daughter to inherit his wealth. Therefore, he wished togive as alms 2/3 of his property. However, the Prophet s.a.w. stated his objections. ThenSa‘ad asked whether he could give away 1/2 of his property. The Prophet s.a.w. still saidno. The Prophet s.a.w. then said: 1/3 (of Sa‘ad’s property to give away as alms) is enough,that too is still too much. Verily, to leave your heir wealthy is far better than to leave yourheir impoverished and dependent on other people’s charity.” 363

• Based on the Prophet s.a.w.’s words, 1/3 or 33.33% “is enough” and can be used as aguideline for the basis of formulating a benchmark. The question is whether this benchmarkis suitable to be used for mixed companies, because it relates to the bequest of property andgiving of alms. Even so, it cannot be denied that it can be used as a benchmark to set theupper limit of a mixture because an amount exceeding the percentage set will be consideredexcessive.

Benchmark Based on Ghabn fahish• There is no argument among scholars that Ghubn fahish is not allowed in Shariah and

renders the financial transaction invalid. On the other hand there is no argument that the

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Ghubn yasir is tolerated by Shariah and the financial contract will remain valid. However,in between there is ambiguity as to whether the Gubbn is considered excessive or tolerated,and this depends on the degree of the Ghubn. Due to this ambiguity in measuring the Ghubnwhich may lead to a dispute, a benchmark setting is needed to stabilize the issuance of aShariah opinion on the securities.

The Securities Commission sets the following benchmark based on the view of the HanafiSchool of Law as follows:

• 5% for ordinary goods;• 10% for animals, including those used for riding; and• 20% for fixed assets.

2.9.4 Image as Criteria for Listed Securities

Image is part of the Shariah criteria which forms the basis of analysis of companies listed onthe stock exchange. According to the SC, image is used as one of the criteria because it refersto the following three bases:

(a) Image based on maslahah rajihah (tangible deeds): Image involving public interest anda mix of activities which do not comply are small and forgivable. For example, hotelactivities. Such an image has a benchmark of 25%;

(b) Image based on sadd zari‘ah: Image involving activities where the benefits are disputed,and may lead to harm and loss of reputation. For example, manufacturing of condoms.Such an image has a benchmark of 5%.

(c) Image based on factors between maslahah and sadd zari‘ah: Image involving activitiesthat largely benefit Muslim society but at the same time with a negative element whichportrays a bad image of Muslim society. For example, the sale of liquor on public transport.Such an image does not have a particular benchmark and its resolution is based on thediscretion of the SAC.37

2.9.5 Quantitative and Qualitative Approach in Screening Process in Capital Market

There are two methods used in the screening process: the quantitative approach and qualitativeapproach.

(a) Quantitative approach: The first method is by way of quantitative approach. By thismethod, the SAC’s decision is based on the percentage (%) contribution of activitieswhich do not comply with the group income and profit before tax set by the Commission.The SAC will compare the percentage with the benchmark which has been fixed, such as5%, 10%, and 25%.

(b) Qualitative approach: The second method is by way of qualitative approach.• This method is a qualitative approach (non-quantitative).• By this method, the SAC’s decision is based on several external factors of the company,

such as image, maslahah, and others.• This method does not refer to the benchmark for activities which do not comply with

the Shariah in deciding the status of the listed company.

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By this method, the SAC’s decision is based on several external factors of the company, suchas image, maslahah, and others. This method does not refer to the benchmark for activitieswhich do not comply with the Shariah in deciding the status of the listed company.

The SAC’s resolution on the status of listed securities related to image depends on thecategories set out below.

2.9.6 Image with Benchmark

Definition of image: It is defined as the Shariah’s view on a certain matter because one’sperception or mental picture of something is meaningless from the legal point of view if it isnot based on Shariah law.

Determining the status of companies based on image is achieved using the quantitativemethod because the SAC has formulated the benchmark for image criteria. It is divided intotwo activities as seen in the following cases:

(a) Hotel activities (inclusive of resorts and chalets) – 25%: The SAC resolved that hotelactivities do not comply with Shariah because of image. This is due to the existence ofnight clubs provided by the hotel management: their contributions are not accounted forbecause they are considered to be complimentary for the hotel guests. In addition, hotelactivities give a negative image to the public. As such, the SAC placed a benchmark of25% on the image factor for hotel activities; and

(b) Manufacturing/marketing of condoms – 5%: The SAC resolved that the manufacturingand marketing of condoms do not comply with Shariah because of their image. As such,the SAC placed a benchmark of 5%. This resolution is based on studies which show thatcondoms are used for immoral activities.

2.9.7 Image without Benchmark

In deciding the status of companies based on image, this is normally done on a case-by-casebasis and it does not involve benchmarks. It is based on qualitative decisions made by theSAC. This can be seen in the following cases:

• Serving of alcoholic drinks on public transport;• Pork-based business;• Sale of alcoholic drinks in restaurants;• Take-over of casino companies;• Advertisements of alcoholic drinks; and• Equity holding of listed companies that do not comply with the Shariah.

2.9.8 Fundamentals of Shariah Assessment on Image Analysis

Most of the resolutions on the image of activities are categorized under activities of mixedcompanies. This means that the same Shariah principles used in assessing mixed companiesare also used for image analysis. The Shariah principles that are used in the studies of imageare as follows.

2.9.9 Relationship of Image and Principle of Shariah

The Shariah principle for mixed companies as clarified earlier is also used to assess imagestatus. In order to make the relationship between the Shariah principle and image even clearer

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and more complete, the following principles are used for the image criteria. The three mainprinciples are:

• Maslahah Rajihah• Sadd Zari’ah• Meeting Point of Maslahah and Sadd Zari’ah

2.9.9.1 Summary of the Method of the Securities Commission of Malaysia

The Securities Commission screening process takes into account two major categories ofShariah-compliant securities as described below.

There are two methods: the quantitative method and the qualitative method:

1. Quantitative Method: In this method the objective is to compute the percentage con-tribution of non-permissible activities to the company’s income and profit before tax. Theincome and profit before tax would be for the latest fiscal year as shown in the company’sincome statement.

The computation of percentage is as follows:Step 1: Determine the earnings (Total Income/Revenue) and profit before tax of the com-

pany.Step 2: Identify and measure the income/earnings and profit before tax from the non-

permissible activities.Step 3: Determine the percentages as follows:

1. Earnings from non-halal activities × 100

Total earnings of firm

2. PBT from non-halal activities × 100

PBT all activities of firm

Figure 2.2

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Step 4: Compare the percentage earnings and profit before tax with the benchmark. TheSAC has determined benchmarks as follows:� 5% benchmark: Companies whose earnings/profit before tax from non-permissible

activities are more than 5% will be listed as non-Shariah-compliant stocks.� 25% benchmark: Group of companies which have subsidiary involvement in non-permissible activities, such as a hotel. If the hotel is earnings/profit before tax is lessthan 25% of the group’s earnings or PBT then the group’s stock would be consideredas non-Shariah compliant. However, if the contribution is less than 25% then the shareswill listed as Shariah-compliant stock.

2. Qualitative Method: The qualitative method is used on a case-by-case basis. Thismethod is applicable for cases where the core business activity of the company has maslahah(benefit) to the ummah but includes small and minor elements of non-permissible activity. Theassessment is based on a benchmark of 10% to 25%.

Example of 5% benchmarkABC Corporation is listed as non-Shariah-compliant because the percentage of revenue

before tax from gambling (a prohibited business activity in Shariah) contributes morethan 5% to the group revenue before tax.

Example of 10% benchmarkABC Corporation is an education provider that places funds in a conventional commercial

bank in fixed deposits. If the percentage contribution of the interest income generatedfrom the fixed deposit account to the group’s revenue exceeds the 10% benchmark, ABCCorporation will not be listed as Shariah-compliant, and their shares will not be listedunder approved Shariah securities.

Core business ac�vi�es Non-Halal Stop/Reject

Mixed business ac�vi�es

Halal & Non- Halal

Proceed to the next level

Core business ac�vi�es Halal & Non-

HalalProceed to the

next level

Primary Shariah screening

1

2

3

Secondary Shariah screening

Out

Quan�ta�ve analysis Qualita�ve analysis

Compare the income generated from non-halal ac�vi�es to the total revenue &

profit before tax

Analysis based on: Image Maslahah

Umum balwaUrf

Benchmark

5% Riba, Gambling, Liquor, Pork

10% interest income, tobacco

20% Mixed Rental income 25% Hotel

Figure 2.3

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Benchmark

% 5% 10% 20% 25%

Descrip�on This benchmark is used to assess the level of mixed contribu�ons from the ac�vi�es that are clearly prohibited such as riba, gambling, liquor and pork.

This benchmark is used to assess the level of mixed contribu�ons from the ac�vi�es that involve the element of (umumbalwa) which is a prohibited element affec�ng most people and difficult to avoid.Such as the interest income from fixed deposit in a conven�onal bank, this benchmark is also used for tobacco related ac�vi�es.

This benchmark is used to assess the level of contribu�on from mixed rental payment from Shariah non compliance ac�vi�es such as the rental payments from the premises that are involved in gambling, sale of liquor etc.

This benchmark is used to assess the level of mixed contribu�ons from ac�vi�es that are generally permissible according to Shariah and have an element of maslahah to the public, but there are other elements that may affect the Shariah status of these ac�vi�es. Among the ac�vi�es that belong to this benchmark are hotel and resort opera�ons, share trading, stockbroking and others, as these ac�vi�es may involve other ac�vi�es that are deemed non-permissible according to Shariah.

Figure 2.4

Source: SC

Example of 25% benchmarkABC Corporation is a group of companies involved in real estate development. One of

its subsidiary companies is a hotel which is involved in non-permissible activities andlisted as a non-Shariah-compliant business according to the Securities Commission inMalaysia. If the revenue before tax from the hotel contributes more than 25% of therevenue before tax of the group, ABC Corporation will be non-Shariah-compliant.38

2.10 APPLYING THE SHARIAH ADVISORYCOUNCIL METHODOLOGY

2.10.1 Case 1: Wawasan Holding39

2.10.1.1 Company Information

Company info Information1 Company structure Principal activity: construction and civil engineering

Subsidiary: DEF CONS. LTD, GHI LTD, MNO LTD(Tobacco Business)Associated: PQR LTD, STU LTD

2 Information Group Info: Group TO: RM 10 MillionGROUP PBT: RM 5 Million

3 Non-permissibleactivities info

TO Tobacco: RM 900,000PBT Tobacco: RM 400,000

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2.10.1.2 Quantitative Analysis

Non-permissible Calculation Quantitative resultPercentage of tobacco to thegroup TO

RM 900,00/RM 10.0 Mil 9%

Percentage of tobacco to thegroup PBT

RM 400,000/RM 5.0 Mil 8%

The above stock can be approved as Shariah-compliant stock because the contributions fromtobacco are 9% and 8% which fall below the benchmark set by the SAC at 10%, meaning thatthe group total profit before tax is below 10%.

2.10.2 Case 2: Gemada Berhad40

2.10.2.1 Company Information

Company info Information1 Company structure Principal activity: construction

Subsidiary: Go Ahead Sdn. Bhd, Ho Hap Sdn. Bhd, GantangBasar Sdn. Bhd (gaming business)Associated: Hud Hud Sdn. Bhd, Garuda Sdn. Bhd

2 Information Group Info: Group TO: RM 10 MillionGROUP PBT: RM 5 Million

3 Non-permissibleactivities info

TO liquor: RM 400,000PBT liquor: RM 1200,00

TO gaming: RM 200,000PBT gaming: RM 100,00

2.10.2.2 Quantitative Analysis

Non-permissible Calculation Quantitative resultPercentage of liquor to thegroup TO

RM 400,00/RM 10.0 Mil 4%

Percentage of liquor to thegroup PBT

RM 120,000/RM 5.0 Mil 2.4%

Percentage of gaming to thegroup TO

RM 200,000/RM 10.0 Mil 2%

Percentage of gaming to thegroup PBT

RM 100,000/RM 5.0 Mil 2%

2.10.2.3 Summary

Group TO = 4% + 2% = 6%

Group PBT = 2.4% + 2% = 4.4%

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The benchmark used by SAC for liquor and gaming is 5% of the group turnover/PBT.Therefore the above stock cannot be approved as Shariah-compliant stock because the contri-butions from non-approved activities, which in the above case are liquor and gaming, exceedthe benchmark set by the SAC of the Securities Commission.

2.11 OTHER METHODOLOGY OF SHARIAH SCREENINGPROCESS FOR SECURITIES

In addition to the methodology of the Securities Commission Shariah Advisory Council ofMalaysia, there are other methods of screening provided by other Islamic index providers suchas the FTSE, the Dow Jones, and the Shariah Capital – we shall highlight some of them.

2.11.1 FTSE Shariah Index Screening Methodology

FTSE has two types of Shariah screening methodology, namely Emas and Hijra, as describedbelow:

(a) FTSE EMAS Shariah index screening methodology: The FTSE Bursa MalaysiaEMAS Shariah index has been designed to provide Malaysian investors with a broad bench-mark for Shariah-compliant investment. The FTSE Bursa Malaysia EMAS Shariah indexapplies the principles set out by the Shariah Advisory Council in the design of this index. Thegeneral criteria stipulate that Shariah-compliant companies must not be involved in any of thefollowing core activities:• Financial services based on riba (interest)• Gambling• Manufacture or sale of non-halal products or related products• Conventional insurance• Entertainment activities that are non-permissible according to Shariah• Manufacture or sale of tobacco-based products or related products• Stock broking or share trading in Shariah non-compliant securities• Other activities deemed non-permissible according to Shariah.41

The above method adopted by FTSE EMAS is the same as that mentioned earlier whichhas been set by the SAC of the Securities Commission of Malaysia.

(b) FTSE HIJRAH Shariah index screening methodology: The FTSE Bursa MalaysiaHijrah Shariah index has been designed to be used as the basis of Shariah-compliant investmentproducts that meet the screening requirements of international Islamic investors. Companiesin the index are screened by the Malaysian Securities Commission’s SAC and the leadingglobal Shariah consultancy, Yasaar Ltd, against a clear set of guiding principles.

Constituents in the FTSE Bursa Malaysia Hijrah Shariah index are required to meet theprinciples set out by the Malaysian Securities Commission’s SAC, and by Yasaar Ltd, to ensurethat they are not involved in any of the following core activities:• Banking or any other interest-related activity, such as lenders and brokerages, but excluding

Islamic financial institutions• Alcohol• Tobacco• Gaming• Arms manufacturing

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• Life insurance• Pork and non-halal food production, packaging and processing or any other activity related

to pork and non-halal foodCompanies that have the following criteria are also not included in the index:

• Companies whose ratios of debt and debt servicing in combination are unacceptable andindicative of an inappropriate use of leverage relative to their assets.

• Companies that have income from cash or near cash equivalents or inappropriate levels ofreceivables to assets; the metrics by which stocks are included or excluded are designed tobe in keeping with Islamic Shariah principles and commonly accepted philosophies.

• Companies whose proportion of liquid assets to illiquid assets exceeds the percentagepermitted under Shariah principles and commonly accepted philosophies.

• Companies whose cash and cash equivalent to total assets exceeds the percentage permittedunder Shariah principles and commonly accepted philosophies.42

2.11.2 Yasaar Shariah Index Screening Methodology

Yasaar provides Shariah-compliant stock screening services for the FTSE series of IslamicIndexes. The broad and indicative Yasaar/FTSE stock screening criteria are listed below.

2.11.2.1 Business Sectors

• Conventional finance such as conventional banking, finance, and insurance, etc.• Alcohol• Pork-related products• Entertainment such as casinos/gambling, cinema, music, pornography, and hotels, etc.• Tobacco• Weapons and defence.

2.11.2.2 Financial Ratios

• Debt/total assets < 33%• Cash and interest-bearing items < 33%• Accounts receivable and cash < 50%• Non-compliant income other than interest < 5%• Total interest income < 5%• Purification ratio: 5% of dividends.43

The above criteria should be considered in order to list the securities as Shariah-compliantstock according to the Yaasar Shariah index.

2.11.3 DJIM Shariah Screening Process

Dow Jones Indexes is a leading full-service index provider that develops, maintains, andlicenses indexes for use as benchmarks and as the basis of investment products. Best knownfor the Dow Jones Industrial Average, Dow Jones Indexes offers more than 130 000 equityindexes as well as fixed-income and alternative indexes, including measures of hedge funds,commodities, and real estate. Dow Jones Indexes employs clear, unbiased, and systematic

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methodologies that are fully integrated within index families. Dow Jones Indexes is part ofCME Group Index Services LLC, a joint venture company which is owned as to 90% by CMEGroup Inc. and as to 10% by Dow Jones & Company, a News Corporation company (NAS-DAQ: NWS, NWSA; ASX: NWS, NWSLV).44 The Dow Jones Islamic Market Index (DJIM),launched in 1999 in Bahrain, was the first index for Shariah-compliant securities provided forinvestors who are seeking Shariah stock investment. Similar to others, the DJIM has a ShariahSupervisory Board who are behind setting the screening process methodology for Shariahstock. The DJIM screening methodologies have adopted the AAOIFI methodology as stated instandard 21. The DJIM uses the quantitative and qualitative methods for measuring and assess-ing the securities before being listed as Shariah-compliant stock. The DJIM family of indexescovers approximately 95% market coverage of 44 countries. To determine their eligibility forthe indexes, stocks are screened to ensure that they meet the standards set out in the publishedmethodology. Companies must meet Shariah requirements for acceptable products, businessactivities, debt levels, and interest income and expenses. The screening methodology is subjectto input from an independent Shariah Supervisory Board. By screening stocks for consistencywith Shariah law, the indexes help to reduce research costs and compliance concerns Musliminvestors would otherwise face in constructing Islamic investment portfolios.45

The Shariah screening process of the DJIM is based on two steps, namely business activitiesand financial ratios. Companies passing through these screening processes will be listed asShariah-compliant securities in the index. The two-step screening process is discussed below.

2.11.3.1 Screens for Acceptable Business Activities

According to the DJIM Index Shariah Supervisory Board established parameters, the busi-nesses listed below are inconsistent with Shariah law. The majority of Shariah scholars andBoards hold that these industries and their financial instruments are inconsistent with Shariahprecepts and hence are not suitable for Islamic investment purposes. Although no universalconsensus exists among contemporary Shariah scholars on the prohibition of tobacco com-panies and the defence industry, most Shariah Boards have advised against investment incompanies involved in these activities.

Income from the following impure sources cannot exceed 5% of revenue:

• Alcohol• Tobacco• Pork-related products• Conventional financial services (banking, insurance, etc.)• Weapons and defence• Entertainment (hotels, casinos/gambling, cinema, pornography, music, etc.).

According to the DJIM, during the component selection process, each company in the indexuniverse is examined based on its revenue allocation. If the company has business activities inany one of the following sectors defined by the Industry Classification Benchmark (ICB), it isconsidered inappropriate for Islamic investment purposes and is excluded from the index.

• Defence• Brewers• Distillers and vintners• Food products

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• Recreational products• Tobacco• Food retailers and wholesalers• Broadcasting and entertainment• Media agencies• Gambling• Hotels• Recreational services• Restaurants and bars• Banks• Full line insurance• Insurance brokers• Property and casualty insurance• Reinsurance• Life insurance• Consumer finance• Specialty finance• Investment services• Mortgage finance.

Companies classified as financial according to the Industry Classification Benchmark (ICB)are considered eligible if the company is incorporated as an Islamic financial institution,such as:

• Islamic banks• Takaful insurance companies

Companies classified as real estate according to the ICB are considered eligible if thecompany’s operations and properties are conducting business within Shariah principles.

2.11.3.2 DJIM Screens for Acceptable Financial Ratios

After removing companies with unacceptable primary business activities, the remaining stocksare evaluated according to several financial ratio filters. The filters are based on criteria set upby the DJIM Index Shariah Supervisory Board to remove companies with unacceptable levelsof debts or impure interest income.

All of the following must be less than 33%:

1. Debt to market cap: Total debt divided by trailing 24-month average market capitalization.This screening process will exclude the companies for which total debt divided by trailing12-month average market capitalization (TTMAMC) is greater than or equal to 33%.Companies that have a portion of the debt of more than 33% would be excluded fromShariah stock.

Total debt = Short term debt + current portion of long term debt

2. Liquid asset to market cap: The sum of a company’s cash and interest-bearing securitiesdivided by trailing 24-month average market capitalization. The companies are excludedif the sum of cash and interest-bearing securities divided by TTMAMC is greater than or

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The computation of DJIM is based on the following ratios:

(1) Debt to Trailing Twelve Month Average Market CapitalizationDebt to TTMAMC

Computed as: =

Benchmark: 33%any company with a debt exceeding 33% will be excluded.

(2)�Liquid Assets to TTMAMC

Benchmark: 33%

(3) Receivables to TTMAMC Computed as: =

Benchmark: 33%

Total Interest Bearing Debt12 Months Average Market Cap ×�100

Computed as: = ×�100Cash Deposits + Marketable Securities + Interest Bearing InstrumentsTTMAMC

×�100Cash Deposits + Marketable Securities + Interest Bearing InstrumentsTTMAMC

Figure 2.5

Comparison on Qualitative Analysis

DJIMFTSESC Malaysia

Public perception of the company’s image, core business.Important and maslahah to the ummah, umum balwa (common plight and difficult to avoid), Urf (custom).

NILNILYes

33% NADebt Total assets

33% market

capitalization

45NAReceivablesTotal assets

33% market

capitalization

33% NACash Total assets

33% market

capitalization

5% Interest Income Total income

5% Total income

5% Total income

Figure 2.6

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equal to 33%, meaning that the company cannot have cash and interest-bearing securitiesof more than 33%.

3. Receivables to market cap: Accounts receivable divided by trailing 24-month averagemarket capitalization, meaning that accounts receivable divided by TTMAMC are greaterthan or equal to 33%.

Accounts receivable = current receivables + long term receivables

Companies passing the screens detailed in the Business Activities and Financial Ratios areincluded as components of the Dow Jones Islamic Market World Index.46

2.12 CONCLUSION

The above discussion showed that there is an appropriate process that should be consideredin product development and approval in Islamic finance. The process is governed by veryprominent parameters and standards to ensure consistency in products offered to the marketplace, whether the products are offered for banking, takaful, or the Islamic capital market. Thereare Shariah frameworks that govern the Islamic finance industry. In addition to the distinctionto be made between Shariah-based products and Shariah-compliant products, each categoryhas its criteria and features and is subject to particular processes in product development andapproval. For securities products there are different methods adopted in the Shariah screeningprocess considered by different index providers.

NOTES

1. “Invention and innovation for sustainable development” Report of a workshop sponsoredby the Lemelson-MIT Program and LEAD International, London, November 2003. THELEMELSON-MIT PROGRAM. School of Engineering, Massachusetts Institute of Tech-nology. p. 9.

2. Global innovation index, 2009 – 2010. INSEAD.3. AAOIFI. Shariah Standards, no. 9. p. 148.4. http://en.wikipedia.org/wiki/Innovation. Accesses 1/6/105. See Imaran, Islamic Jurisprudence, pp. 149–150.6. Ibid.7. Ibn Ashur, Maqasid al Shariah, p. 928. Abdul Sattar, Abu Ghuddah (2007), p. 377.9. Ibid., p. 371.

10. Al Ghazali, al Mustasfa min ilm al-Usul, p. 216.11. See Ibn Ashur, Muhammad al Tahir, Maqasid al Shariah al-Islamiah (Malaysia: Islamic

Book Trust, 2006), p. 87.12. Ibn Ashur, Maqasid al-Shariah, p. 171.13. Ibid., p. 301. And see Mohammad Akram Laldin, The Shariah Objectives of Financial

Contract and Islamic Banking (International conference on Islamic jurisprudence IIUM,2006), p. 244.

14. Alal al-Fasi, Maqasid al-Shariah (Beirut: daru al-garb al-Islami, 5th edn, 1993), p. 7.15. Ahcene Lahsasna, Understanding Maqasid al Shariah, p. 5. Imran Ahsan Khan Nyazee,

Islamic Jurisprudence (International Institute of Islamic Thought: Islamabad, 2000),

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p. 199. See also Al Ghazali, al mustasfa, p. 216. Al shtibi, al muwafaqat, vol. 2, p.324.

16. See Ahcene Lahsasna, Maqasid al Shariah in Islamic Finance and Economics, p. 10.17. Shariah resolution in Islamic finance, Bank Negara Malaysia, p. 88.18. http://www.aaoifi.com/Objectives.html. Accessed 18/9/2008.19. http://www.ifsb.org.20. http://www.ifsb.org/objectif.php. Accessed 18/9/2008.21. See AAOIFI, Shariah Standards, p. 137.22. AAOIFI, p. 452.23. GPS1 guideline, p. 6.24. IFSB corporate governance guidelines, p. 11.25. Ibid., p. 11.26. Ibid., p. 12.27. Ibid., p. 12.28. Ibid., p. 12.29. See Ahcene Lahsasna, Fatwa its Process and Methodology in Islamic Banking and

Finance, p. 37.30. Ibid.31. Securities Commission Malaysia (2009), Islamic Equity Market, KL. LexisNexis, p. 14.32. Ibid., p. 15.33. Securities Commission resolutions 144.34. See Securities Commission resolutions 145–149.35. Ibid.36. Ibid.37. Ibid.38. Securities Commission resolution 165.39. Source: SC, Introduction to Equity Market, p. 24.40. Source: SC, Introduction to Equity Market, p. 25.41. FTSE, publication on website, pp. 1–2. http://www.ftse.com/. Accessed 15/01/2010.42. Ibid.43. Yassar, Publication on website. http://www.yasaar.org/. Accessed 15/01/2010.44. http://www.djindexes.com/aboutus/. Accessed 01/06/2010.45. http://www.djindexes.com/islamicmarket/. Accessed 01/06/2010.46. Guide to the Dow Jones Islamic Market Indexes, pp. 4–5. Securities Commission, Intro-

duction to Equity Market, p. 18.

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c03 JWBK508-Hassan February 1, 2011 9:54 Printer: Yet to come

3

Integration of Social Responsibilityin Financial Communities

Sayd Farook and Rafi-Uddin Shikoh

3.1 INTRODUCTION

From the fraud cases of Bernie Madoff and Maan Al-Sanea to Wall Street’s sub-prime lending-led global financial crisis, the Financial Industry is faced with a growing black eye. This globaltrust deficit was affirmed by a 2009 BSR (Business for Social Responsibility)/GlobeScan Stateof Sustainable Business Poll, in which respondents rated the financial services industry as theleast socially responsible amongst nine of major global industries.

The repercussions of the financial community’s actions are indeed far and wide. The WallStreet-triggered global financial crisis has led to millions of job losses, foreclosures, andbankruptcies driving families and individuals into deep social crises – impacting their qualityof life and even survival. The World Bank Group has calculated the impact of the globalfinancial crisis on global poverty – estimating that the resulting global economic downturnwould force 46 million more people around the world to live on less than $1.25 a day, and anadditional 53 million would have to cope with less than $2 per day.1

To be fair, such unprecedented social crises and burdens cannot all be linked to actions ofthe financial community alone. Nevertheless, the financial community’s central role in havingfar-reaching social impact, more than any other business community, is hard to argue against.

Conversely, through profitable investments and financing, financial communities also playthe most significant social role as the engine for economic growth – driving job creation andsmall business growth and facilitating major social developments in healthcare, food services,housing, education, and more.

In a global environment where other social-economic crises, such as climate change, foodshortage, water shortage, and global energy needs, have all reached unprecedented levels,financial communities are again arguably one of the most capable communities to addresssuch crises.

Given the chronic global social challenges and the impact financial communities can have,addressing effective social responsibility integration becomes a matter not only of the financialcommunity’s health and survival, but also that of our very existence. No doubt, in a highlyconnected global financial world, Islamic financial institutions are very much linked to thiscommunity and face if not same then similar responsibilities, challenges, and opportunities.

It is with this perspective and context that we discuss the critical need for effective integrationof social responsibility into financial communities. With the Islamic financial community asthe focus of our discussion, we look at how Islamic finance, as a seemingly bright spot


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of the global financial community, has an opportunity to contextualize integration of socialresponsibility under its own unique light to enable significant positive social impact. However,we first look at the contrary view – that Islamic finance today is leading to ineffective orminimal integration of social responsibility within it.

Meanwhile, we also look at the fundamental drivers of capitalism that have shaped con-ventional social responsibility practices and the differences that exist compared to the Islamicperspective. At the same time, we acknowledge the progress and success being achieved byquickly evolving conventional CSR (Corporate Social Responsibility), Socially ResponsibleInvesting (SRI), and Social Entrepreneurship (SE) initiatives in order to draw lessons. Thesediscussion points, we hope, will provide a framework for financial communities to effectivelyintegrate social responsibility into their business models.

3.2 THE CONFLICTING IDEOLOGUESWITHIN ISLAMIC FINANCE

Given the social and economic imperatives of Islam on a global level (described later), Islamiceconomists have long struggled to devise and execute a cohesive micro-economic plan thatleads to the fulfilment of the macro-economic objectives of Islam. Efforts of the IslamicDevelopment Bank (IDB Group) are commendable in this respect. Given its explicit socialdevelopmental objectives, some would argue that it is well placed to do so, but others arguethat it does not represent the strategies of other Islamic businesses and financial institutions.

In contrast, the social responsibility efforts of Islamic Financial Institutions (IFIs) have beenlimited and therefore do not really tackle the global social imperatives with a well-plannedand cohesive strategy. Anecdotal evidence over the past few years suggests that Islamic banksand financial institutions view Shariah compliance in financial product structures as theirprimary requirement to be classified as an Islamic institution.2 This is evidenced through arigid adherence to the contractual processes required by the Shariah and reviewed by internalShariah audit mechanisms along with an institutional Shariah advisory board. There are threereasons why the majority of Islamic banks have focused on product structures as the primaryarea to adopt the principles of Islam into their business activities.

First is perhaps the historical and political influence on both Muslim populations andbanking as a profession. Since the fall of the Ottoman Empire and some would argue evenearlier than that, Muslim populations have been subject to secular law (albeit somewhatinfluenced by theological laws from the Abrahamic religions). Whether it is common law orcode law, the law in Muslim countries, as enforced by foreign colonial powers, did not ensurethat Islamic principles were considered to decide on a case. With the exception of family lawand inheritance, any conception of Islamic laws and commercial rules were stripped from theday-to-day practice of Muslims. Advancements in Islamic intellectual thought did continuebut with limited audiences, with the world embracing one form or another of capitalism orsocialism. Consequently, banking has been dominated for the past two centuries by a mindsetthat principally focuses on interest rates and maturity arbitrage.

Secondly, familiarizing conventional bankers with Islamic finance has been a dauntingtask to begin with. It has been 35 years since the first Islamic banks were established (IslamicDevelopment Bank and Dubai Islamic Bank), and we are now seeing the emergence of a secondgeneration of Islamic bank executives and employees who are being trained from the groundup in Islamic finance along with conventional finance. Universities such as the International

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Integration of Social Responsibility in Financial Communities 71

Islamic University Malaysia, University of Durham, Markfield Institute of Higher Education,Loughborough University, and Trisakti University are some that have fostered a strong Islamiceconomics agenda with their students through their teaching methods and course materials.The influence of this generation will inevitably see a resurgence of a global vision of Islamiceconomics and finance.

Thirdly, and most importantly, there is a large group of younger Shariah-trained profes-sionals, taught by the existing and experienced “traditional” scholars who reign supreme inIslamic finance, who may have different views of Islamic finance. Many of these “traditional”scholars adopt the view that the only responsibility of Islamic finance is to be efficient andprofitable, while remaining within the parameters of Islamic commercial laws. Beyond that, itwould be unacceptable to expect IFIs to dedicate their time, efforts, and shareholders’ fundsto social causes. Arguments are made to the effect that just because IFIs happen to operate inan industry that is plagued by impermissible transactions does not mean that they should haveto bear the brunt of societal expectations of responsibility and charity. As a result, the onlyresponsibility that IFIs do have is to ensure that they avoid what is considered impermissibleby structuring their products to be Shariah-compliant.

This line of thinking has far-reaching consequences for the ideology and practices ofemployees in Islamic financial institutions, who are clearly the key contributors to the shapeof Islamic finance in the future. It is important to note that this is not the only view heldby many prominent Shariah scholars. Many do support and encourage a wider, more holisticresponsibility domain for Islamic banks.

3.3 CORE MOTIVATIONS OF CONVENTIONAL BUSINESSMODELS AND THEIR SOCIAL RESPONSIBILITY MANDATES

Islamic banks are certainly interlocked with the larger global financial community. Many arepart of parallel systems within Muslim countries, or engaged in global trade and investments,or members of the regulatory imperatives of the global financial economy. As described earlier,this connectivity also has a business mindset influence on Islamic banks as this backgroundalso shapes their business thinking, approach, strategies, and business culture.

Given this dominant role of modern day free market capitalism on the developing Islamicfinancial community as well as the broader global financial community, it is relevant toexplore the fundamentals of this prevalent economic mindset and determine its approachtowards corporate social responsibility.

If we sample the major thought-leaders that have shaped and influenced global free marketcapitalism, their mix of premises about a business’s core purpose focuses on serving customers,maximizing shareholder value, and supporting the role of “enlightened self-interest”. It is thisDNA of today’s business enterprise, including financial communities, with which vast effortsin CSR are being pursued.

Adam Smith’s book The Wealth of Nations (1776) is a pioneering economic work that hasshaped the nature of modern capitalism. His key concept in support of limiting governmentintervention and promoting free enterprise was that individuals acting in their own self-interestwould naturally seek out economic activities that provided the greatest financial rewards. AdamSmith asserted that this self-interest would in turn maximize the economic well-being of societyas a whole. His idea of the “invisible hand” is used today to refer to the role of enlightened

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self-interest. Ultimately he states in the book: “The great object of the political economy ofevery country is to increase the riches and power of that country.”

Milton Friedman, another major economist who has influenced modern day capitalism,asserted that the social responsibility of business is to increase its profits with a primary goalof responsibility to shareholders. In his book, Capitalism and Freedom, he argues: “[T]here isone and only one social responsibility of business – to use its resources and engage in activitiesdesigned to increase its profits so long as it stays within the rules of the game, which is to say,engages in open and free competition without deception or fraud.”

Peter Drucker, the legendary management thinker who defined modern day managementand also did pioneering work for the non-profit sector, had also addressed the need forbusiness and society to have ethical, purpose-driven leaders. However, he influenced modernday management to prioritize their existence in serving the needs of customers. In his bookManagement, Peter Drucker defined a business by saying “There is only one valid definition ofbusiness purpose: to create a customer . . . It is the customer who determines what a businessis . . . The customer is the foundation of a business and keeps it in existence. He alone givesemployment.”

These key business purpose definitions showcase how modern day management is drivenby a focus on profits and related performance. Similar theories such as legitimacy, stake-holder or political economy theory suggest that businesses rely on stakeholders for theirlegitimacy, without which institutions lose their right to operate in society. If businesses donot adopt policies that are stakeholder friendly, they may see their revenues collapse andthen finally file for bankruptcy. Businesses may also come under strain if stakeholders insociety become aware of significant violations by businesses of that society’s perception ofresponsibility.

Hence, according to these theories, it is in the best interest of businesses in the long termto legitimize their operations and act according to the expectations of the broad consensusopinion of society. To that extent, social responsibility in the contemporary secular literature isas much about influencing stakeholders through media and public relations (PR) as it is aboutconducting activities in a manner that is aligned with stakeholders’ expectations.

However, this does not imply that the capitalist environment is devoid of ethics and socialresponsibility. Indeed, the modern system has also developed very successful practices thatsupport equal opportunity work environments and encourage and instill attributes such aswork ethics, integrity, and honesty. Millions of working immigrants have benefited from suchdeveloped work environments that live by modern day capitalism and serve as the means foreconomic opportunity and prosperity for many. It is in the same spirit that CSR has becomean advanced and mature form of every modern day corporate structure.

The question this raises for the global financial community is: what is the place ofsocial responsibility within the ultimate purpose of modern day business enterprises? Does abusiness’s ultimate profit driven motive give social responsibility a voluntary place within anorganization, or limit it to its customer demands, or leverage it more as a PR tool? Is this whymost social responsibility reports, activity, and performance is handled by the media or PRunits of businesses, rather than a policy or compliance unit?

Many contemporary Islamic financial institutions, influenced by the popularity of CSR,have also maintained a PR strategy for CSR in a bid to legitimize their operations to a wideraudience. For the Islamic financial community, do the above business motives drive theircurrent view of social responsibility, and if so, should they?

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3.4 ISLAM, BUSINESS, AND SOCIAL RESPONSIBILITY

Before we make the case for the Islamic financial community’s broader social responsibilityobligation, it is pertinent to look at the core purpose of business as defined by Islam. Similarto our review of the ultimate purpose of today’s capitalism-centred business environment, areview of Islam’s core mandates relating to economic activity would give us a good way toassess its corporate social responsibility paradigm.

The perennial question therefore is: what exactly is an Islamic business? Does Islam, asan all-encompassing regulatory system, have a role to play in influencing the vision, mission,strategy, and policies of businesses? Is it enough for Muslims to avoid the wrong or impermis-sible transactions? Or is there a role for businesses and individuals to engage in or encourageother types of social activities? What is, then, the scope of social responsibility in Islam?

Some core Islamic concepts we discuss here shape our view of social responsibility for theIslamic financial community.

3.4.1 “Taqwa-Centricity” (God Consciousness) and Human Beingsas Vicegerents on Earth

A practising Muslim, not just a “compliant” Muslim, acknowledges that everything he/shedoes is for the pleasure of God. All concentration of effort and activity is geared toward onesole purpose – consciousness and recognition of the overwhelming presence of God or whatis known as “taqwa”.

In reality, this translates into accepting and encouraging whatever God has required orrecommended for us and discouraging and forbidding with all our efforts and wisdom whateverGod has forbidden for us. In this context, some will say that for an average compliant Muslim,as long as he/she is avoiding the impermissible (haram) and doing the obligatory (fardh),he/she is doing all that is necessary or expected from human beings. Doing the obligatoryentails the five pillars of Islam: witnessing God and his final messenger (shahadah), prayingfive times (salat), giving the prescribed tithe (zakat), fasting (saum), and conducting thepilgrimage (hajj) if within their means. In addition, the obligatory would be observing therules associated with the rights of spouses, relatives, and the treatment of orphans and parents,among others. As long as a Muslim is doing these, there is no other obligation per se, but onlyrecommended acts.

However, a closer look at the Quran, the holiest book of Islam, suggests that this is anincomplete view and that responsibility does not end in merely performing the obligatoryaspects of Islam as required by God, but on every aspect of our existence. This is where theconception of the examination or test of this world plays a vital role.

Numerous times in the Quran, God mentions that He will test humans, since humans are thedesignated representative or vicegerent (khilafah) of God on this earth and that the world is notowned by humans but given as a trust (amanah). This principle of examination is expoundedin several verses of the Holy Quran, two of which are:

“Allah takes careful account of everything”,3 and,“Then anyone who has done an atom’s weight of good shall see it and anyone who has done

an atom’s weight of evil, shall see it.”4

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The outcome of this test is the attainment of an eternal place of abode, whether it is heavenor hell. The extent to which the attainment of either is based on merely doing the obligatory isnot certain, perhaps intentionally, since a person may perform just the obligatory, but may failother tests or violate God’s expectations in other respects. This accountability should thereforebe the basis for all actions of a “practising Muslim”.5

3.4.2 Primary Responsibilities: To Educate and Establish Justice

The question then becomes what these expectations should be for a Muslim from a broaderperspective and more specifically for each individual. What emerges from a careful synthesisof the Quran is an overwhelming emphasis on establishing justice in all forms of the word andcategories possible. The Quran states:

“The Believers, men and women . . . enjoin what is just (accepted), and forbid what is unjust(rejected) . . .”6

The principle of enjoining good and forbidding evil encapsulates the responsibilities thatAllah places on Muslims as trustees and vicegerents. This responsibility is overwhelming andencompasses all aspects of a Muslim’s life.

Indeed, if one were to review the majority of Shariah constraints on commercial transactions,the purpose of each one is to ensure justice; that both parties to a transaction are on a levelfooting when entering into a contractual relationship. From the prohibition of riba or usury(to ensure that a capital deficient individual is not exploited by the capital owner) to therequirement of capacity in contracts (to ensure that the parties understand their obligationsunder a contract) and the prohibition of gharar or ambiguity/uncertainty (to ensure that bothparties are aware of the key terms of a contract and to avoid instances of zero-sum outcomes), allIslamic commercial transaction requirements point to only one sole objective, i.e. to establishjustice in dealings with the least amount of post-contractual conflict.

However, individuals are not only about contracts. Individuals also live in a society wherethey must behave in a certain manner. They make decisions on how to behave with the poor orthe rich, the privileged and the unprivileged, and they also make decisions that do not alwaysinvolve contracts. While riba is emphasized in the Quran, it does not merely relate to instancesof financial transactions, but also sets a tone for all types of injustice. In a sense therefore, itis an individual’s responsibility not only to engage justly in good and just behaviour, but toeducate others in how to live their lives according to divine guidance, whether by exemplaryconduct or through directed actions.

Indeed, Kamali goes to the extent of stating that educating an individual in taqwa is higherin the priority of the objectives of the Shariah than justice itself, since education “seeks tomake each individual a trustworthy agent just so as to strive to realize these values whichbenefit himself and the community”.7

However, defining the specific ambit of this responsibility within the Shariah and in the con-temporary context of highly advanced societies is a very challenging task, as this responsibilityis not something that is necessarily set in the core laws of the Shariah, such as the avoidance ofriba. Indeed, a large part of this responsibility is in discretionary actions by individuals basedon a set of principles derived from the Quran and the traditions of the Holy Prophet (PBUH)(Sunnah).8

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The manifestations of such principles in the form of discretionary actions, particularly ininstitutional settings, therefore need some articulation.9

3.4.3 Ability-Based Focus

The Prophet Muhammad (PBUH) said:

“Every Muslim has to give in charity.” The people then asked: “(But what) if someone has nothingto give, what should he do?” The Prophet replied: “He should work with his hands and benefithimself and also give in charity (from what he earns).” The people further asked: “If he cannotfind even that?” He replied: “He should help the needy who appeal for help.” Then the peopleasked: “If he cannot do (even) that?” The Prophet said finally: “Then he should perform gooddeeds and keep away from evil deeds, and that will be regarded as charitable deeds.”10

What is evident from the above statement is that the obligation for social responsibilityis based on the ability of individual or institution with fluid parameters, rather than a fixedobligation that should be regulated and enforced by religio-legal authorities.

There are, therefore, two aspects of this saying that deserve analysis in the context of socialresponsibility and capacity. The first aspect is that the Prophet (PBUH) did not impose aminimum requirement in any conduct, other than fasting and praying. For instance, the Hajjand the payment of zakah is only mandatory for individuals who have the capacity or abilityto do so. It is evident that the Prophet placed a great emphasis on the importance of promotingthe necessities first, before achieving the recommended. As a result, most social obligationsare based on capacity to perform. It is for this reason that there are duties that Allah commandsus to do (fardh), while there are duties that Allah recommends us to do for additional rewardsand our betterment (mustahab).11

Hence, fardh rules are given preference in drafting any set of rules in preference to activitiesthat are recommended or discretionary (mustahab or mandoob). This is because recommendedforms of conduct are not always within the reach or capacity of individuals and their repre-sentative institutions, while explicitly stated rules cannot be foregone or compromised, sinceGod has commanded them. Also, explicitly stated rules such as the rules of worship (ibadah)or commercial transactions (muamalat) are activities within the capacities of individuals anddo not necessarily depend on the individual having certain benefits.

The second aspect is that the Prophet (PBUH) emphasized the importance of utilizing one’shands to benefit oneself and to give in charity, effectively meaning that individuals and byextension institutions should do what they are best placed to do to provide charity or what ineconomic circles is known as comparative advantage.

3.4.4 Individual vs. Institutional Responsibility

At its core, the responsibility of a representative organization such as the IFI is the same asthe individual social responsibility of each Muslim: to enjoin good (right) and to forbid evil(wrong).

It therefore follows that the organizations that are under human control or ownership mustalso bear the same level of ability-based moral responsibility as the human. In fact, theresponsibility of organizations may be more, since it may have even better capabilities tofulfil the responsibilities than humans. Similar to individuals, financial institutions occupy aparticular area of influence in society within which they specialize and have relative strengths.

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Hence, any conceptualization of an organization’s responsibility to society is as a representativeof humans who are in turn representatives/vicegerents of God.

It is therefore proposed that any notion of social responsibility for IFIs should be de-signed to meet this divine theory of regulation. Hence, IFIs should only comply with somemandatory guidelines (analogous to fardh duties) that are fundamental to their existence asIFIs, while it is recommended that they undertake voluntary activities which are within theircapacity and which are synergistic to their operations as financial intermediaries (analogousto mustahab/mandoob duties).

3.4.5 Existing Paradigms of Social Responsibility Discourse in Islam

Dusuki and Abdullah12 attempt to provide a juristic framework by which an Islamic conceptionof institutional social responsibility should be perceived, taking into consideration reality andever-changing circumstances. In essence, they argue that the conception of institutional socialresponsibility should be defined within the boundaries of Maslahah (public good). WhileMaslahah does not receive broad support from all schools of Islamic thought as a source oflaw, it is argued to be the closest juristic conception due to its capacity to provide a platformfor applications outside the strict Shariah law, but which are deemed necessary to serve thepublic good.13

Maslahah essentially implies acquisition of benefit and repulsion of harm, but its widermeaning as a source of law means anything that helps preserve the objectives of the Shariah.14

It is for this reason that Maslahah is sometimes utilized interchangeably with Maqasid.15 It isthe opinion of contemporary scholars that Rahmah (mercy) is the all-encompassing objective ofthe Shariah. Indeed, the emphasis on justice more than 53 times in the Quran is a manifestationof God’s Mercy.16

Accordingly, the primary objectives of the Shariah in order of priority would therefore be:

1. To educate (tadhib al-fardh) the individual in taqwa so that he may become an embodi-ment of mercy and justice

2. To establish justice (adl) in society through one’s conduct.

Al-Ghazzali refines the essence of this objective. He stipulates that anything that promotesthe well-being of all mankind, which lies in safeguarding their faith, life, intellect, posterity,and wealth, is within the ambit of Maslahah.17 Therefore, the definitive parameters of Islamicsocial responsibility must be based on achieving the overall objective of the Shariah, to promotegood (justice) and forbid evil (injustice), and which is manifested in the concept of protectingthe faith, life, intellect, posterity, and wealth of mankind.

3.5 CASE FOR BROADER SOCIAL RESPONSIBILITY MANDATE

The core concepts of “taqwa-centricity” discussed – human beings as vicegerent on earth,ability-based responsibility, and pursuit of justice – apply not only to Muslims as individualsbut translate equally, if not more, to Islamic Financial Institutions. Indeed, many scholarsconcur that this overall objective is translated into a focused goal of Islamic economics:to promote justice in economic transactions (Mirakhor, 2007). With these core concepts inperspective, we look at the reasons why Islamic Financial Institutions have a broader socialresponsibility mandate then narrowly focusing on e.g. product structure compliance. Figure 3.5provides a theoretical construct of the key drivers that provides Islamic financial institutionswith a unique approach to social responsibility.

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“Taqwa”-centricity

Pursuit ofJustice

GlobalSocial

Challenges

Role – Fardkifayah;

Role –Allocative

Justice God’sVicegerency

Role –Visible

Example

OperationalObligations

IslamicFinancialInstitution

Ability-basedResponsibility

Social Responsibility Drivers for IslamicFinancial Institutions

Figure 3.1 Social responsibility drivers for Islamic Financial Institutions

3.5.1 IFIs’ Special Obligation

Because of the individual inability to avoid the overwhelming and prevalent riba-based system,IFIs came into existence as a collective religious obligation (fard kifayah) on the largercommunity (Ummah).18 This obligation is to operate a financial intermediary for individualsin the community wishing to comply with Islamic law (Shariah). To that extent, IFIs arerepresentatives for individuals who:

i. invest their money as shareholders or investment account holders,ii. have cooperative, partnership, or borrowing relations with the IFI,

iii. are employed by the IFI,iv. have other explicit contractual relations with the IFI,v. in addition to the above, have an implicit social contract with the IFI as part of the larger

community (Ummah).

In this special position, IFIs are able to perform the obligations and recommended actionsthat Muslims cannot perform individually. Indeed, the very prohibition of riba could notnecessarily be satisfied without the requisite institutional mechanisms such as IFIs. In thisposition, IFIs also have the ability to influence allocative justice through their transactions,something beyond the reach of an individual Muslim, but recommended by Islamic principlesand a key consensus objective of Islamic economics (Mirakhor, 2007):

He has raised you in ranks, some above others: that He may try you in the gifts He has given you:for your Lord is quick in punishment: yet He is indeed Oft-forgiving, Most Merciful.19

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Also, IFIs fall in the category of highly visible institutions in society as financial intermedi-aries that source and allocate funds. The example set by IFIs has an impact on other individuals,institutions, and organizations, who are influenced by the actions of the IFI. Indeed, IFIs havethe potential to “educate” individuals and communities to apply justice in all facets of theirlives based on the IFIs’ example.

It is for these two reasons that IFIs and any other representative “Islamic” institutions areperforming a collective obligation (fard kifayah) and have a special duty of social responsibility.This social responsibility is an extension of the social responsibility of every Muslim, but it isa responsibility that Muslims do not have the capacity to perform individually.

3.5.2 Religious and Financial Obligations

Religiously, IFIs have a responsibility to comply with the form and substance of Islamic lawin all aspects of their operations. This is because they are in a representative and exemplaryreligious position, whereby they represent the interests of their stakeholders and at the sametime are exemplars to their stakeholders. This implies that all aspects of their operations shouldbe conducted in a permissible or recommended manner. If it is conducted in an impermissibleor not recommended manner, it has an obligation to disclose to its stakeholders the reasonsfor that particular conduct. This is what could be termed as a narrow sense of the socialresponsibility due from IFIs and follows from a strict compliance with Islamic law. This canbe extended to activities that serve the public good (maslahah) of society such as alleviatingpoverty, protecting the faith of Muslims, and building the wealth of poorer sections of society.IFIs have generally been slower or inactive in encouraging or participating in such activities.

Financially, IFIs are intermediaries that mobilize funds from investors and allocate themto projects and other investments. In this context, it is the responsibility of IFIs to mobilizefunds from permissible and recommended sources and to invest them in permissible and rec-ommended projects. Further, IFIs are also in an exemplary position as financial intermediariesand hence can significantly impact the conduct of their stakeholders in terms of the idealIslamic investment and allocation process. It is in this expanded role that IFIs are able toeducate (tadhib al-fardh) their stakeholders through exemplary conduct aimed at achievingthe objectives of the Shariah such as allocative and redistributive justice.

3.5.3 New Realities

The ambit of social responsibility for man as defined within an Islamic framework does notnecessarily translate into a definitive framework for Islamic Financial Institutions, since IFIsare specific organs in society with characteristics different from those of individuals.

Furthermore, these principles only translated to rules for behaviour and action fourteenhundred years ago when the world and its problems were much simpler and more localized.While some of the principles of man’s social responsibility are universal such as riba, mostcannot be easily extended to contemporary situations, which are much more complex. Forinstance, while poverty certainly did exist in those days, the global imbalances in wealththat are witnessed now, with billions living in extreme poverty and only a select few millionenjoying above-par lifestyles, is unparalleled. We did not have the environmental challengesthat we face now, nor did we have the consumption and waste challenges that are threateningthe very existence of life on this earth.

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Those fundamental principles must therefore be adapted and articulated for the contem-porary world. Since nowadays financial institutions operate in a global world with globalinterconnectivity, it is arguable that challenges such as mass scale poverty reduction and envi-ronmental preservation must now be also tackled with a global mindset and agenda. This willrequire new forms of systems and processes.

Hence, it is crucial to define specific parameters of social responsibility for the IFI inaddition to the Shariah legitimacy of such parameters.

3.5.4 Different from Charities

IFIs are profit generating entities and this motive, and its maximization, is permitted withinthe framework of IFI’s core responsibilities laid out above. However, with higher profits,an institution’s “ability” and hence obligation towards society increases. The nature of IFIs’responsibilities can further be distinguished from those of charitable organizations that existin Islamic societies, which are also a function of individual social responsibility. Charitableorganizations only redistribute wealth while IFIs have the dual ability to redistribute andallocate wealth to selective investments that contribute to the betterment of society. It is thisallocation power that differentiates IFIs from other institutions and indeed bestows upon themspecial responsibilities.

3.6 CURRENT CHALLENGES AND RECOMMENDED APPROACHTO ISLAMIC SOCIAL RESPONSIBILITY

As stated above, social responsibility is comprised of a prescription towards positive (permis-sible and recommended) actions and a prescription against negative (impermissible and notrecommended) actions. IFIs are widely accused to have generally ensured their operational sta-tus by avoiding negative actions or impermissible activities, while conducting recommendedactivities only minimally and to a variable extent.

This may be a function of two overlapping issues. The first issue is that IFIs are unsure ofwhat is expected of them based on Islamic prescriptions other than to avoid riba and gharar.In this confusion, approach to social responsibility widely varies based on individual IFIpreferences. The second issue is that, even if it is assumed that IFIs are conducting their socialresponsibility activities, they may not be informing the rest of society through disclosure,leading to an expectation gap. Many defend that IFIs are complying to the fullest extentof their abilities with Islamic notions of social responsibility, but due to Islamic injunctionstowards modesty when conducting charity this is not publicized.

Below is a recommended social responsibility framework for the Islamic financial com-munity. This framework, implementation processes, benchmarking methodologies, and casestudies should be managed and regularized by an industry agency. As described later,incorporation of disclosure practices as a means of accountability and social responsibility isequally important.

3.6.1 Regularize a Framework of Mandatory and RecommendedSocial Responsibilities

It is recommended that regulatory authorities standardize the notions of social responsibilityfor IFIs within a dual level framework of public good (Maslahah), if they are to retain their

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legitimacy as “Islamic” organizations. Hence, two sets of conduct could be prescribed forIFIs, one deemed to be necessary (Daruriyat) and one deemed to be either complementaryor “embellishments” (Hajiyat or Tahsiniyat).20 Indeed, the Prophet Muhammad, through hissaying, emphasized that the repulsion of evil or haram is higher in the priority of actions thanthe realization of benefit:

When I order you to do something, do it to the extent of your ability, but when I forbid you fromsomething, then avoid it altogether.

It is therefore logical to suggest that any form of regulation for IFI social responsibilitywould require the prevention of haram (through mandatory preventative measures) or ensuringobligatory acts over the realization of good through recommended and voluntary acts. Kamali21

utilizes the illustration of prayers (Salah) to demonstrate the difference between the necessary(Daruriyat) and the embellishments (Tahsiniyat). One could pray with full concentrationand sincerity, giving each part its due attention or pray with haste and thoughtlessness. Thedifference between the two ends of the spectrum is that at one end the prayer (Salah) isespoused with the attainment of both the essential and the desirable, and at the other end, itcan at best be seen as discharging a duty. In the context of IFIs for instance, it would be amatter of obligation to avoid the payment of interest, but not to finance investments that havesocial or development consequences. However, engaging in such voluntary activities wouldlead to the IFI’s attainment of refinement and excellence in its character as an IFI.

Therefore, the social responsibility conduct deemed to be necessary on the part of IFIswould be considered mandatory in the regulatory framework, while those deemed to becomplementary or embellishments would be considered recommended or voluntary.

3.6.2 Mandatory Forms of Social Responsibility

Mandatory forms of social responsibility refer to conduct that the IFI has to avoid. The follow-ing are the key recommended areas that fall under the mandatory form of social responsibility.

3.6.2.1 Screening of Investments

Muslims cannot invest their money in enterprises that engage in impermissible activities, forinstance, a pig farm, an alcohol producing factory, the tobacco industry, etc. Furthermore,they cannot invest in activities that are financed by debt or interest-based activities. In thiscontext, it is imperative that IFIs screen their investments for compliance with Islamic lawsand principles. IFIs should have a clear policy outlining their method of screening investmentsand the depth of their screening and gain approval of this screening process from their ShariahSupervisory Board.

3.6.2.2 Earnings Prohibited by Shariah

Since Muslims cannot also engage in impermissible activities, earnings from impermissibleactivities cannot be utilized for the operations of the firm and must be dealt with accordingto the Shariah Supervisory Board’s opinion. To that extent, Islamic stakeholders need to beassured that the representative IFI is acting in accordance with Islam by ensuring that no part ofthe stakeholder’s wealth or income or activity is impermissible, and where it is impermissible,how it is dealt with.

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3.6.2.3 Responsible Dealings with Clients

As representatives of Islamic stakeholders, IFIs need to ensure that they substantively followIslamic prescriptions on how to deal with debtors as stipulated in the Holy Quran:

“If the debtor is in difficulty, grant him time till it is easy for him to repay. But if you remit it bythe way of charity, that is best for you if you only knew.”22

The Quranic prescription contains a mandatory and a recommended action. The mandatoryaction in this circumstance is allowing the debtor time to pay it off if he/she is in difficulty.Indeed, the substance behind the prohibitions against riba (usury) was to ensure that clientsdo not fall into excessive debt.23 To fulfil this prescription in its true substance, IFIs shouldimplement both ex ante (prior to giving fund to a client) and ex post (when the client is infinancial difficulty) measures.

3.6.2.4 Employees

IFIs must be just in all their dealings with employees, customers, and all other members ofsociety. The Quranic principle of brotherhood is particularly pertinent in the discussion of thetreatment of employees as Muslims treat one another as brothers.24 On the basis of justice,this relationship would also extend to its non-Muslim employees. IFIs therefore should havea policy providing an environment free of exploitation and discrimination, free from class orrace barriers, and equal opportunity for all based on merit regardless of gender, race, religion,disability, or socio-economic background.

3.6.2.5 Zakah

Paying Zakah is a mandatory obligation on the part of all Muslims to purify their wealth.AAOIFI has already mandated standards for the accounting treatment of Zakah (FAS 9).However, these standards do not recommend the creation of a policy on Zakah as it is partof the obligatory social responsibility of Muslims. To complement this existing standard, thestandard setter should mandate that there is a policy for Zakah in every Islamic institutionthat is unambiguous about the obligations of the IFI with regard to collection and payment ofZakah. It is nevertheless acknowledged that there is controversy in the Islamic literature as towhether Islamic businesses are obligated to pay this tax, or whether it is only obligatory forindividuals.25 To that extent, some IFIs do not necessarily need to establish a policy on Zakah,unless they feel it is within the capacity of the IFI. Hence, the direction taken by AAOIFI inthis regard should either be to supplement the existing standard on Zakah to mandate a policyfor those IFIs that have to pay Zakah to their government and for those IFIs that voluntarilypay Zakah. Alternatively, there should be a provision that mandates the establishment of aZakah policy as a mandatory form for those IFIs that have to pay Zakah and as a recommendedform for those IFIs that do not have to pay Zakah.

3.6.3 Recommended Forms

Recommended forms of social responsibility refer to those complementary actions that gobeyond the mandatory requirements and are done purely voluntarily based on the capacity of

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the IFI to undertake such activities. This is in line with the Islamic vision of spreading Islamicjustice and mercy through all facets of an individual’s life and consequently all aspects of theIFI’s operation. Similar to personal prescription to conduct oneself with al-rifq (gentleness),husn al-khulq (pleasant speech and conduct), and ihsan (fair dealing), such conduct would leadto the voluntary attainment of refinement and excellence in all aspects of the IFI’s conduct.

The categories are self-explanatory and are founded on Quranic principles.

3.6.3.1 Qard Hasan

Qard Hasan is the only type of loan recognized in Islam. Allah refers to it in the Quran:

Who is it that will give Allah a gratuitous loan (Qard Hasan), which Allah will double into hiscredit and multiple many times?26

It is a gratuitous loan given to needy people for a fixed period. The recipient is only requiredto repay the principal. As a financial intermediary, the IFI is in a special position in society toencourage Qard Hasan activities from within its operations and with its clients and customers.For instance, IFIs can open special Qard Hasan accounts through which deposits can bereceived, which would then be transferred to needy clients, such as those unable to pay theirdues to IFI or newly married couples unable to purchase household items, or students unable toget an education as a result of financial hardship. IFIs can run special fund raising campaigns toincrease their Qard Hasan funding with minimal marginal expenditure through their existinginfrastructures.

3.6.3.2 Environmental Considerations

As vicegerents of Allah in earth, Muslims are accountable to Him to protect and preserve whathas been entrusted to them (amanah). Destruction of or damage to the physical environment,if it is considered harmful to the interests of the individual or the society at large, is prohibitedin Islam. Indeed, it is necessary for every individual to ensure that their actions have minimalenvironmental consequences. As a trustee of several contracting parties, including individualsand organizations who deposit or invest their money with the IFI, the IFI has a responsibilityto ensure that any harmful investments are avoided and that the IFI actively promotes, throughinvestment quotas, projects that have a beneficial impact on the environment. IFIs for instancecould re-direct funds from the consumable energy sector to projects that increase the capacityfor renewable energy utilization.

3.6.3.3 Screening Clients and Contractors (Additional Criteria)

Depending on their bargaining power with clients, contractors, and infrastructure capacity, IFIscan both screen and negotiate terms with clients and contractors to ensure that their activitiescomply with Islamic principles as contained in the mandatory section of the proposed standard.For instance, they can ensure that clients’ and contractors’ businesses do not associate withother contractors that support or engage in activities such as usury (riba), alcohol, gambling(maysir), extreme uncertainty (gharar), and tobacco or arms production. Further, IFIs can alsoensure that contractors treat their employees to the standard applied in the IFI itself. This isconsistent with Islamic accountability and allows for IFIs to enjoin good and forbid evil to thefullest extent of their capacity.

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3.6.3.4 Industry-Wise Investment Quotas

In line with its responsibility to enjoin good and forbid evil on a macro-financial scale, IFIsare able to implement policies to ensure that investments are directed towards those industriesthat are most beneficial to economic development and are also aligned to Islamic principles ofsocial equity and distributive justice. IFIs have a special financial position whereby they areentrusted with funds from individuals and other organizations. They are also able to utilizeeconomies of scale to invest in ventures that lead to socio-economic development throughmaximum and intensive utilization of unskilled and skilled labour. For instance, investment inagriculture technologies or the manufacturing or service sector companies (e.g. call centres)can increase the level of formal salaried employment. This does not preclude the fact that IFIswill invest in such industries based on the underlying economic rationality of the particularventure/project, not on altruism.

3.6.3.5 Social Impact-Based Investment Quotas

Since IFIs have a special financial position (because of their diversification capabilities andeconomies of scale), they are able to invest in industries that produce social, cultural, orreligious development in line with Islamic ideals. IFIs can set aside a portion of their investmentquota as a target for increasing investments in social impact-based projects. Individual researchundertaken by the IFIs could lead to an appreciation of the particular projects that have thegreatest social impact. For instance, positive NPV investments in projects such as integratedvalue-based educational facilities can be classified as social impact-based investments. Again,this does not preclude the fact that IFIs will invest in such projects based on the underlyingeconomic rationality of the particular venture/project, not on altruism.

3.6.3.6 Par Excellence Customer Service

Islamic ideals of justice and brotherhood imply a treatment of all human beings with dignityand respect.27

To that extent, an IFI should require its agents (employees and contractors) to provide thebest service possible to its clients and customers, regardless of their societal status, financial orotherwise. IFIs should utilize performance measures and incentives to encourage employeesto behave with the best of manners between each other and with clients and customers.

3.6.3.7 Micro and Small Sized Business and Social Savings and Investments

A key principle of Islam in achieving its ideal of redistributive justice is the support andempowerment of the weak. Indeed, numerous verses of the Quran point to the assistance of theweak (in education, economic, and family affairs).28 This can be achieved most significantlythrough the financial empowerment of family units in the lowest echelons of society. IFIscan also make profitable divisions serving this class of clients, particularly because existingexamples of conventional micro-credit IFIs are very successful (for instance, Grameen Bank).

3.6.3.8 Employee Welfare (Extension)

As previously stated in the mandatory section, employees should be treated on the basis ofthe principle of brotherhood in Islam and justice. This requires some mandatory acts to be

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definitely carried out; examples of these include pay/salary guarantees, equal opportunity, andlack of discrimination. Beyond this, there is encouragement to create provisions for thoseclasses/segments of society that require it. This may include special provisions for minorityraces, the disabled, and flexible hours for mothers.

3.6.3.9 Charitable Activities

Numerous verses of the Quran encourage Muslims to give charity.29 As a representativeIslamic organization, it is recommended that IFIs also give charity to the fullest extent oftheir capacity. With minimal financial outlay, IFIs are able to create charity accounts and fundraising drives for charity from customers and clients to complement their banking operations.Awqaf (religious endowment) is a vital part of Islamic infrastructure due to the crucial Islamicservices their revenues provide. Because IFIs already have the technologies to provide efficientfinancial intermediation, they can play an important role in securing revenues from Awqaf anddistributing them to the specified charitable causes, with minimal marginal outlay.

3.7 DISCLOSURE AS A MEANS OF ACCOUNTABILITY

Disclosure is a crucial aspect of the accountability function of an IFI to its stakeholders. Theother such accountability function is the Shariah Supervisory Board. However, the ShariahSupervisory Board often cannot disclose all social responsibility duties. Hence, it shoulddisclose as much information as possible in a succinct, truthful, and understandable mannerto its stakeholders.

From an Islamic perspective, the main objective of corporate reporting that overrides otherobjectives is to allow Islamic enterprises to show their compliance with Shariah (Baydounand Willett, 1997). The implication of this objective is that IFIs have a duty to disclose allinformation necessary to their stakeholders about their operations, even if such information isadverse to the IFIs’ interest (Maali, Casson, and Napier, 2006). This is derived from the divineduty of accountability that each Muslim bears.30

As representative organizations, IFIs have a duty to disclose their compliance with theprinciples and laws of Islam to stakeholders. This is because the stakeholders (Muslim orotherwise) have a relationship or are represented in some form or manner by IFIs even if theIFI has no direct contractual relationship with the individuals. As Maali et al.31 explain, “therequirement for Muslims to uncover the truth is intended to help the community to know theeffect of a person or a business on its well being” (p. 273). It is this social dynamic that makesit essential that IFIs disclose all relevant information truthfully to their Islamic stakeholders.

Maali et al. (2006) categorize three broad objectives that are used as the basis for socialresponsibility disclosures by Islamic businesses:

1. To show compliance with Islamic principles and laws, in particular dealing justly withdifferent parties.

2. To show how the operations of the business have affected the well being of the Islamiccommunity.

3. To help Muslims to perform their religious duties.

In addition to the obligatory objectives of disclosures, disclosures also fulfil an importantrole in achieving the educational (tadhib al fardh) objective of the Shariah. The promulgationas of 1 January 2010 of the Accounting and Auditing Organization for Islamic Financial

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Institution (AAOIFI) voluntary Governance Standard Number 7 on CSR has come a long wayto requiring such disclosures of financial institutions.

3.8 LESSONS FROM CURRENT SOCIALLY RESPONSIBLEBUSINESS PRACTICES

CSR amongst global financial institutions and others is an established global practice.However, these efforts have received much criticism because of their PR/economics drivenmotives. Regardless of the question of IFI motives, billions of dollars are spent annually insupport of socially responsible initiatives, serving as the lifeline for many social initiativessuch as low-income housing, food shelters, medical assistance, schools, etc. Through the pastfew decades, the developed process of CSR has also defined effective policies and programmesthat support environment, employee, partner, supplier, and other rights.

Given the sophistication of the existing CSR processes, benchmarking tools, and operations,there is much that can be learned from and perhaps improved upon.

Wal-Mart, the world’s largest retailer, has recently introduced a groundbreaking SustainableProduct Index to measure the sustainability of products for the first time.32 It will begin witha survey of its more than 100 000 suppliers around the world with questions focusing on fourareas: energy and climate, material efficiency, natural resources, and people and community.This unprecedented initiative by the world’s largest retailer speaks to the role a highly influentialorganization (ability-based) can play in directing good actions across the global suppliernetwork. This initiative is bound to take current social responsibility efforts to further maturity.

Socially Responsible Investing or ethical investing is another social business practice whereinvestment strategies seek to maximize both financial return and social good. In the US alone,the Social Investment Forum’s 2007 Report on Socially Responsible Investing Trends identified$2.71 trillion in total assets under management based on the three core socially responsibleinvesting strategies – screening, shareholder advocacy, and community investing.33 There isindeed much commonality here with Shariah-compliant investing. The Islamic Investmentcommunity should certainly expand its domain to engage in and lead in this global trend.

Social Entrepreneurship is also a fast growing trend where businesses focus on areas thathave societal impact. Microfinance institutions such as Kiva and Grameen are great examplesof such for-profit social businesses. Grameen Bank, although based on conventional financestructures, is a great example of profitable ventures that address much-neglected social needs.According to B Lab, a non-profit organization that certifies these purpose-driven companies,there are more than 30 000 such social enterprises, together representing some $40 billion inrevenue.34

Within the Islamic finance industry, the first 2009 Social Responsibility Survey of IslamicFinancial Institutions by DinarStandard/Dar Al Istithmar showcased IFIs’ limited emphasison social responsibility beyond the core aspect of their business model (emphasis on sharingrisk, avoiding riba and gharar).

3.8.1 Key Lessons from Current Practices

Conventional CSR practices today serve as great models in campaign development, programmemanagement, general methodologies, processes, and practical implementation. Conversely, asdiscussed earlier, the misalignment of their motives and drivers with a business’s priorities arekey shortcomings that need to be addressed.

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Islamic concepts of a business’s justice and responsibility-driven purpose offer a practicalmodel with which IFIs can align their social responsibility efforts. However, the key short-comings are the lack of existing processes, methodologies, and examples upon which to basethis perspective. It is here that the IFIs can learn and greatly benefit from their conventionalcounterparts.

An example is that of HSBC Amanah, an Islamic finance subsidiary of a conventionalglobal bank, HSBC. Its social responsibility efforts are greatly benefiting from its conventionalcounterparts’ extensive experience in this area. HSBC Amanah has set itself goals to reduceelectricity, waste, water, and CO2 emissions based on existing mature initiatives of the parentbank. They are developing proactive investment strategies for renewable energy sources andfor waste management opportunities for more effective waste mitigation. Similarly, they arelooking at ways to create access to the capital markets for forest operators and, in return,enable them to monetize future cash flows. In water financing, its projections forecast that,from 2006 to 2025, the world will need to spend between $1.8 trillion and $3 trillion oninstalling, operating, and maintaining water and sewage facilities. Due to the potential lack ofavailable funding, there will be a potential shortfall of between $1.3 trillion and $2.4 trillion,which means private sector financing is very significant.

With its conventional parent’s experience in such financing, HSBC Amanah is in a positionto evaluate such opportunities that will not only include large-scale investment from a financialpoint of view but will also provide opportunities with several underlying technologies, such asfiltration membranes, disinfection systems, information technology for water utilities, waterpumps, and pipes.

3.9 CONCLUDING THOUGHTS

This chapter presents a holistic perspective on integration of social responsibility within IFIsand issues for the conventional finance community to consider as well.

There is a critical need for financial communities to address social responsibility effectivelyas they hold much leverage in the global economy and in society. The developing ethicalinvesting and social entrepreneurship trends, as well as Islamic finance’s responsibility-centricbusiness purpose, offer much hope for the financial community to profitably take a leadershiprole in social business responsibility.

For Islamic Financial Institutions, the recommended realignment of their business pur-pose with social responsibility obligations may seem impractical to some. However, it is theresponsibility of its practitioners to be true to the spirit of its Islamic identity, as discussedabove. This should not be viewed as a business-limiting approach, but as an opportunity toredefine leadership within the global financial community and to address humanity’s socialchallenges profitably.

NOTES

1. The World Bank, “Crisis Hitting Poor Hard in Developing World, World Bank says”The World Bank Group News, available at: http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:22067892∼pagePK:64257043∼piPK:437376∼theSitePK:4607,00.html. Accessed 1 March 2010.

2. See S. Sairally (2005) Evaluating the “Social Responsibility” of Islamic Finance: Learningfrom the Experiences of Socially Responsible Investment Funds. Paper presented at the

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6th International Conference on Islamic Economics and Finance: Islamic Economics andBanking in the 21st Century, 21–24 November 2005, Jakarta, Indonesia.

3. A.Y. Ali (1989) The Holy Qur’an: Text, Translation and Commentary, Amana Corporation:Maryland, Washington Surat Al Nisa (Women) verse 86.

4. Ibid, Surat Al Zalzala (The Earthquake), verse 7-8.5. One who submits to the will of Allah.6. Ali, above n. 4, Surat Tawba (The Repentance), verse 71.7. M.H. Kamali (1989) Sources, nature and objectives of Shari’ah, The Islamic Quarterly,

215–35 at 216.8. Ibid.9. What is nevertheless clear is that the responsibility of a human being, while being a fluid

concept that surrounds itself around the human’s being life and his activity, is centred onimplementing justice in his life. What is desirable and what is not desirable must be drivenby a consideration of the justice paradigm outlined. In the individual’s context, justice asdiscussed would refer to every aspect of the individual’s life as the Prophet (PBUH) hasarticulated himself, when he was asked where someone with limited means can derivesomething to give to charity when that person has nothing material to give: “Indeed thegates to goodness are many: glorifying God, praising Him, magnifying Him, saying ‘Thereis no god but Allah,’ enjoining the good and forbidding the wrong, removing (any sourceof) harm from the road, making the deaf hear (and understand), guiding the blind, showingthe seeker his need, striving as far as your two legs could carry you and with deep concernto give succor to him who asks, carrying with the strength of your arms (the burdens of)the weak. All these are (acts of) charity.” And he added, “And your smiling in the face ofyour brother is charity, your removing of stones, thorns, and bones from people’s paths ischarity, and your guiding a man gone astray in the world is charity for you.” The Prophet(PBUH) is therefore articulating a set of principles that could be applied as rules or normsof conduct to this day and age.

10. M.I.I. Al-Bukhari (1980) The English Translation of Sahih, Al Bukhari With the ArabicText, Lebanon: Al Sadawi, Publications, Vol. 2, Hadith 524.

11. “On no soul does Allah Place a burden greater than it can bear.” Ali, above n. 5, Surat AlBaqarah (The Heifer), verse 286.

12. Asyraf Dusuki and Abdullah Nurdianawati (2007) Maqasid al-Shari’a, Maslahah andcorporate social responsibility, The American Journal of Islamic Social Sciences, 24(1)25–45.

13. Ibid.14. A. Al-Raisuni (1992) Nazariah al-Maqasid ‘inda al-Imam al Shatibi, Dar al-Alamiyah

Kitab al-Islami: Riyadh, pp. 41–5.15. Kamali, above n. 11.16. Ibid.17. M.U. Chapra (2000) The Future of Economics: An Islamic Perspective, The Islamic

Foundation: Leicester, p. 118.18. Fard Kifayah refers to a collective religious duty which, if performed by some, would

exempt others from performing it. However, if it is not performed by any, the entirecommunity is sinful.

19. Ali, above n. 4, The Livestock (Surat Al-Anaam) 165.20. Kamali, above n. 11.21. Ibid.

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22. Ali, above n. 4, Surat Al Baqarah (The Heifer), verse 280.23. For an in-depth analysis of the substantive intuition behind Islamic laws and their place in

the development of Islamic premodern laws, please see El-Gamal (2006) Islamic Finance:Law, Economics and Practice, Cambridge University Press: New York.

24. Ibid., Surat Al Hujraat (The Apartments), verse 10.25. Trevor Gambling and A.A. Karim Rifaat (1991) Islam and Social Accounting, Mansell.26. Ali, above n. 4, Surat Al Baqarah (The Heifer), verse 245.27. Surant Al Mumenoon (The Believer), verse 52, Surat Al Anbiya (The Prophets), verse

52, Surat Al Hujraat (The Apartments), verse 10. Indeed manners are emphasized as themost important attribute of an individual’s Islamic character as emphasized by the ProphetMuhammad (PBUH):

“The best amongst you are those who have the best manners and character.” Translationof Sahih Bukhari, Virtues and Merits of the Prophet (pbuh) and his Companions, Vol. 4,Book 56, Number 759.

28. For instance, Ali, above n. 4, Surat Al Baqarah (The Heifer), verse 273 or Surat An-Nisa(Women), verse 436.

29. For instance, Ali, above n. 4, Surat Al Baqarah (The Heifer), verses 43, 110, 177, 273,283.

30. However, this is not to say that Allah needs to know through disclosure the activities ofthe IFI. Indeed, Allah knows and hears everything and is omniscient: “I know what youreveal and I know what you hide” and also,

“He knows what is manifest and He knows what is hidden.” Surah Al-Ala (The MostHigh), verse 7.

31. N.B. Maali, P. Casson, and C. Napier (2006) Social reporting by Islamic banks, Abacus,42(2) 266–89.

32. http://walmartstores.com/factsnews/newsroom/9277.aspx.33. http://www.socialinvest.org/pdf/SRI Trends ExecSummary 2007.pdf.34. http://images.businessweek.com/ss/09/04/0403 social entrepreneurs/index.htm.

REFERENCES

Ali, A.Y. (1989) The Holy Qur’an: Text, Translation and Commentary, Amana Corporation: Maryland,Washington.

Al-Bukhari, M.I.I. (1980) The English Translation of Sahih, Al Bukhari With the Arabic Text, Lebanon:Al Sadawi, Publications, Vol. 2, Hadith 524.

Al-Raisuni, A. (1992) Nazariah al-Maqasid ‘inda al-Imam al Shatibi, Dar al-Alamiyah Kitab al-Islami:Riyadh, pp. 41–5.

Baydoun, N., and Willett, R. (1997) Islam ethical issues in the presentation of financial information,Accounting, Commerce and Finance: The Islamic Perspective Journal, 1(1).

Chapra, M.U. (2000) The Future of Economics: An Islamic Perspective, The Islamic Foundation:Leicester.

Dusuki, A.W., and Abdullah, N.I. (2007) Maqasid al-Shari’a, Maslahah and corporate social responsi-bility, The American Journal of Islamic Social Sciences, 24(1) 25–45.

El-Gamal, M.A. (2006) “Islamic Finance: Law, Economics and Practice”, Cambridge University Press,New York.

Gambling, T. and Karim, R.A.A. (1991) Islam and Social Accounting, Mansell.Kamali, M.H. (1989) Sources, nature and objectives of Shari’ah, The Islamic Quarterly, 215–35.Maali, B.M., Casson, P., and Napier, C. (2006) Social reporting by Islamic banks, Abacus, 42(2), 266–89.

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Mirakhor, A. (2007) A Note on Islamic Economics IDB Prize Winner’s Lecture Series No. 20, IslamicDevelopment Bank: Jeddah.

Sairally, S. (2005) Evaluating the “Social Responsibility” of Islamic Finance: Learning from the Experi-ences of Socially Responsible Investment Funds. Paper presented at the 6th International Conferenceon Islamic Economics and Finance: Islamic Economics and Banking in the 21st Century, 21–24November 2005, Jakarta, Indonesia.

Smith, A. (1776) The Wealth of Nations.

FURTHER READING

Dar, H. (2002) Islamic house financing in the United Kingdom: problems, challenges and prospects,Review of Islamic Economics, 12, 47–71.

Farook, S.Z. (2004) Determinants of corporate social responsibility disclosure: the case of Islamic banks,Honours Thesis, University of Technology, Sydney.

Freedman, M. (1967) Capitalism and Freedom, The University of Chicago Press: Chicago.Hallaq, W.B. (2004) A History of Islamic Legal Theories: An Introduction to Sunni Usul Al-Fiqh

(Cambridge University Press: Cambridge).Haron, S., and Hisham, B. (2003) Wealth Mobilization by Islamic Banks: The Malaysian Case. Paper

presented at the International Seminar on Islamic Wealth Creation, 7–9 July 2003, University ofDurham, United Kingdom.

Kamali, M.H. (1989) Principles of Islamic Jurisprudence, Pelanduk Publications: Petaling Jaya,Malaysia.

Obaidullah, M. (2007) Fighting poverty in Islamic societies, Islamic Banking and Finance Review, 3(2),1–6.

Shihaddeh, S. (1987) “Financial Accounting Theory from an Islamic perspective” Al-Zahraa [In Arabic].

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90

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4

The Dispute Resolution Framework forthe Islamic Capital Market in Malaysia:

Legal Obstacles and Options

Umar A. Oseni* and M. Kabir Hassan**

4.1 INTRODUCTION

With the growing global awareness of Islamic banking and finance products and the needto explore alternative modes of investment and securities, the Islamic capital market nowcommands increasing global attention in both developed and developing countries across theworld. The recent global financial meltdown has led the stakeholders in global finance to otheralternative modes which may contribute to global financial stability. The world has come tounderstand and appreciate the significance of Islamic finance in the global financial system.Therefore, the Islamic capital market is a significant option to financial products and servicesin the modern international markets (Ali, 2008).

This recognition has encouraged the steady growth of new products as well as efforts atdevelopment and promotion. The establishment of the Dow Jones Islamic Market Index and theFTSE Global Islamic Index Series is testimony of the international recognition of the tremendouspotential represented by the Islamic capital market.1

Islamic bonds were first issued successfully in 1983 by the Malaysian Government whenthe Government Investment Issue or GII (formerly known as the Government InvestmentCertificate or GIC) was issued (OICU-IOSCO, 2004).

The expansion of Islamic banking and financial services has opened more vistas for fur-ther research in the legal framework regulating the products emanating from the sector. Thetremendous growth in the global share index of Islamic bonds (sukuk) may invariably triggeran increase in the number of disputes within the industry. This chapter examines the needfor an appropriate legal framework for resolving disputes that may arise among the marketparticipants. Disputes usually arise among operators and investors, investors and the commis-sion, operators and the commission, and even among the investors themselves.

Due to the unique nature of the Islamic capital market, the legal framework must includeboth the dispute resolution aspect as well as the dispute avoidance mechanism to regulate thematrixes of the financial products in the market. This research focuses on the Islamic capitalmarket in Malaysia which is a pioneering model in the modern world. It is argued that theregulatory matrix must totally comply with the Shariah principles especially issues of disputeavoidance and resolution. In the light of the spirit of the Capital Market and Services Act 2007


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of Malaysia, there is need for an appropriate system for the settlement of disputes “to promoteand maintain a fair, efficient and orderly capital market” (section 379 of the Act). Bearing this inmind, what body should have competent jurisdiction in the Islamic capital market transactionsfrom the Islamic legal perspective? This question as well as other incidental matters constitutethe centre of gravity of this chapter.

It is axiomatic to observe that the Islamic capital market is a fast growing area which hasattracted the attention of many researchers. However, despite the fact that a good number ofresearch works have been produced in this field, much remains to be done to fill some importantgaps which touch on the legal framework and core institutions (Ali, 2008). Therefore, in orderto cover the field and fill the necessary gaps, this research focuses on the need to have aShariah-based dispute resolution framework for cases arising from the Islamic capital markettransactions. This is necessary to enhance the development of the market.

4.2 THE LEGAL FRAMEWORK OF THE ISLAMIC CAPITALMARKET IN MALAYSIA

The Islamic capital market (ICM) is an integral part of the Islamic financial system. It canbe recalled that the Islamic financial system has three major components – Islamic banking,Islamic insurance (Takaful) and the Islamic capital market. The ICM provides long-termfunding and investment which enhances the liquidity of the Islamic financial system. Withoutdoubt, the ICM has become a substantial part of the global financial market due to the increasinginterest in it as a viable alternative model of financial intermediation in the modern world (Cox,2004). As an important contributor to the economic growth, the ICM is a component of theCapital Market in Malaysia. The Securities Commission identified the need to develop theICM as part of the development of the Malaysian Capital Market. This was incorporated intothe Malaysian Capital Market Masterplan which was launched on 22 February 2001 withthe major objective of making Malaysia an international ICM centre (Securities Commission,2001 and 2007).

The ICM is regulated by certain legislations which are primarily aimed at regulating theprocedures for operations. There are three key aspects covered by the legal framework ofthe ICM as identified by Hassan and Yusoff (2009) which are the regulatory authorities,legislations, and the regulatory framework of operations. In this chapter, we shall focus on thelegislations and regulatory frameworks to streamline the operations of the ICM in Malaysiawhich will serve as a leading model for other markets across the world (Mahmood, 1996).As a leading figure in the world’s ICM, Malaysia has enabling legislations, guidelines, rules,and practice notes to regulate the ICM in the country. These are made pursuant to the powersconferred on the Securities Commission of Malaysia by the Capital Markets and Services Act2007 (Act 671). It is however important to add that the Securities Commission is the mainregulatory body of the Capital Market in Malaysia (Low, 2001).

4.2.1 Relevant Legislations Regulating ICM in Malaysia

A number of legislations directly and indirectly regulate the ICM in Malaysia. One cannotdiscuss the legal framework of ICM without making reference to the legislations. Therefore,the relevant legislations include Capital Markets and Services Act 2007 (Act 671), SecuritiesCommission Act 1993 (SCA), Banking and Financial Institutions Act 1969 (BAFIA), and theIslamic Banking Act 1983 (IBA). These legislations are each significant to the Malaysian ICM

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The Dispute Resolution Framework for the Islamic Capital Market in Malaysia 93

in one way or the other. It is apposite to dedicate separate discussions to each of the laws inorder to establish their areas of convergence and how they concurrently regulate the ICM.

4.2.1.1 Capital Markets and Services Act 2007 (Act 671)

The purpose of the CMSA as set forth in its preamble is the enactment of “[a]n Act toconsolidate the Securities Industry Act 1983 [Act 280] and Futures Industry Act 1993 [Act499], to regulate and to provide for matters relating to the activities, markets and intermediariesin the capital markets, and for matters consequential and incidental thereto”. Before the cominginto force of the CMSA in 2007, the securities legislations in Malaysia comprised of thefollowing four principal pieces: the Securities Industry Act of 1983, the Securities Industry(Central Depositories) Act of 1991, the Securities Commission Act of 1993, and the FuturesIndustry Act of 1993. These legislations were consolidated in the CMSA in 2007 therebyproviding for a one-stop comprehensive legislation to regulate the Malaysian Capital Market.Meanwhile, there is no separate legislation for the ICM in Malaysia. All incidental mattersrelating to the ICM which include the Islamic securities and the issuance of Islamic bonds areall provided in the CMSA.

“The introduction of the CMSA marks significant enhancements in the Malaysian capitalmarket regulation by providing effective measures for investor protection, market integrityand the stability of the marketplace” (Hassan and Yusoff, 2009). Section 379 of the CMSAprovides for the settlement of disputes in order “to promote and maintain a fair, efficientand orderly capital market” which undoubtedly includes the ICM. Pursuant to this landmarkprovision, Schedule 10 of the Act empowers the Securities Commission to make necessaryregulations, with the approval of the Minister, on a number of regulatory issues in the CapitalMarket. The relevant provision in the Schedule is contained in paragraph 38 which empowersthe Commission to make necessary regulations that provide “for all matters relating to thesettlement of disputes involving securities, future contracts, or involving clients of a holderof a Capital Markets Services Licence”. It is important to emphasize that since the MalaysianCapital Market now operates a fused system of both the conventional and Islamic securitiesunder the same roof but with different frameworks, all relevant provisions in the CMSArelating to the regulatory framework of the Malaysian Capital Market include the ICM.

Another interesting requirement introduced in the CMSA is a fundamental provision inSection 38 of the Act which provides for the power of the Securities Commission to approvea clearing house. Section 38(2)(d) of the Act provides that the rules of the proposed clearinghouse must set out provisions for a quick and fair method of settling disputes between –

(i) the clearing house and its participating organizations or affiliates; and(ii) those participating organizations or affiliates and their clients.

This is very important because delays in the court system through protracted cases thatlinger on for many years as well as the stringent rules and procedures in modern arbitralproceedings may be detrimental to the credibility and creditworthiness of the clearing house.So, it is expedient for the stakeholders in the ICM to begin to think of some Shariah-basedprocesses of dispute resolution to emphasize the functionality of the Islamic legal solution tocases emanating from all sectors of the ICM (Kahf, 2000). In a bid to further streamline theprocess of dispute resolution with regard to court referrals to the Shariah Advisory Council ofthe Securities Commission, some amendments were introduced in the CMSA 2007 with theenactment of the Capital Markets and Services (Amendment) Act 2010 (Act A1370) whichcame into force on 1 April 2010.2

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4.2.1.2 Securities Commission Act 1993

The phrase “Securities Commission Act 1993” is mentioned twelve times in the CMSAas a complementary Act. This establishes the nexus between the CMSA and the SecuritiesCommission Act 1993 (SCA) which is further reinforced by the saving provisions in Section386(1) of the CMSA. The SCA (Act 498) as amended in 1998 is a general Act that provides forthe establishment of the Securities Commission and matters connected therewith and incidentalto the day-to-day functions of the Commission as a key regulatory body of the Capital Marketin Malaysia. The Act has seven parts which include the preliminary provisions, SecuritiesCommission, Finance, Issues of Securities and Takeovers and Mergers, Enforcement andInvestigations, General provisions, and Repeal and Transitional provisions.

The Securities Commission has the powers to regulate all matters in the Malaysian CapitalMarket. Section 15 of the SCA clearly provides for the powers of the Commission whichinclude powers to regulate all matters relating to securities and futures contracts; ensure thatthe provisions of the securities laws are complied with; regulate the mergers and takeovers ofcompanies; regulate all matters relating to unit trust schemes; be responsible for supervisingand monitoring the activities of any exchange, clearing house, and central depository; takeall reasonable measures to maintain the confidence of investors in the securities and futuresmarkets by ensuring adequate protection for such investors; promote and encourage properconduct amongst members of the exchanges, clearing houses, central depository, and alllicensed persons; consider and make recommendations for the reform of the law relating tosecurities and futures contracts; and encourage and promote the development of securities andfutures markets in Malaysia including research and training in connection thereto (Low, 2001).It is however part of the inherent powers of the Commission as now provided for in Section379 of the CMSA to make necessary regulations for the settlement of disputes among the keyplayers in the Malaysian Capital Market. This is implied in the powers of the Commission asenumerated in Section 15 of the SCA.

4.2.1.3 Banking and Financial Institutions Act 1989 and the Islamic Banking Act 1983

The Banking and Financial Institutions Act 1989 (Act 372) is a Central Bank of Malaysiaadministered piece of legislation which is an Act to provide new laws for the licensing andregulation of institutions carrying on banking, finance company, merchant banking, discounthouse, and money-broking businesses; for the regulation of institutions carrying on certainother financial businesses; and for matters incidental thereto or connected therewith. On theother hand, the Islamic Banking Act 1983 (Act 276), which is also a Bank Negara Malaysiaadministered piece of legislation, provides for the licensing and regulation of Islamic bankingbusiness in Malaysia. The relevance of these two important Acts to the Malaysian ICMis beyond doubt because the financial institutions licensed under them are considered as“registered persons” legally permitted to deal with the capital market services. This permissionis given in Section 76 and Schedule 4 of the CMSA. According to Hassan and Yusoff,

the CMSA also allows the relevant institutions to act in the capacity of principal advisors forcertain types of corporate proposals under Part VI of the CMSA, subject to the approval of theSecurities Commission. Investment banks that hold (sic) a merchant banking licence issued byCentral Bank of Malaysia under the BAFIA as well as Capital Markets Services licence issuedby the Securities Commission under the CMSA have the right to offer a full scope of integratedcapital market and financial services which include corporate finance, debt securities trading anddealing in securities. (Hassan and Yusoff, 2009)

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The implication of the wide spectrum of the nature of business of Islamic banks andfinancial institutions, which is recognized by the CMSA, proves the interdependence of thethree sectors in Islamic financial services – Islamic Banking and Finance, Takaful, and theICM. This is the universal nature of Islamic financial services (Abdullah, 1997). To this end,all the laws regulating Islamic financial services in Malaysia which includes the ICM providethat the products, principles, and procedures to be adopted in carrying out relevant businessmust comply with the Shariah and must be approved by the Shariah Supervisory Councils.It is however the aim of this research to further argue that to achieve this great feat, it isnecessary for the Shariah Supervisory Councils to pass binding resolutions for the creationof a proper legal framework for the settlement of disputes from the ICM as part of beingShariah-compliant.

4.2.2 Guidelines and Practice Notes

The guidelines issued by the Securities Commission of Malaysia are specifically meant toadminister and regulate the ICM in the country. They are issued pursuant to Section 377 of theCMSA and are meant to clarify and interpret relevant provisions of the law as well as relevantrules related to the ICM. Policy decisions are also expressed through the guidelines whichare meant to be followed by the key players in the ICM (Hassan and Yusoff, 2009). Someof the important guidelines that have been issued by the Commission in respect of particularprovisions of the CMSA that relate to ICM include:

1. Guidelines on the Offering of Islamic Securities2. Guidelines on Islamic Fund Management3. Guidelines for Islamic Real Estate Investment Trusts4. Guidance Note on the Secondary Trading of Foreign Currency-denominated Debentures

and Foreign Currency-denominated Islamic Securities

4.2.2.1 Practice Notes

Practice Notes give further directions on the application of the guidelines. A number ofPractice Notes have been issued by the Malaysian Securities Commission. Practice Note 1 ison the application of the guidelines on the offering of Islamic securities to the issue of, offerfor subscription or purchase of, or invitation to subscribe for or purchase, foreign currency-denominated Islamic securities. It was revised on 15 September 2005. Furthermore, PracticeNote 2 was issued on 10 November 2004 which covers the application of the Guidelines onthe Offering of Islamic Securities to the Issue, Offer or Invitation of Ringgit-denominatedIslamic Securities by a Multilateral Development Bank or Multilateral Financial Institutionin Malaysia. Pursuant to the guidelines on the offering of Islamic securities and the PracticeNote 2, Practice Note 2A was issued on 23 March 2006 on the application of the Guidelines onthe Offering of Islamic Securities to Foreign Governments and Agencies or Organisations ofForeign Government. This was followed by the issuance of the Practice Note 3 on 12 December2005 on the application of the Guidelines on the Offering of Islamic Securities to the Issuanceof Islamic Negotiable Instruments with Original Tenures of More Than Five Years. Followingsuit is Practice Note 4 issued on 24 April 2006 on the application of the Guidelines on theOffering of Islamic Securities to an Issuance of Islamic Commercial Papers or a Combinationof Islamic Commercial Papers and Medium Term Notes. These Practice Notes were madepursuant to the Guidelines to streamline the practice and procedure of ICM.

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4.3 THE NATURE OF DISPUTES AMONG MARKET PLAYERS

A number of judgments were handed down by the English courts in 2009 which involvedcases on jurisdictional issues that have arisen on disputes over capital market transactions. Ina similar vein, the courts are now receiving cases from the Malaysian Capital Market. Someof the very recent cases that are directly or indirectly related to transactions in the MalaysianCapital Market include PB Securities Sdn Bhd v Lee Kwee Heng3 and BSNC CorporationBhd v Ganesh Kumar Bangah,4 the dominant effect of which may be experienced sooner orlater in the ICM. This argument is supported by the fact that Islamic banking and financeproducts are already being litigated in the High Court in Malaysia. Therefore, where thereis inconsistency in the transaction document or in a situation where such document is silentabout a particular procedure, the parties must be able to have recourse to a competent authorityfor the interpretation, clarification, or resolution of the issue outside the courtroom.

The nature of disputes in the ICM falls under the category of regulatory issues which mustbe addressed by the stakeholders. Generally, regulation of issues of this kind has been a thornyaffair in most jurisdictions across the world where Islamic banking and finance products arein vogue. One of the most important regulatory issues, apart from deciding whether a productis Shariah-compliant or not, is whether disputes in the ICM transactions should be referredto the Shariah courts rather than the civil courts or alternative means of dispute resolution.It is believed that in order to ensure clarity, certainty, and the ease of doing business, thereis need for a modicum of regulation in the ICM. This does not to suggest stripping themarket players of their freedom of contract which is crucial in the development of Islamicfinancial products.

With the tremendous growth in the ICM and its resilient attitude through the rough watersof the global economic meltdown, it is important to examine briefly the nature of foreseeabledisputes in the industry with a view to proposing cost-efficient, timely, credible, reliable, andvaluable alternatives to the current framework for the resolution of disputes (Rose, 2005).Meanwhile, after scanning the available case law on Islamic banking, finance, and the ICMin Malaysia, one discovers that the products in the ICM have not be sufficiently tested in thecourts of law but the increasing interest in the ICM is likely to give rise to few disputes in thenear future. The stakeholders must be proactive in proposing an alternative legal frameworkfor both dispute avoidance and dispute resolution.

The nature of disputes in the Malaysian Capital Market envisaged in Section 379 of theCMSA includes disputes in ICM transactions. The nature of such disputes includes disputesbetween the holders of a Capital Markets Services Licence who carry on the business ofdealing in securities; disputes between the holders of a Capital Markets Services Licencewho carry on the business of trading in futures contracts; disputes between a participatingorganization and a stock exchange; disputes between an affiliate and a futures exchange;disputes between a participant and an approved clearing house; disputes between an affiliateand an approved clearing house; disputes between a holder of a Capital Markets ServicesLicence and its clients; or disputes between persons involved in a Capital Market transaction.As part of the regulatory role of the Securities Commission and in order to promote a fair,efficient, and orderly market, it has some powers under the law to make relevant regulationsto regulate the Malaysian Capital Market. Since cases of this nature which may emanate fromthe ICM may be considered as sui generis,5 they should not go to the normal civil courts.In a similar vein, we doubt whether the Shariah courts will be able to handle such mattersbecause the jurisdiction of the court is largely restricted to Islamic personal matters which do

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not necessarily include Islamic financial transactions. This explains the need for an alternativelegal framework to ensure better performance in the ICM (Kada, 2008).

4.4 CONSTRAINTS AND CONCERNS OVER THE CURRENTLEGAL FRAMEWORK

The current legal framework for dispute resolution in the Malaysian ICM is not favourableto the development of more Islamic financial products. Legal bottlenecks and vacuums insome instances have appeared as stumbling blocks to the amicable resolution of disputes. Wehave identified some challenges facing the legal framework of the ICM in relation to disputeresolution. Some of the challenges in the current legal framework include the superimpositionof the jurisdiction of the High Court on disputes arising from the Capital Market transactions,failure to provide for Shariah dispute resolution for Shariah-compliant products, and theinadequacy of existing legal reforms.

4.4.1 Jurisdiction of the High Court vs Shariah Court

As earlier observed, disputes arising from the Capital Market are generally of a special nature.Above all, those arising from ICM transactions are more complex particularly when Shariahissues are in question. To this end, the word “court” is not defined in the interpretation clauseof the CMSA but the word appears throughout the Act. When the CMSA is read with the SCA1998 which is complementary in general matters setting the framework for the regulatorybody in the Malaysian Capital Market, it is found that the word “court” is defined in theinterpretation clause in Section 2 of the SCA as:

(a) a High Court established under Article 121 of the Federal Constitution or a judge of theHigh Court; or

(b) Sessions Court or a Magistrate’s Court established under section 3 of the SubordinateCourts Act 1948 or a Sessions Court Judge or a Magistrate.

The High Court and the Sessions Court or Magistrate’s Court are all common law courtswhose jurisdiction is more appropriate for cases arising from the Malaysian Capital Market.In addition, Article 121 of the Federal Constitution provides unequivocally that the civil courthas jurisdiction over Shariah matters in respect of mercantile, Islamic banking, as well asbusiness and commercial issues. Some have argued that with the provision for expert evidencein the Evidence Act and the Rules of the High Court, there may not be any need for expertdetermination of the cases emanating from Islamic financial services. This clear positionplaces the civil courts in the right direction as far as jurisdiction is concerned. With all senseof humility, it is important to observe that expert evidence can be misleading in some cases.This is all the more reason why the judges themselves must be learned in the subject matterof the dispute rather than just listening to the expert evidence of both parties and evaluatingwhich of the evidence is more authoritative.

However, with the introduction and crystallization of the ICM, it is apposite to provide forcorresponding jurisdiction in the appropriate courts like the Shariah court in Malaysia. In theMalaysian Capital Market, the disputes or issues going to the court can either be administrativeor civil actions. In such a situation, since the Shariah court can easily give orders in respect ofadministrative actions, it can also be empowered to hear and decide the civil actions. If disputesarising from the ICM cannot be classified under the extended jurisdiction of the Shariah court,

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the other option is to establish a body within the Securities Commission that should hear anddetermine such cases.

4.4.2 Shariah Dispute Resolution in the Malaysian ICM

It is observed that the current legal framework for dispute resolution in the ICM does notreally provide for a proper Shariah dispute resolution mechanism. The latest amendmentsas contained in the Capital Market and Services (Amendment) Act 2010 only replicates theprovisions setting out the powers and functions of the Shariah Advisory Council (SAC) inthe Central Bank of Malaysia Act 2009 which provide for court and arbitral referrals and theeffect of any ruling made by SAC. Meanwhile, the SAC of the Securities Commission wasestablished on 16 May 1996 as the central approval authority for Islamic capital products andissuance of Islamic guidelines and provision specific to ICM products (see Table 4.1 below).The establishment of SAC for the Securities Commission

was endorsed by the Minister of Finance and it was given the mandate to ensure that the imple-mentation of the Islamic capital market complied with Shariah principles. Its scope of jurisdictionis to advise the Commission on all matters related to the comprehensive development of theIslamic capital market and to function as a reference centre for all Islamic capital market issues.(Securities Commission, 2007)

Going by the terms of reference of the establishment of the SAC, it is supposed to serveinter alia as a reference centre for all ICM issues in Malaysia. It is argued that disputesand controversies among the market players fall under this category of issues. However, theSAC may not be the appropriate body to resolve disputes among the market players becauseit is originally saddled with the responsibility of developing and approving capital marketproducts as being Shariah-compliant where applicable. In other words, the SAC cannot bethe approving authority of Shariah-compliant products and also be the dispute resolution

Table 4.1 Shariah-compliant securities on Bursa Malaysia (as at 30 November 2009)

Main Market/ACE Market

Shariah-compliantsecurities Total securities3

Percentage ofShariah-compliant

securities (%)

Consumer Products 126 135 93Industrial Products 280 290 97Mining 1 1 100Construction 48 50 96Trading/Services 171 199 86Properties 73 88 83Plantation 38 43 88Technology 98 101 97Infrastructure (IPC) 6 7 86Finance 5 40 13Hotels Nil 4 NilClosed-end Fund Nil 1 Nil

Total 846 959 88

Source: Sharı’ah Advisory Council of the Securities Commission Malaysia (Securities Commission, 2009a)

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body to hear any disputes arising from transactions of such market products based on thelegal principle: nemo judex in causa sua which means “no one should be a judge in his owncause”. The jurisdiction of the SAC does not extend to dispute resolution in the MalaysianICM. Therefore, there is a need for an independent body for the resolution of disputes in theICM. The nature and structure of such independent body will be proposed in the next section ofthis chapter.

From the foregoing, it is clear that there is no clear and definite framework for the resolutionof disputes arising from the ICM in the appropriate manner. In fact, “[t]he legal documen-tation of Islamic finance transaction is premised on the principles of Law of Contracts andother principles of English common law. Accordingly, disputes in Islamic finance transac-tions are dealt with in the civil courts” (Securities Commission Malaysia, 2009b). This wasemphasized by Abdul Wahab Patail J. in Arab-Malaysian Finance Bhd v Taman Ihsan JayaSdn Bhd & Ors (Koperasi Seri Kota Bukit Cheraka Bhd, third party)6 where he observedinter alia:

In dealing with cases involving Islamic financing facilities, the civil court functions strictly asa civil court. It remains for all purposes a civil court. It does not become a Syariah Court.Nor does it proceed to apply Islamic law according to the interpretations and beliefs of anyparticular mazhab as it might if it were a Syariah Court. The civil court’s function is to rendera judicially considered decision on the particular facts of the specific case before it accordingto law.

Some judges even find it difficult to differentiate between the law applicable to Islamicbanking transactions and conventional banking. In Bank Kerjasama Rakyat Malaysia Bhd vEmcee Corporation Sdn Bhd,7 the Court of Appeal observed that the applicable law in Islamicbanking transactions is no different from that law governing the conventional banking.

To this end, it is important to examine how Islamic finance products have been adjudicatedin the Malaysian courts. Though very few judges in the Malaysian courts are trained inIslamic finance products and Shariah in general, most of them are not trained in Shariahmatters. Meanwhile, the introduction of Islamic financial products into the Malaysian economyhas given rise to a number of cases relating to some of the products. The chronologicaldevelopment of the case law on this aspect of Islamic finance in Malaysia started with theTinta Press Sdn Bhd v Bank Islam (M) Bhd8 case which was the first reported decisionon the validity of Islamic finance products in Malaysia. Another interesting case is BankIslam Malaysia Bhd v Adnan bin Omar.9 Without probing into the facts of the case, itsuffices to emphasize that the case relates to the legality of Bay Bithaman Ajil commonlycalled BBA (Mohamed, 2008; Mohamed Shariff, 2005; Hj Ab Latif, 1997; Illiayas, 1995;Azahari, 2009; Abu Backer, 2002; Shariff, 1998, 2006; Mohd Yasin, 1997). Other casesheard and decided by the civil courts in Malaysia are Dato Hj Nik Mahmud bin Daud vBank Islam Malaysia Bhd10 and Affin Bank Bhd v Zulkifli bin Abdullah.11 “In all thesecases, the civil courts had used the civil law and procedures in reaching their decisions.Apparently, the civil courts did not consider whether the application of the existing lawwould have contradicted the Shariah or affect the validity of the documents” (The MalaysianBar, 2008).

As far as Islamic banking and finance products are concerned in Malaysia, the SAC ofthe Central Bank of Malaysia and the Securities Commission are the highest authoritiesrespectively. However, of late it seems there is a clash of jurisdictions regarding the binding

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nature of the resolutions of the SAC on the courts. The courts have been very reluctant to refercases to the SAC of either the Central Bank of Malaysia or the Securities Commission. Thisis evident in a number of cases where the judges expressly stated that referring such issues tothe SAC will amount to “indefensible abdication” of the functions of the court. Abdul WahabPatail J. in Affin Bank Berhad v Zulkifli Abdullah12 affirmatively observed about the positionof the court:

Since the question before the court is the interpretation and application of the terms of thecontractual documents between the parties and of the decisions of the courts, reference of thiscase to another forum for a decision would be an indefensible abdication by this court of itsfunction and duty to apply established principles to the question before it. It is not a questionof Syariah law. It is the conclusion of this court, therefore, that there is no necessity to refer thequestion to another forum.

In a similar vein, in the recent case of Tan Sri Abdul Khalid bin Ibrahim v Bank IslamMalaysia Bhd and another suit,13 Rohana Yusuf J. clearly expressed the position of the courtregarding the binding nature of the resolution of the SAC on the court even though she referredan issue to SAC and accepted the opinion:

The Legislature had intended the SAC to be a legally recognised body under the law to ascertainthe Islamic law applicable to Islamic banking and finance. With such specific legislative provisionit is obvious that the SAC is a body empowered and recognised under the legislation to issueruling and direction on the applicable Shariah law in Islamic banking business. . . .

Having examined the SAC, its role and functions in the area of Islamic banking, I do not seethe need for me to refer this issue elsewhere though I am mindful that under s 16B(7) I am notbound by its decision.

In order to remedy this inconsistency in the law, the new Central Bank of Malaysia Act2009 as well as the Capital Markets and Services (Amendment) Act 2010 came with far-reaching amendments of the existing law. With the enactment of the Capital Markets andServices (Amendment) Act 2010, clear and definite powers have been given to the SAC ofthe Securities Commission with the introduction of Sections 316A, 316B, 316C, 316D, 316E,316F, 316G, and 316H respectively. These provisions follow the pattern of the Central Bankof Malaysia Act 2009 where the powers of SAC in relation to pending cases in court andarbitral proceedings are clearly defined. The relevant provisions in the new Act are givenin Sections 316A–316H. Section 316A provides for the establishment of the SAC; Section316B provides for the functions of the SAC; Section 316C provides for the appointment ofmembers to the SAC; Section 316D provides for the Secretariat to the SAC; Section 316Eprovides that the licensed person, stock exchange, futures exchange, clearing house, centraldepository, listed corporation, or any other person should consult the SAC or refer issues to itfor a definite ruling; Section 316F provides for reference to the SAC for ruling on any matteron ICM business or transaction from court or arbitrator; Section 316G provides for the effectof the Shariah ruling by the SAC; and Section 316H ultimately provides that the ruling of theSAC prevails over the ruling of any registered Shariah advisor to a person engaging in anyICM business or transaction.

It may be instructive to expressly state the provision of Section 316G on the effect ofthe Shariah ruling of the SAC which is relevant to the issue in question: “Any ruling madeby the Shariah Advisory Council under section 316E or 316F shall be binding on (a) thelicensed person, stock exchange, futures exchange, clearing house, central depository, listed

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corporation or any other person referred to in section 316E; and (b) the court or arbitratorreferred to in section 316F.” This provision unequivocally states that such ruling made by theSAC is binding on the court or arbitrator. With this new specific legislative provision coming onthe heels of controversial decisions from the courts, it is likely the intention of the Legislature isto ensure expert determination of Islamic banking and finance cases whether before the courtsor arbitration panels. It was added to remedy the mischief occasioned in the earlier cases heardby the courts. Under the former regime, though a court may refer any Shariah issue to SAC,it was not obliged to do so. However, we submit that as stunning as this provision might be, ithas its own drawbacks. Though Section 316F provides for a sort of “mandatory reference” toSAC for ruling from the court or arbitration panel with the use of the word “shall”, the HighCourt may invoke its inherent jurisdiction to circumvent such mandatory reference as it did inthe earlier cases. This attitude may bring about more problems when the courts refuse to referShariah issues in Islamic financial matters before them to the SAC.

4.4.3 Inadequacy of the Existing Legal Reforms

The Governor of the Central Bank of Malaysia, Zeti Akhtar Aziz, has said: “To complement thecourt system, disputes may also be referred to the arbitration centre for resolution. In this regard,the Kuala Lumpur Regional Centre for Arbitration will be enhanced to serve as a platform todeal with cases involving Islamic banking and finance, and to extend these services beyond ourborders” (StarBiz, 2004). This is a landmark observation which ultimately led to the draftingand launching of the Rules for Islamic Banking and Financial Services Arbitration (IBFSArbitration Rules) in 2007 by the Kuala Lumpur Regional Centre for Arbitration (KLRCA).This bold initiative to introduce alternative means of resolving disputes arising from Islamicfinancial services transactions was as a result of the guidance and support of the Central Bankof Malaysia and the Securities Commission of Malaysia (Abdul Rahim, 2008). This was ina bid to introduce some reforms into the legal framework for dispute resolution of Islamicbanking and finance cases in Malaysia and beyond.

The Model Arbitration Clause provided in the IBFS Arbitration Rules is adapted from theUNCITRAL Model Arbitration Clause14 and it provides:

Any dispute, controversy or claim arising from Islamic banking business, Takaful business,Islamic financial business, Islamic development financial business, Islamic capital market productor services or any other transaction business which is based on Shariah principles out of thisagreement/contract shall be decided by arbitration in accordance with the Rules for Arbitration ofKuala Lumpur Regional Centre for Arbitration (Islamic Banking and Financial Services).

The importance of this model clause is that it covers all aspects of Islamic financial services.It covers any dispute, controversy, or claim arising from Islamic capital market products orservices with the aim of subjecting same to arbitration under the rules. This is an alternativeto court adjudication though the court still has some interventional powers in issues that aremeant to facilitate the arbitral proceedings which do not really affect the substance of thecase as provided in the IBFS Arbitration Rules and under the UNCITRAL Rules. Having saidthis, a careful scrutiny of the IBFS Arbitration Rules reveals certain inconsistencies with theIslamic law of arbitration (tahkım).

Without probing into the details of the inconsistent provisions in relation to the Islamiclaw standards, it suffices to observe that the Model Arbitration clause needs to be further

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amended to reflect the applicable law for the arbitral proceedings (lex arbitri) which in allcases is Islamic law in tahkım proceedings. This should be expressly highlighted in theArbitration clause. Part (e) of the Arbitration clause provides that “[t]he law applicable to thisagreement/contract shall be that of . . .”. The parties are required to stipulate this as part ofthe Arbitration agreement within the underlying contract. The freedom given to the partiesin the Model clause to determine the applicable law is not consistent with Islamic law thoughthe latter allows for prevailing customary trade practices. In addition, another important issuein the IBFS Arbitration Rules relates to the amiable composition and the power of the arbitralpanel to decide a case applying the principles of equity. Rule 39(2) of IBFS ArbitrationRules provides that “[t]he arbitral tribunal shall decide as amiable compositeur or ex aequo etbono only if the parties have expressly authorised the arbitral tribunal to do so and if the lawapplicable to the arbitral procedure permits such arbitration”. This provision was adopted fromthe UNCITRAL Rules. In tahkım proceedings, once the arbitral panel assumes jurisdiction,it is impliedly empowered to decide the case applying the principles of equity, fairness, andmaslahah (public policy) as amiable compositeur. The panel does not need any express writtenconsent from the parties or any other person to act as such (Oseni, 2010).

As the saying goes “A stitch in time saves nine” – it is expedient for the stakeholders togo back to the drawing table and introduce a formidable legal framework for the unforeseendisputes in the ICM. It is important to add that whatever alternative framework will beintroduced, the arbitration agreement which should be based on the Islamic legal principlesshould be set out in clear terms that can be easily recognized and interpreted by the courts.

4.5 DISPUTE RESOLUTION MODELS FOR THECAPITAL MARKETS

This section of the chapter explains the popular means of dispute resolution in the ICM insome Muslim countries. It is however important to emphasize that most Muslim countrieshave their regulatory process for resolving disputes arising from the Capital Markets. In thischapter, we intend to briefly appraise two models – the Saudi Arabian Model and the UnitedArab Emirates Model. The choice of these two models is just for the purpose of convenienceand established practices which can be adapted in other countries to regulate the ICM. As away forward to dealing with the identified constraints and challenges facing the regulatoryframework for dispute resolution in the ICM, the third part of this section offers a proposedhybrid framework for the Malaysian ICM.

4.5.1 The Saudi Arabian Model

Saudi Arabia has an overwhelming Muslim majority and its laws are streamlined towardsthe complete application of the Islamic law. The regulatory body for the Capital Market isknown as the Capital Market Authority (CMA). It was established under Article 4 of theCapital Market Law (CML), issued by Royal Decree No. (M/30) dated 2/6/1424 AH. Its mainfunction as provided for in the Law is to regulate and develop the Saudi Arabian CapitalMarket which is predominantly an ICM. Just like the Malaysian Securities Commission, theCMA is empowered under Article 5 of the Law to issue required rules and regulations forthe implementation of the provisions of the CML to create a conducive environment for thegrowth of investment activities.

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The most striking feature of the CML which is related to the regulatory framework fordispute resolution and avoidance in the Capital Market is the establishment of the Committeefor the Resolution of Securities Disputes (CRSD). Article 25(a) of the CML provides:

The Authority shall establish a committee known as the “Committee for the Resolution ofSecurities Disputes” which shall have jurisdiction over the disputes falling under the provisionsof this Law, its Implementing Regulations, and the regulations, rules and instructions issued bythe Authority and the Exchange, with respect to the public and private actions. The Committeeshall have all necessary powers to investigate and settle complaints and suits, including the powerto issue subpoenas, issue decisions, impose sanctions and order the production of evidence anddocuments.

From the foregoing provisions, it is clear that the Saudi CMA has a well-established,experience-driven, and specialized framework for the resolution of securities disputes outsidethe court system. Article 25(b)(i) provides for the incidental matters in relation to the procedureto be adopted in the resolution of securities disputes. The Law provides for two committeesto settle securities disputes. The first is the CRSD while the second is an Appeal Panel whichhears appeals against the decisions of the CRSD. The Appeal Panel is to be constituted by theCouncil of Ministers and it comprises three experts representing the Ministry of Finance, theMinistry of Commerce and Industry, and the Bureau of Experts at the Council of Ministers.An appeal against the decision of the CRSD must get to the Appeal Panel within thirty days ofthe notification date. The decisions of the Appeal Panel are final and are not subject to furtherreview by any court. The final decisions are enforceable through the government agencyresponsible for the enforcement of court judgments.

Between 2007 and 2008, the Appeal Panel passed sixty-five decisions relating to variouscivil, administrative, and penal cases arising from the decisions of the CRSD on securitiesdisputes. Tables 4.2 and 4.3 show the number of cases filed and the decisions issued by theAppeal Panel in 2007 and 2008 respectively.

From Tables 4.2 and Tables 4.3 and Figure 4.1, the total number of cases filed at the AppealPanel in 2008 was 100 compared to 2007 when 69 cases came to appeal. From the chart, it isclear that most cases filed in 2008 were civil which accounted for 97% of the total number ofcases filed. On the other hand, the Appeal Panel issued a total number of 34 decisions in 2007while in 2008, there was an increase of 91% with a total number of 65 decisions issued (CapitalMarket Authority, 2008). This is a comprehensive legal framework set up within the CMA forthe resolution of disputes which can be replicated and adapted for the ICM in other countries.

In a similar vein, it is part of the functions of the Board of Directors of the Saudi StockExchange (SSE), a body established under Article 20 of the Law as a joint-stock company

Table 4.2 Total number of cases filed with the Appeal Panel in 2008 and 2007

2008 2007

Case Number % Number % % Change

Civil 97 97% 69 100% 41%Penal 3 3% 0 0% 0Administrative 0 0% 0 0% 0

Total 100 100% 69 100% 45%

Source: Annual Report 2008, Capital Market Authority, Kingdom of Saudi Arabia

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Table 4.3 Cases filed with the Appeal Panel and decisions issued in 2008 and 2007

Total Number

Subject 2008 2007 % Change

Total Deposited Cases 100 69 45%Number of Decisions Issued 65 34 91%


and sole entity authorized to carry out trading in securities in Saudi Arabia, to propose thenecessary regulations, rules, and instructions for the operation of the Exchange includingthe settlement of disputes among members of the Exchange and between the members andtheir clients. Apart from this, the CMA also has an Enforcement Department which serves asan ombudsman body within the Authority. It is responsible for the review, verification, andprompt investigation of complaints lodged by the public. It also resolves disputes that mayarise among market participants and monitors the implementation of decisions issued by theBoard and the CRSD. In all, it is clear that the legal framework for dispute resolution in theCMA is on the right track as far as securities disputes are concerned.

100

Civil Penal Administrative

2008

2007

90

80

70

60

50

40

30

20

10

0

Figure 4.1 Total number of cases filed with the Appeal Panel in 2008 and 2007


4.5.2 United Arab Emirates Dispute Resolution Framework for the Capital Market

The Securities and Commodities Authority, which is the regulatory body for the UAE CapitalMarket, was established under Article 2 of Federal Law No. 4 concerning the EmiratesSecurities and Commodities Authority. Article 4(2) of the Law provides for the powers of theAuthority which allows it to make certain regulations after due consultation and coordinationwith the markets licensed in the State. One such regulation relates to arbitration in disputesarising from trading in securities and commodities as provided for in Article 4(3)(a) of the

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Law. The Chairman of the Board of Directors of the Securities and Commodities Authority isempowered to approve such regulations. In pursuance of the enabling provision in the Law, theChairman of the Board approved the regulations known as: Decision No. 1 of 2001 Concerningthe Regulations as to the Arbitration of Disputes Arising from the Trading of Securitiesand Commodities issued on 5 February 2001 in Abu Dhabi (Securities & CommoditiesAuthority, 2008).

The Regulation on Arbitration contains 55 articles and it seems that it does not totally adoptthe UNCITRAL Rules of 1976 or the UNCITRAL Model Law on International CommercialArbitration of 1985 (2006 Amendments). However, the Regulation on Arbitration is purelya procedural law to guide the arbitral proceedings. One good thing about the Regulation isthe fast-track arbitration procedure introduced even though the word “fast-track” has not beenmentioned. Article 37 of the Regulation provides that disputes must be heard expeditiously andwithout being bound by technicalities of the normal civil procedure in the courts. In additionto this, Article 38 expressly provides that the award must be rendered within a period notexceeding 60 days from the commencement date of the timetable which was laid down for thecourse of the arbitral proceedings. Furthermore, Article 41 satisfies the requirements of thetahkım proceedings by providing for settlement of dispute amicably between the parties duringthe course of arbitration. This is also in line with Article 34 of the UNCITRAL ArbitrationRules of 1976.

Issuing the guidelines for arbitration of disputes arising from Islamic capital products isa welcome development but the nature of arbitration in the modern world is mind-numbing.Arbitration has become a dinosaur which has assumed different dimensions in the modernworld. Arbitral proceedings are now fraught with legal technicalities and it is becomingmore complex than typical litigation in the court of law. Despite the enthralling provisionsof the Regulations, what is experienced in modern arbitral proceedings betrays the classicalarbitration we know. Though issuing guidelines for arbitration of disputes arising from tradingof securities and commodities in the Capital Market is a good step in the right direction,the arbitral panels as well as other stakeholders must make sure the lawyers do not turn theproceedings into virtual litigation.

4.5.3 A Hybrid Model for the Malaysian Islamic Capital Market

The essence of the two models discussed earlier is to examine best practice within the industryand adapt them to the Malaysia Capital Market. Going by the provisions of the CMSA, theSecurities Commission of Malaysia is legally empowered as the sole regulatory authority thatcan make relevant regulations and issue guidelines for the amicable settlement of disputes aris-ing from the Malaysian Capital Market which, as a matter of fact, includes ICM transactions.In order to position the Malaysian Capital Market as a leading market for Islamic financialproducts, the Securities Commission should consider having a formidable framework for theresolution of domestic as well as cross-border disputes arising out of ICM transactions. Indoing this, a hybrid model is required that will fulfil the needs of the securities market.

It is apposite to have legislative backing for the hybrid model being proposed; we shall haverecourse to the CMSA and the SCA. While Section 16 of the SCA provides for the powersof the Commission which can exercise any powers as may be necessary in connection withthe performance of its functions, Section 18 of the same Act specifies that the Commission isempowered to establish a committee as it considers expedient to help in the performance ofits function under the law. When Sections 16 and 18 of the SCA and 316(3)(c) of the CMSA

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are read together, it becomes clear that the Securities Commission of Malaysia can specifyin guidelines made under Section 377 any other matter that may be deemed appropriate ingiving full effect to the principles of Shariah in relation to a transaction in respect of Islamicsecurities.

Since the Shariah Advisory Council cannot be a judge in its own cause by sitting to hearand determine disputes arising from ICM transactions earlier sanctioned by it, it becomesnecessary to propose an independent body for the resolution of such disputes. It is proposedthat an independent body be established in line with the guidelines issued under the CMSAand such body may be constituted by just one person who is learned in ICM transactions. Theperson hears, investigates, and determines cases as an ombudsman attached to the SecuritiesCommission. This office should be known as the Islamic Capital Market Ombudsman whomust be learned in Shariah with particular bias towards Islamic financial services. An expertwho works within the Commission with a wealth of experience may be appointed to fill theposition of ICM Ombudsman. The Ombudsman institution serves two important objectivesof dispute avoidance and dispute resolution among market players. The Ombudsman shouldstrive to safeguard the interest of the investors. This is not new in modern Capital Markets. InIndia, the Securities and Exchange Board of India has set up the institution of Ombudsman toregulate the capital markets (Aparna, 2004). In Islam, this institution is known as Muhtasiband it is a well-established body in Islamic legal history which is still relevant in the modernera (Hamdani, Spring 2008; Vogel, Fall 2003). The award or decision of the Ombudsmanis final and binding on the parties. However, if there is substantial miscarriage of justice orthere is a prima facie error in the award, an appeal on any of those two grounds should lieto an Independent ICM Tribunal to be established under the relevant laws and constituted byrepresentatives of all stakeholders in the Capital Market. The decision of the Independent ICMTribunal is final and is not subject to further appeal to any other authority including a courtof law. The tribunal should have its rules and procedure and must apply the Islamic law ofarbitration (tahkım). The Tribunal can receive expert evidence but legal representation shouldnot be condoned.

4.6 CONCLUSION

It is established that the growth of Islamic financial services which has gained momentum inthe modern world will be better enhanced when appropriate steps are taken through a properlegal framework. The ICM has come to stay and it will continue to grow in leaps and boundswhen the proper precautions are taken to streamline the dispute resolution framework. TheMalaysian example is a good model and the case studies given from the practices in the SaudiArabian Capital Market and UAE should serve as leading models in the global capital market.It is high time the stakeholders developed necessary policies to globalize best practice in theindustry, particularly in relation to the legal framework of ICM. The countries having viableICM should come together to sign Multilateral Treaties that will provide for cross-borderdisputes in the global ICM. The prospects for ICM are bright but the key players in theindustry must take the bull by the horns by making necessary adjustments to further reform themarket for better results. The governments of countries where the ICM thrives should amendthe laws and policies as necessary to regulate the industry in order not to stifle its developmentwith these counterproductive challenges. It is therefore crucial to conclude that for a maturedICM, there is need for an effective dispute resolution framework that will not only take intoconsideration the legal principles but will also consider the sacrosanct Shariah requirements.

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CASE STUDIES

Case Name Bank Islam Malaysia Bhd v Lim Kok Hoe & Anor and other appeals

Citation [2009] 6 MLJ 839; [2009] 6 CLJ 22

Court/Date ofDecision

Court of Appeal (Putrajaya)/26 August 2009

Coram Raus Sharif, JCA. Abdull Hamid Embong, JCA. Ahmad Maarop, JCA

Facts This judgment concerned an appeal by the Bank Islam Malaysia Bhd(BIMB), the appellant, against a common judgment delivered by the HighCourt for 12 cases (“the common judgment”), which involved Islamicfinancing. The respondents in all the 12 cases were BIMB’s customerswho had entered into Bai Bithaman Ajil contracts (BBA contracts) withBIMB. A BBA contract, the most common form of financial transactionsused in Islamic banking, is a deferred payment sale contract that is used tofinance bank’s customers to purchase their own properties. In such a contractthe customer first sold the property to the bank under the property purchaseagreement (the PPA), which was a cash sale. With that purchase the propertybelonged to the bank and the customer had to buy it back from the bank ata sale price that included the bank’s profit on the sale. In effect the bankwould sell the same property it had purchased from the customer to thatcustomer under a second document known as the property sale agreement(PSA). In the common judgment the High Court judge (“the trial judge”)questioned the validity and enforceability of the BBA contracts on two maingrounds, namely that he found the BBA contracts to be more onerous thanthe conventional loan with riba which was prohibited in Islam; and that hefound that the BBA contract practised in this country was not acceptable byall the four schools of thought (madh-habs) in Islam. He thereby concludedthat the BBA contracts were contrary to the basic principles of Islam. Basedon such a conclusion the trial judge found that an Islamic bank could onlyrecover the balance of the facility plus profit on the balance principal cal-culated at a daily rate until payment. The main issues for determination inthis appeal were thus whether the BBA contract was more onerous than theconventional loan agreement with riba and also whether the BBA contractwas prohibited in Islam.

Judgment The Court of Appeal held, allowing the appeal with costs:

• The trial judge’s comparison between a BBA contract and a conventionalloan agreement was not appropriate. A BBA contract was a sale agreementwhereas a conventional loan agreement was a money lending transaction.As such, the profit in a BBA contract is different from the interest arisingin a conventional loan transaction. Thus the trial judge was plainly wrongwhen he equated the profit earned by BIMB as being similar to riba orinterest when the two types of transactions cannot be similar and whenthe BBA contract is in fact a trade transaction. Further, the comparisonbetween a BBA contract and the conventional loan agreement is of norelevance and serves no purpose as the law applicable in a BBA contractis no different from the law that is applicable in a conventional loan

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agreement. The law is the law of contract and if the contract is not vitiated byany vitiating factor such as fraud, coercion, undue influence, etc. the courthad a duty to protect the sanctity of the contract entered into between theparties.

• By replacing the sale price under the PPA with an equitable interpretationof the same and by substituting the obligation of the customer to pay thesale price with a loan amount and profit computed on a daily basis the trialjudge was in fact rewriting the contract for the parties. It is trite law that thecourt should not rewrite the terms of the contract between the parties that itdeems to be fair or equitable.

• The trial judge had misinterpreted the meaning of “Islamic banking business”under s. 2 of the Islamic Banking Act 1983 (the Act). “Islamic bankingbusiness” as defined in s. 2 of the Act does not mean banking businesswhose aims and operations are approved by all the four madh-habs. Further,the judges in civil courts should not take it upon themselves to declarewhether a matter is in accordance to the religion of Islam or otherwise asit needs consideration by eminent jurists who are properly qualified in thefield of Islamic jurisprudence. Moreover, as we had the legal infrastructureto ensure that Islamic banking business as undertaken by the banks in thiscountry did not involve any element not approved by Islam, the court had toassume that the Sharıah Advisory Council under the aegis of Bank NegaraMalaysia had discharged its statutory duty to ensure that the operation ofthe Islamic banks was within the ambit of Islam.

• In any event it was clear that the validity and enforceability of the BBAcontract had been ruled upon by the superior courts. It is trite law that basedon the doctrine of stare decisis a decision of the superior court is bindingon all courts below it. In the light of this, the trial judge ought to have heldhimself bound by those decisions instead of ignoring or disregarding thedecisions of the Supreme Court or the Court of Appeal as that would createmisapprehensions in the judicial system.

Comments It is crystal clear that the Court of Appeal, while disagreeing with the decisionof the lower court, upheld the validity and enforceability of the BBA contracts.The court observed that since the legal system has a mechanism of ensuringthe compliance of every Islamic finance product in the country to the detailedprovisions of Islamic law, the BBA contract is Sharıah-compliant. An importantassumption made by the court is the reference to the Sharıah Advisory Councilof the Bank Negara Malaysia which is statutorily empowered to give its opinionon the validity or otherwise of a particular Islamic finance product referred toit either by the court, arbitral panel, or the banks. Under the current legalregime as provided in s. 57 of the Central Bank of Malaysia Act 2009, anyruling made by the Sharıah Advisory Council shall be binding on the court,arbitral panel or the Islamic financial institutions. Therefore, since the SharıahAdvisory Council had ruled in favour of the validity of the BBA contract, theapex court as well as all the subordinate courts are bound by this ruling, andonce the Federal Court had upheld such validity, it becomes binding on all thecourts in the country.

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AlternativeProcedure

BBA contract is an Islamic law issue which requires expert determination.When such cases are referred to the conventional courts, the law of contract incommon law is applied. Whether the court arrived at a correct decision or not,it must be emphasized that the substantive and procedural laws applicable in allIslamic commercial transactions is Islamic law. This is a highly regulated aspectof Islamic law though there is still enough room for independent deductionsthrough the process of ijtihad. This can only be done by experts in the field.This kind of case can be better resolved without the prolonged appeals witha hybrid process of Med-Ex and arbitration in Islamic law. Since a statutorymechanism has been created to provide for the binding nature of the SharıahAdvisory Council of Bank Negara, there may be need for the establishmentof Islamic banking and finance tribunal that will be saddled with the soleresponsibility of hearing and determining cases brought before it. Such tribunalshould be empowered to exclusively determine cases of Islamic banking andfinance and its decision will be final. About two or three hybrid processesof dispute resolution recognized in Islamic law may be adopted to fulfil theneeds of all stakeholders. This process will definitely be faster, cost-effective,party-friendly, and consensus-building.

Case Name Consolidated Cases involving Bank Islamic Malaysia Berhad (BIMB)

Citation BIMB v Azhar Osman; BIMB v Ramli Suhaimi & Anor; BIMB v MohdAzmi Mohd Salleh; BIMB v Mohd Noor Salleh

Court/Dateof Decision

High Court of Malaya, Kuala Lumpur (Commercial Division)/28 January2010

Judge Dato’ Rohana Yusuf

Facts • Two sets of appeal went before the Court of Appeal relating to Bai BithamanAjil (BBA) contracts in Islamic banking. The first set of appeals involves11 Writs of Summons and one Originating Summons. They were heardtogether and decided by the Court of Appeal on 26.8.2009 and reported inBank Islam Malaysia Berhad v Lim Kok Hoe & Anor and Other Appeals[2009] 6 CLJ 22. The Court of Appeal held that a BBA contract is validand enforceable and reversed an earlier decision of the High Court in Arab-Malaysian Finance Bhd v Taman Ihsan Jaya Sdn Berhad & Ors [2008] 5MLJ 631. Subsequent thereto all cases involving BBA contracts that wereheard together thereat were sent to the High Court for determination of thequantum of the plaintiff’s claim. The High Court was therefore requestedto determine the quantum of the plaintiff’s (BIMB) claim in two Writs ofSummons and the amount due under the two Originating Summonses. Theplaintiff in each of the four cases was BIMB.

• The four cases were referred to the High Court for the single purpose ofhearing and determining the issue of quantum of the plaintiff’s claim sincethey were all based on BBA contracts. On the day set for hearing, none of thedefendants appeared except Mr Azhar Osman (appeared in person) who isthe defendant in the Originating Summons D4-22A-395-2005. Mr OommenKoshy appeared for BIMB in the four cases. Mr Oommen Koshy contended

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that in a BBA contract the Bank has a legal right to claim for the full sale priceas stipulated in the Property Sale Agreement (PSA). Accordingly, he arguedthat in an application pursuant to an Originating Summons, the court oughtto grant an Order for Sale based likewise, on the full sale price, irrespectiveof a premature termination. The bases of Mr Oommen Koshy’s argumentsare two. First, he contended that the court should honour and enforce theclear written terms of the contract and should not interfere with the intentionof parties by imputing any other term. Since parties had agreed as to theamount of sale price as stipulated in the PSA, the defendant is under a legalobligation to pay the full sale price, irrespective of when a breach occurs.Secondly, by virtue of the doctrine of stare decisis, the court is bound by thedecision of the Court of Appeal in Lim Kok Hoe which, according to Mr.Oommen Koshy, upheld and acknowledged the obligation to pay the fullsale price under the PSA.

Judgment • In response to the argument of the learned counsel who represented theplaintiff, the court held that whilst it is true that the Court of Appeal inLim Kok Hoe held that a BBA contract in a way differs from conventionalbanking because it is a sale transaction, it cannot however be regarded asa sale transaction simpliciter. The BBA contract is secured by a chargeand concession as ibrar is given as a matter of practice to all prematuretermination. Further, it is not a simple sale because even if the bank doesnot make payment of the full purchase price under PPA the bank would stillbe entitled to claim the amount already paid. Whereas in a simple sale if thefirst leg of the transaction fails, the bank’s right to the amount paid will notipso facto accrue since the sale was never completed.

• After citing a number of cases where the court decided the quantum ofclaims, the learned judge concluded that when a BBA contract is prematurelyterminated upon default by the borrower, the court did not allow the bank toenforce the payment of the full sale price in a premature termination. Theunderlying principles which come to the fore, derived from these decisionsare clear. The court does not enforce payment of the full sale price butintervenes on equitable grounds, albeit based on different approaches. Forthe purpose of determining the quantum of claim, the court took an approachto enforce an implied term of Islamic banking practice in this case. In thisrespect, the learned judge was guided by the Federal Court case of Sababumi(Sandakan) Sdn Bhd v Datuk Yap Pak Leong [1998] 3 MLJ 151 where ZakariaYatim FCJ (as he then was) stated that the court may infer an implied termfrom evidence that the parties to a contract must have intended to includeit in the contract, though it has not been expressly set out in the contract.Therefore when an Islamic bank practices granting of rebate on a prematuretermination, it creates an implied term and legitimate expectation on thepart of the customer. Accordingly it is only proper that such expectation andpractice be read into the contract. The court therefore held that where theBBA contract is silent on issue of rebate or the quantum of rebate, the bankmust grant a rebate and such rebate shall be the amount of unearned profitas practised by Islamic banks.

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• On the issue of the binding nature of the decision of the Court of Appealraised by the plaintiff’s counsel, the learned judge observed that thepertinent question to be asked is what then of the Court of Appeal decisionin Lim Kok Hoe that binds this court, bearing in mind that under thedoctrine of stare decisis that binding precedent is the ratio decidendi.It must be noted at the outset that the decision of the Court of Appealin Lim Kok Hoe revolves around the issue of validity and enforceabilityof BBA contracts. Having deliberated on the arguments of counsel, theCourt of Appeal upheld the validity of BBA agreement as an enforceablecontract. The reasons are stated in the judgment of His Lordship MohdRaus JCA (now FCJ) at page 23. Applying the doctrine of stare decisisto Lim Kok Hoe, this court is bound to hold that a BBA contract is avalid and enforceable agreement. In fact, the Court of Appeal did notmake any finding on the issue of quantum of claim. It was not raisedat the Court of Appeal and it is for that reason that the cases are sentdown for the quantum of claim to be determined. If the doctrine of staredecisis was to be applicable, only a ratio decidendi of a superior courtdecision will bind the lower tier. By merely citing all these decisionswith approval it cannot be said that the Court of Appeal adopts thedecision of these cases in toto. It would be indeed necessary to analysewhat the reference to all these cases entail. After a careful scrutiny ofthe cases the court found that none of the decisions has established theratio decidendi suggested. It is true that the Court of Appeal in Lim KokHoe acknowledges these cases which ultimately resulted in granting andenforcing payment of the full sale price under the PSA, however none ofthe cases had in the judgment treated it to be the ratio decidendi of thedecision.

• The learned judge was not able to find any affirmation on the quantum tobe enforced in a BBA contract by the Superior Court. Thus, Her Lordshipheld that there is no binding precedent by the Superior Court for her tofollow to enforce the sale price under the PSA at all costs. There is nota slightest suggestion in Lim Kok Hoe that the issue of quantum hasbeen canvassed before the court by counsel. Furthermore, by the veryfact that the Court of Appeal sent the cases back to the High Court fordetermination of quantum, says it all.

• In conclusion, the learned judge allowed the plaintiff’s claim with costs,in the Writ of Summons Suit No. 22A-263-2006 for the outstanding sumof RM 391 634.66 and in Suit No. 22A-193-2006 for the sum of RM 190476.54. These judgment sums are subjected to deduction of the unearnedprofit by the plaintiff (if any) upon full realization. As for the OriginatingSummons, a new hearing date of 22.2.2010 was fixed for the plaintiff inthe Originating Summons No. D4-22A-395-2005 in order for BIMB tofile supplemental affidavit to state the outstanding sum, after deductingthe unearned profit due to be deducted, on the date the order for saleis to be obtained. At the request of BIMB, Originating Summons No.D4-22A-399-2005 was struck out.

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Comments The complexity and legal complications of the conventional process of adju-dication has led to ingrained inconsistency in the judgments of the court. Thehierarchical structure of the courts provides for stare decisis which engendersthe principle of binding precedents in the common law jurisdictions. As a com-mon law jurisdiction, the Malaysian judicial system is bound by the applicablerules which provide that decisions of superior courts are binding on the sub-ordinate courts. The principle of stare decisis is not applicable in Islamic lawtransactions. In Islamic law, every case is decided on its own merit. Decisionsof superior courts or courts with coordinate jurisdiction may be persuasive butcannot be binding in Islamic law.

This case was a referral from the Court of Appeal for the specific purposeof determining the quantum of the plaintiff’s claim after the superior courthad resolved the issue of validity and enforceability of the BBA contracts.The learned judge was cautious in arriving at a logical conclusion even thoughthe learned counsel for the plaintiff had invoked the principle of stare decisis.The learned judge carefully distinguished the cases and observed that the ratiodecidendi of the decision of the superior court is the only binding factor whichmust be taken into consideration by the lower court. In the instant case, theprinciple of stare decisis cannot be invoked since it is the Court of Appeal thatsingle-handedly referred the determination of the quantum of the plaintiff’sclaim in the contract to the High Court. In such circumstances, the judge isobliged to use his discretion to determine the quantum of the claim based onthe principles of fairness and equity. This is what the learned judge rightly didin the case by not ordering the payment of the full sale price under the PSA asrequested by the plaintiff’s counsel.

AlternativeProcedures

It is apposite to examine how this case can be resolved through Med-Ex or Arbi-tration from the Islamic law standpoint. It is beyond doubt that this kind of caseis sui generis and is regulated by specific rules in Islamic law. Without enteringthe arena of jurisdictional controversy on the proper court that should hear anddetermine any case involving Islamic law in Malaysia, it is safe to observe thatcases of this kind emanating from the Islamic financial services, particularly inthe Islamic capital market, cannot be determined and resolved finally using theconventional administration of justice system. So many issues, which includethe binding nature of the decision of superior courts, applicability of the rules ofcourt, and the type of legal documentation for such transactions, may constitutesome sorts of cogs in the wheel of proper determination of the case. This isthe reason why such issues should be referred to experts in the field for finaldetermination. In the dispute resolution models of Islamic law, two prominentprocesses that may be relevant for this kind of case are Med-Ex and tahkım.While the former is a hybrid process of Mediation (sulh) and Expert Determi-nation (fatwa of a muftı ), the latter is arbitration in Islamic law. If such a casehas been referred to the Med-Ex process, which would have afforded the par-ties the uncommon opportunity of amicably resolving the relevant issues in thecase through compromise, any decision arrived at will be based on learnedbinding opinions of experts in Islamic finance. The institutionalization ofMed-Ex as a formal tribunal for Islamic banking and finance cases willenhance the administration of justice system and prevent legal complexitiesand procedural complications usually occasioned in court proceedings.

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NOTES

* LLB (Unilorin, Nigeria), BL (CLE, Nigeria), MCL with Distinction (IIUM, Malaysia)and Solicitor and Advocate of the Supreme Court of Nigeria. PhD Research Scholar atAhmad Ibrahim Kulliyyah of Laws, International Islamic University Malaysia, workingon Dispute Resolution.

** Professor of Economics, University of New Orleans, Louisiana, USA.1. See http://www.sc.com.my/ENG/HTML/resources/speech/sp 20040707.html.2. The relevant provisions of the new Act will be discussed in the appropriate sections of

this chapter.3. [2010] 1 MLJ 133.4. [2010] 7 MLJ 85.5. This means the ICM cases are unique in nature and they are in their own category. Ordinary

common law principles of contract cannot be applied to these ICM transactions in theevent of a dispute. These forms of dispute require expert determination by experiencedpersons in the field.

6. [2008] 5 MLJ 631 at 638.7. [2003] 2 MLJ.8. [1987] CLJ 396; [1987] 2 MLJ 192.9. [1994] 3 CLJ 735; [1994] 3 AMR 44.

10. [1996] 4 MLJ 295 (High Court); [1998] 3 MLJ 396 (Supreme Court).11. [2006] 3 MLJ 67.12. [2006] 1 CLJ 438 HC.13. [2009] 6 MLJ 416 at 426–7.14. “UNCITRAL” stands for the United Nations Commission on International Trade Law. The

Commission was established by the United Nations General Assembly by its resolution2205 (XXI) of 17 December 1966. According to the “The UNCITRAL Guide”, this Com-mission “plays an important role in developing that framework in pursuance of its mandateto further the progressive harmonization and modernization of the law of internationaltrade by preparing and promoting the use and adoption of legislative and non-legislativeinstruments in a number of key areas of commercial law. Those areas include disputeresolution, international contract practices, transport, insolvency, electronic commerce,international payments, secured transactions, procurement and sale of goods.” See “TheUNCITRAL Guide” available at http://www.uncitral.org/pdf/english/texts/general/06-50941 Ebook.pdf.

REFERENCES

Abdul Rahim, Noorashikin (2008) Arbitration for Islamic financial business under the auspices of theKuala Lumpur Regional Centre for Arbitration, MIF Monthly 2008 Legal Supplement, 9–10.

Abdullah, K.A. (1997) The Issues and Prospects of Establishing a Sound Islamic Capital Market. LabuanInternational Summit on Islamic Financial and Investment Instruments, Financial Park Complex,Labuan.

Abu Backer, Hamid Sultan Bin (2002) Is there a need for legislative intervention to strengthen SyariahBanking and Financial Instruments? MLJ, 3, clxx.

Ali, S.S. (2008) “Introduction – Islamic capital markets: current state and developmental challenges”in S.S. Ali (ed.), Islamic Capital Markets Products, Regulation & Development, IRTI-IDB: Jeddah,Saudi Arabia, pp. 1–19.

Aparna, M. (2004) Ombudsman (OM’ .BUDS .MAN): With Reference to Capital Markets in India,Proshare, 27 December.

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Azahari, F. (2009) Islamic banking: perspectives on recent case development, MLJ, 1, xci.Capital Market Authority (2008) Annual Report 2008. Capital Market Authority: Riyadh, Saudi Arabia.Cox, S. (2004) The Development of the Islamic Capital Market. 3rd Annual Finance Summit, Euromoney

Seminar, London, UK.Hamdani, A. (2008) The Muhtasib as guardian of public morality in the Medieval Islamic city, Digest

of Middle East Studies, Spring, 92–104.Hassan, R., and Yusoff, A. (2009) The outlook of the Malaysian Islamic capital market, MLJ, 3, cxvii.Hj Ab Latif, Samsar Kamar Bin (1997) Legal aspects of interest-free banking in Malaysia, MLJ, 2, xcii.Illiayas, M. (1995) Islamic/interest-free banking in Malaysia: some legal considerations, MLJ, 3, cxlix.Kada, M. (2008) The Future of Islamic Capital Markets, Thomson Reuters: London.Kahf, M. (2000) Market Regulation in Islamic Perspectives: Principles,Objectives and Tools. Seminar

on Islamic Approach to Market Regulation and Economic Stability, Tehran.Low, C.K. (2001) Revisiting the regulatory framework of capital markets in Malaysia. Columbia Journal

of Asian Law, 14, Spring, 277–308.Mahmood, N.R. (1996) Regulatory Framework and the Role of the Securities Commission in Developing

the Islamic Capital Market. National Conference on Islamic Banking and Investment, 19 November,Kuala Lumpur.

Mohamed Shariff, Mohamed Ismail Bin (2005) The legislative jurisdiction of the Federal Parliament inmatters involving Islamic law, MLJ, 3, cv.

Mohamed, A.A. (2008) Al-Bai’ Bithaman Ajil – Its consistency with the religion of Islam: with specialreference to Arab-Malaysian Finance Bhd v. Taman Ihsan Jaya Sdn bhd & Ors and other cases. MLJ,xvii.

Mohd Yasin, Norhashimah (1997) Islamic Banking: Case Commentaries Involving Al-Bay’ BithamanAjil. MLJ, 3, cxcii.

OICU-IOSCO (July 2004) Islamic Capital Market Fact Finding Report. Report of the Islamic CapitalMarket Task Force of the International Organization of Securities Commission.

Oseni, U.A. (2010) Islamic Banking and Finance Disputes: Synchronizing the Traditional with ModernMechansims of Dispute Resolution. 4th International Conference on Islamic Banking & Finance:Risk Management, Regulation and Supervision, Central Bank of Sudan and IRTI: Khartoum-Sudan,pp. 85–97.

Rose, N. (2005). Islamic finance: dispute resolution, Islamic Finance News, 4 April.Securities Commission (February 2001) Capital Market Masterplan, Securities Commission: Kuala

Lumpur.Securities Commission (2007) Resolutions of the Securities Commission Shariah Advisory Council (2nd

edn), Securities Commission: Kuala Lumpur.Securities Commission (2009a) List of Shariah-Compliant Securities by the Shariah Advisory Council

of the Securities Commission Malaysia. Kuala Lumpur.Securities Commission Malaysia (December 2009b) Mega Sukuk Defaults-Acid Test for Islamic Fi-

nance? Malaysian ICM.Securities & Commodities Authority (2008) Annual Report 2008, Securities & Commodities Authority

Abu Dhabi, UAE.Shariff, M.I. (1998) The development of Islamic banking law in Malaysia, MLJ, 1, cxlv.Shariff, M.I. (2006) The Affin Bank Case: Is Islamic banking just conventional banking in a green garb?

Affin Bank Bhd v Zulkifli bin Abdullah [2006] 3 MLJ 67, MLJ, 3, cli.StarBiz (2004) StarBiz, 26 August.The Malaysian Bar (2008) Legal and Regulatory Framework of Islamic Banking and Finance in Malaysia.

MIF Monthly 2008 Legal Supplement.Vogel, F.E. (2003) The public and private in Saudi Arabia: restrictions on the powers of committees for

ordering the good and forbidding the evil, Social Research, 70(3), Fall, 749–68.

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5

The Small World of Islamic Finance:How Good Governance can Assist inTaking the Islamic Finance Industry

to the Next Level

Murat Unal

5.1 INTRODUCTION

When we laid the foundation for our network analysis in the Islamic finance industry, in 2008,looking at Shariah scholars and their board memberships, we fuelled a great move towardshigher transparency and governance in the sector across the world, a development which inthe meantime has gained further momentum.

By systematically screening over 2000 financial services institutions related mainly to andactive in the GCC and beyond (including 24 countries), we found, as of April 2010, 291institutions involved in Islamic finance activities. We identified 1053 Shariah board positionsand showed for the first time, using objective numbers, the concentration of scholars withinthe system (specifically focusing on countries outside Malaysia). Six out of 221 availablescholars made up almost 32% of all available board positions. We argue that this concentrationwithin the system poses potential risks to the governance of the Islamic finance sector whichis reported to represent a US$ 900–1000bn industry.

Throughout our ongoing research we have used network analytic techniques and arigorous scientific methodology to carry out the screening, covering mainly financial servicescompanies such as banks, asset management companies etc. We specifically looked for thosededicated fully to Islamic finance services, or offering Islamic windows, and tracked theirscholars by analysing, inter alia, official documents such as audit reports, annual reports,news feeds, and thousands of other sources consistently, triangulating our sources, and usingappropriate cross checks.

This research has generally revealed several shortcomings in the governance of the above-mentioned institutions and lack of transparency, specifically when disregarding the Malaysianmarket which over the last few years has even increased its measures to provide good gov-ernance. The Islamic Financial Services Board’s (IFSB) December 2009 paper on “GuidingPrinciples on Sharia Governance Systems for Institutions Offering Islamic Financial Services”is a good starting point in the right direction, aiming to provide solid governance standards toorganizations involved in the Islamic finance industry.


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In the following sections we highlight the findings of our latest research, which in themeantime has been further advanced, but we will also give recommendations in relation tosome of the shortcomings we see within the system and what changes could be made. Ourrecommendations for changes in the governance system are currently developed extensivelyto be published in the next six to nine months, and therefore the following points representonly selected points to be taken to increase the resilience of the system and ensure the trust ofthe various stakeholders. As some recommendations are already covered in the IFSB paper,we will build on it but at the same time focus on the delta of additional measures to bringabout good governance among Islamic Finance Institutions specifically outside of Malaysia.This chapter is only supposed to be a starting point for a major discussion to which we willadd significantly in the coming months.

5.2 SHARIAH SCHOLARS IN THE GCC – A NETWORKANALYTIC PERSPECTIVE

Here we would like to set the stage for one of the most striking results of the research, i.e. theconcentration within the system. In times where Corporate Governance specialists across theworld consider limiting the exposure of people on boards, as has been done in Malaysia forexample, we have a situation in the Islamic finance industry where a few individuals controlmany board positions and many actually have no adequate access to boards, whatever thereasons may be (there is ample anecdotal evidence but we are not going to delve into this). Sothe distribution is heavily skewed towards a few scholars.

If you look at the top ten scholars by chairman positions (Table 5.1) you will see that theymake up 67% of all chairman positions. Although Sheikh Ahmad Bazie Al-Yaseen sits on 13boards, for example, he is chairman of almost all of these boards. Dr Mohammad Daud Bakaron the other hand, who occupies 38 positions, is not listed as chairman of a single board.

As chairmen play a vital role within the board from the point of view of decison making, itmakes a lot of sense to be aware of the above information. Age and seniority, apart from otherfactors, of course play a crucial role and this overview neatly addresses these points.

Table 5.1 Top ten scholars by chairman positions

Name of the scholar

Number ofchairmanpositions

Number ofpositions atinternationalorganizations

Number ofcorporatepositions

Number ofoverall

positions

Shaikh Dr Abdul Satar Abdul Karim AbuGhuddah

21 5 72 77

Dr Hussain Hamid Hassan 21 3 29 32Sheikh Abdullah Sulaiman Al Manee’a 20 4 34 38Sheikh Ahmad Bazie Al-Yaseen 12 0 13 13Shaikh Nedham Mohamed Saleh Yacoubi 10 6 72 78Justice Muhammad Taqi Usmani 9 3 14 17Dr AbdulAziz Khalifa Al-Qassar 9 0 38 38Dr Mohamed Ali Elgari 8 3 62 65Dr Ali Mohuddin Al’Qurra Daghi 7 5 26 31His Eminence Dr Youssof Al Qaradawi 5 2 6 8

Source: Funds@Work AG

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The Small World of Islamic Finance 117

Although Sheikh Yacoubi, for example, has most of the board positions, chairman positionstend to be occupied by others, and he is ranked No 5 in terms of chairman positions. Chairmenon the other hand will certainly play a crucial role in the hiring and recommendation of otherboard members.

Prominent scholars will predominantly occupy more chairman positions in their homecountry than outside their core market.

The top six out of 221 scholars

1) Sheikh Nedham Yacoubi (78 positions)2) Shaikh Dr Abdul Sattar Abu Ghuddah (77 positions)3) Dr Mohamed Ali Elgari (65 positions)4) Sheikh Abdullah Sulaiman Al Manee’a (38 positions)5) Dr Abdulaziz Khalifa Al-Qassar (38 positions)6) Dr Mohammad Daud Bakar (38 positions)

make up at least 31.7% of the entire universe of almost 1054 board positions. Again wesay “at least” as many of the scholars are active for consulting companies which on the otherhand cater for the needs of banks, real estate companies, and mutual funds as well as assetmanagement companies, and others, which ultimately leads to a higher exposure of individualscholars through consulting activities and one-time services. Among the consulting companiesmentioned are ones such as Dar Al Sharia, Al-Rayah, Minhaj Advisory, or Dar Al Istithmar.

The top six scholars in Bahrain (out of 36 scholars) make up 55.22% of all positions(134 board positions).

The top six scholars in Kuwait (out of 47 scholars) make up 48.68% of all positions(228 board positions).

The top six scholars in Qatar (out of 26 scholars) make 56.10% of all positions (61 boardpositions).

The top six scholars in Saudi Arabia (out of 39 scholars) make up 60.94% of all positions(128 board positions).

The top six scholars in the UAE (out of 35 scholars) make up 50.91% of all positions(165 board positions).

The top ten scholars in the whole of the GCC (out of 132 scholars) make 46.23% of allpositions (716 board positions).

The top ten scholars internationally (ex GCC)* – out of 93 scholars active both within andbeyond the GCC – make up 51.68% of all positions (238 board positions).

The country by country or regional perspective gives insights into the relevant scholars mostexposed to financial services companies in the relevant markets. In the following (Table 5.2)we will use the example of Bahrain (more details can be found in our original report).

As you can see in the following graph, dedicated to Bahrain, 18 scholars occupy only oneboard position, and five two board positions. This is again by no means a normal distributionand there is certainly potential for integrating a large number of scholars much better into thesystem! This is a pattern that we will see throughout the following charts (Figures 5.1 to 5.6),a fact that contradicts the myth of a “lack of scholars”.

In this context it is also worthwhile looking at Kuwait (Table 5.3) as it is rather a closedshop when you look at the top rankings.

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Table 5.2 Top six Bahrain scholars – chairman and board positions

Top six Bahrain (out of 36)


Number ofoverall board

positions

Shaikh Nedham Mohamed Saleh Yacoubi 6 28Shaikh Dr Abdul Satar Abdul Karim Abu Ghuddah 3 15Dr Mohamed Ali Elgari 2 11Dr Fareed Mohammed Hadi 0 7Shaikh Osama Mohammed Bahar 1 7Sheikh Abdullah Sulaiman Al Manee’a 5 6

Overall number of positions 74

Percentage of all positions in Bahrain 55.22%


Again, as in the case of Bahrain and other GCC countries such as Saudi Arabia, Qatar, andthe UAE the distribution of scholars is very much skewed towards a few. Figure 5.2 aboutKuwait is a good indication of this.

5.3 GOOD GOVERNANCE-RELATED POINTS

The Islamic Financial Services Board’s (IFSB) December 2009 paper on “Guiding Principleson Sharia Governance Systems for Institutions Offering Islamic Financial Services” serves asa good sounding board with regard to proposed measures but can also be further developed toaddress additional points.

It highlights the great importance of the Shariah boards by pointing out that concernsover the roles and functions of the Shariah boards, which constitute part of the broader

30

18

12 2 2 2

5 5 67

11

1 1

15

28

Number of positions

Overall scholars

1

4 4

25

20

15

10

5

0

Figure 5.1 Bahrain scholars – number of board positions held


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30

18

12

3 3

5

1 1 1 1 1 1 1 11

78

9 1011

13

3

19

23

30

Number of positions

Overall scholars

4 4

10

25

20

15

10

5

0

Figure 5.2 Kuwait scholars – number of board positions held


governance system, have been a recurring theme. The IFSB goes even further by highlightingthat this is crucial, considering that compliance with Shari’ah rules and principles is the raisond’etre of the Islamic Financial Institution. In fact other IFSB standards – such as those on riskmanagement, capital adequacy, and supervisory review process – also contain requirements andrecommendations aimed at ensuring that an appropriate Shariah governance system is in place.

Undergraduate Studies

University of Kuwait

University of Qatar

Al-Azhar University

Imam Muhammad ibn Saud Islamic University

Islamic University, Madina

0 1 2 3 4 5 6 7 8

8

5

4

4

9

9

10

Figure 5.3 Top 5 ranking of universities by degrees earned by Shari’ah scholars, UndergraduateStudies (Bachelors degrees)


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Graduate Studies

National University of Malaysia

University of Damascus

International Islamic University (IIUM)


AI-Azhar University

0 2 4

4

5

86

6

6

10 12 14

14

16

Figure 5.4 Top five ranking of universities by degrees achieved by Shari’ah scholars, Graduate Studies(Masters and Honours degrees)


Interestingly enough, the IFSB in one of its footnotes also highlights that “in recent yearsthere has been an increasing trend towards the formation of Shariah advisory firms, which offerservices such as Shariah audit/review, although they cannot be considered as an alternative toa proper full-panel Shariah board” in their view.

Our research also included these Shariah advisory firms as they specifically work for com-panies with Islamic windows or consult on a project basis with generally short to medium-term

Doctoral Degrees

University of Cairo 4

5

7

9

18

University of Umm AI-Qura

Edinburgh University


AI-Azhar University

0 2 4 86 10 16 18 2012 14

Figure 5.5 Top five ranking of universities by degrees achieved by Shari’ah scholars, Doctoral Degrees


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Teaching Positions

University of Bahrain, United Arab EmiratesUniversity, Islamic Science University of

Malaysia, University of Qatar

University of Damascus

International Islamic University (IIUM),Malaysia

Imam Muhammad ibn Saud IslamicUniversity

University of Kuwait

0 2 4 6 8 14 16

15

11

10

5

4

10 12

Figure 5.6 Top five ranking of universities by teaching positions of Shari’ah scholars

Source: Funds@Work AGAll of the four universities mentioned in the first bar (University of Bahrain, United Arab Emirates University, IslamicScience University of Malaysia, and University of Qatar) are home to four scholars each

involvement. Shariah advisory firms might provide a solid infrastructure though which to assistspecific scholars in managing their board memberships and training future scholars/advisorsto take on new responsibilities.

The IFSB also highlights in its paper that

[i]n some jurisdictions, supervisory authorities have their own Shari’ah board that works togetherwith them in issuing standardised Shari’ah pronouncements/resolutions, as well as aligning rel-evant policy and regulatory frameworks with the Shari’ah. Although they may be known by

Table 5.3 Kuwait top six ranking scholars in terms of chairman and board positions

Top six Kuwait (out of 47)


Number ofoverall board

positions

Dr AbdulAziz Khalifa Al-Qassar 8 30Dr Essa Zaki Essa 3 23Sheikh Dr Khaled Mathkour Al-Mthkour 3 19Sheikh Ahmad Bazie Al-Yaseen 12 13Sheikh Dr Mohammed Abdul Razaq Al-Tabtabae 2 13Shaikh Dr Esam Khalaf Al-Enezi 3 13

Overall number of positions 111

Percentage of all positions in Kuwait 48.68%


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different names such as National Shari’ah Advisory Council, National Fatwa Council, HighShari’ah Board, etc., their functions are similar – that is, to become the highest body issuingShari’ah pronouncements/resolutions for IFSI in the country. Some of these supervisory authori-ties have even gone one step further, whereby they prohibit the members of the national Shari’ahpanel from sitting on a Shari’ah board of the market players in order to remove any perception ofconflicts of interest. In addition, each member of the Shari’ah board is restricted in terms of thenumber of Shari’ah boards of market players that he or she can serve. This restriction is intendednot only to minimise the conflict of interest and maintain an appropriate firewall to manage con-flicts and preserve confidentiality, but also (perhaps more importantly) to ensure that the membersof a Shari’ah board can dedicate adequate time and effort to each IIFS that they serve.

In the IFSB paper’s recommendations for operating procedures of the Shariah Board youwill also see that “one of the members of the Shariah board shall be elected as its Chairman.The Chairmanship should preferably be on a rotation basis, such as whenever there is areappointment of the Shariah board. In the event that the Chairman is unable to attend themeeting, the members shall elect one of themselves to become the Alternate Chairman topreside over the meeting.”

When you consider the concentration that our research has found you can certainly say thatnot only minimizing conflicts of interest but also ensuring that the individual Shariah scholarshave sufficient time to devote to its boards is an important goal to pursue. There is ampleacademic evidence out there to underline the importance of this.

Dharwadkar et al. (2008) looking, for example, at increases in the size of portfolio holdingsof asset management companies come to the conclusion that asset managers, depending onthe size of their portfolio holdings, will exert less time and effort in monitoring all of theirinvestments. The same can be true for leading Shariah scholars maintaining up to 78 boardpositions in more than a dozen different countries, as our research shows. The greater thenumber of board memberships, the potentially greater probability of not paying sufficientattention to the needs of individual boards. Anecdotal evidence from the industry and recentmedia coverage shows that various financial services institutions linked to prominent scholarshave difficulty in getting hold of their scholars, with long lead times that can take up tothree months, and may therefore consider changing their board members going forward. Ourresearch actually delivered the basis for market participants to understand why scholars arehard to get hold of.

The number of board memberships could also reduce the identification of scholars withparticular organizations. Hillman et al. (2008) show, for example, that a director’s identificationwith the organization can affect his or her monitoring and resource provision as well. Thusthe more strongly an individual identifies with the organization, the more he will work tobenefit it.

Moore et al. (2006) have looked in depth at potential conflicts of interest explaining whyprofessionals are often unaware of how morally compromised they have become by conflictsof interest. They also add that people believe that they are not doing anything wrong and feelthat their professional decisions are justified and that concerns about conflicts of interest areoverblown by ignorant or demagogic outsiders.

The IFSB in its report even urges readers that

an Islamic Financial Institution should be fully aware of the possibility of, among other things:ensuring that the Shari’ah board is more focused, with more time spent on each assignment andconflicts of interest adequately managed, which may imply that its members should not serve morethan a limited number of clients, hiring and nurturing young members of the Shari’ah board with

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promising potential, to expand the talent pool in the profession; and engaging other professionals,such as lawyers, accountants and economists, to assist and advise the Shari’ah board, especiallyon legal and financial issues.

This is clearly in line with network analytic findings that suggest that a complementaryboard might be more innovative but at the same time also avoid group think where, accordingto Janis & Mann (1977), group think could be an outcome when members ignore obviousdanger, take extreme risk, and are overly optimistic (illusion of invulnerability) or discreditand explain away warnings contrary to group thinking (collective rationalization). Membersbelieve that their decisions are morally correct, ignoring the ethical consequences of theirdecisions (illusion of morality) and the group constructs negative stereotypes of rivals outsidethe group (excessive stereotyping). There is also pressure for conformity where memberspressure any in the group who express arguments against the group’s stereotypes, illusions,or commitments, viewing such opposition as disloyalty and self-censorship might take placewith members withholding their dissenting views and counter-arguments. Members perceivefalsely that everyone agrees with the group’s decision; silence is seen as consent (illusion ofunanimity) and some members appoint themselves to the role of protecting the group fromadverse information that might threaten group complacency (mindguards).

Moore et al. (2006) also refer to a minimal group paradigm highlighting how easy it is toestablish a group identity that leads people to favour fellow in-group members.

When it comes to the topic of minimum competence requirements, the IFSB, among others,also lays down that a scholar must at least hold a bachelor’s degree from a recognized universityin the sciences of Shari’ah, including Islamic transaction/commercial law and be able todemonstrate an adequate understanding of finance in general, and Islamic finance in particular.

However one clearly needs to address which universities should be seen as “recognized”.Our research reveals that the body of scholars hold a variety of degrees from 82 differentuniversities across the world, with differing majors. Since we binarized the data we cancertainly give an answer to who might be adequately qualified or complementary in a specificboard, based on his/her education or even sector experience. The IFSB though probably needsto draw up a list of recognized tertiary educational institutions.

5.4 SUMMARY

Good governance mechanisms in the Islamic finance industry can take numerous forms.We have only focused on a few and we have also built on IFSB’s December 2009 paperto highlight some of these. Since we published our first network analysis and visualizedscholars’ involvement, market participants have received hard data in order to better judge thecurrent situation in the Islamic finance industry. Since then the call for minimum qualificationand training, accountability, structural changes to the board (rotation, complementary andspecifically independent board members, objective and transparent nomination process), butalso the procedural aspects of the board have surfaced much more strongly (keeping ofminutes, highlighting dissenting views, communicating fatwas etc.). The future looks brightas the industry will move towards a more transparent and equitable setting with more scholarshaving the opportunity to engage in boards but at the same time driving down concentration.Our next comprehensive paper will be devoted extensively to governance mechanisms in orderto bring about a more resilient industry. We need some kind of central authority not only tomonitor Shari’ah Board activities but also to provide transparency. Our research for example

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showed how difficult it is to even monitor the joining or leaving of the board by a scholar.There is no central file where Islamic Financial Institutions have to report changes in theirboards (including dates of joining but also of leaving the organization) which in itself couldbe a great step forward. It is currently up to people like us to track those changes based onprimary and secondary data.

In times where we are all faced with the impact of the global financial crisis – and the Islamicfinance model will certainly gain in importance – our work will contribute to a heightenedalertness about the potential risks that we need mutually to address and thus help in buildinga more resilient system. Integration of our scholar data with actual product or company data(see also www.shariahscholars.com) will open up a variety of new research opportunitiesallowing academics to test whether the success of Islamic instruments (such as in relation totheir distribution) are, for example, related to the presence of certain scholars.

REFERENCES

Dharwadkar, R., Goranova, M., Brandes, P. and Khan, R. (2008) Institutional ownership and monitoringeffectiveness: It’s not just how much but what else you own, Organization Science, 19(3), May–June,419–40.

Hillman, A.J., Nicholson, G. and Shropshire, C. (2008) Directors’ multiple identities, identification andboard monitoring and resource provision, Organizational Science, 19(3), May–June, 441–56.

IFSB (Islamic Financial Services Board) (2009) Guiding principles on Shariah governance systems forinstitutions offering Islamic financial services, IFSB paper, December.

Janis, I.L., and Mann, L. (1977) Decision Making: A Psychological Analysis of Conflict, Choice, andCommitment, Free Press: New York.

Moore, D., Tetlock, P.E., Tanlu, L. and Bazerman, M.H. (2006) Conflicts of interest and the case ofauditor independence: moral seduction and strategic issue cycling, Academy of Management Review,31(1), 10–29.

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6

The Alpha and Omega ofAbrahamic Finance

Mufti Talha Ahmad Azami and Shahzad Siddiqui*

The Alpha and the Omega, the first and the last, the beginning and the endDescription of the Divine in the Bible, Revelations 22:13

6.1 INTRODUCTION

“Abrahamic” finance can be defined as a form of finance which draws its parameters fromJudaism, Christianity, and Islam. While the Islamic world has been at the forefront of applyingreligion to finance, the Judeo-Christian and Socially Responsible Investing (SRI) investmenttraditions can assist Islamic finance in broadening its parameters and appealing to a largeraudience of investors.

This chapter has been divided into two distinct parts. The first part (omega) will introducefinancing guidelines for each of the Abrahamic religions. We will briefly describe the negativescreening criteria pertaining to the three Abrahamic faiths, and the similarities that each ofthese faiths have in the realms of financial investments. By way of example each of theAbrahamic faiths finds usury and pornography morally and socially abhorrent.

We advocate, as a strategy, the exclusion of stocks not allowed under other ethical frame-works of investing like Socially Responsible Investing (SRI). This would include compa-nies that employ child labour and companies that pollute the environment. These practices,although religiously frowned upon in all the Abrahamic traditions, have yet to find a place intheir investment guidelines.

In addition to highlighting the negative screening criteria of Abrahamic finance and SRI, wewould like to emphasize the positive screening attributes that SRI funds seek in companies,including but not limited to: a sound record on conservation of energy and natural resources,protection of the environment, and good customer relations. A negative and a positive bifur-cate feature has yet to be incorporated into faith-based investment strategies. For example,the authors are unaware of any fund that both screens out companies that engage in usurywhile actively looking for companies that are improving the environment. Research in all threeAbrahamic traditions suggests that the use of both positive and negative screening will gener-ally be consistent with the teachings of the Quran; the Catholic Church and its commitmentto advocate for systemic changes to improve the well-being of individuals and communities;1

and the strong focus on the ethical conduct of business affairs in the Jewish tradition.2


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The second part (alpha) of this chapter is where we explore and, hopefully, dispel the percep-tion that constraints in participating outside certain sectors such as gambling and pornographywould result in substandard performance of Abrahamic funds, as compared to their con-ventional counterparts. The hypothesis that we attempt to evaluate is that faith-based fundsoutperform the conventional indices in bull markets and show robustness in bear markets.Conclusions would then be drawn from the study.

6.2 JEWISH FUNDS

Jewish people, both individually and collectively as a community, have been investing theirmoney according to the strict remit of their faith for thousands of years. The practice is nowstarting to institutionalize itself in the form of modern-day mutual funds, and we are nowwitnessing a few examples of Jewish investment funds. A report by the Financial Times, foundthe existence of at least nine kosher investment funds being managed in Israel.3

In earlier research on such funds, Mark Schwartz, Meir Tamari, and Daniel Schwab foundthat, while funds based on Christian and Muslim ethics were quite prevalent, “a Jewish-based ethical fund is sorely lacking”. Schwartz, a professor at York University, has writtenextensively on business codes and ethics,4 Tamari has served as a Senior Economist at theBank of Israel, Senior Lecturer on Economics at Bar Ilan University, and has establishedthe Center for Business Ethics in Jerusalem.5 Schwab is the founder and Managing Directorof Kayema Investments Ltd, a South African investment advisory firm that specializes insustainable development.6 Schwartz, Tamari, and Schwab revealed the following in theirunpublished study on using Judaism’s ancient sources to establish a fund:

Such a fund would maintain a unique perspective on minority shareholders [and] could be cate-gorized under seven headings: abiding by Jewish law; abetting; justice and goodness; abiding bycontracts; preserving life; settlement of the world; Sabbath, festivals and kosher food.7

The AMIDEX35 Israel Mutual Fund launched in 1999 was the first US-based, open-endedmutual fund investing exclusively in Israeli companies. A second fund, the Blue & WhiteMutual Fund, has since also been introduced. There is also a closed-end fund: the First IsraelFund.8 A survey of funds invested in by the Jewish Communal Fund indicated an interest ina wide array of fund managers from SRI fund manager Calvert to Neuberger Berman whoseRegency funds earned a return of 48% in year 1 of data collected and then fell to a negativereturn of 6.3% in year 2, reflecting a tracking of volatility in the overall market.9 While thesefunds, and the Israeli funds mentioned above, cannot be considered “Jewish” per se, theirsuccess can be parlayed into interest in participating in a more holistic Abrahamic fund.

The core principles of an ideal Jewish investment fund are derived from the Talmud; theseinclude the principles of Tzedakah, justice and goodness, Pikuach Nefesh, preservation oflife, Yishuv Ha Olam, settlement of the world, Lo tashchit, prohibition against the wantondestruction of nature,10 and inveighing against lifnei iver, assisting moral misconduct.

With respect to Yishuv Ha Olam, authors Schwartz, Tamari, and Schwab read this principleto include environmental consciousness:

. . . investments need to be vetted carefully on the effects of the environment, bearing in mind therights of future generations and other societies whose environment is affected by the investmentpolicies of the firms in which one invests.11

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The Alpha and Omega of Abrahamic Finance 127

Meanwhile, with regard to the issue of lifnei iver, the same authors argue that by investingin companies engaged in activities such as tobacco, arms sales for non-defensive purposes andpornography, investors are creating a demand for a market based on the sale of forbidden goodsand encouraging religious and moral transgressions by the investee company.12 This argumenthas some merit, in that the “lifeblood” of most companies lies in financing and revenuegeneration and the interplay between the two. We do know, for example, that divestmentcampaigns and consumer boycotts had a devastating impact on the economy of South Africa.By supporting South African companies, many consumers outside of South Africa had beencomplicit in its crimes.

According to www.fintactica.com, Jewish investors have recently taken issue with therecords of pharmaceutical corporations regarding the HIV/AIDS epidemic in Africa, highlevels of executive compensation, transparency in the political involvement of corporations,(the impact of businesses on) global warming, and equal employment opportunities.13

6.3 CATHOLIC FUNDS

The doctrine of the Catholic Church establishes the fundamental framework behind Catholicinvestment funds. This framework prevents investment in two major categories of companies:those involved in the practice of abortion, and those whose policies are judged to be anti-family. Companies deemed “anti-family” would include distributors of pornographic materialand businesses whose policies undermine the Sacrament of Marriage.14 George Schwartz,President of Schwartz Investment Counsel Inc., the advisor for Ave Maria Mutual Fundsdefines the Sacrament of Marriage as the following:

Our Catholic Advisory Board believes that marriage between a man and woman is a sacramentinstitute by God, therefore when a company offers to put a non-marital union on par with marriage,it’s a slap in the face to the Catholic Church and such companies should be screened out.15

Ave Maria has seen its assets climb to $600 million. George Schwartz predicts that assetsin the funds are expected to exceed $3 billion by 2013.16 Trinity Fidiciary Partners LLC ofFort Worth, Texas, is another firm involved in Catholic-oriented investments. Its EpiphanyCore Equity Fund tracks the Faith and Family Values 100 index, a sector-neutral market-capweighted index comprising of the 100 largest US-based companies that meet the fund’s moraland ethical standards.17

Luther King Capital Management of Fort Worth, currently managing $100 million, andChristian Brothers Investment Services Inc. of New York, managing $4.2 billion in assets, aresome of the other players devoted to Catholic investing.18

6.4 SOCIALLY RESPONSIBLE INVESTING (SRI) FUNDS

SRI is an investment strategy that seeks to maximize both financial returns and the social goodof investors. Its historical roots can be traced as far back as the Religious Society of Friends(Quakers), when in 1758, the Quaker Philadelphia Yearly Meeting prohibited members fromparticipating in the slave trade.19 Modern-day milestones include the 1971 US Pax WorldFund, which was set up with a specific avoidance of any investments related to the VietnamWar. Friends Provident launched their first ethically-screened fund, the Stewardship Fund, inthe UK in 1984.20 Assets under management currently exceed £3 billion.21

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Table 6.1 A comparison of faith-based screening: Jewish, Christian, Islamic and SRI

Perspective Faith-consistent Investment Exclusionary Screens

Jewish Tobacco, alcohol, gambling, homosexuality, abortion, pornography, ribit(charging interest), and kashrut (sales of non-Kosher food)

Christian Abortion, contraception, tobacco, alcohol, pornography, weapons, interestdealings, child labour, and protecting the environment

Islamic Conventional financial services, alcohol industry, pork products, gamblingindustry, and adult entertainment

SRI Stewardship Exclusionary screens include: tobacco production, alcohol production, gambling,pornography or violent material, manufacture and sales of weapons, animalexploitation, nuclear power generation, poor environmental practices, humanrights abuses, and poor relations with employees, customers or suppliers

SRI investment is attracting the attention of key individuals at large institutional investors,especially at retirement funds in the northeastern United States and California. For example,New York State Comptroller, Thomas DiNapoli, pushed the New York State Common Retire-ment Fund (NYSCR) into indices that “screen for green”. In a report by Institutional Investor,DiNapoli expressed his motivations for investing in the indices: “We have to act now. There’stoo much at risk for our planet.”22 Meanwhile, Denise Nappier, state treasurer and sole fidu-ciary of the $26 billion Connecticut Retirement Plans and Trust Fund (CRPT), has worked onissues such as environmental compliance and corporate governance. She successfully com-pelled American Electric Power to report its plans to reduce the company’s greenhouse gasemissions. Nappier also had a role in the decision by the Walt Disney Co. to split the role of itsBoard Chairman and Chief Executive Officer.23 Furthermore, retirement funds have been activein the development of SRI principles. When the United Nations unveiled its Principles for Re-sponsible Investment in 2006, among the 250 signatories were NYSCR, CRPT, and CalPERS.24

6.5 ISLAMIC FUNDS REDUX

Investors in Islamic funds have much the same objective as any other faith or non-faith driveninvestor, in that they seek profits from capital gains or dividends paid out by the underlyingcompanies in their portfolio. Avoiding certain companies that are involved in haram activitiesand observance of Islamic prohibitions pertaining to debt and interest, which exists in othertraditions but is generally not implemented, are what set Islamic funds apart from otherfund varieties.

The evolution of Islamic funds dates back to 1968, when the first Islamic fund DanaAl-Aiman was launched in Malaysia, and it is still active to this day. As of October 2009,the fund size was RM 66.93 million.25 After that, the first Islamic equity fund launched inMalaysia was by Arab-Malaysia Unit Trust Berhad Malaysia in 1993. The growing awarenessand rising popularity of fund products in majority Muslim countries have supported theirexpansion. This reflects in the 19.7% compound annual growth rate (CAGR) in terms ofasset under management (AUM) witnessed by the global Islamic funds industry during theperiod 2003–07,26 compared with 17.0% CAGR for the conventional global asset managementindustry during the same period. Despite the global recession that engulfed the capital markets,AUM of Islamic mutual funds reported a steady 4.9% year-on-year growth in 2008 to US$43bn.This increased to US$44bn in Q1, 2009.

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Graph 1: Graph 2: New Islamic funds launched (2006-1Q09)

0

10

20

30

40

50

2003 2004 2005 2006 2007 2008 1Q09

US

D b

n

Assets under Management

0

40

80

120

160

200

2006 2007 2008 1Q09

New Islamic funds launched

Figure 6.1 Global assets under management and number of entrants in Islamic funds

Source: Ifir 2009, Ernst & Young, NCBC Research

Indicative of the overall interest and growth in the Islamic fund management industry is theaugmentation of products and services which support the management of Shariah-compliantportfolios, which include the establishment of Islamic indices. The first Islamic equity indexwas launched in Malaysia by RHB/Unit Trust Management Berhad in May 1996. This wasfollowed by the launch of Dow Jones Islamic Market Index (DJIM) by Dow Jones & Companyin Bahrain in February 1999, and the launch of the Kuala Lumpur Shari’a Index (KSLI), nowthe Bursa Malaysia in April 1999.27 More recently, Russell Investments and Jadwa Investmentannounced the launch of the Russell-Jadwa Shariah Index family for their institutional investorclient base.28 In Toronto, on 27 May 2009, the S&P launched its S&P/TSX Shariah Index.29

Shariah screens are increasingly well known; Shariah-sensitive investors cannot invest in theabove-mentioned industrial sectors, namely, conventional financial services, alcohol industry,pork products, the gambling industry, and adult entertainment. These investors also refrainfrom investing in companies that have inordinate amounts of debt (usually a 33% debt-to-equityratio30), high levels of accounts receivable (usually 45%) and unacceptable levels of impureincome from, inter alia, the above-mentioned sectors (usually more than 5% of corporateearnings).

Shariah screens can serve as early warning signals. For example, a year before its collapse,Worldcom was taken off the Dow Jones Islamic Market Index (DJIMI), due to high levelsof corporate debt.31 The DJIMI similarly screened out Enron, due to its sharply increasingdebt load, shortly before its scandal-plagued collapse.32 However, it must be noted that in aglobalized world, Islamic finance and conventional finance “breathe the same air and swimin the same water”. The current financial crisis has exposed how interconnected both systemsof finance actually are. As global real estate and private equity values plunged, so did thevalues of many Islamic financial institutions (IFIs). Most Islamic financial transactions are stillbenchmarked to the London Interbank Offered Rate (LIBOR), exposing them to movements ininterest rates. However, as argued in this chapter, mutual funds with Shariah screens remainedlargely robust.

Shariah screens have the potential to be highly adaptable and to incorporate non-traditionalconsiderations that arise with the new challenges each generation faces. For example, even

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though Shariah screens do not usually include environmental concerns, Muslims are remindedin their scripture that they are meant to be caretakers of the earth.33

Alberto Brugnoni, founder of ASSAIF,34 asserts the following:

Islamic environment funds and Shariah-compliant financing mechanisms need to seriously con-sider supporting projects that are involved in carbon trading, bio-fuel ventures, solar and hydro-gen power plants, waste incineration and recycling projects. Such investments are the need ofthe hour and represent a serious alternative to the unchecked free market approach. Growth inIslamic banking should equal the swift increase in awareness on climate change and its impendingconsequences and develop into a more environmentally friendly path.

A focus on environmental considerations is also practical, in that companies who areenvironmentally sensitive and otherwise ethical will also likely adhere to good corporategovernance and business practice. Screens could also accommodate issues such as sweatshoplabour, since Muslims are told repeatedly in the Holy Quran that they should be kind to orphansand the poor.35

The very objective of Shariah – literally, “beaten path to the watering hole” – is to promotethe welfare of the people, which encompasses the safeguarding of five crucial matters, as statedby Imam al-Ghazali Chapra, 1992):36 Faith (Din), Life (Nafs), Posterity (Nasl), Property (Mal),and Reason (Aql). Similarly, Ibn al-Qayyim al Jawziyyah states that the basis of the Shariahis wisdom and welfare of the people in this world and the hereafter.37

Imam al-Shatibi too contends that the Shariah aims at the welfare of the people in this lifeand in the life hereafter by protecting its objectives or maqasid, which can be classified asfollows: Daruriyyah (necessities); Hajiyyah (requisites); and Tahsiniyyah (beautification).

Daruriyyah, as explained by Ahamed Myrdin, “are objectives which are a must and basicfor the establishment of people’s welfare in this world and the hereafter; the ignoring of whichcan cause fasad [corruption] to prevail”.38

The protection of people’s welfare and the prevention of corruption are also Christianvirtues. Indeed, issues like the environment and sweatshop labour are drawn from Catholicand secular socially responsible screens and continue to inform mutual funds run by MotherEarth Inc. and more traditional fund managers like Calvert. In a comment on Catholic screens,Hari Bhambra of Praesidium LLP states:

Akin to the concept of vicegerency in Islam, Catholic investments are also reiterating the conceptof “Human Stewardship” and the role of mankind as a manager not an owner of resources andtherefore the implicit moral responsibility associated with such a function is similar to principlesin Islam . . . Catholic investment vehicles have grown in the US such as the Eva Maria Funds*

[sic] which invest in accordance with moral principles and values avoiding investments in certainindustries such as those which promote or facilitate abortion. Catholic funds are a form of sociallyresponsible investments or morally responsible investments.39

These sorts of comprehensive screens formed the basis of the world’s first Shariah SRI fund,launched by BMB Islamic in 2009. As stated by Mufti Talha in an earlier work, written as arepresentative of BMB Islamic:

This product is likely to resonate well with the values and needs of all investors – both Muslimsand non-Muslims alike. Such a product has the potential to be commercially successful in linewith similar products in the market. For example, if we were to analyse the performance of SRIassets from 2005–2007 alone, we find that they have increased more than 18%, while non-SRIfunds in general have increased less than 3% during the same period.40

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Many observers, Muslims and non-Muslims alike, have commented on the correlationsbetween Shariah and SRI. For example, asset manager John Sandwick has stated:

Religion is relevant to ensure that security selection for clients who wish to invest accordingto Shari’a principles remains in compliance with the specific requirements. In many ways it isanalagous to the discipline of ethical investing. In this respect, Islamic asset management remainsin line with the universally accepted principles of asset management.41

Here, Brugnoni chimes with a prescription:

Islamic finance should move away from being concerned with just the way in which activities arebeing financed to start focusing on what kind of activities are funded and on their impact on theenvironment. The negative screening provided by the halal/haram divide that excludes investmentsthat fail to meet religious standards should be complemented by a positive screening based onmeeting standards and takes into account all environmental and social issues.42

With regard to the long-standing issue of interest, commentators in the Islamic financearena have castigated compromises made by their Christian counterparts and the way thosecompromises have affected the nascent field of Islamic finance. For example, in comparingthe medieval contractum trinius, sanctioned by the Catholic church, with its modern “Islamic”equivalents, Tarek El Diwany states:

An interest-free loan is halal, a gift is halal, and a promise is halal; individually these arepermissible contracts, but when they are put together this equates to an Interest Bearing Loan.This is because a fixed rate of return is predetermined by banks. If I lend you a 100 on thecondition that you return 150, this is clearly haram, and these banks are doing just what theChristians did.43

In light of remarks like these, and the uncomfortable truth behind them, it is instructive forIslamic finance institutions to rethink their long-term strategies and contemplate a return tocore principles. The first of these principles would be condemnation of usury, which Islamshares with early Judaism and Christianity. On a purely religious level, then, the Islamic worldcan play a part in influencing its Judeo-Christian brethren to invest in portfolios that do notinclude interest-based financial institutions. The Islamic world can point to the devastationcaused by the global credit crisis, which had its roots in a toxic mixture of interest, uncertainty,and gambling. It can also direct its Christian counterparts to the compelling words of theVatican newspaper, L’Osservatore Romano, which stated in the midst of the crisis:

The ethical principles on which Islamic finance is based may bring banks closer to their customersand to the true spirit which should mark every financial service.44

In a dynamic counter-play, the Judeo-Christian tradition can convince the Islamic financeworld to widen investment screening criteria to include caretaker considerations like theenvironment and sweatshop labour. Hitherto, these two important screens have been absentfrom Islamic funds but may find traction in the future, especially as fund managers realize thata wellspring of consumer consciousness underlies environmental and labour screening andthat such screening is in complete consonance with the Shariah.

Ultimately, all three traditions are focused on the proper use of tangible wealth and the fruit-ful generation of intangible wealth. Intangible wealth can be said to include emotional, mental,and community well-being and is treasured by all of the Abrahamic and world traditions.

Following the launch of BMB’s Shariah SRI Fund, the time is ripe for the next phase ofreligious-ethical investing: the creation of Abrahamic funds. By combining SRI stewardship

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Figure 6.2 “Real wealth”45

principles with Catholic considerations like child labour, existing Islamic funds can becomeAbrahamic ones, appealing to socially conscious Jewish, Christian, and Muslim investorsworldwide. Ultimately, the proposed Abrahamic ethical fund concept represents a convergenceof pluralistic ethical thought with increasingly global finance.

6.6 ALPHA: QUANTITATIVE RESULTS OF ABRAHAMIC FUNDS

ART THOU NOT aware how God sets forth the parable of a good word*? [It is] like a good tree,firmly rooted, [reaching out] with its branches towards the sky, yielding its fruit at all times byits Sustainer’s leave. And [thus it is that] God propounds parables unto men, so that they mightbethink themselves [of the truth]. And the parable of a corrupt word is that of a corrupt tree, tornup [from its roots] onto the face of the earth, wholly unable to endure

Sura Abraham: 24–2646

There is compelling evidence showing that faith-based funds outperform the overall stockmarket in bull markets and remain robust during bear markets (or at least more robust than theirconventional counterparts). In a report for Business Islamica, Jahangir Aka of SEI found thatoutperformance in volatile markets and meritorious performance across a full market cycleboth augured well for Shariah-compliant investing.47 Meanwhile, a meta-analysis of broader

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Raw Universe of Stocks

Ethically-Compliant Universe of Stocks

Abrahamic SRI Universe of Stocks

Application of an SRI Stewardship Criteria

Application of Abrahamic investment criteria

Re-application of economic metrics and fund manager’s investment strategy

Investible universe

An overview of stock investment scheme

Figure 6.3 Flow diagram of Stock Investment Scheme

Abrahamic screens by Lightstone Capital shows an “outperformance in up and robustness indown” market pattern. Detailed research by John Lightstone and Gregory Woods shows thatboth Islamic strategies outperform conventional benchmarks in 21 years of backtesting andthat indices containing more recent Abrahamic considerations outperform their conventionalbenchmarks in eight years of backtesting.48

Some funds are actively searching for these outperformance/robustness results. For example,the Mizan Fund has seven sub-portfolios with different investment strategies. The objectiveof the Small Cap Growth sub-fund is to “outperform the Russell 2000 Growth Index in upmarkets, while showing smaller declines than the Benchmark in down markets”.49 Meanwhile,the Small Cap Growth at a Reasonable Price sub-portfolio is “expected to outperform Russell2000 Growth Index in both up and down markets”. The most ambitious objective, however,belongs to the Small Cap Value sub-fund: “expected to outperform the Russell 2000 ValueIndex over various market cycles”.

The overall objective of the Mizan Fund is to save American Muslims with an eye onretirement nesteggs from an “untenable position: having to choose between participating intheir employer’s 401(k) plan (and their desire to build retirement assets for the future), or

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Figure 6.4 Mizan All Equity Moderate Allocation Fund

investing in ways that are consistent with their faith”.50 The fund accomplishes this becauseit is available to most retirement service providers through trading platforms like CharlesSchwab, Merrill Lynch, Wachovia Bank/Wystar, and Fidelity.51

If the Mizan fund is able to meet its Shariah and economic metrics, it will be a boon tothe American Islamic investment industry and an excellent template for potential Abrahamicfunds. Mizan would also follow the outstanding track record set by the Amana Mutual FundsTrust (which includes the Amana Growth and Amana Income funds), managed by SaturnaCapital Corporation. From November 1997 to November 2007, Amana grew in assets from$25 million to over a $1 billion.

As a value investor, Amana keeps stock turnover low and has adopted a buy and holdstrategy with largely blue-chip companies including Apple, Qualcomm, and Adobe.52 BothAmana funds have won Lipper Awards for demonstrating consistently strong risk-adjustedreturns compared to peer funds. The Amana Growth fund was placed first for Best Multi-CapGrowth Fund in both the three- and five-year periods at the 2009 Lipper Fund Awards, chosenfrom 392 funds in its category over three years through December 2008, and from 326 fundsin the five-year period.53 The Amana Income Fund was placed first for the second consecutiveyear for Best Equity Income over three years at the 2008 Lipper Fund Awards. The Fund waschosen from 198 funds in its category and rated the best fund over three years through 31December 2007.54 While the Amana Income fund outperformed the markets during the bullyears, it also stayed more resilient during the critical bear year: in 2008, the fund lost 25.8%of its value compared with a US mutual fund average loss of 44%.55

In this respect, Amana overtook other faith-based funds like the Timothy Plan, which hadstarted the 2008 bear year ahead of Amana. As noted by Deborah Brewster of the FinancialTimes:

The Timothy Plan, a mutual fund group that invests according to “pro-family, biblically based”Christian values was the top performing faith-based fund in the US last year. Timothy’s returnswere higher than those of most hedge funds and beat 35 other faith-based funds, including theAmana Trust funds, which invest according to Islamic principles.56

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6.7 AMANA AND THE BENCHMARKS

Research by Jarmo Kotilaine of NCB Capital vindicates the fact that Islamic funds weatheredthe global financial crisis relatively better than conventional funds. This can be attributedto the inherent security mechanism in the Islamic financial services sector, provided by theprohibition on non-Shariah-compliant activities.57 Kotilaine’s research shows that GCC-basedShariah funds fell 21.7% during the past year, compared with the 26.4% decline in conventionalfunds. The S&P Sharia Index fell by 28% between 1 January 2008 and 19 June 2009 comparedwith the 37% decline in the S&P Index during the same period. Dr Kotilaine’s reflection onthis period is noted in the following:

Though the indices for both Islamic finance and conventional systems recorded negative returnsduring 4Q-08 and early 2009, the quantum of losses recorded by Islamic indices or products waslower.58

Other faith-based funds had similar success. For example, the Ave Maria Mutual Fundswere also divided into several sub-portfolios. The Ave Maria Growth Fund was awarded the2009 Lipper Fund Award, after ranking first out of 653 funds in its category for the three yearspreceding 31 December 2008.59 Meanwhile, the Ave Maria Opportunity Fund posted returnsof 34.31% for the period starting 1 January to 30 September 2009.60 The largest part of theportfolio was held in cash, while the next highest sector weightings were as follows: energyand mining, technology, financial, and then healthcare. As with other Ave Maria sub-funds,the fund advisor (Schwartz Investment Counsel) agreed to cap its fees to 1.25% of the sub-funds’ average daily net assets until at least 1 May 2010. Ave Maria Mutual Funds are alsoavailable through trading platforms like Charles Schwab, Merrill Lynch, and Fidelity, alongwith Canadian-owned TD Ameritrade.61

Tel Aviv-traded stocks outperformed the S&P and the Dow Jones Industrial average for aperiod between 1999 and 2004. Since January 1999 to April 2004, the TA-25 was up 60%.62

More recently in 2009, The American Israeli Shared Values Fund was returning 21.32%,according to a report by Dow Jones Newswires.63

On the other hand, some researchers have found more or less the same performance betweenIslamic and conventional funds. For example, Noripah Kamso, chief executive of CIMB-Principal Islamic Asset Management, did a comparison of 10-year performance ending March2009 between the Dow Jones Islamic Market Index and the Dow Jones World Stock Index.Looking at performance using three measures (monthly, cumulative, and rolling three-year

Table 6.2 Amana average annual total returns (quarter ended 30 September 2009)

1 Year 5 Years 10 Years

Amana Income 1.53% 8.92% 5.97%Amana Growth −0.14% 8.93% 6.96%Benchmark comparisonsS&P 500 index −6.91% 1.01% −0.15%Russell 2000 index −9.55% 2.45% 4.94%Dow Jones Islamic Index US −5.11% 2.56% −1.38%

Source: www.amanafunds.com*

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40

50

60

70

80

90

100

110

Feb-08 Apr-08 May-08 Jul-08 Sep-08 Nov-08 Dec-08 Feb-09 Apr-09 Jun-09

FT All share FT Shariah All worldS&P 500 SHARIAH S&P 500 INDEXDow Jones Islamic index Dow Jones World Index

Figure 6.5 Performance of Islamic and conventional indices*

Source: Bloomberg, NCBC research, *Indices Re-based to 100

performance), she came to a simple conclusion: similar performance. However, she alsocommented that:

Shariah-compliant companies may tend to be more resilient should an economic downturn sud-denly occur compared to their conventional counterparts whose financial position may be moreprecarious because of their more leveraged financial position.64

Other researchers have found comparable results. In one report calling for further research,business school professors from the University of St Andrews and University of South Australiastated:

[W]e find some evidence that Islamic equity funds exhibit a hedging function in case of a losingglobal equity market. This is intuitive; since they are restricted to invest in assets with a low debtto equity ratio . . .65

6.8 CONCLUSION

Those interested in the Abrahamic Ethical Fund concept would do well to heed the call formore research into Islamic equity’s downside risk exposure and upside potential. Even if weconsider the low intensity research so far, Islamic equity funds (led by the Amana mutualfund family) would appear to bear out the hypothesis in this chapter: that Islamic fundsgenerally outperform their conventional counterparts in upmarkets and suffer less of a fall indownmarkets.

For the devout, such a fund constitutes a strong worldly proposition: the investor mayfollow the dictates of the Divine in financial decisions while simultaneously making a greaterinvestment return. In following these dictates, the devout investor can also contribute tocommunity well-being, which is the true source of wealth in any society.

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During the global crisis, thousands of devout Jews, Christians, and Muslims who hadinvested in conventional mutual funds saw unprecedented devastation to their portfolios, dueto the heedlessness of a minority in the financial industry. As Omar Clark Fisher put it:

The magnitude of the financial catastrophe and consequential hardships hardly seems a just or fairprice for societies to pay for the greed, corruption and moral failure of a relatively few financiers.No doubt, this global economic meltdown has left the entire world poorer.66

Had the monotheistic investors shown more faith in religiously inspired screens (be theyJewish, Christian, or Islamic), they might have seen their mutual fund portfolios outperformthe conventional market while remaining more robust during the unremitting devastation ofthe crisis.

Post-crisis, faith-based screens remain an attractive alternative for believing and non-believing investors alike and will likely inspire greater research and, we hope, an actualAbrahamic Ethical Fund.

APPENDIX: THE ABRAHAMIC FAMILY TREE

From an Islamic perspective, Muslims believe that the three monotheistic traditions, namelyJudaism, Christianity, and Islam share the same lineage/bloodline that can be traced back allthe way to Prophet Abraham.

The final prophet of the Jews, Prophet Moses was a descendant of Prophet Isaac who wasthe second son of Prophet Abraham. Similarly, Mary the mother of Christ, the apostle ofChristianity had Jewish ancestral roots that can similarly be traced back to Prophet Isaac. Thefinal Prophet of Islam, Prophet Muhammad was a direct descendant of Prophet Ishmael, thefirst son of Prophet Abraham (peace be upon all of them).

NOTES

* Mufti Talha Ahmad Azami is a Shariah manager at BMB Islamic UK Ltd, one of theworld’s leading Shariah advisory and assurance firms. He has trained in traditional Islamicsciences and completed his education with a Master’s degree at Loughborough University.He can be reached at [email protected] +44-778-617-0298

Shahzad Siddiqui is the Chief Legal Officer at Broadwater Capital Inc. and was formerlythe principal of Shahzad Siddiqui Professional Corporation, a Toronto-based law firmwhich focuses on Shariah-compliant corporate, real estate transactions, estates and endow-ment work, and complex litigation. He can be reached at [email protected], +1-647-628-5157

Mufti Talha and Shahzad Siddiqui presented this paper at “Building Bridges Acrossthe Financial Communities,” Ninth Harvard Forum on Islamic Finance at Harvard LawSchool on March 28 2010 and are indebted to Dr Nazim Ali and the Harvard IslamicFinance Project for an opportunity to present this paper.

1. “Chapter 9: Investment Policies and Guidelines” www.archden.org/PastoralHandbook.Chapter9Rev9 26 2007.pdf (accessed 6 December 2009).

2. Mark Schwartz, Meir Tamari, and Daniel Schwab (2002) “Capital Marketsand Jewish Teaching”, www.kayema.com/. . ./Capital%20Markets%20and%20Jewish%20Teachings.pdf (accessed 15 December 2009).

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3. Tobias Buck, “Israelis Savour Rise in Kosher Investments”, Financial Times www.ft.com/cms/s/0/96fe312c-254d-11df-9cdb-00144feab49a, i email=y.html (accessed 5 March2010).

4. “Mark Schwartz”, http://bloodstone.atkinson.yorku.ca/projects/researchak/people.nsf/researcherprofile?readform&shortname=schwartz (accessed 28 January 2010).

5. “Dr. Meir Tamari”, www.torah.org/learning/business-ethics/ (accessed 28 January 2010).6. “Daniel Schwab’s Page”, www.vc4africa.com/profile/Danielschwab (accessed 28 January

2010).7. Mark Schwartz, Meir Tamari, and Daniel Schwab (2002) “Capital Markets and

Jewish Teachings”, www.kayema.com/. . ./Capital%20Markets%20and%20Jewish%20Teachings.pdf (accessed 15 December 2009).

8. Maariv online, “Taking Stock in Our Future” 26 April 2004, www.amidex.com/articles/index.cfm?id=97 (accessed 13 December 2009).

9. Jewish Communal Fund, “Performance comparison of investments”, period ending 31December 2009.

10. Paul Lungen, “Ethical investing grows in popularity” Canadian Jewish News, 28August 2008 p. B14. www.ethicscan.ca/aboutus/media/canadian jewish news 28-08-08.pdf (accessed 15 December 2009).

11. Mark Schwartz, Meir Tamari, and Daniel Schwab (2002) “Capital Markets andJewish Teachings”, www.kayema.com/. . ./Capital%20Markets%20and%20Jewish%20Teachings.pdf (accessed 15 December 2009).

12. Ibid.13. “Introduction to Ethical Investment”, www.fintactica.com/ethical investment/articles/

document 8 43.php (accessed 23 November 2009).14. “Chapter 9: Investment Policies and Guidelines”, www.archden.org/PastoralHandbook.

Chapter9Rev9 26 2009.pdf (accessed 6 December 2009).15. William Baue, “Ave Maria Fund Promote Catholic Values through Morally Respon-

sible Investing”, 12 September 2003, www.socialfunds.com/news/article.cgi/1219.html(accessed 17 December 2009).

16. Andrew Coen, “Advisers, investors put faith in Catholic funds”, 12 May 2008,www.investmentnews.com/apps/pbcs.dll/article?AID=/20080512/REG/614910111&template=printart (accessed 17 December 2009).

17. Ibid.18. Ibid.19. Mufti Talha Ahmad Azami, “Linking Shariah-based products and socially responsi-

ble investing” Islamic Finance News, 9 October 2009, www.islamicfinancenews.com/listing article ID1.asp?nm id=15239&searchid=9249 (accessed 5 November 2009).

Also reproduced as, “Crossing the chasm into Sharia based products”, Al Watan Daily,11 October 2009, p. 11.

20. “History of socially responsible investment”, www.baigriedavies.co.uk/why-choose-us/SRI.pdf (accessed 15 December 2009).

21. “Stewardship – from inception to future trends”, www.cafonline.org (accessed 15 Decem-ber 2009).

22. Frances Denmark, “Being green gets easier” Institutional Investor, November 2009, p. 29.23. Sam Mamudi, “The rise of activist shareholder in the US boosts socially responsible

investment” FT.com, 5 November 2007 (accessed 17 December 2009).24. Ibid.

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25. ASM Financial Services Berhad, “Fund Fact Sheet as at 30 October2009”, www.asmb.com.my/uniTrust/factsheet/2009/FundFactSheet-30October2009.pdf(accessed 5 February 2010).

26. Ernst & Young, Islamic Funds and Investments Report 2009.27. For a brief history of Islamic indices, including those developed by the Dow Jones, FTSE

and Kuala Lumpur Stock Exchange, see Rushdi Siddiqui (2004) “Islamic indexes: theDJIM framework” Islamic Asset Management: Forming the Future for Shari’a-CompliantInvestment Strategies, ed. Sohail Jaffer, Euromoney Books: London.

28. Press Release: “Launch of the Russell-Jadwa Shariah Indexes” 24 June 2009, www.russell.com/news/press releases/pr20090624 indexes.asp (accessed 23 August 2009).

29. Eric Lam, “New Shariah Index follows letter of law” Financial Post, 27 May 2009:www.financialpost.com/story.html?id=1633883 (accessed 12 August 2009).

30. The acceptable debt ratio of 33% is based on a Prophetic hadith that “a third is a lot”.However, that Prophetic guideline related to the size of charitable donations that testatorscould bequeath through their estate. Therefore, the arguably “more compliant” measurefor an Islamic equity fund, public or private, may be zero long-term debt in the port-folio companies and, further, that any short-term debt meets the accepted parametersof 33%.

31. Khalid A. Hussein, Islamic Development Bank, “Islamic Investment: Evidence from DowJones and FTSE Indices”, www.kantakji.com/fiqh/Files/Markets/Khaled A Hussein 1.pdf (accessed 23 August 2009). See also Umesh Desai, “Islamic finance can giveearly warning of debt woes”, Reuters, 4 April 2008: www.reuters.com/article/ousiv/idUSSP19096920080404 (accessed 23 August 2009).

32. Ibid.33. For example, in sura Baqarah (The Cow) of the Holy Quran, verse 30, it states:

(Remember) when your Lord said to the angels, I am going to create a deputy on theearth a khalif (vicegerent; caretaker), they said: What! wilt Thou create there one whowill spread disorder and cause bloodshed, while we proclaim Your purity, along with yourpraise, and sanctify Your name? He said, “Certainly, I know what you know not.”

See also sura Fatir (The Originator), verse 39, where God says, “He it is Who made youkhalifa (vicegerents) in the land.” Muhammad Asad has translated khalifa as inheritorsimplying the grant to mankind the ability to discern between right and wrong as well asbetween truth and falsehood.

34. ASSAIF is a financial engineering think tank at the forefront of designing Shariah-compliant financial instruments in the investment and retail banking, wealth management,takaful, and microfinance sectors. This quotation is from A. Brugnoni, “Smoke signals”Islamic Banking & Finance, vol. 7, 2(22), p. 16.

35. For example, in sura Duha (Earning Morning Light) of the Holy Quran, it states: “Asfor the orphan, do not oppress him, and as for the begger, scold him not; and as forthy Lord’s blessing, declare it” [93:9–11]. See www.altafsir.com/ViewTranslations.asp?Display=yes&SoraNo=93&Ayah=0&Language=2&LanguageID=2&TranslationBook=5(accessed 6 December 2009).

Also in sura Al-Ma’un (Small Kindnesses) of the Holy Quran where it states: “Have youseen him who denies the Requital? So, he is the one who pushes away the orphan, and doesnot persuade (others) to feed the needy” [107:1]. See www.altafsir.com/ViewTranslations.asp?Display=yes&SoraNo=107&Ayah=0&Language=2&LanguageID=2&TranslationBook=9 (accessed 6 December 2009).

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Also the Prophetic hadith “The people who are compassionate draw the compassionof the Divine (Most Compassionate); So Be compassionate to those on the earth, and theOne in the skies will be compassionate upon you. [Tirmidhi: Chapter on Dutifulness andMaintaining Ties of Kinship]

36. M. Umer Chapra (1992) Islam and the Economic Challenge, Islamic Foundation: Leices-ter, p. 2.

37. Ibid.38. A.K. Myrdin and M. Larbani, “Seigniorage of Fiat Money and the Maqasid al-Shariah

– The Unattainableness of the Maqasid”, www.ahamedkameel.com/MaqasidPaper1.pdf(accessed 9, December 2006).

* Ave Maria Funds, discussed further below, is America’s largest family of Catholic MutualFunds. It has a distinguished Catholic Advisory Board, guided by the Magesterium ofthe Church, which sets the criteria for screening out companies on religious principles.Equal emphasis is placed on investment performance and moral criteria. That meansshareholders do not have to sacrifice financial performance potential because of their pro-life and pro-family beliefs: see www.avemariafund.com/home.htm (accessed 4 December2009).

39. Hari Bhambra (2009) “Islamic finance across the GCC and cross-border considerations”in Euromoney Encyclopedia of Islamic Finance, ed. Aly Khorshid, Euromoney Books:London, footnote 9 and accompanying text, pp. 158–9.

40. Mufti Talha Ahmad Azami (2009) “Linking Shariah-based products and socially respon-sible investing” Islamic Finance News, 9 October 2009, www.islamicfinancenews.com/listing article ID1.asp?nm id=15239&searchid=9249 (accessed 5 November 2009).

Also reproduced as “Crossing the chasm into Sharia based products” Al Watan Daily,11 October 2009, p. 11.

41. John Sandwick (2009) “Islamic wealth management” in The Chancellor Guide to theLegal and Shari’a Aspects of Islamic Finance, ed. Humayon A. Dar and Umar F. Moghul,Chancellor Publications Ltd: London, p. 106.

42. A. Brugnoni, “Smoke signals” Islamic Banking & Finance, 7(2) 22, pp. 15–16.43. Tarek El Diwany (2004) “Step by Step You Shall Follow Them,” Dinar Exchange pre-

sentation, Edinburgh, 30 April 2004. Repeated in Joseph DiVanna (2006) UnderstandingIslamic Banking: The Value Proposition That Transcends Cultures, Leonardo and FrancisPress, Ltd: Cambridge, p. 20.

44. “Vatican offers Islamic finance system to Western banks” World Bulletin,www.worldbulletin.net/news detail.php?id=37814 (accessed 7 May 2009).

For the original in Italian, see online archives of the Vatican newspaper, L’OsservatoreRomano, www.vatican.va/news services/or or http://rassegnastampa.mef.gov.it/mefnazionale/PDF/2009/2009-03-04/2009030412006886.pdf.

45. The source of this excellent graphic is Dr Omar Clark Fisher (2009) “Real wealth – anIslamic perspective” in Euromoney Islamic Wealth Management: A Catalyst for GlobalChange and Innovation, ed. Sohail Jaffer, Euromoney Books: London, p. 141.

46. See www.altafsir.com/ViewTranslations.asp?Display=yes&SoraNo=14&Ayah=24&Language=2&LanguageID=2&TranslationBook=7 (accessed 7 December 2009).

* In its wider meaning, the term kalimah (“word”) denotes any conceptual statement orproposition. Thus, a “good word” circumscribes any proposition (or idea) that is intrinsi-cally true and – because it implies a call to what is good in the moral sense – is ultimatelybeneficent and enduring; and since a call to moral righteousness is the innermost purport

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of every one of God’s messages, the term “good word” applies to them as well. Similarly,the “corrupt word” mentioned in verse 26 applies to the opposite of what a divine messageaims at: namely, to every idea that is intrinsically false or morally evil and, therefore,spiritually harmful.

47. Jahangir Aka (2009) “Through bull and bear: Shari’ah investing performs over the longterm” Business Islamica, December 2009, www.islamica-me.com/article.asp?cntnt=412(accessed 13 December 2009).

48. John Lightstone and Gregory Woods, “Searching for alpha: developing Islamic strate-gies expected to outperform conventional equity indexes”, Islamic Finance World,Bridgewaters, New York, 19–22 May 2008, http://lightstonecapital.com/PaperSearchingForAlphaTerrapinIslamicConferenceNYCMay2008Final.pdf (accessed 13 December2009). In this case a meta analysis was done by focusing on estimate revisions some-thing that Lightstone Capital has termed “Earnings Pressure”, as opposed to an analysisof the existing data sets.

49. “Mizan: A Sharia-compliant investment fund” Hand Benefits & Trust, p. 5, www.mizanfunds.com/document.htm (accessed 13 December 2009).

50. “Mizan: A Sharia-compliant investment fund” Hand Benefits & Trust, p. 2, www.mizanfunds.com/document.htm (accessed 13 December 2009).

51. “Mizan: A Sharia-compliant investment fund” Hand Benefits & Trust, p. 7.52. Deborah Brewster, “Muslim investors top 2005 faith fund table” FT.com, 28 December

2008 (accessed 13 December 2009).53. “Lipper recognizes Amana growth with awards”, www.amanafunds.com/lipperaward

2009.html (accessed 13 December 2009).54. “Lipper recognizes Amana income with award two tears in a row”, www.amanafunds.com/

lipperaward2008.html (accessed 13 December 2009).55. Deborah Brewster, “Amana stays ahead of faith-based funds” FT.com, 27 December 2008

(accessed 13 December 2009).56. Deborah Brewster, “Christian group tops among US faith-based investors” FT.com, 14

January 2008 (accessed 13 December 2009).57. The prohibition of riba (interest), gharar (excessive uncertainty), maisir (gambling), and

haram (forbidden) activities.58. Dr Jarmo Kotilaine (2010) “Islamic capital markets” Global Islamic Finance Report 2010,

BMB Islamic: London, p. 62.59. Ave Maria Mutual Funds, “Unaudited Semi-Annual Report” 30 June 2009, and

in particular, introductory letter of George Schwartz dated 7 August 2009,www.avemariafund.com/pdf/AMSAR09.pdf (accessed 13 December 2009).

60. Ave Maria Mutual Funds, “Summary as of September 30, 2009”, www.avemariafund.com/home.htm (accessed 13 December 2009).

61. Ibid.62. Maariv online, 26 April 2004 “Taking Stock in Our Future”, www.amidex.com/

articles/index.cfm?id=97 (accessed 13 December 2009).63. Jweekly.com, “American Israeli mutual fund posting promising returns” Thursday,

9 July 2009, www.jweekly.com/article/full/38536/american-israeli-mutual-fund-posting-promising-returns (accessed 13 December 2009).

64. Datuk Noripa Kamso (2008) “Does investing the Shariah-compliant way limit long-term returns?” Smartinvestor, June, p. 29: www.cimb-wealthadvisors.com (accessed 13December 2009).

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65. Andreas G.F. Hoepner, Hussain G. Ramal, and Michael Rezec (2009) “Islamic mu-tual funds’ financial and investment style: evidence from 20 countries”, 17 September,http://ssrn.com/abstract=1475037 (accessed 14 December 2009). These academic authorssuggest that future research could pursue a large scale analysis of Islamic equity funds(downside) risk exposure to shine more light on their potential hedging function, whichwould likely also appeal to investors of another faith.

66. Dr Omar Clark Fisher (2009) “The sky is falling: an Islamic view of the global creditcrisis” Global Outlook: World Economy, October, www.islamic-net.com (accessed 20December 2009).

REFERENCES

Aka, Jahangir (2009) “Through Bull and Bear: Shari’ah Investing Performs Over the Long Term”,Business Islamica, December 2009, www.islamica-me.com/article.asp?cntnt=412. Accessed 13December 2009.

Azami, Talha Ahmad (2009) “Crossing the chasm into Sharia based products,”, Al Watan Daily, 11October 2009, p. 11.

Azami, Talha Ahmad (2009) “Linking Shariah-based products and socially responsible investing”,Islamic Finance News, 9 October.

Baue, William (2003) “Ave Maria Fund Promote Catholic Values through Morally ResponsibleInvesting”, 12 September, www.socialfunds.com/news/article.cgi/1219.html. Accessed 17 Decem-ber 2009.

Bhambra, Hari (2009) “Islamic finance across the GCC and cross-border considerations” inEuromoney Encyclopedia of Islamic Finance, ed. Aly Khorshid, London: Euromoney Books: London,pp. 158–9.

Brewster, Deborah (2008) “Muslim investors top 2005 faith fund table” FT.com, 28 December 2008.Accessed 13 December 2009.

Brewster, Deborah (2008) “Christian group tops among US faith-based investors” FT.com, 14 January2008. Accessed 13 December 2009.

Brewster, Deborah (2008) “Amana stays ahead of faith-based funds” FT.com, 27 December 2008.Accessed 13 December 2009.

Brugnoni, Alberto, Smoke signals, Islamic Banking & Finance, 7(2), 16.Buck, Tobias (2010) “Israelis savour rise in Kosher investments” Financial Times www.ft.

com/cms/s/0/96fe312c-254d-11df-9cdb-00144feab49a, i email=y.html. Accessed 5 March 2010.Chapra, M. Umer (1992) Islam and the Economic Challenge, Islamic Foundation: Leicester.Coen, Andrew (2008) “Advisers, investors put faith in Catholic funds” 12 May 2008: www.

investmentnews.com/apps/pbcs.dll/article?AID=/20080512/REG/614910111&template=printart.Accessed 17 December 2009.

Denmark, Frances (2009) Being green gets easier, Institutional Investor, November, p. 29.Desai, Umesh (2008) Islamic finance can give early warning of debt woes, Reuters, 4 April 2008:

www.reuters.com/article/ousiv/idUSSP19096920080404. Accessed 23 August 2009.Diwany, Tareq (2004) “Step by Step You Shall Follow Them”, Dinar Exchange presentation, Edinburgh,

30 April 2004.DiVanna, Joseph (2006) Understanding Islamic Banking: The Value Proposition That Transcends Cul-

tures, Leonardo and Francis Press, Ltd: Cambridge, p. 20.Ernst & Young, Islamic Funds and Investments Report 2009.Fisher, Omar Clark (2009) “Real wealth – an Islamic perspective” in Euromoney Islamic Wealth Manage-

ment: A Catalyst for Global Change and Innovation, ed. Sohail Jaffer, Euromoney Books: London,p. 141.

Fisher, Omar Clark (2009) The sky is falling: an Islamic view of the global credit crisis, Global Outlook:World Economy, October 2009, www.islamic-net.com. Accessed 20 December 2009.

Hoepner, Andreas G.F., Ramal, Hussain G., and Rezec, Michael (2009) “Islamic MutualFunds’ Financial and Investment Style: Evidence from 20 countries”, 17 September 2009,http://ssrn.com/abstract=1475037. Accessed 14 December 2009.

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Kamso, Noripa (2008) “Does investing the Shariah-compliant way limit long-term returns?”, Smartin-vestor, June, p. 29

Kotilaine, Jarmo (2010) Islamic capital markets, Global Islamic Finance Report 2010. BMB Islamic:London.

Lam, Eric (2009) “New Shariah Index follows letter of law” Financial Post, 27 May 2009.Lightstone, John, and Woods, Gregory (2008) “Searching for Alpha: Developing Islamic Strategies

Expected to Outperform Conventional Equity Indexes” Islamic Finance World, Bridgewaters, NewYork, May 19–22.

Lungen, Paul (2008) “Ethical investing grows in popularity” Canadian Jewish News, 28 August 2008,p. B14.

Mamudi, Sam (2007) “The rise of activist shareholder in the US boosts socially responsible investment”,FT.com, 5 November 2007. Accessed 17 December 2009.

Myrdin, A.K., and Larbani, M.M., “Seigniorage of Fiat money and the Maqasid al-Shariah –The unattainableness of the Maqasid”, www.ahamedkameel.com/MaqasidPaper1.pdf. Accessed 9December 2006.

Sandwick, John (2009) “Islamic wealth management” in The Chancellor Guide to the Legal and Shari’aAspects of Islamic Finance, ed. Humayon A. Dar and Umar F. Moghul, Chancellor Publications Ltd:London, p. 106.

Schwab, Daniel, Schwartz, Mark, and Tamari, Meir (2002) “Capital Markets and Jewish Teach-ing”, www.kayema.com/.../Capital%20Markets%20and%20Jewish%20Teachings.pdf. Accessed 15December 2009.

Schwab, Daniel, Schwartz, Mark, and Tamari, Meir, http://bloodstone.atkinson.yorku.ca/projects/researchak/people.nsf/researcherprofile?readform&shortname=schwartz. Accessed 28 January 2010.

Schwab, Daniel, Schwartz, Mark, and Tamari, Meir, www.vc4africa.com/profile/Danielschwab.Accessed 28 January 2010.

Schwab, Daniel, Schwartz, Mark, and Tamari, Meir, www.torah.org/learning/business-ethics/. Accessed28 January 2010.

Siddiqui, Rushdi (2004) “Islamic indexes: the DJIM framework” in Islamic Asset Management: Formingthe Future for Shari’a-Compliant Investment Strategies, ed. Sohail Jaffer, London: Euromoney Books:London.

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Part II

Global Islamic Capital Market Trends

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7

Islamic Derivatives: Past, Present,and Future

Priya Uberoi and Ali Rod Khadem

7.1 INTRODUCTION

While it is fairly well understood that Shariah principles prohibit transactions involving certaindiscrete goods and practices,1 conventional derivatives instruments are incompatible withIslamic contract law for independent reasons that remain obscure within the larger financecommunity. In part, this is due to the fact that derivatives remain a topic of considerable debateamong Shariah scholars and in many respects represent the current frontiers of the Islamicfinance industry. Scholars at one extreme argue that conventional derivatives are Shariah-compliant in their current form, because the nature of the modern derivatives industry includescertain structures and safeguards which render these instruments exempt from the primafacie Shariah contract rules. Scholars at the other extreme argue that modern derivatives areirreconcilable with the Shariah and any attempt at financial engineering to comply with theformal requirements of Islamic contract law is futile, because the resulting products willnevertheless fail the test with respect to their overall substance and purpose.

The current authors, however, argue that this deadlock of extremes may be overcome byway of the middle position that has been central to the recent and historic publication of theISDA/IIFM Tahawwut Master Agreement (March, 2010). This middle position asserts thatalthough conventional derivatives fail to comply with some of the formal and substantiverequirements of Islamic law, these obstacles may nevertheless be overcome by drawing uponthe rich internal resources of Islamic jurisprudence (fiqh) which allow for the engineeringof endogenous Islamic derivatives solutions and products. The fact that the current practiceof Islamic Financial Institutions (IFIs) is to indirectly “embed” conventional derivatives intheir practices serves as an embarrassing indicator of the critical and unavoidable role thatderivatives play in the modern economy, and consequently the great need for creating Shariah-compliant alternatives.2 The creation of Shariah-compliant derivatives is therefore imperativeto the general welfare (maslaha) and future of the Islamic finance industry, and is thus arguablya matter of religious duty on the part of the scholarly establishment.

In arguing the above, this chapter begins by discussing the formal/technical Shariah-basedobjections to conventional derivatives, as well as possible solutions (Section 7.2). It thenproceeds to introduce the substantive Shariah-based objections and debates with respect toderivatives, laying particular emphasis upon the question of spirit versus form, the meaning ofspeculation, and its relationship to uncertainty (gharar) and gambling (maysir) (Section 7.3).


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Finally, Section 7.4 focuses upon swaps and currency transactions as a case study illustratingthe possibilities for creating and applying Islamic derivatives.

7.2 FORMAL SHARIAH OBJECTIONS AND SOLUTIONS

7.2.1 Forwards and Futures

Three aspects of forwards and futures are particularly problematic from a formal Shariahperspective. First, forwards and futures allow a buyer to purchase goods that are non-existentat the time of the actual contract, thus violating a fundamental principle of Islamic contractlaw requiring the object of sale to exist at the time of contract. Secondly, even if the object ofa forward or futures contract exists at the time of contract, forwards and futures allow sellersto sell prior to holding property title to the contract object (i.e. short-selling), thus violatinganother fundamental principle of Islamic contract law requiring a seller to have ownershipof contract object at the time of the contract. Thirdly, forwards and futures permit buyersto resell the contract object, or to otherwise settle the contract obligations, prior to actualdelivery/receipt of the object, thus violating the possession-and-delivery (qabdh) requirementof Islamic contract law, requiring physical delivery of the object to occur prior to resale orsettlement.3

These tripartite requirements (existence, ownership, possessions) are interconnected andcumulative. While existence implies the mere existence of the sale object, ownership pre-supposes existence and adds to it the requirement that the seller hold valid title to the itemprior to sale. Possession also presupposes existence, and normally assumes ownership as well(though it is possible for one to possess an item which one does not own – such as in the caseof agency or trusteeship). The rationale behind the possession requirement is that the objectshould be at the seller’s ready disposal such that it can be validly delivered to the buyer. Pos-session is thus the most “packed” of these three concepts, usually presupposing both existenceand ownership. If any one of these three elements is missing with respect to the sale object,then the contract is vulnerable to being declared invalid or defective due to the presumptionof gharar.

Though conventional forwards and futures do not fulfil these tripartite requirements, Islamicjurisprudence fortunately provides examples of special nominate contract forms and princi-ples that amount to important exceptions to the prima facie tripartite rules. For the purposesof forwards and futures, the two most important of these exceptions are the Islamic istisna’(manufacturing) and salam (forward investment) contracts. The istisna’ contract is a synal-lagmatic agreement wherein a buyer and seller contract for the seller to produce a specific,made-to-order item for the buyer, to be delivered at a future point and for a deferred payment.The good to be manufactured clearly does not exist at the time of the contract, and the raisond’etre of this contract is to bring the desired product into existence. Salam, on the other hand,is a synallagmatic contract wherein the investor-buyer provides full payment or capital (ra’sal-mal) to the seller at the time of the contract, which the seller uses in order to produce oracquire a fungible good to be delivered to the seller at a later designated time.4 Two types ofsalam transactions exist: the first type is a salam pertaining to fungible goods that do not existat the time of the salam contract and which the seller must produce; the second type is a salampertaining to goods that already exist, but which the seller must acquire.

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Islamic Derivatives: Past, Present, and Future 149

Insofar as there can be no ownership when an item does not exist, all istisna’ contractsand all salam contracts of the first type (described above) not only illustrate the possibilitywithin Islamic law of selling non-existing items, but also that of selling without ownership.An even more poignant illustration of the possibility of selling items without ownership,however, lies in the second type of salam contract – i.e. the salam pertaining to items whichalready exist, but which the seller does not yet own and must acquire. Because of the lack ofownership over the item, jurists reason that the “item” which is sold in a salam sale is actuallythe promise/obligation (dayn) of the seller which resides in the seller’s legal personality(dhimma). The fungible good to be acquired and then delivered is not, strictly speaking, thesale item, but is merely the object of this promise/obligation. As such, Islamic jurisprudenceformally classifies the salam sale as the “sale of debt for a specific consideration” (bay’ al-daynbi’l-’ayn).5

While the special rules of the istisna’ and salam contracts expressly resolve the problematicsof non-existence and non-ownership of the contract object, the issue of possession (qabdh)remains as a Shariah-based obstacle. As mentioned, the prima facie Shariah rule is that inaddition to existence and ownership, the sale object must also be in the physical possession ofthe seller so that possession can be readily delivered to the buyer. Conversely, buyers cannotresell items until they have first received them from their original purchase. Under Islamic law,this possession-before-resale requirement applies equally to ordinary sales, as well as salesunder the istisna’a and salam contracts. Conventional forwards and futures, on the other hand,clearly do not fulfil this requirement because they are designed to allow the sale objects to beresold or otherwise settled prior to actual delivery and possession of the contract object (forinstance, the majority of futures transactions are closed by the parties entering into reversetransactions – rather than by actual deliveries).

This problem of possession may be resolved, however, by considering the distinctions madein Islamic jurisprudence between different types of possession. This distinction arguably wasaccepted in principle by classical and early modern scholars, such as Ibn Taymiyya and IbnQudama, who suggested that the meaning of qabdh can only be determined by reference toprevailing custom. In the context of the modern economy and financial markets, many modernscholars of Islamic commercial law have held that the possession requirement can be fulfilledeither by “actual physical possession” (al-qabdh al-haqiqi) or by “constructive possession”(al-qabdh al-hukmi).6 For example, in the case of purchase and sale of company shares, thepossession requirement can be fulfilled by the delivery of share certificates, even if no otherphysical objects are moved.7 In the context of forwards and futures, application of the doctrineof “constructive possession” would enable the possession requirement to be fulfilled by way ofthe recording and registration of documents in the international markets and clearing houses.The fact that the physical goods underlying the contracts do not in fact change hands betweenthe buyers and sellers would, therefore, be a non-issue. So long as the documents are properlyexecuted, recorded, and registered upon each transaction, the possession requirements can bedeemed to have been fulfilled, and reselling without receiving physical delivery would poseno problems from a Shariah perspective.

7.2.2 Options

The prima facie Shariah objections to options represent a special case within the largerdiscourse regarding existence, ownership, and possession. While Islamic law expressly allows

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the parties to a sale to embed options within their contract (such as the options of acceptance,8

determination,9 inspection,10 optional conditions,11 and option upon defect),12 parties are notallowed to separate such options from the contract and trade them as independent goods, as isthe practice in modern options markets. The reason for this prohibition lies in the ontologicalstatus of options as pure rights. Islamic legal theory makes the a priori assumption that inorder for something to be the valid subject of a purchase or sale contract, it must either be aproperty (mal), a usufruct (manfa’ah), or a pecuniary right (haqq mali). Options fall into noneof these three categories because they are essentially pure rights. While they may be embeddedinto sales contracts, this will be merely as conditions or attributes of the sales contracts, notas independent goods that may be isolated or distinguished from the contract. It is on suchgrounds that numerous modern scholars, such as the members of the Fiqh Academy of theOrganization of Islamic Conference, have ruled that options are illegal contracts.

This general prohibition on options sales, however, can nevertheless accommodate somepartial solutions to the engineering of Islamic options as independent, tradable assets. Moderncall options, for instance, can be approximated by way of the Islamic ‘urbun contract. ‘Urbunis a down-payment sale wherein the buyer of a good pays the seller an advance prior to finalexchange of the countervalues. The buyer has the option to either leave the sale uncompleted(in which cases the down-payment premium is forfeited as a “gift” to the seller) or to enforcethe completion of the sale, in which case the seller is obliged to sell at the agreed-uponprice. While some classical jurists opposed this practice on the basis of gharar, ‘urbun wasexpressly permitted by the Islamic Fiqh Academy in 1993. Although ‘urbun closely resemblesthe modern call option, two important differences should be noted, both of which are due to theontological limitations of options as pure rights and therefore as improper sale objects per se(as explained above). First, Islamic law considers the buyer’s payment for the ‘urbun option tobe a down-payment on the full sale price rather than a payment for the option itself. Secondly,and more importantly, the ‘urbun buyer is not allowed to (re)sell the option to a third party oron secondary markets. The ‘urbun option, in other words, requires privity of contract, and isin fact considered a mere attribute of the sales contract for the proper good.

While the ‘urbun sale is a generally accepted way of approximating the modern call option,Shariah-compliant put options are somewhat more difficult to engineer and are subject togreater debate in the current Islamic finance. One possibility for engineering Shariah-compliantput options lies in employing the concept of unilateral promise (wa’ad) in Islamic law.Although the default presumption in Islamic jurisprudence is that a wa’ad promise is non-binding because of lack of consideration, the modern Islamic finance industry has beenapproaching a consensus on the notion that wa’ad should be treated as binding and enforceablein cases where the promisee has relied upon the promise and incurred liabilities thereby(though typically a wa’ad is cancellable up until a designated effective date). This morenuanced conception of wa’ad offers an approximation of a modern put option. To illustrate,if counterparty A gives counterparty B a wa’ad promise to purchase B’s goods at a specifiedprice, B can subsequently opt to enforce A’s promise to purchase, so long as B can showreliance. While the scope of such usage of wa’ad within Islamic finance is still being debated,the Islamic Fiqh Academy upheld the enforceability of wa’ad in the context of murabahasales.13 Subsequently, AAOIFI held that wa’ad may be employed as an enforceable obligationin the context of currency exchange transactions (further discussed below). Nevertheless, anyattempt to use wa’ad as a put option should be done with the same major caveat as with ‘urbuncall options: because of their ontological status as pure rights, the exercise of these options

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requires privity of contract, and they therefore cannot be sold to third persons on secondarymarkets.

7.2.3 Swaps and Currency Transactions

The prima facie Shariah objections to swaps and currency transactions rest upon fundamentallydifferent grounds from the objections to forwards, futures, and options. As explained above,the objections to the latter three stem from the fact that Shariah principles imposes the tripartiterequirements of the existence, ownership, and possession upon all actual, specified sale objects(a’yan). These prima facie requirements apply with equal force whether the sale object is afungible, physical commodity (as in forwards and futures), or pure rights (as in options).

However, because currency transactions are essentially the exchange of cash flows, theyare exempt from these requirements. Cash and currency enjoys a special ontological statusin Islamic legal theory (usul al-fiqh). The dominant position is that cash is an absolute priceand a pure media of exchange. As such, cash never holds the status of an actual, specificobject (‘ayn), but rather is always considered to be an incorporeal obligation/debt (dayn).The ultimate guarantor and “seat” of all obligations/debts is the individual’s legal personality(dhimma), which is understood to have an infinite capacity to incur new obligations and debts,regardless of its particular state of solvency. This theory of obligation14 has several importantconsequences. First, because the dhimma has an infinite capacity to incur new obligations,Islamic law typically allows buyers to enter into purchase contracts even if they do nothave ready cash on hand. Furthermore, the concept of all obligations as being incorporealrealities that are impossible to actualize and specify means that all obligations are essentiallyfungible, exchangeable, and settleable with respect to other obligations (they all have the samegenus in terms of monetary value). Thus, even if a buyer, during the course of negotiationswith a seller, points to certain particular coins that will be used to pay the purchase price,the buyer is nevertheless free to substitute these coins for different forms of payment, sincecurrency is never actual or specified and is always fungible because it represents the obligation.Furthermore, two counterparties in a transaction who owe debts to one another may fulfil theirmutual obligations by way of settling/clearing their debts (maqassa).

Though the cash exchanges that take place in swaps and currency transactions are thusexempt from the standard existence, ownership, and possession requirements, they are never-theless subject to a different set of Shariah requirements that are no less stringent. In a famoushadith undergirding much of Islamic commercial practice, the Prophet (PBUH) is reported tohave stated: “Exchange gold for gold, silver for silver, wheat for wheat, barley for barley, datesfor dates, salt for salt in the same amount and of the same type and must be handed over in an‘aqd ceremony. If what you have exchanged differs in type, you can trade according to yourwishes but it must be done on the spot.”15 This hadith forms the basis in Islamic jurisprudencefor the special rules governing transactions involving gold, silver, wheat, barley, dates, andsalt. Collectively, these items are categorized as the ribawi items, and transactions involvingthem are ribawi transactions – i.e. transactions that are susceptible to unjust enrichment (riba)unless properly regulated.

Though the first sentence of this hadith lists only six items explicitly, scholars from thevarious schools of Islamic law have almost unanimously expanded the category of ribawiitems to include other items.16 This expansion results from a process of analogical legalreasoning (qiyas) whereby a particular legal cause or ratio legis (illa) is posited as the basis of

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the aforementioned hadith, thereby enabling all additional items which purportedly share thislegal cause to be subsumed within the ribawi category. While the various schools of Islamiclaw differ on their definitions of the ‘illa underlying the hadith, virtually all of the varyingaccounts of the ‘illa expand the ribawi category in a manner which includes all forms ofmodern currencies.17

Having thus expanded the category of ribawi items, scholars have then interpolated twofundamental transaction types (each with concurrent rules) from the second sentence of thehadith.18 The first transaction type is the trade of two ribawi items of different kinds (e.g. goldfor dollars or silver; dollars for wheat; barley for wheat, etc.). The second transaction type isthe trade of ribawi items of the same genus (e.g. gold for gold; barley for barley; dollars fordollars). Both transaction types require spot exchange (qabdh). Failure to effect spot exchange(whether actual or constructive) will invalidate the entire transaction due to riba al-nasi’ah,which represents an unjustified excess in time (delay) added to the transaction. While spotexchange is the only requirement of the first transaction type, the second transaction typehas the additional requirement of trade in equal measures (al-tamathul fi’l qadr). Failure totrade in equal measure will invalidate the transaction due to riba al-fadl, which represents anunjustified additional increase to the countervalue (e.g. in a loan, riba al-fadl is the forbiddeninterest that charged).

More particularly, when the only items being traded are gold, silver, or currencies, suchtransactions are called “exchange transactions” (sarf ) and constitute a specialized version of theribawi transaction. Scholarly discussions of the exchange transaction often involve the caveatthat the best of all currencies are gold and silver, since these items are explicitly mentionedin the Quran, and gold and silver dinars and dirhams were the currencies used during thetime of the Prophet (PBUH). Despite the superiority of gold and silver, modern currencies areacceptable19 in commercial transactions out of the principle of necessity (maslahah), since themodern economy is dominated by paper currencies. The preferred type of paper currencies,however, are those that are backed by gold, such as the pre-1972 Bretton Woods currencies,because a holder of these paper currencies had the right to redeem them for physical gold.20

There are a total of eight possible types of “exchange” transactions (see Table 7.1): (1)sale of gold for gold; (2) sale of silver for silver; (3) sale of gold for silver; (4) the saleof gold or silver for currencies/securities that are directly tied to gold or otherwise repre-sent gold (al-nuqud al-warqiyya al-na’iba ‘an dhahab; or al-nuqud al-warqiyya al-wathiqa)(e.g. gold ownership certificates; pre-1972 Bretton Woods currencies tied to gold); (5) the saleof gold or silver for modern currencies/securities that are not tied to the gold standard (e.g.post-1972 Bretton Woods modern currencies); (6) the sale of currencies/securities tied to goldfor other currencies/securities tied to gold; (7) the sale of currencies/securities tied to gold forcurrencies/securities not tied to gold; and (8) the sale of currencies/securities not tied to goldfor currencies/securities not tied to gold.

Insofar as all swaps and currency transactions involve agreements to exchange cash flowsand currencies in varying amounts, all such transactions violate the sarf requirement ofspot exchange, thus incurring riba al-fadl, and many such transactions violate the additional(Transaction Type 2) sarf requirement of exchange in equal measures, thus incurring ribaal-nasi’ah.

Although resolving the Shariah objections to swaps and currency transactions (Table 7.2) issignificantly more formidable than the solutions already discussed in the context of forwards,futures, and options, it may nevertheless be accomplished by way of sophisticated engineeringtechniques which employ a combination of Islamic nominate contract forms. When used

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Table 7.1 Exchange transactions

Description

Type of Ribawi Transaction(Type #1 = Different Genus)(Type #2 = Same Genus)

Is SpotExchangeRequired

Equality ofMeasureRequired?

1. Sale of Gold for Gold Transaction Type #2 YES YES2. Sale of Silver for Silver Transaction Type #2 YES YES3. Sale of Gold for Silver Transaction Type #1 YES NO4. Sale of Gold/Silver for Currencies/

Securities Directly Tied to GoldTransaction Type #2 YES YES

5. Sale of Gold/Silver for Currencies/Securities Not Directly Tied to Gold

Transaction Type #1 YES NO

6. Sale of Currencies/Securities Tied toGold for Currencies/Securities Tied toGold

Transaction Type #2 YES YES

7. Sale of Currencies/Securities Tied toGold for Currencies/Securities NotTied to Gold

Transaction Type #1 YES NO

8. Sale of Currencies/Securities Not Tiedto Gold for Currencies/Securities NotTied to Gold

Arguably Transaction Type #1 YES Debatable

Table 7.2 Summary: Formal Shariah objections and solutions to conventional derivatives

Formal Shariah Objections toConventional Derivatives

Ratio Legis(‘Illah)

Shariah-CompliantSolutions

Forwards &Futures

Non-Existence of Sale Object(Sometimes)

Non-Ownership of Sale ObjectNon-Possession of Sale Object

Gharar

GhararGharar

Salam; Istisna’a

Options Selling of Pure RightsTransferring of Pure Rights

GhararGharar

‘Urbun; Wa’ad

Swaps Trading Same Genus, DifferentAmount

Trading Same Genus, Time Delay

Riba al-Fadl

Riba al-Nasi’ah

Complex: CombiningMultiple Contracts

carefully, these techniques enable the structuring if derivatives products such as Shariah-compliant cross currency swaps, foreign exchange options, profit rate swaps, and even totalreturn swaps. Section 7.4 considers these relatively complex solutions in greater detail.

7.3 SUBSTANTIVE SHARIAH OBJECTIONS AND RESOLUTIONS

While the engineering techniques described above may be used to fulfil the formal Shariahcontract requirements, some scholars argue that the proposed solutions nevertheless failbecause they employ questionable legal strategems (hiyal)21 in order to achieve overall pur-poses that are illicit (a procedure known as sadd al-dhara’i). At bottom, this debate largelyamounts to a fundamental dispute over form versus substance in Islamic law. Scholars whounreservedly accept the engineering techniques described in the previous section tend to view

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form as the primary criterion of Shariah compliance. These scholars typically defend theirposition by pointing to hadith texts such as one in which the Prophet (PBUH) reprimanded afollower for trading two measures of lower quality dates for one measure of higher quality dates(thus violating the riba rules), but then suggested that the follower could instead have sold thelower quality dates on the spot market for cash, and used the proceeds to have purchased thesame higher quality dates. Even though the overall economic result and substance of the twotransactions were identical, the fact that the Prophet advocated the latter but forbade the formerindicates that the form of the transaction is all-important. Such arguments, however, do notsatisfy other scholars who are more concerned with the overall substance of a transaction, andindeed the overall purposes of the Shariah (i.e. promotion of life, property, faith, etc.). Withrespect to the question of derivatives in particular, such scholars present several purpose-basedand substantive criticisms, described below.

7.3.1 Existence, Ownership, Possession

Arguably the most obvious substantive criticism of Islamic derivatives is that even if thefinancial engineering techniques described in the previous section are employed to bypassthe classical tripartite requirements (existence, ownership, possession), the fact remains thatthese requirements are not met in substance. Gharar is thus still committed, and the wholeenterprise of “Islamic engineering” amounts to an embarrassing if not shameful attempt tothwart the overall spirit and purpose of the Shariah.

Some contemporary scholars respond to this criticism by denying the very applicabilityof the tripartite requirements (existence, ownership, possession) to derivatives, thereby sug-gesting that conventional derivatives are compliant as is, and Islamic engineering is thusnot even necessary in the first place. For instance, regarding the requirements of existenceand ownership, Mohammad Hashim Kamali has undertaken a critical analysis of the hadithproof-text (“do not sell what is not with you”).22 After pointing to weaknesses in the chainof transmission (isnad) of this hadith, Kamali highlights the fact that the text is open to thefollowing interpretations: (i) total ban on selling what one does not own; (ii) ban on sellingonly specified objects (‘ayan) – and not fungibles – that are not owned; and (iii) a ban onselling what is not present and which the seller is unable to deliver. Kamali’s conclusion isthat the existence and ownership requirements apply only to sales involving specific objects(‘ayn), not fungible goods, and are therefore inapplicable to derivatives such as forwards orfutures.23 Similarly, with respect to the possession requirement, Kamali argues for a positionthat is prominent in the Maliki and Hanbali schools (and shared by the Shariah Commit-tees of Kuwait Finance House and the Islamic Bank of Sudan): namely, that the possessionrequirement applies only to perishable foodstuffs. Insofar as most conventional forwards andfutures do not involve perishable foodstuffs as their underlying, the possession requirement isinapplicable to them.24

Similarly, numerous alternative interpretations have been given of the hadith proof-textsunderlying the rule of possession (e.g. “he who buys foodstuffs should not sell it until he hastaken possession of it”).25 On the one hand, the Shafi’i school has historically provided thestrictest interpretation of this hadith, understanding it to mean that the possession require-ment pertains to all classes of sale items.26 This interpretation has been adopted by modernorganizations, such as the Jeddah-based Organization of Islamic Conference Fiqh Academy.On the other hand, the Hanafi and Hanbali schools have historically offered a more nuanced

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interpretation of the underlying hadith texts, understanding the possession rule to apply to onlycertain classes of goods, with other classes being exempt (e.g. real estate, goods obtained bygift or inheritance, etc.).27 Even more importantly, the Hanafi school explains that possessionis not a requirement of contract validity, but is merely a condition for proper fulfilment of acontract, meaning that a sale transaction can be validly conducted without possession, thoughit will remain in abeyance until possession occurs. While this interpretation of possessionsolves the problem of forwards and futures in which future delivery actually occurs, it does notresolve the greater problem of transactions which are closed by way of reverse transactions,and in which delivery therefore never takes place.

More particularly, with respect to options, the argument is made that options are in factindependent goods that may be bought and sold, and therefore recourse to Islamic engineeringis not even necessary for the most part.28 Two main grounds support this argument. Firstis a more comprehensive definition of property which accommodates options. The Shafi’ischool, for instance, defines property as that which can be benefited from. Scholars such as al-Duraini argue that the definition of property is defined by custom.29 Similarly, though the earlyHanafi school offered a more limited definition of property (as that which can be physicallypossessed), later Hanafi scholars such as Ibn ‘Abidin defined property as “everything thathas a value and can be valued by darahim or dananir”.30 This definition of property clearlyfocuses on value, which in turn rests upon customary usages. Insofar as conventional optionsare valued in modern society (due to their utility in managing risk, etc.), it is argued thatoptions (as well as other non-corporeal assets, such as intellectual property) are valid forms ofproperty that can be independently bought and sold. Secondly, precedents exist within Islamicjurisprudence wherein the buying and selling of pure rights is expressly permitted. As pointedout by al-Amine, the Hanafis, as well as other schools, have permitted parties to buy andsell the right to manage trust (waqf ) property, or the right to be a prayer leader in a mosquebuilt under a trust.31 Similarly, permission has been given to trade in the right granted by ahome-owner for another person to pass through the house for access, or to run water through it,to build upon it, and so forth.32 Yet another example is a ruling that can be found in the Malikischool which allows wives of polygamous husbands to sell a right to the husband enablinghim to spend less time with her than with his other wives (the default rule is that the husbandmust divide his time among his wives equally).33

7.3.2 Speculation, gharar, and maysir

While many Shariah scholars acknowledge that derivatives can provide significant and legit-imate benefits when used for hedging purposes (so long as the underlying commodities arelicit), there is far less acceptance of the use of derivatives for purposes of pure speculation.Section 2 of the Explanatory Memorandum to the ISDA/IIFM Tahawwut Master Agreement,explicitly states that “transactions should be entered into only for the purpose of hedgingactual risks of the relevant party . . . transactions should not be entered into for purposes ofspeculation”. In this instance, when we reference “hedging” we mean that transactions docu-mented under the ISDA/IIFM Tahawwut Master Agreement need to be linked to an underlyingtangible transaction and not to a synthetic exposure, e.g. a car manufacturer hedging his FXexposure from buying cars in Germany in Euros and selling these same cars in Dubai inDirhams. From a Shariah perspective, the distinction between hedging and speculation is thathedging provides buyers and sellers of commodities with useful risk-management benefits and

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therefore arguably reduces overall gharar, whereas speculation is typically viewed as primafacie evidence of both gharar and gambling (maysir).

This distinction between hedging and speculation, though it may at first seem satisfactory,actually begs the further question of what is speculation, and what is the nature of its rela-tionship to gharar and maysir? English-based sources offer varying definitions of speculation.The Oxford English Dictionary, for instance, defines speculation primarily as “form[ing] atheory or conjecture without firm evidence” (i.e. speculation is associated with uncertainty),and secondarily as the act of “invest[ing] in stocks, property, or other ventures in the hope offinancial gain but with the risk of loss” (i.e. speculation is associated with risk). Furthermore,if one looks at the definition of a derivative in accordance with IAS 39, the definition is specif-ically designed to capture the element of extreme “risk” which forms part of the concept ofa “derivative” in conventional financial markets. It is for this reason that Western accountingstandards ensure that derivatives are accounted for on a “fair value basis” and the reason whyUK taxation of financial instruments (bank debt instruments and derivatives) are linked to theiraccounting treatment.

As with Western sources, Shariah sources also offer varying accounts of speculation, defi-nitions which tend to fluctuate between association with gharar, on the one hand, and maysir,on the other. Although the linkage of speculation with gharar is obvious (speculation isusually associated with unusually high levels of risk and uncertainty), different views existas to whether speculation and gharar are one and the same. While some scholars implythat all speculation amounts to gharar, others suggest that all business transactions involvesome level of risk and speculation, and it is therefore necessary to consider the degree of theresulting gharar prior to stamping a transaction as valid or invalid. ‘Abd al-Razzaq al-Sanhuri,for instance, expanded upon certain concepts articulated by Ibn Taymiyya’s famous student,al-Jawziyya, and thereby asserted a distinction between two categories of gharar: immaterial(yasir) and exorbitant (fahish), the former being permissible and the latter illicit.34 Othershave further expanded upon this distinction, arguing that determination of the gharar status ofa transaction requires a cost–benefit analysis of the risks, uncertainties, and benefits. To thisend, several have suggested that the benefits of derivatives markets (e.g. increasing liquidityin markets; allowing for macro-level reductions in price fluctuations; managing structuralmismatches between asset and liability positions etc.) outweigh the fact that these marketsattract some participants who are pure speculators, as evidenced by empirical studies indicatingthat pure speculators represent a smaller percentage of futures traders than non-speculators,and that their speculative activity can in certain circumstances help to smooth rather thanexacerbate price fluctuations35 (e.g. speculation, ironically, seems to reduce overall gharar onfutures markets). Conversely, financial crises and turbulent price fluctuations are due to badbusiness practice and lack of regulatory oversight – such as the practice of aggressive sellingof underlying mortgages to home buyers who clearly could not afford the repayments on thoseunderlyings, which when packaged up into different structured products, contributed to therecent Lehman’s crisis.

Differences of views also exist as to whether speculation and gambling (maysir) are syn-onymous or conceptually distinct.36 The Islamic prohibition of gambling is grounded both inQuranic texts (e.g. 2:219) as well as hadith texts which proscribe certain games and sales ofchance (e.g. bay’ al-hasah, bay al-mulamasah, bay’ al-munabadha, etc.). A common elementin the scholarly definitions of maysir is that it involves the creation of risks and risk-taking(mukhatarah) that would not be present otherwise and which amount to zero-sum transactionsthat are socio-economically non-productive (in contrast, legitimate investments are ones which

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are socio-economically productive, and the risks inherent in such investments are incidentalto the enterprise, rather than the purpose of it).

Despite the general agreement upon this definition, the relationship between maysir andspeculation is debated. At one extreme is the viewpoint that all activities involving speculationare forms of gambling, and are therefore illicit. Insofar as speculation is intrinsic to theworkings of the modern derivatives industry, such a view entirely proscribes derivatives, evenif they manage to fulfil the formal requirements of Shariah contract law (only approximately10% of market participants in conventional derivatives markets use derivatives as real hedgingtools, the remainder being primarily interest in opportunities for arbitrage and speculation;mathematically total bank derivatives exposure at the end of 2009 stood at 3.99 USD trillion;10% is still 400 USD billion). A more sophisticated view among scholars, however, is thatspeculation is conceptually distinct from maysir, and therefore does not render a transactioninvalid per se. Muhammad Hashim Kamali, for instance, explains that whereas gamblingamounts to the creation and trading of risks that would not otherwise exist, speculation doesnot create risks but rather trades in risks that otherwise arise from the natural production andmarketing processes of productive enterprises.37 To illustrate the point, Kamali explains thatthe risk of price fluctuation in the wheat industry is due to the seasonal nature of harvest,and not due to the existence of the wheat futures market. While speculators on the wheatfutures market may have the same motivation as gamblers, the role they play is in factfundamentally different from gambling: by accepting the risk of wheat price fluctuations, theyare in fact providing a productive service of reallocating risk from those who do not want it (e.g.producers and consumers) to those who are willing and able to bear it. In short, he concludesthat futures markets are economically beneficial and productive “risk-transfer mechanisms”,and futures speculators “are not simply gamblers, for the risks are real commercial risks,quite different from gambling, where no risk is assumed other than that created by the rulesof the game”.38 Other recent scholars have supported this line of reasoning (e.g. Muhammadal-Bashir Muhammad al-Amine, who argues in support of al-Tashkiri of the OIC-FA, assertingthat unlike gambling which involves one-sided gains, derivatives transactions always involvemutual gain of certain benefits, even if nominal).39

It should also be noted that scholars such as Kamali, al-Amine, and others who distinguishderivatives trading from gambling, nonetheless emphasize the importance of government reg-ulation in protecting the integrity of derivatives markets in order to ensure that the legitimateactivity of hedging (and even speculation) does not turn into a vehicle of maysir and gharar.Government regulators, for instance, should not neglect responsibilities such as imposing quan-titative limits on daily trading volume and position limits, regulating contractual relationships,brokerage activities, disciplinary procedures, and so forth.

Interestingly, recent legislative changes have been mooted in the US Senate, to include,inter alia, reform of the OTC domestic market. Both the Senate and House bill would requireswaps dealers and major swap participants to be regulated by the Securities and ExchangeCommission (SEC) and the Commodity Futures Trading Commission (CFTC). The bill wouldalso provide that swaps that are eligible for clearing must generally be cleared and tradedthrough an exchange unless one of the parties to the swap is an end-user that is hedgingcommercial risk. The most controversial provision of the OTC derivatives section of the bill isthe so-called “push-out” provision. This provision states that no federal assistance (includingFederal Reserve loans or Federal Deposit Insurance Corporation (FDIC) insurance) may beextended to any swaps entity, which includes a swap dealer. It is widely believed that thisprovision would prevent a bank from being a swap dealer because banks cannot, in practice,

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give up the right to receive Federal Reserve loans or FDIC insurance. However, the House billdoes not include the push-out provision, so it is not clear what will happen when the Houseand Senate bills are reconciled on 4 July 2010.

Interestingly, from the above, it would seem as if the Western world is moving moretowards an Islamic derivatives model, with sharper boundaries and checks being put in placeto minimize uncertainty within this asset class.

7.3.3 Trading Obligation for Obligation

Another substantive Shariah-based criticism is that almost all conventional derivatives involvedeferment of both countervalues. According to Shariah principles, in plain sales, the paymentof price may be deferred (bay’ muajjal), but the sale object must be delivered immediately,resulting in the classification of “sale of specific objects for debt obligations” (bay’ al-’aynbi’l-dayn). The salam is the mirror image of the plain sale, but nevertheless allows for onlysingle deferment: delivery of the sale object is deferred to the future, but payment of pricemust be done during the contract session, hence the classification of “sale of an obligation fora specified price” (bay’ al-dayn bi’l-’ayn). While double deferment is permissible within thescope of the istisna’ contract (as explained in the previous section), the istisna’ is unfortunatelynot particularly useful for the structuring of derivatives due to the simple reason that the saleobject of the istisna’ does not consist of fungibles, but rather is typically a unique, made-to-order item. As such, istisna’ transactions tend to be more suitable for project and infrastructurefinancings than for derivatives.

The standard rationale given for the prohibition of double deferment is that it is based upona hadith, reported by Musa ibn Ubayd, which states that “the Prophet, peace be upon him,prohibited bay’ al-kali bi’l-kali”.40 Though al-kali is a somewhat unusual term in Arabic, ithas come to be understood as synonymous with “debt”. On this ground, jurists have reasonedthat this hadith prohibits the sale of one debt, or obligation, for another, which in turn is due tothe ratio legis of both riba and gharar. On this basis, the double-deferment inherent in mostfutures, options, and swaps can be viewed as grounds for rejecting derivatives altogether.

A closer look at Islamic legal history, however, reveals that numerous scholars have ques-tioned the meaning as well as the authenticity of the aforementioned hadith. Figures of thestature of Imam al-Shafi’i, Ibn Qudama, and Ibn Taymiyya, for instance, have considered thehadith to be of weak authenticity, due to both its broken chain of transmission (isnad) andbecause it was not reported through numerous independent lines of transmission.41 In addi-tion, Ibn Taymiyya and numerous others found the meaning of the word al-kali to be unclear,and did not equate it with “debt”. Numerous modern scholars, such as Kamali, Hammad,al-Tijani, and al-Masri have invoked the authority of these classical scholars and arguments,and have thereby expressly asserted the permissibility of the sale of obligations for obligationsin general, and its manifestation in the derivatives industry in particular.42

7.4 ISLAMIC SWAPS AND CURRENCY TRANSACTIONS

7.4.1 Cross-currency Swap

A conventional cross-currency swap (Figure 7.1) usually consists of three cash flows: (i) a spotexchange of principal at the outset (Initial Exchange), (ii) a continuing exchange of interestpayments during the swap’s life (essentially a series of FX forward trades, linked to a notional)

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BANK COUNTERPARTY

1 Initial ExchangeMYR 350 at inception

USD 100 at inceptionInitial Exchange

2

MYR interest quarterly(Interim Amount)

MYR 350 at maturity(Final Amount)

USD 100 at maturity(Final Amount)

USD interest quarterly(Interim Amount)

Counterparty = Paying MYR and Receiving USDBank = Paying USD and Receiving MYRExchange Rate: 1 USD = 3.5 MYR (appr.) (as at 11 August 2009)


111

222

Figure 7.1 Conventional cross-currency swap (MYR/USD)

(Interim Amounts), and (iii) a re-exchange of principal at the maturity of the contract (FinalExchange). Clearly, the prohibitions on riba, maysir, and gharar would render such a structureuntenable under Shariah principles.

The challenge, therefore, is to generate cash flows which are economically similar to aconventional currency swap, but within a Shariah-compliant framework. To this end, one canuse reciprocal murabaha transactions, whereby the parties enter into murabaha contracts (aPrimary (Term) murabaha and a Secondary (Reverse) murabaha) to sell Shariah-compliantassets (often London Metal Exchange traded metals, such as copper and aluminium) to eachother for immediate delivery but on deferred payment terms.43

7.4.1.1 The Primary (Term) murabaha

Under this transaction the Bank (i) sources commodities from a commodity broker (BrokerA) at Cost Price (step 1, in Figure 7.2); and (ii) on-sells these commodities to the swapcounterparty (the Counterparty) (step 2). The value of commodities bought and on-sold (insteps 1 and 2 respectively) are both denominated in Currency A (MYR).

Payment by the Counterparty for the commodities purchased under the Primary murabahais on a deferred basis, in instalments payable on pre-agreed payment dates (each a DeferredPayment Date). Each instalment represents a portion of the pre-agreed profit element, withthe exception of the final instalment, which also includes payment in full of the Cost Price.The commodities are delivered on the date on which the transaction is entered into. On receiptof the commodities, the Counterparty (or its agent) promptly on-sells the commodities to a

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3

BROKER B

4


7

2

6

5

1

3

4

Counterparty = Paying MYR and Receiving USDBank = Paying USD and Receiving MYR

7

2

6

5

To cash account of theIslamic Counterparty with

Bank

Seller

Buyer

immediately

3

Sells Metals at MYR 350

33

COUNTERPARTYBANK

Seller

Deferred Payment of MYR 665 in40 instalments

Buyer

BROKER A

Proceeds in USD44

Deferred Payment of USD 190in 40 instalments


7

Sells Metalsat cost price(MYR 350)

Bank buysMetals atcost price(MYR 350)

77

222 Terrm Murabaha

On-Sells Metals atMYR 665

666

On-Sells Metals atUSD 190

Reverse Murabaha

5Sells Metals at Relevant

Amount

55

111

Figure 7.2 Islamic cross-currency swap (MYR/USD)

different commodity broker (Broker B) to generate a Currency B (USD) payment (steps 3and 4).

7.4.1.2 The Secondary (Reverse) murabaha

To initiate the Secondary Murabaha, the Counterparty (i) purchases commodities from BrokerB and makes payment in Currency B (step 5), and (ii) immediately on-sells these commoditiesto the Bank for immediate delivery (step 6). The commodities sold under the SecondaryMurabaha should have the same value as those purchased under the Primary Murabaha (theCurrency B equivalent of the Cost Price being the Relevant Amount, in Figure 7.2). Paymentby the Bank is on a deferred basis in instalments in Currency B, such instalments to representa portion of the pre-agreed Secondary Murabaha profit element (with the exception of thefinal instalment which also includes payment in full of the Currency B equivalent of theCost Price). Instalment payment dates under the Secondary Murabaha mirror those under thePrimary Murabaha (i.e. on each Deferred Payment Date, a payment shall be due (i) fromthe Bank to the Counterparty in Currency B; and (ii) from the Counterparty to the Bank inCurrency A). Upon receipt of the commodities, the Bank immediately on-sells these to BrokerA (step 7) to generate a Currency A payment.

7.4.1.3 Industry Usage

In October 2006, Citigroup designed a currency swap for the Dubai Investment Group (DIB)to hedge the currency risk on DIB’s RM828 million (approximately £119 million) investmentin Bank Islam Malaysia.44 Standard Chartered Saadiq, Al Hilal Bank, and Calyon also marketproducts based on Shariah-compliant cross-currency swaps.45

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7.4.2 Profit Rate Swap

A profit rate swap is best analogized to a conventional interest rate swap, under which the partiesagree to exchange periodic fixed and floating payments by reference to a pre-agreed notionalamount. As with many conventional derivative products, a conventional interest rate swap isproblematic from a Shariah perspective as it potentially contravenes the Shariah prohibitionson riba, maysir, and gharar. The profit rate swap seeks to achieve Shariah compliance byusing reciprocal murabaha transactions (similar in some respects to the structure used for across-currency swap, as discussed above). A term murabaha is used to generate fixed payments(comprising both a cost price and a fixed profit element) and a series of corresponding reversemurabaha contracts are used to generate the floating leg payments (the cost price elementunder each of these reverse murabaha contracts is fixed but the profit element is floating).46

7.4.2.1 The Primary (Term) murabaha

The process is initiated by the floating rate payer (the Floating Rate Payer) (i) sourcingcommodities from a commodity broker (Broker 1) (step 1, in Figure 7.3); and (ii) on-sellingthese commodities to the swap counterparty (the Fixed Rate Payer) (step 2). The value ofcommodities bought and on-sold is the pre-agreed Cost Price for the transaction and thecommodities are delivered on the date on which the transaction is entered into. On receipt ofthe commodities purchased, the Fixed Rate Payer (or its agent) on-sells those commoditiesimmediately to a different commodity broker (Broker 2) (step 3) to generate cash. The FixedRate Payer pays for the commodities purchased under the Term Murabaha on a deferred basis,in instalments payable on a series of pre-agreed payment dates (each a Deferred PaymentDate) (step 4). Each instalment comprises both a Cost Price element (a repayment of a setpercentage of the Cost Price) and a fixed profit portion (paying a portion of the Floating RatePayer’s profit on the transaction).

FLOATING RATE PAYER

FIXED RATE PAYER

Broker 1

Cashflow = Cost Price + fixed profit portion

Term Murabaha

Sells Commodities

Broker 2

$

FLOATING RATE PAYER

FIXED RATE PAYER

Broker 1

Cashflow = Cost Price + fixed profit portion

Term Murabaha

Sells Commodities

Del

iver

sC

omm

oditi

esC

ost P

rice

Sells Comm

odities

Broker 2Single Term Murabaha

Series of fixed periodicpayment dates

1

2

3

4

Figure 7.3 The primary Murabaha

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FIXED RATE PAYER

BROKER 1

$

BROKER 2

5

6

8

FLOATING RATE PAYER

FIXED RATEPAYER

BROKER 1

Delivers Comm

odities

Revolving Murabahaswith payment infull at maturity

Sells Commoditiesevery 3 months

Cashflow = Full commodity price + floating rate profitportion (linked to LIBOR)

Sells

Com

mod

ities

$

BROKER 2

Full comm

odity priceFull payment and

physical settlement periodically

5

6

7

8

FLOATING RATEPAYER

Figure 7.4 Secondary reverse murabaha contracts

7.4.2.2 The Series of Sequential Secondary Reverse murabaha Contracts (SRMCs)

An agreement by which the Floating Rate Payer simply agrees to pay a variable amount (linked,for example, to LIBOR) to the Fixed Rate Payer on certain pre-specified dates would not beShariah-compliant due to the uncertainty (gharar) associated with such a structure. SRMCshelp us resolve this problem, as each floating rate payment is linked to an underlying purchaseand sale of commodities. The first SRMC (SRMC1) is entered into on the date of entryinto the Primary Murabaha transaction and is initiated by the Fixed Rate Payer purchasingcommodities from Broker 2 (step 5, in Figure 7.4). For the purpose of SRMC1, the Fixed RatePayer uses only that portion of the Cost Price which is due to be repaid to it on the first DeferredPayment Date as capital for purchasing commodities from its broker. The Fixed Rate Payerimmediately on-sells these commodities to the Floating Rate Payer for immediate delivery(step 6) and the Floating Rate Payer immediately on-sells such commodities to Broker 1(step 7) to generate cash. Payment by the Floating Rate Payer is on a deferred basis by a singlebullet payment comprising (i) the full value of the commodities purchased under the relevantSRMC plus (ii) the Fixed Rate Payer’s profit (such profit being calculated by reference to afloating rate formula (e.g. linked to LIBOR) and thus generating the floating rate element)(step 8). Each such payment is due on the next Deferred Payment Date under the PrimaryMurabaha (at a frequency of every three months, in Figure 7.4).


In October 2006, Standard Chartered Saadiq entered into a $150 million three-year profit rateswap with Kuwait-based Aref Investment Group SAK. Commenting on the deal, Dr Ali AlZumai, Chairman and Managing Director of Kuwait-based Aref Investment, said: “[t]he swapis a significant development in broadening capital market instruments. It gives us the flexibilityto hedge through a Shariah compliant solution.”47 BNP Paribas, Al Hilal Bank and Calyon

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have also developed products based on Shariah-compliant profit rate swaps.48 A variation ofthis structure is that of a series of sequential murabahas generating the fixed leg of the swapand a series of sequential murabahas generating the floating leg. Such a structure would assistin generating an Early Termination Amount based on replacement value (as set out in theISDA/IIDM Tahawwut Master Agreement) very similar to a conventional Early TerminationAmount based on a marked-to-market valuation.

7.4.2.4 Profit Rate Swap Structure

FIXED RATEPAYER

Revolving Murabahas to match theperiodic payment dates under the

Term Murabaha

Cashflow = Cost Price portion + fixed profit portion on periodic fixed payment dates

Term Murabaha

Sells Commodities

Sells Commodities

Cashflow = Full commodity value + floating rate profit portion (linked to LIBOR) payable at the

end of each revolving murabaha

(NB. The full commodity value payable should mirror thecorresponding Cost Price payment under the Primary Murabaha)

BROKER 1FLOATING RATE

PAYERBROKER 2

Figure 7.5 Profit rate swap structure

7.4.3 FX Option

A conventional option gives the buyer of the option the right, but not the obligation, to enterinto a certain transaction (i) on a future date (European option), or (ii) on any of certainspecified future dates (Bermudan option), or (iii) within a specified period, till the expirationof the option (American option). The wa’ad can be used to structure a Shariah-compliantFX (i.e. currency) option. Under one application of this structure, (i) the Client promises theBank (the date of such promise being the Trade Date) to sell a particular amount of a currency(Currency B) against another currency (Currency A) on a pre-determined date (SettlementDate) and at a pre-determined rate; (ii) the Bank acknowledges the Client’s promise but makesno promise to the Client; and (iii) the Bank pays a non-refundable fee (premium) to the Client,regardless of whether the Bank chooses to exercise the call option by enforcing the wa’ad(the Bank’s decision whether or not to exercise the option being dependent upon whether theoption is in-the-money on or about the Settlement Date). The Bank, therefore, has a right toaccept the promise (and thereby exercise the wa’ad-based option) or cancel the promise bysending a cancellation notice. In the context of a similar wa’ad-based FX option developedby a multinational bank, the relevant Shariah Board stated that the concerned product is “forhedging or cost reduction purposes only and not for speculation”.49

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7.4.3.1 Scenario (A)

If the Bank exercises the option (i.e. if the Bank does not send a cancellation notice to theClient):

Specified amount in currency B

Non-refundable fee(Payable on Trade Date)

Purchase Price in Currency A

BankClient(Payable on Settlement Date)

7.4.3.2 Scenario (B)

If the Bank sends a cancellation notice to the Client and therefore does not exercise the option(note: in the following example, the Client is the “Seller” and the Bank is the “Buyer” of theoption):

Non-refundable fee (Payable on Trade Date)

BankClient


In February 2009, the Gulf Finance House (GFH) announced a partnership with DeutscheBank in a first-of-its-kind foreign exchange hedging deal worth over €30 million ($39.4million). The deal utilizes a Shariah-compliant FX-option developed by Deutsche Bank andapproved (for the purposes of the above deal) by the Secretary General and member of GFHShariah Board, Dr Fareed Hadi. Commenting on the deal, Mr Abdul Rahman Al Jasmi, DeputyChief Executive Officer, GFH said: “We are proud to be the first bank to utilize the IslamicFX Option provided by Deutsche Bank. This pioneering product will help GFH to eliminateforeign exchange risks and as such we are pleased to be able to add this type of promissory noteor option to our inventory of risk management tools”50 (emphasis supplied). Calyon, Al HilalBank, and the State Bank of Pakistan have also developed products based on Shariah-compliantoptions.51

7.4.4 Total Return Swap

The underlying economic reasons for entering into a conventional total return swap are that (i)it allows investors to gain exposure to an asset which it does not necessarily need to hold on itsbalance sheet, and (ii) payoffs can be structured so that the other party can hedge against theupside or downside related to that particular asset or class of assets. Under Shariah, a similareconomic profile can be generated by using a double wa’ad structure. Under this structure, anSPV Issuer issues Trust Certificates to investors in return for the issue price (steps 1 and 2, inthe diagram below). The Issuer then uses the issue price to acquire a pool of Shariah-compliantassets from the market (Shariah-compliant Assets) (steps 3 and 4). These Shariah-compliant

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Bank Issuer Certificate Holder

Markets

Sharia-compliant Assets

Issue Price2

Certificates

1


4

5

the Assets at Wa’ad Sale Price

6

7

Wa’ad Sale Price

3

Bank Issuer

Markets


Issue Price22

Certificates

11


44

55Wa’ad (1) – Issuer promises to sell the Assets at Wa’ad Sale Price

Wa’ad (2) – Bank promises to buy the Assets at Wa’ad Sale Price

(Numbers in the above diagram denote chronology of events. In point 5 only onewa’ad will ever be exercised, never both.)

66

77

£ to purchase the Assets(Purchase Price)

33

Figure 7.6 Total return swap

Assets could, for example, be shares listed on the Dow Jones Islamic Market Indexes (DJIMI).The investors (holders of the Trust Certificates) gain exposure to an underlying index or assets(the Underlying) based on two mutually exclusive wa’ads between the Issuer and the Bank.Under one wa’ad (Wa’ad 1), the Issuer promises to sell the Shariah-compliant Assets to theBank at a particular price (which is linked to the performance of the Underlying) (Wa’adSale Price) (step 5), while under the other wa’ad (Wa’ad 2), the Bank promises to buy theShariah-compliant Assets from the Issuer at the Wa’ad Sale Price (step 6). Out of these twowa’ads, only one shall ever be enforced.

Numbers in the above diagram denote chronology of events. In point 5 only one wa’ad willever be exercised, never both.

At maturity, the Bank will calculate how the Shariah-compliant Assets have performedrelative to the Underlying, and (i) if the Wa’ad Sale Price is greater than the market value ofthe Shariah-compliant Assets, then the Issuer shall enforce Wa’ad 2 (similar to a conventionalput option), or (ii) if the Wa’ad Sale Price is less than the market value of the Shariah-compliant Assets, then the Bank shall enforce Wa’ad 1 (similar to a conventional call option).The commercial significance of this structure lies in the fact that, similar to a conventionaltotal return swap, it offers Islamic investors the opportunity to potentially swap the returnsin one basket (as generated from the Shariah-compliant Assets) with the returns in anotherbasket (the Wa’ad Sale Price, as calculated with reference to the Underlying).

The total return swap mechanism has been criticized by Sheikh Yusuf Talal de Lorenzo(a prominent Shariah scholar) on the basis that it was devised with a view to “wrap up anon-Shari’ah compliant underlying into a Shari’ah compliant structure”. Sheikh de Lorenzoargues that such a structure is not Shariah-compliant because: “the returns, under such struc-tures (overall, termed ‘Shari’ah Conversion Technology’), are determined by the performanceof funds which are not Shariah-compliant and which could invest in haraam securities; a

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qiyas (analogy) cannot be drawn between the use of LIBOR for pricing (which is generallyconsidered to be permissible) and the use of the performance of non-Shariah-compliant assetsfor pricing; since while the former is used to indicate the return, the latter is used to deliverthe return; and the cash-flows in a total return swap based on a double wa’ad indicate that theinvestment by an Islamic investor operates as a trigger for a series of transactions which arenot necessarily Shari’ah-compliant.”

On the other hand, Hussein Hassan, head of Islamic Finance and Structuring for the MiddleEast and North Africa at Deutsche Bank, claims that in the Deutsche Bank structure using thedouble wa’ad mechanism, Deutsche Bank kept Islamic investors’ investments isolated fromharam assets, as demonstrated by the Shariah audits carried out by the bank.52 It is furtherargued by supporters of the double wa’ad structure that the use of the Underlying as a point ofreference is no different from issuing a sukuk benchmarked against LIBOR.53 In addition toDeutsche Bank’s use of the double wa’ad structure, it has also been approved by the ShariahBoard of Dar Al Istithmar (Shariah Advisor to Deutsche Bank), consisting of five of theworld’s leading Shariah scholars: Dr Hussein Hamed Hassan, Dr Ali Al-Qaradaghi, Dr AbdulSattar Abu Ghuddah, Dr Mohamed Ali Elgari, and Dr Mohamed Daud Bakar. According toHussein Hassan, “Driven by investor demand, the technique has been instrumental in openingup investment in asset classes that have previously been closed to Islamic investors.”54

7.5 ISDA/IIFM TAHAWWUT MASTER AGREEMENT,PUBLISHED 1 MARCH 2010

The ISDA/IIFM Tahawwut Master Agreement has taken the market over four years to pro-duce. Based in form and structure on the 2002 ISDA Master Agreement, the ISDA/IIFMTahawwut Master Agreement (the “Agreement”) has a number of key distinguishing featuresin comparison with a conventional ISDA Master Agreement. However, the aim is still thesame: for this Master Agreement to bring efficiency, liquidity, and certainty to this practicearea. Additional Representations have been inserted to ensure that the Agreement (and allTrades thereunder) are Shariah-compliant. The Agreement essentially has waiver of interestprovisions embedded within its structure, hence no compensation or interest is payable ondefaulted or deferred payments or deliveries or on unpaid amounts. In addition an arbitrationclause has been inserted and certain Events of Default and Termination Events amended to fitthe structure of a Shariah-compliant derivative transaction.

From an architectural point of view, the concept of “Designated Future Transactions” and“Transactions” has been hardwired into the Agreement and it is important to note that thisAgreement sits outside the ISDA modular library. However, it is a first in this esoteric field inthat it may be used by all market participants in all geographical areas, regardless of a marketparticipant’s leaning to any particular madhab. Furthermore, the Agreement is a multiproductAgreement – all murabaha, musawama, and wa’ad-based products may be documented onthe ISDA/IIFM Tahawwut Master Agreement. The theological analysis relating to salam andarbun-based products is still ongoing; however, there would be no immediate reason why suchproducts may not also be documented on such an Agreement.

The cornerstone of this Agreement is the parallel close-out mechanism which has takenover four years to negotiate. Whilst the triggers for an Early Termination Date are verysimilar to those of a conventional Master Agreement, the valuation methodology is based on acombination of an accelerated calculation and the 1992 ISDA Master Agreement methodologyof Market Quotations with a fallback to Loss. The manner in which the Close-out Amount is

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crystallized is also different in that a musawama is needed to transfer either the gain or lossacross to the non-defaulting party.

Going forward, the next steps are for the ISDA/IIFM working group to draft template confir-mations and also to develop a series of product specific template confirmations. Enforceabilityand netting opinions will also need to be commissioned by ISDA to ensure the enforceabilityof close-out provisions and the recognition of netting for regulatory capital purposes in tandemwith legislative changes required for the recognition of enforceability of the Agreement underthe insolvency laws of some key jurisdictions.

Eventually a Shariah-compliant CSA/Deed may also be commissioned, but that may besome months down the line.

7.6 CONCLUSION

As has hopefully become clear, the field of Islamic derivatives is not one that can be explainedsimply. While the multiplicity of Shariah sources and fiqh principles allow for vigorous debateupon the topic, the arguments in favour of Shariah-compliant derivatives are compelling and aresupported both by inherent Shariah principles as well as overall public interest and necessity.While most structures to date have been relatively vanilla, the total return swap based on thewa’ad structure, the short-selling structures based on ‘urbun (e.g. Shariah Capital’s platformestablished in 2008) and salam (e.g. Newedge’s platform established in 2005) show impressiveingenuity by practitioners and scholars in this field. Going forward, one would assume thatthe industry will make more use of ‘urbun and salam structures as the composite and intrinsicIslamic nominate forms that constitute the basis of an Islamic swap. One would hope that thepublication of the ISDA/IIFM Tahawwut Master Agreement will bring efficiency, liquidity, andgreater certainty to the Islamic derivatives market, as did the launch of the Master Agreementsfor the conventional derivatives market. The aim is to achieve “critical mass” in the hopes thata parallel market can co-exist with the conventional derivatives market, in order to ensure thatIslamic finance grows and deepens as a source of financing, and that structural mismatchescan be addressed methodically and in a manner that does not offend Shariah principles.

NOTES

1. E.g. pork, alcohol, the charging of interest, etc.2. See, generally, Derivatives in Islamic Finance: Examining the Role of Innovation in the

Industry, Moody’s Investor Service, March 2010.3. These basic requirements of Islamic contract law can be readily found in many classical

juridical manuals, as well as modern commentaries. For an example of the former, see, e.g.,Burhaniddin Abi’l-Hasan al-Marghinani, Kitab al-Hidaya, Vol. XVI (the “book of sale”).

4. On the background and history of the salam contract, see generally Baber Johansen, TheSalam Contract: Law and Capital Formation in the Abbasid Empire. See also, BesharaDoumani, Urban-Rural Relations in the Highlands of Ottoman Palestine: The SalamContract.

5. See, e.g., Robert Brunschvig (1976) “Corps certain et chose de genre dans l’obligation endroit musulman”, in idem., Etudes d’Islamologie (Maisonneuve et Larose: Paris), vol. II,pp. 305–6).

6. See, generally, Shari’a Standards, Accounting and Auditing Organization for IslamicFinancial Institutions (AAOIFI) (2003) (Chapter I: Trading in Currencies).

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7. See, generally, Yusuf Tala DeLorenzo, A Compendium of Legal Opinions on the Opera-tions of Islamic Banks: Ijarah, Sarf, and Riba (Institute of Islamic Banking and Insurance,2000).

8. According to this type of option, either party has freedom to withhold acceptance, afterthe other’s tender, until the breaking up of the meeting.

9. The option of a buyer, after having purchased one out of two or more fungible items, tofix the choice of which particular one.

10. The option of rejecting a good after inspection.11. The stipulation of a period of time (often limited to three days) before final assent to the

contract is given.12. Option of dissolution upon discovery of defect in the sale object.13. It should be noted that two versions of the murabaha sale exist – the first is a spot-

murabaha, wherein a seller purchases goods and then marks them up for resale on thespot market, and the second is an ordered-murabaha, wherein a buyer gives the sellera unilateral promise (wa’ad) that it will purchase a good from the seller at an agreedmarked-up price, subsequent to which the seller purchases the good and sells it to thebuyer.

14. See, generally, Joseph Schacht, An Introduction to Islamic Law (1983) “Obligationsin General” (Chapter 20) and “Obligations and Contracts in Particular” (Chapter 21).See also, Chafik Chehata (1969) Theorie Generale de l’Obligation en Droit MusulmanHanefite. Les sujets de l’obligation (Editions Sirey: Paris).

15. See Muslim, Sahih. Variations on this hadith include the following: “Gold for gold, silverfor silver – until he said – equal for equal, like for like, hand to hand, if the kind of assetsdiffer, you may sell them as you wish provided it is hand to hand” (Bukhari, Sahih); and“Umar b. al-khattab said, ‘Do not sell gold for gold or silver for silver except in equalquantities. Moreover, do not trade gold for silver with one of them deferred. Even if yourtrading partner asks you to wait until he can fetch the money from his house, do notaccept the deferment. I fear that you will fall in riba.” Similarly: “Abu Bakr said: ‘TheProphet (p.b.o.h.) said: do not trade gold for gold except in equal measure, or silver forsilver except in equal measure; but trade gold for silver, and silver for gold, as you wish’ ”(Bukhari, Sahih; 379/4).

16. The exception is the Zahiri school, due to their rejection of the methodology of analogicalreasoning (qiyas). See, generally, Nabil Saleh, Unlawful Gain and Legitimate Profit inIslamic Law (1992).

17. Nabil Saleh at 18–20.18. Nabil Saleh at 21–4.19. A minority of scholars, it should be noted, hold the extreme view that all currencies other

than gold and silver are illicit.20. See, e.g., ‘Abbas Ahmad Muhammad al-Baz, Ahkam Sarf al-Nuqud wa al-’Umulat fi

al-Fiqh al-Islami wa Tatbiqatuhu al-Mu’asirah (Dar al-Nafa’is, 1999). See also, ‘AliMuhammad Mahmud Bani ‘Ata, Qawa’id al-Sarf wa Ahkamuhu fi al-Iqtisad al-Islami(Dar al-A’lam, 2007).

21. See, e.g., Mahmoud El-Gamal, Islamic Finance (2006) at 44.22. Mohammad Hashim Kamali, “Fiqhi Issues in Commodity Futures” in Financial Engi-

neering and Islamic Contracts (ed.) M. Iqbal and T. Khan (2005).23. Idem. at 42.

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24. Kamali further argues that if this rule were applicable to fungibles, the ratio legis (’illah)of this rule is to mitigate against the gharar that would occur by way of the seller’s inabilityto deliver. Such a concern, however, is unwarranted in modern futures contracts, sinceregulatory safeguards exist to guarantee delivery and contract performance. See Idem.

25. Sahih Al-Bukhari, 3:194.26. Kamali at 31–2.27. Idem.28. See, e.g., Muhammad al-Bashir Muhammad al-Amine, “Commodity derivatives: an Is-

lamic analysis” in Financial Engineering and Islamic Contracts (ed.) M. Iqbal and T.Khan (2005).

29. Idem. at 77–82.30. Idem.31. Idem.32. Idem.33. Idem.34. See Nabil Saleh at 68.35. See, e.g., Kamali at 38–42.36. The presumption of gambling is asserted by some scholars as another ground for the

prohibition of speculation, independent from that of gharar. Maysir has a close conceptualrelationship to gharar, and may even be viewed as a particular species of gharar. Whilethe general concept of gharar refers to uncertainty/risk which is incidental to a transaction,the concept of maysir describes uncertainty/risk which is the very purpose of a transaction.

37. Kamali at 38–42.38. Idem. at 39.39. Al-Amine at 82–4.40. Al-Shawkani, 5:176.41. See, e.g., Kamali at 33–7.42. Idem.43. Richard Tredgett and Priya Uberoi, Islamic derivatives case study: a cross currency swap,

Derivatives Week, 16 June 2008.44. Mark Bendeich, Islamic Commodities: what would Mohammed do?, 8 December 2006,

available at http://www.gata.org/node/4587.45. http://www.standardchartered.com.my/islamic-banking/wholesale-banking/treasury-

products/en/; http://www.calyon.com/business-lines/calyon-at-the-heart-of-the-development-of-islamic-banking.htm; http://www.alhilalbank.ae/web/?page=treasuryunit.

46. Priya Uberoi and Nick Evans, Islamic Finance: Profit Rate Swap, PFI, October 2008.47. AME Info, Standard Chartered executes Profit Rate Swap deal with Aref Investment, 4

November 2006, available at http://www.ameinfo.com/100675.html.48. http://www.calyon.com/business-lines/calyon-at-the-heart-of-the-development-of-

islamic-banking.htm; http://www.alhilalbank.ae/web/?page=treasuryunit; Abdulkader S.Thomas, Stella Cox, and Bryan Kraty, Structuring Islamic Finance Transactions, p. 197.

49. Calyon at the heart of Islamic banking, available at http://www.calyon.com/business-lines/calyon-at-the-heart-of-the-development-of-islamic-banking.htm.

50. GFH partners with Deutsche Bank with Historic Shariah Compliant Islamic FX Option,available at http://tyo.ca/islambank.community/modules.php?op=modload&name=News&file=article&sid=2471.

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51. http://www.calyon.com/business-lines/calyon-at-the-heart-of-the-development-of-islamic-banking.htm; http://www.alhilalbank.ae/web/?page=treasuryunit; http://209.85.229.132/search?q=cache:0cKCGrGQZewJ:www.sbp.org.pk/departments/ibd/derivativesislamic.pdf+arbun+option&cd=10&hl=en&ct=clnk&gl=uk.

52. Daniel Stanton, Don’t fear the riba, 24 January 2008, available at www.arabianbusiness.com/509145-dont-fear-the-riba.

53. Idem.54. Meeting all tastes, Risk, September 2008, available at http://www.risk.net/public/show

Page.html?page=813157.

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c08 JWBK508-Hassan December 30, 2010 10:12 Printer: Yet to come

8

Overcoming Incentive Problems inSecuritization: Islamic Structured

Finance

Andreas A. Jobst1

8.1 INTRODUCTION

Since the summer of 2007 the global financial system has undergone several periods of dra-matic turbulence, which has resulted in rising concerns surrounding fiscal sustainability andthe continued weakness in the financial system. The implosion of the US sub-prime mortgagemarket, the collapse of Lehman Brothers, and numerous bank failures have triggered unprece-dented and sweeping crisis interventions that have effectively stabilized the global financialsystem. Although irreparable damage to the financial sector has been averted, there are mount-ing concerns surrounding the fiscal positions of sovereigns that have borrowed excessivelyto stabilize their financial systems. The recent crystallization of sovereign risk and relatedspillover effects have led to a renewed deterioration of market conditions notwithstandinga number of encouraging market developments. Policy makers and regulators are pressingahead with the completion of the regulatory agenda in order to avoid substantial risk of amajor relapse in the recovery of the financial system.

Market sentiment remains erratic and many investors, unsettled by excessive risk-taking andasset price volatility, are increasingly turning to alternative modes of finance. Although marketruptures caused by the headlong flight to safety during the initial phase of the credit crisisseem to have been contained, the growing strains on credit markets are felt most profoundlyin structured finance, and in particular, asset securitization. The market for structured debtremains tense as banks dispose of non-core assets and raise capital to de-lever while curtailingnew lending. After having ground to a halt in 2009, securitization has been staging a modestcomeback after the renewed turbulence in capital markets in 2010, but current efforts fall shortof fully restoring investor confidence. With few credit channels available outside the bankingsector, restarting securitization has become an increasingly important area for policy-makersto restore stable growth.

Securitization has come into sharp focus on account of its role in propagating the economicfallout from the US sub-prime crisis, causing a major reassessment of risk, and the price itshould command across all asset classes. In principle, securitization is a capital market-basedsource of refinancing profitable economic activity in lieu of intermediated debt finance. Itprovides an alternative source of finance that serves to mitigate disparities in the availabilityand cost of credit in primary lending markets through the commoditization of credit claims in


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capital markets. Thus, the emergence of securitization helps remedy deficiencies in financialmarkets arising from incomplete capital allocation.

The collapse of the securitization market and the ensuing market turbulence that precipitatedthe global credit crisis have cast serious doubt on this economic proposition of unbundling,transforming, and redistributing credit risk via structured finance instruments. In view ofsweeping fiscal intervention in the financial sector, a widespread retrenchment of mortgageexposures, and substantial liquidity injections by central banks to support inter-bank moneymarkets, both the scale and persistence of the current credit crisis seem to suggest that pervasivesecuritization – together with improvident credit origination, inadequate valuation methods,and insufficient regulatory oversight – can perpetuate market disruptions, with potentiallyadverse consequences for financial stability and economic growth.

This charge begs the question of how securitization could have contributed to excessivecomplacency in financial markets. In response to cost pressures and regulatory reforms overthe years, an increasing number of financial institutions have adopted an “originate-and-distribute” business strategy of loan origination by using securitization to transfer credit riskfrom their balance sheets to other banks, insurance companies, hedge funds, and other financialinstitutions. Since credit risk is customized to the preferences and tolerances of agents, thetradability of securitized debt should improve the capacity of the financial system to bearrisk and intermediate capital. Sadly, it did not. Instead, securitization weakened minimumstandards of prudent lending, risk management, and investment at a time when low returns onconventional debt products, default rates below the historical experience, and the availabilityof cheap hedging tools encouraged more risk-taking for yield despite early signs of heightenedsystemic vulnerabilities in the financial sector.

In this context, the current soul-searching in conventional structured finance has directedattention to Islamic finance to fill the void of unmet credit demand. Although Islamic financedid not entirely escape the implications of persistent counterparty risk concerns and deep-seated investor distrust of credit-sensitive assets, Islamic finance has arguably managed toharness the current market adversity as a result of greater focus on collateralization, thecontempt for excessive leverage, and the near absence of “distressed legacy assets”, such asmortgage-backed securities (MBS). Predatory lending, empty short-selling, and a series ofincentive problems between originators, arrangers, and sponsors, all of which have infestedthe conventional structured finance, go against fundamental Islamic principles, which ensurethat contractual certainty and a mutually beneficial balance are maintained between borrowersand lenders (Wilson, 2004).

This chapter surveys the unique structural features of sukuk and relates the characteristics ofthis form of securitization to calls for enhanced disclosure and standardization, ratings agencyreforms, price transparency, and better transparency of origination and underwriting practicesin conventional structured finance. In particular, it assesses the potential of conflicts of interest(which became apparent in the US sub-prime mortgage crisis) to contaminate the integrity ofthe securitization process if it were conducted in compliance with Shariah principles.

8.2 INCENTIVE PROBLEMS OF CONVENTIONALSECURITIZATION

The main cause of the US sub-prime crisis, which precipitated a global meltdown of financialmarkets during 2008, can be traced to market failure stemming from conflicts of interests inthe securitization process and ill-designed mechanisms to mitigate the impact of asymmetric

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Overcoming Incentive Problems in Securitization: Islamic Structured Finance 173

information. By substituting intermediated lending with capital market finance, securitizationcreates considerable agency cost (which is ultimately borne by investors) if agents are temptedto pursue their own economic incentives. The most prominent incentive problems involve fric-tions among the borrowers, originators, issuers, arrangers, and investors as well as additionalagents, such as servicers, credit rating agencies, and third-party guarantors, whose functionsare the direct result of the fragmentation of risk ownership in securitization (and the incentiveproblems it creates).

First and foremost, valuation uncertainty about the quality of securitized assets could lead tomoral hazard by originators if they have limited liability on downside risk. Since securitizationis predicated on the transfer of credit risk from the originator to a bankruptcy-remote issuingagent, such as a special purpose vehicle (SPV) or conduit, either via a transfer of title (“true salesecuritization”) or the purchase of credit protection (“synthetic securitization”), originatorshave an incentive to limit their (unobservable but costly) effort of screening borrowers oncethey are protected from any adverse performance of the “reference portfolio” of securitizedassets. This friction is exacerbated by potential collusion between originators and borrowers,which may result in the misrepresentation of creditor quality.

The information advantage of the originator with regard to the quality of borrowers and thehistorical performance of individual asset exposures could also give rise to adverse selection.The complex security design of securitized debt suggests superior information of arrangersabout the true valuation of securitized debt. Since arrangers underwrite the sale of asset-backedsecurities (ABS), they might choose certain reference assets and transaction structures to opti-mize their own payoffs (rather than those of ultimate investors). Therefore, rational issuers (andinvestors) would form negative beliefs about the actual quality of reference assets consistentwith the lemons market problem a la Akerlof (1970). On the assumption of all (or most) assets(and transactions) being of poor quality, they would request a reservation utility in the form ofa lower selling price and/or higher return (“underpricing”) as compensation for the anticipatedinvestment risk of receiving a disproportionately large exposure to poorly performing assets(compared to any residual claims retained by the originator). Any selective bias (“cherry pick-ing”) associated with the transfer of securitized assets also affects the relationship of arrangerswith warehouse lenders and credit rating agencies. Warehouse lenders provide interim fundingfor the acquisition of assets during the “ramp-up phase” until the transaction can be finalized.Since required haircuts on securitized assets imply over-collateralization, forcing the arrangerto assume a funded equity position, any change in views about credit quality increases the costof the securitization transaction. Credit rating agencies face a similar lemons problem due tolimited due diligence on arrangers and originators.

In addition, the servicing of securitized assets is afflicted by possible conflicts of interestbetween originators (or third-party agents) on one hand, and borrowers, asset managers, andinvestors on the other. Unless loan servicing remains with the originator, the issuer appoints aservicer that collects payments from borrowers, makes advances of unpaid interest, accountsfor principal and interest, holds escrow or impounds funds related to the payment of propertytaxes and hazard insurance, notifies delinquent borrowers and supervises foreclosures as wellas property dispositions (Ashcraft and Schuermann, 2008). Servicers commonly receive aperiodic fee as compensation for their monitoring effort, which directly affects the realizedlevel of losses and the distribution of cash flows to the arranger (and ultimately to investors).Almost all reimbursable expenses associated with the administration of deteriorating assetquality, such as the foreclosure cost of mortgages, are back-loaded, while advances of unpaidinterest (and possibly principal) occur early on. Since their fee-based income increases over

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time, servicers have the natural incentive to inflate expenses to offset fixed upfront costs andkeep securitized assets on their books as long as possible to assess late fees. For instance,in mortgage securitization, a servicer would prefer to modify the terms of a delinquent loanand/or delay liquidation (rather than foreclose), which stands in conflict with the best interestof both asset managers and investors to foreclose promptly once a loan is deemed uncollectibleso as to prevent lost interest and lapses in maintenance from inflating losses.

However, the mode of payment collection and creditor forbearance impedes a coherentdebt resolution strategy between agents. Any measure to limit debt modification (and otherpossible restrictions on the collection of delinquent debt) hampers the ability of servicersto resolve their own moral hazard problem with borrowers, whose willingness to pay (andpreserve collateral value) declines as their option to walk away becomes more valuable thantheir equity claim on the underlying collateral. This conflict of interest is compounded by thefact that mortgage loans in the United States do not involve asset recourse, so that borrowersdo not have to declare personal bankruptcy upon default, amplifying moral hazard concernssurrounding the administration of reference assets of deteriorating quality. In addition, trusteesof ABS structures have the natural tendency to limit any efforts aimed at reducing moral hazardof the asset originator and arranger. Although they generally undertake contract enforcementand hold the benefit of covenants and collateral for the end-user (and other creditors), theresponsibilities of servicers do not involve monitoring activities or the obligation to act unlessinstructed by a majority of end-users. Thus, the potential of “wilful blindness” on the part ofthe trustee imposes a further constraint on the integrity of the securitization process.

Finally, uncertainty about the true quality of securitized assets creates a principal-agentproblem between asset managers and investors. Since investors cannot observe the effort ofasset managers in screening potential investments and selecting the best trades, over-relianceon credit ratings for complex transactions, such as collateralized debt obligations (CDOs),and insufficient due diligence might encourage managers to engage in asset substitution. In“active” CDO structures, a manager is entrusted with the task of monitoring and, if necessary,trading credits within a dynamic reference portfolio of one or more credit-sensitive asset classes(and possibly different issuers and/or industry sectors) in order to protect the collateral valuefrom impairment due to a deterioration in credit quality. Managers would adjust investmentexposures over time to satisfy covenants on the weighted average rating of the portfolioand position limits on low-grade securities and/or meet a certain degree of diversification inresponse to changes in risk sensitivity, market sentiment, and/or timing preferences. However,investors in managed CDOs do not know what specific assets the CDO managers will investin, and understand that those assets will change over time as managers alter the compositionof the reference portfolio. Thus, investors face both credit risk as well as the risk of poormanagement. While credit rating agencies help resolve the apparent information gap betweeninvestors and asset managers by enhancing transparency due to greater disclosure about thequality of the reference portfolio (and the investment mandate of the asset manager), theefficacy (and objectivity) of ratings could be hampered by the dependence of rating agencieson fees paid by the arranger (“issuer-pays model”).

Agents in the securitization process can attenuate various conflicts of interest arising fromasymmetric information (and limit the agency costs associated with the lemons premium)by soliciting creating greater transparency about the true value of securitized assets throughsignalling and screening mechanisms.

• Given the significant agency cost from adverse selection and moral hazard, issuers commitadditional internal and external resources to a securitization transaction, such as reserve

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funds, and variable proceeds from excess spread, and retain some securitized exposure,which, in substance, provide some degree of added protection to other parties to the trans-action and serve as costly signals of asset quality. In order to signal credit quality it is stillnot uncommon for issuers to retain the most junior claim in a securitization structure as alow-cost risk-sharing and support mechanism. In addition, a subordinated security designencourages incentive compatible behaviour across investors at different points of the capitalstructure.

• Arrangers, who oversee the transfer of assets to the trust and underwrite securitizationtransactions (after consultation with one or more rating agencies), conduct (continuous)due diligence on originators, including the review of financial statements, underwritingguidelines, and background checks, while originators make a number of representationsand warranties about the borrower and the underwriting process. This requires adequatecapitalization of originators to reduce counterparty risk in the event of legal recourse. Downpayments and the modification of loan contracts, in turn, limit the originators’ exposure tomoral hazard arising from borrower leverage.

• Arrangers reduce uncertainty about the performance of servicers by balancing the inten-sity of monitoring efforts (and costly state verification) with the minimization of servicingexpenses through forbearance. In addition to limits on loan modifications, servicer qual-ity ratings and the installation of master servicers, which monitor the compliance withpooling and servicing agreements and enforce remedies of servicer default, help mitigatemanagement risks.

• Arrangers themselves are subject to market discipline in the form of reputational risk, theprovision of credit support, and due diligence by the asset manager aimed at restoringincentive compatibility with investors.

• Investors overcome the principal-agent problem vis-a-vis asset managers by imposinginvestment mandates and ex post evaluation of asset performance relative to benchmarks,which align investment strategies with their own risk-return expectations. Since investorsdo not observe the manager’s effort, choice, and trading behaviour, restrictions on thecomposition of the reference portfolio are based on average rating classification and/or typeof eligible assets.

• In addition, credit rating agencies assess the credit risk and the suitability of a givensecuritization transaction based on expectations about the short run and through-the-cycleperformance of the reference portfolio, which defines a certain risk-return profile. Sincethe business model of rating agencies depends as much on structuring fees as it does onreputation, any encroachment by arrangers on the objectivity of the rating process seemsonly a remote possibility.

8.3 THE RISE OF ISLAMIC FINANCE

The financial crisis invites a distinction of conventional and Islamic finance principles inthe context of securitization and a comparison of their capacity to sustain efficient capitalallocation and financial stability. Islamic finance is driven by the general precept of extendingreligious doctrine in the Shariah to financial agreements and transactions.

The central tenet of this form of finance is the prohibition of riba, whose literal meaning,“an excess”, is interpreted as any unjustifiable increase of capital in the form of interest (i.e.usury), whether through loans or sales.3 Islamic finance is distinct from conventional financeinsofar as it substitutes the (temporary) use of assets (or services) by the borrower for apermanent transfer of funds from the lender as a source of indebtedness. Payment obligations

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arise from the use of existing or future (contractible) assets and not from the time value ofmoney, making asset-backing (in the form of tangible investment) an essential element of anycommercial transaction under Shariah law (Jobst, 2007). Whereas money has become a storeof value in conventional finance, the asset-based organization of Islamic finance implies thatmoney is not considered a commodity but a measure of value through which there can bean exchange and payment of goods and services.4 Shariah law bans the sale and purchase ofdebt contracts, profit-taking without real economic activity, as well as activities that are notconsidered halal (i.e. Shariah-compliant).

Since Islamic law does not recognize the concept of time value of money (as in conventionalfinance), contractual relationships between financiers and borrowers are not governed bycapital-based investment gains but shared business risk (and returns) from entrepreneurialinvestment in lawful activities. Any financial transaction under Islamic law implies directparticipation in asset performance, which constitutes entrepreneurial investment with clearlyidentifiable rights and obligations for which investors are entitled to receive commensuratereturn in the form of unsecured, state-contingent payments based on asset performance. WhileShariah does not object to payment for the use of an asset, profits are not guaranteed ex ante butaccrue only if the investment itself yields income. In this regard, Islamic finance is beholdenby the objective of maintaining a mutually beneficial balance between borrowers and lenderswith a view to serving the public interest (maslaha).

Besides the prohibition of interest-based forms of income and unethical (or sociallydetrimental) activities (haram), Islamic law also prohibits betting and gambling (maisir)as sinful behaviour in contracts with a remote probability of positive payoffs to the investor(“games of chance”), as well as preventable contractual uncertainty and/or contingency riskof performance (gharar),5 for instance, contractual payments without an underlying assettransfer.

The Islamic finance industry has grown precipitously in recent years. There are currentlymore than US$ 800 billion worth of deposits and investments lodged in Islamic banks, mutualfunds, insurance schemes (known as takaful), and Islamic branches of conventional banks. Thecurrent growth has been fuelled not only by surging demand for Shariah-compliant productsfrom financiers in the Middle East and other Muslim countries, but also by investors around theworld seeking Islamic investment as a means of diversification, thus rendering the expansionof Islamic finance a global phenomenon (Hesse et al., 2008a, 2008b, and 2008c).

8.4 THE CASE OF ISLAMIC SECURITIZATION

8.4.1 Definition of Islamic Securitization

Recent excesses in conventional financial markets have shed light on Islamic finance asan alternative framework for securitization. Predatory lending, deteriorating underwritingstandards, and a series of incentive problems between originators, arrangers, and sponsors,of which all have infested the conventional securitization process, belie fundamental Islamicprinciples.

Although the rapid expansion of Islamic finance is taking place across the whole spectrumof financial activities, perhaps the most striking element has been the fast growth of sukuk,the most popular form of securitized credit finance within Islamic finance. Sukuk encompass abroad range of Shariah-compliant financial instruments and can be best described as participa-tion certificates that grant investors return based on profitable investment resulting from actual

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Table 8.1 Modes of secured and unsecured capital market funding

Short-term funding instruments Long-term funding instruments

Off-balance sheetfunding

repo, sale-buyback, securities lending,asset-backed commercial paper(ABCP) conduits and SIVs, tenders,standing facilities

asset-backed securitization (ABS),2

sukuk (after February 2008)

On-balance sheetfunding

short-term deposits, commercial paper Long-term (wholesale) deposits,asset-backed bonds (ABBs), coveredbonds, sukuk (before February 2008)

asset ownership. Since asset-backing, entrepreneurial investment, and specific credit parti-cipation in identified business risk are fundamental to any Islamic transaction, securitizationrepresents a straightforward capital market-based corollary to Shariah-compliant lending.

Sukuk commoditize the proceeds from asset transfers between providers and users of funds indifferent Shariah-compliant finance contracts. In this way they do not pay interest but generatereturns through actual transactions. In their basic concept, sukuk represent the “capital marketcorollary” to a singular lender in Islamic finance. Sukuk transform the (intended) capitalgains from bilateral risk-sharing between borrowers and lenders in Shariah-compliant financecontracts – such as lending transactions (instalment sale) or trust-based investments in existingor future assets – into marketable securities. Hence, sukuk usually refinance the assets of one (ora combination) of three basic forms of Islamic finance6 – (i) debt-based contracts, e.g. syntheticloans/purchase orders (murabahah) and sale-buybacks (bay al-inah); (ii) asset-based contracts,e.g. leases (ijara) and sale-leasebacks (ijara thumma al-bay); or (iii) equity-based contracts,e.g. profit-sharing/partnership (musharakah) and “sweat capital”/seed funding arrangementsor trusts (mudarabah) (Iqbal and Mirakhor, 2006).

While sukuk are structured in a similar way to conventional asset-backed securities (ABS)or covered bonds, they can have significantly different underlying structures and provisions(see Table 8.1 and Figure 8.1). Originators sell existing or future revenues from lease receiv-ables (asset-based), “sale-back profit” (debt-based), or profit participation from private equityarrangements by transferring legal ownership of a portfolio of Islamically acceptable assetsto a special purpose vehicle (SPV),7 which refinances itself by issuing securities to marketinvestors. Investors own the underlying asset(s) via an SPV that funds direct investment inreal, religiously sanctioned economic activity. As such, they assume the role of a “collec-tive financier” whose entrepreneurial investment does not involve guaranteed, interest-basedearnings. A conventional pass-through payment structure seems to be closest to the strictinterpretation of Islamic principles, which requires the transfer of a minimum level of owner-ship to ensure direct investor participation in the business risk associated with the performanceof a dedicated collateral pool of securitized assets.

8.4.2 Current Market Situation

Until 2007, the sukuk market soared in response to surging demand for Shariah-compliantproducts as alternative investments (Jobst et al., 2008). At the end of 2007, the outstandingvolume of sukuk globally exceeded US$ 90 billion (Moody’s, 2007 and 2008; see Figure 8.2).

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Issuing Agent/Conduit(e.g., Special

Purpose Vehicle (SPV))

Asset Originator/ Sponsoring

Entity

Capital Market Investors

21

Transfer of assets (true sale) or credit risk (synthetic) from the

originator/sponsor to the issuer

SPV issues debt securities (asset-backed) to investors

Issued Asset-backed

Securities (ABS)

Underlyingassets

Reference Portfolio

(“collateral”)

Hedge Agreement

- legal form of transfer: legal/equitable assignment (synthetic) or contingent "perfected security interest" (true sale))

- assets immune from bankruptcy of originator (non-recourse financing)

- originator retains no legal interest in assets, though some economic benefit may be retained

- typically structured into various classes/tranches, rated by one or more rating agencies, underwritten by the sponsoring entity.

- with:- fixed/floating rate coupons- sequential/pro-rated payout- bullet, sinking fund or pass-

through payment

Hedge Agreement

Senior Tranche(s)

Mezzanine Tranche(s)

Equity Tranche

Figure 8.1 Basic structure of a conventional securitization transaction

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of i

ssue

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Figure 8.2 Sukuk issuance (2003–2010)

Source: Islamic Finance Information Service (IFIS)

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Gross issuance quadrupled from US$ 7.2 billion in 2004 to close to US$ 39 billion by the end of2007, owing in large part to enabling capital market regulations, a favourable macroeconomicenvironment, and large infrastructure development plans in some Middle Eastern economies(IOSCO, 2008).

However, sukuk have not escaped unscathed from the credit crisis. By 2008, sukuk volumescontracted sharply as a result of challenging market conditions, liquidity constraints, and thepresentation of new rules on the Shariah compliance of sukuk (Jobst et al., 2008). In particular,the less supportive economic environment in the Gulf Corporation Council (GCC) countriesand the regional real estate sector troubled by the slowdown of global trade and foreign directinvestment have contributed to this development.

Amid a gradual normalization of credit conditions in early 2009, incipient demand in tandemwith a greater sovereign issuance helped stabilize the primary market for sukuk. In 2009, globalsukuk sales exceeded US$ 25 billion, up from US$ 17.2 billion in 2008 (see Figure 8.2). Onthe assumption of a stable rate of growth, the volume of sukuk issued by governments andcorporates is expected to regain traction over the medium term, spurred by demand especiallyfrom banks, insurance companies, and pension funds in countries where sukuk are emergingas an attractive diversification tool to the equity and real estate markets.

8.4.3 Sukuk – The Good Side of Securitization?

Sukuk might be a viable source of funds that could help stabilize the securitization market, asthey already contain many contractual features that are now being considered instrumental toa resolution of inherent conflicts of interest between agents in the conventional securitizationmodel. While sukuk are structured similarly to ABS, risk-sharing and the full participation ofboth issuers and investors in the underlying asset performance (and how it affects the capitalstructure of the transaction) offer an alternative mechanism to conventional securitization inestablishing incentive-compatible behaviour.

There are several Islamic principles governing sukuk, which could potentially redress manyconflicts of interest and valuation problems that infested the conventional securitization pro-cess:

• between asset manager and investor (“principal-agent dilemma”):◦ The religious prohibition of both gambling (maisir) and speculation (gharar) prevents

excessive risk-taking (in the form of asset substitution) and commands clear objectcharacteristics and/or delivery results as part of contractual certainty at the time ofinception.

◦ The trading activity of asset managers is restricted to bona fide merchant transactions onreal debt while investor return must be derived from defined asset value associated witheffective (or intended) ownership interest.

◦ Since there is definite performance underpinned by actual and direct transfer of asset asobject of unconditional sale in Islamic contracts, i.e. no mutual deferment of contractualobligations, any contingency risk from unfunded claims is limited to predefined timingmismatch of delivery or payment in accepted contracts (salam/istisna vs. bay al’ajal/baybithaman ajil).

◦ Trust-based contracts in Islamic law, such as mudaraba, limit the liability of the assetmanager (mudarib) to cases of negligence, misconduct, or breach of contract (rep-resentations and warranties). That being said, (i) partnership structures with fixed

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contribution ratios (musharaka) – and the possibility of additional participation of profitsdepending on verified effort choice – or (ii) principal-agent contracts (wakala)8 with fixedmanagement fees (including performance remuneration) help incentive problems fromcompromising pre-agreed investment strategies while maintaining positive-sum payoffsof both agents and investor.

• between originator and issuer:◦ The Shariah approval and certification process promotes adequate disclosures under-

pinned by a solid foundation of religious standards.• between issuer and investor:

◦ Investor return derived from effective (or intended) ownership of real asset(s) underlyingthe securitization structure (after actual and direct transfer as object of an unconditionalsale) generates indebtedness and amounts subject to direct recourse.

• between servicer and investor/asset manager:◦ Contract certainty rules out potential of inflated, back-loaded (and variable) servicer

expenses (and cannot be prioritized due to prohibition of provisions aimed at creatingunilateral gains from interim changes in asset characteristics and valuation). Servicerfees are fixed and defined ex ante.

• between borrower and originator:◦ The Islamic principle of social benefit as public interest (maslaha) and the precept of

supporting a system of distributive justice would preclude any moral hazard of originators(“predatory lending”) or borrowers (“walking away”). Moreover, the Shariah prohibitsdebt modification and unilateral gains (which are considered exploitation).

• between arranger and guarantor:◦ Guarantees must not establish the possibility of mutual deferment of contractual obli-

gations without actual transfer of asset. Thus, only funded agency contracts with pre-specified terms would be deemed sufficient to rule out contingency risk of payment andactual delivery.

The principles underlying sukuk fall in line with recent policy moves to rehabilitate structuredcredit markets. Since recommendations issued by the Accounting and Auditing Organizationof Islamic Finance Institutions (AAOIFI) in February 2008, sukuk have become more akinto asset-backed, pass-through off-balance sheet structures, without institutional guarantees onthe asset performance. Principal and coupon payments depend on the cash flows derived fromthe pool of underlying assets, and on the structure of the transaction. If securitized assets areremoved from the originator’s balance sheet, ownership conveyance through true sale ensures(i) the exclusive dedication of cash flows from the underlying asset to establish the linkageof ownership interest to identifiable economic activity and (ii) secured but unconditionalrepayment from underlying assets. Unlike ABS, however, sukuk afford investors direct recourseto a defined portfolio of underlying assets, which fund secured repayment from profitableinvestment in religiously sanctioned, real economic activity.

Nonetheless, many pitfalls of financial innovation that contributed to the US sub-primecrisis also apply to Islamic finance in an even larger measure, hence the importance ofsound risk assessment, adequate rating processes, and the use of integrated risk mitigants.For instance, inflated asset prices of difficult-to-value collateral could obfuscate lower-than-expected asset performance, increase residual equity, and help maintain artificial arbitragegains of asset managers. Also high execution costs, heightened administration, and collectionrisks can amplify the potential for principal-agent problems in the absence of long default

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histories, robust recovery rate estimates due to untested collateral enforcement procedures,and sufficient asset diversity.

8.4.4 Economic Challenges

Despite considerable, and growing, demand for Shariah-compliant assets, the further develop-ment of sukuk depends on essential economic, regulatory, and infrastructural conditions. Amidweak reliance on capital market financing in many Islamic countries, issuers of sukuk are firstand foremost faced with several critical economic impediments that pertain to their ability to(i) identify reference assets that meet Shariah requirements and offer attractive returns, and (ii)substitute standard structural features in conventional securitization structures, such as creditenhancement and liquidity support, which are not permissible in an Islamic context. Giventhe limited sourcing and structuring of eligible asset portfolios, Islamic issuers have begun tooriginate their own Islamically acceptable assets rather than buy asset pools in the market.

However, the sukuk market is still plagued by illiquidity in the secondary market, withthe combination of high originator concentration and regional fragmentation clouding theoverall positive outlook. Although the concept of asset backing is inherent to Islamic finance,structured credit transactions are few and far between where financial transactions have tofollow the precepts of the Shariah. The current level of sukuk issuance by corporations andpublic sector entities still remains a fraction of the global fixed income markets. Since onlya handful of large banks and managers are behind the bulk of transactions completed by asmall number of repeat issuers, origination and servicer risk from narrow asset supply poseschallenges to investor diversification. In addition, the lack of information from private sourcesabout securitized assets in many sukuk and the prevalence of “buy-and-hold” investmentsinhibit efficient price discovery and information dissemination.

8.4.5 Legal Challenges – Regulatory Consolidation and Supervisory Harmonization

Governance issues, especially the Shariah compliance of products and activities, constitute amajor challenge for the Islamic finance industry. Although Shariah rulings (fatwas) by legalscholars are disclosed, there are currently no unified principles on the basis of which Shariahscholars decide on the Shariah compliance of new products and convey their assessment. Theserulings are not consolidated, which inhibits the dissemination, adoption, and cross-fertilizationof jurisprudence across different countries and schools of thought. As a result, there is stillconsiderable diversity and inconsistency in corporate governance principles and opinions ofShariah Boards. Moreover, there is still considerable heterogeneity of scholastic opinion aboutShariah compliance, which undermines the creation of a consistent regulatory framework andgovernance principles. Therefore, the fragmented opinions of Shariah Boards, which act asquasi-regulatory bodies, remain a source of continued divergence of legal opinion.

Recent efforts to achieve regulatory consolidation and standard setting have addressed legalcontingencies imposed by Islamic jurisprudence but might mute some of the recent enthusiasmfor Islamic capital market products. Leading regulatory organizations in Islamic finance,such as the Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI),the General Council for Islamic Banking and Finance Institutions (GCIBFI), the IslamicInternational Rating Agency (IIRA), the Islamic Financial Services Board (IFSB), and the FiqhAcademy in Jeddah, have been working on aligning Shariah principles on a consistent basis.In February 2008, the Shariah committee of AAOIFI issued new recommendations regarding

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the role of asset ownership, investment guarantees, and the Shariah advisory and approvalprocess in sukuk origination and trading. Most sukuk have explicit repurchase agreements thatguarantee the repayment of principal but violate the profit and loss sharing (PLS) features ofShariah law. The debate about the general applicability of these recommendations with regardto the approval process of sukuk (and the screening of both their structure and characteristicsof underlying assets) has raised concerns about the economies of Islamic securitization andthe Shariah governance of Islamic capital markets at large.

8.5 CONCLUSION

With more than US$ 2 trillion of credit demand projected to be unmet in the next three yearsas the conventional securitization market remains dysfunctional, the current market situationprovides a window of opportunity for sukuk. Seemingly, the religious overlay of sukuk hashelped temper unfettered financial innovation and (unnecessary) structural complexity, bothof which have become the undoing of conventional securitization. The adversity of currenteconomic conditions, however, is likely to also prolong the recovery of Islamic finance, whichis not insulated from fundamental developments. As policy makers in mature markets enter theuncharted territory of dealing with troubled banks, restoring confidence in financial markets,and restarting economic growth, heightened risk-aversion and depressed asset prices portenda further contraction of credit in the near future.

For Shariah-compliant structures to become veritable alternatives to conventional instru-ments and fill some of the void left behind by the broad-based retrenchment of conventionalstructured finance, improvements in legal certainty and transparency are needed. Recently,investor sentiment has been severely damaged from the initial debt standstill imposed on oneof the most prominent sukuk issued by property developer Nakheel and might halt the strongrebound of the market in the wake of continued uncertainty about investor protection.9 At thesame time, recent legal charges brought against arrangers of Islamic capital market transac-tions have further deepened scepticism by confounding the delineation between conventionaland Shariah law.10

NOTES

1. Andreas Jobst is an economist in the Monetary and Capital Markets Department of theInternational Monetary Fund in Washington, DC. The views expressed in this chapter arethose of the author and should not be attributed to the IMF, its Executive Board, or itsmanagement. Any errors and omissions are the sole responsibility of the author. Contact:[email protected].

2. In February 2008, the Shariah committee of the Accounting and Auditing Organizationof Islamic Financial Institutions (AAOIFI) issued recommendations regarding the role ofasset ownership, investment guarantees, and the Shariah advisory and approval process insukuk origination and trading. These recommendations led to a critical reassessment ofoutstanding sukuk issues and lengthened the approval process of new issues in 2008.

3. This definition refers to any positive and predetermined return that is tied to the maturityand the amount of principal, resulting in wealth creation regardless of the outcome ofasset performance (or the success of the business operations of the borrower).

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4. Stripped of its religious elements, this concept parallels the free-money theory of interest(“Freiwirtschaft”), which postulates an economic system where the most talented peoplewould have the highest income, without forgery by interest and rent charge (Gesell, 1958).

5. There is no standard definition of gharar. It may also result from jahl (ignorance), inade-quate information, or lack of transparency.

6. Some recent references on Islamic finance include Jobst et al. (2007), Sole (2007), andJobst (2007).

7. In conventional securitization, an SPV is set up solely for the purpose of the securitizationand might be a trust, limited liability company, partnership, or a corporation. In Islamicsecuritization, the objectives set out in the constitutional documents of the SPV also mustnot infringe the prohibition of riba and haram under Islamic law.

8. Wakala defines a principal-agent relationship in which a fund manager acts as the agentof investors in accordance with pre-agreed investment parameters. The primary fee isfixed, for instance, as a percentage of assets under management. There may also be aperformance-based fee but not a simple sharing of profits.

9. The recent debt restructuring of Dubai World and the last minute rescue of propertysubsidiary Nakheel, which issued one of the largest sukuk three years ago, has shakenthe confidence in Islamic finance owing to growing controversy about the interactionof Shariah compliance and principles of investor protection in times of distress. TheUS$ 3.5 billion Nakheel structure, explicitly guaranteed by Dubai World (but not bythe Government of Dubai), was a commercial leasehold interest-based sukuk al-ijara(lease-based) with assets being mostly Dubai waterfront properties. While the issuanceof sukuk certificates in this transaction was governed by English law, the issuing special-purpose vehicle (SPV) itself was incorporated in the Jabel Ali Free Zone, subjecting thesale or lease of the collateral assets to Shariah-based United Arab Emirates (UAE) lawas applied by Dubai courts. However, this arrangement raised questions as to whetherShariah compliance would uphold legal enforceability of investor claims, and possiblyencroach upon dispute resolution under conventional law.

10. In the recent UK court case, the Kuwaiti asset management firm, Investment Dar, wrangledover the repayment of a separate type of debt to Bank Blom, a Lebanese bank, claiming thatthe purported wakala (principal-agent) agreement between both firms was not consistentwith shari’ah law. The English court ruled that Investment Dar was only liable for theprincipal and not the profit share, and, thus, also adjudicated on the religious underpinningsof the legal dispute between both parites. It remains to be seen what the full repercussionsare for Islamic finance but there is a danger that the court ruling could set a precedent forother similar cases.

REFERENCES

Akerlof, G.A. (1970) The market for lemons: quality uncertainty and the market mechanism, QuarterlyJournal of Economics, Vol. 84, 488–500.

Ashcraft, Adam B., and Schuermann, Till (2008) “Understanding the Securitization of Subprime Mort-gage Credit”, mimeo, Federal Reserve Bank of New York.

Gesell, Silvio (1958) The Natural Economic Order. Revised edition. Peter Owen: London.Hesse, Heiko, Jobst, Andreas A., and Sole, Juan (2008a) Trends and challenges in Islamic finance, World

Economics, 9(2), 175–93.Hesse, Heiko, Jobst, Andreas A., and Sole, Juan (2008b) Trends and challenges in Islamic finance,

Islamica, September, 28–33.

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Hesse, Heiko, Jobst, Andreas A., and Sole, Juan (2008c) “Quo Vadis Islamic Finance?”,RGE Monitor, 27 November, 28–33. Available at http://www.rgemonitor.com/us-monitor/254573/quo vadis islamic finance.

IOSCO (2008) “Analysis of the Application of IOSCO’s Objectives and Principles of Securities Regula-tion for Islamic Securities Products”, International Organization of Securities Commissions (IOSCO),September, Paris.

Iqbal, Zamir, and Mirakhor, Abbas (2006) An Introduction to Islamic Finance – Theory and Practice,Wiley Finance Editions, John Wiley & Sons, Inc., Hoboken, NJ.

Jobst, Andreas A. (2007) The economics of Islamic finance and securitization, Journal of StructuredFinance, 13(1), Spring, 1–22. Also published as IMF Working Paper 07/117 (International MonetaryFund (IMF): Washington DC).

Jobst, Andreas A., Kunzel, Peter, Mills, Paul, and Amadou, Sy (2008) Islamic bond issuance – whatsovereign debt managers need to know, International Journal of Islamic & Middle East Financeand Management, 1(4). Published also in IMF Survey Magazine, International Monetary Fund (MF),Washington, DC (19 September 2007).

Moody’s (2008) Focus on the Middle East, Inside Moody’s, Spring, 4.Moody’s (2007) Focus on the Middle East, Inside Moody’s, Winter, 4.Wilson, Rodney (2004) “Overview of the Sukuk market”, in N.J. Adam and A. Thomas (eds), Islamic

Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. Euromoney Books: London.

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9

The Evolution of Takaful Products

Mervyn K. Lewis

9.1 INSURANCE UNDER ISLAM

The first Islamic insurance company (the Islamic Insurance Company of Sudan) was estab-lished in 1979, followed shortly afterwards in the same year by the formation of the IslamicInsurance Company of Saudi Arabia. Twenty years on in 1999 there were 34 takaful institu-tions in operation (Lewis and Algaoud, 2001). Since then, the industry has grown rapidly and,by 2008, the number had grown to between 100 and 150 companies (SwissRe, 2008). Someeven put the number as high as 250 takaful operators.1 These companies, operating within thelarger sphere of Islamic finance, have been formed primarily with the aim of offering insur-ance coverage in Shariah acceptable ways to Muslim families and business enterprises, in boththe life (family) insurance and non-life (general) insurance market segments, on an individ-ual and group basis. To serve this end, the business of the companies must be conducted inaccordance with Islamic principles, rules, and practices.

If Islamic insurance is viewed as an integral part of the Islamic economic and financialsystem, its goals become apparent. In general terms the aims of an Islamic economic systemare to (i) implement the commands of the Creator and His Apostle and (ii) provide an envi-ronment where it becomes convenient for individual Muslims to follow Islamic injunctionsin commercial and financial transactions (Siddiqui and Al Athmey, 2007). These injunctionsare laid out in Shariah, the body of Islamic law, and in fiqh-al-mu’amalat, that branch ofIslamic jurisprudence which defines the requirements for economic transactions to complywith Shariah.

In essence, then, Islamic insurance (as the name implies) is insurance that is “Islamic”, inthat it conforms to Islamic law (Shariah). To be Shariah-compliant, insurance must necessarilyfollow the sources of Shariah. The four fundamental sources of Shariah are the Holy Quran,Sunna, Ijma (consensus), and Qiyas (analogy) respectively. Faced with a problem, one mustlook first to the Holy Quran for the solution. The Holy Quran is the ultimate source of Islamicprinciples, revealed by Allah to the Prophet Muhammed. If a rule exists, it is taken. If not,one next searches the sunna, the sayings and actions of the Prophet. Both the Quran andthe sunna are divinely inspired. If no ruling is found in the Quran or the sunna, the ijma ofthe imam mujtahids (those who undertake ijtihad) is referred to next. If there is none, thenone relies upon ijtihad (independent judgment) to come up with a ruling based on qiyas. Bythese means, solutions to new problems are sought by Islamic jurists (scholars).

On certain issues, such as not allowing the charging and receiving of interest (riba, usury),the rules are clear. On other questions, such as how Shariah-compliant insurance is to be


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conducted, there are various judicial opinions (fatwa) detailing and giving legal opinions onwhat transactions are permissible. While there is far from unanimity on all issues, there isgeneral agreement that the following are to be avoided.

Riba. The payment of riba and the taking of interest as occurs in a conventional financialsystem is explicitly prohibited by the Holy Quran in the most unequivocal manner (S2: 275–81,S3: 30–2, S4: 161, S30: 39), and thus investors must be compensated by other means.

Maysir. The Holy Quran (S5:90–1) uses the word maysir for games of hazard, implyingthat the gambler strives to amass wealth without effort. Gambling in all its forms is forbiddenin Islamic jurisprudence. Along with explicit forms of gambling, Islamic law also forbids anybusiness activities which contain any element of gambling (Siddiqi, 1985). In the interestsof fair, ethical dealing in commutative contracts, unjustified enrichment through pure chanceshould be prohibited.

Gharar. Another feature condemned by Islam is the undertaking of economic transactionsinvolving elements of speculation, gharar (literally “hazard”). While riba and maysir arecondemned in the Holy Quran, condemnation of gharar is supported by ahadith. In businessterms, gharar means to undertake a venture blindly without sufficient knowledge or to under-take an excessively risky transaction. By failing or neglecting to define any of the essentialpillars of contract relating to the consideration or measure of the object, the parties undertakea risk which is not indispensable for them. This kind of risk is deemed unacceptable andtantamount to speculation due to its inherent uncertainty.

Haram. A group of Muslim jurists acting as independent Shariah auditors and advisorsensures that a strict code of “ethical investments” operates. Islamic financial institutionscannot finance activities or items forbidden (i.e. haram) in Islam, such as trade of alcoholicbeverages and pork meat. Furthermore, as the fulfilment of material needs assures a religiousfreedom for Muslims, Islamic institutions are encouraged to give priority to the production ofessential goods that satisfy the needs of the majority of the Muslim community.

These essential elements constitute the basis of “justice in exchange” (Iqbal and Lewis,2009: 83). Those unfamiliar with them may conclude incorrectly that Islam is opposed toprofit-oriented business activities. In fact, from its inception, Islam has extolled trade andaccommodated the existence of monetized free market exchange. What was needed was todetermine which transactions were just and which were unjust. On this account, a detailedframework was developed from Shariah that prohibits usury, gambling, and gharar. Elimi-nating these unjust features from trade and encouraging just exchange is an important steptowards the promotion of socio-economic justice in society.

These basic injunctions have led to the condemnation of some or all types of insurance byMuslim scholars. There are, in all, from the viewpoint of Islamic law, three main problems withconventional, especially life, insurance. First, it violates the prohibition of gharar (uncertainty)since the benefits to be paid depend on the outcome of future events that are not known atthe time of signing the contract (for example, with whole-of-life, the time frame, i.e. thelifetime of the insured, is not known and cannot be known until the event (death) itself occurs).Secondly, insurance is regarded as maysir (gambling) because policyholders are held to bebetting premiums on the condition that the insurer will make payment (indemnity) consequentupon the circumstance of a specified event (for example, with pure endowment policies, thatthey will still be alive by the end of the term of the policy to receive the benefits stated in thecontract). Thirdly, with all insurance policies (including general insurance) the insurer investsprepaid premiums on behalf of those insured, and the underlying investment activities of manyinsurance companies are riba-based.

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The Evolution of Takaful Products 187

These views, however, are not universally held amongst Islamic jurists, and the question ofthe acceptability of insurance remains a controversial one within the Muslim community. Atone extreme there is the position of Sheik Al-Azhar Al-Sheikh Jad-al Haq Ali Jad al-Haq ofEgypt, who in 1995 declared all life insurance to be prohibited under Shariah (Wahab, 1999;Billah, 2001). Also, the Fiqh Academy of the Muslim League (with one dissent) declaredthat “[c]ommercial insurance is a form of gambling, since the insurer pays a premium andeither receives no compensation or one far exceeding what he paid” (El-Gamal, 2006: 147).At the other extreme, there are other jurists who view insurance differently. In his dissentto the Fiqh Academy ruling, Professor Mustafa Al-Zarqa wrote: “I have found no proof inthe text of Shariah, or its legal theory, that would forbid insurance. On the contrary, I foundproof of Shariah and its general objectives, to point jointly towards its permissibility andapprobation, as a means of eliminating risk and losses” (El-Gamal, 2006: 150). In this context,the legal maxim of ibanah provides that everything that is not prohibited is permissible as faras mu’amalat (pecuniary transactions) is concerned.2 Insurance is then allowed because thereis no specific injunction against it and a mere presumption of unlawfulness is insufficient.Al-Zarqa argued that insurance companies pool the risks of a large number of people andredistribute funds in a way that helps alleviate the losses of the unfortunate (Salahi, 2003).3

On this interpretation, insurance is accepted because it is intended for a good cause4 – that is,so long as it avoids interest and investments in non-permitted activities.

Neither of these positions has gained traction among Islamic jurists. The majority view isrepresented by the OIC Islamic Fiqh Academy which, at its second session held in Jeddah on10–16 Rabi’ll, AH (22–28 December 1985), resolved as follows:

1. “The commercial insurance contract with the fixed premium offered by commercialinsurance companies is a contract that contains excessive and, hence, contract-invalidatinggharar. Therefore, it is haram (forbidden) by the Shariah.

2. An alternative contract that meets Islamic principles for transactions is a cooperativeinsurance contract based on voluntary contributions and cooperation. The same appliesto reinsurance based on cooperative insurance.

3. Islamic countries should be called upon to set up cooperative institutions of insurance andreinsurance . . .” (cited in Dhareer, 1997: 57)

Such views have led to the development of takaful (cooperative) insurance which oper-ates in accordance with the Islamic financial principles. Takaful is based on the concept ofshared responsibility, joint indemnity, and mutual protection, whereby a group of participantsmutually guarantee each other against losses or damages. It builds on the twin principles ofmutual assistance (ta’awun) and voluntary contribution (tabarru) by which the risk is sharedcollectively and voluntarily by a group of participants. The necessary mind-shift comes fromrecognizing that there are participants, not policyholders, and contributions or donations, notpremiums. Through the payment of a voluntary contribution and a clear definition of the type ofloss, gharar (uncertainty) and maysir (excessive risk-taking) are eliminated from the contract.

Consequently, takaful is Islamically acceptable due to the following characteristics: theparticipants cooperate among themselves for their common good; every participant pays his orher subscription in order to assist those of them who need assistance; it falls under a donationcontract that is intended to divide losses and spread liability according to the community pool-ing system; the element of uncertainty is eliminated insofar as subscription and compensationare concerned; and it does not aim at achieving advantage at the cost of other individuals.

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For these aims to be achieved, an appropriate organizational form and business modelneeds to be established. However, there are a number of organizational structures and businessmodels in operation, with very different features.

9.2 ORGANIZATIONAL STRUCTURES ANDOPERATIONAL MODELS

If the historical development of conventional insurance is considered, it is found that threepredominant legal forms have been used:5

(a) an association of individuals (e.g. Lloyd’s)(b) stock companies(c) mutual companies, and clubs.

A Lloyd’s Association is an organization of individuals joined together to underwrite riskson a cooperative basis, normally grouped in syndicates. Here the individual underwritersassume risks in their own name and do not bind the organization for their obligations. Allmembers are separately liable to the full extent of their personal fortunes for all debts inrespect of insurance contracts to which they have subscribed. In this respect, it can be said thata Lloyd’s Association is a proprietary organization bent on profit and the underwriter is alwaysan individual. On the other hand, a stock company is the corporate body of stockholders that isorganized as a profit-making venture in the field of insurance with limited liability (restrictedto shareholders’ capital). Mutual companies, and clubs, are organized as non-profit corporatebodies which are owned by the policyholders themselves as there are no separate stockholders.

Given the emphasis in takaful principles upon mutual assistance and joint risk-bearing, onemight expect takaful companies to be organized as mutual companies. Yet, while takaful restson principles of mutuality and shared responsibility, and indeed is in certain respects similarto mutual insurance organizations, the vast majority of takaful companies are formed as pro-prietary stock companies, many as subsidiaries of Islamic banks – the so-called bancassuranceor bancatakaful model. In effect, the charter and the corporate objective of the typical Islamicinsurance company is to provide Islamic insurance or takaful services on a commercial forprofit basis in accordance with Islamic principles and so offer to those participating the serviceof insurance in a form permitted in Shariah.

Although most takaful companies are akin in structure to a proprietary life office or generalinsurance company, which is wholly owned either by shareholders or by another company, thetakaful company’s main purpose and the way it operates and distributes its excess or profitsmakes it more like a mutual or cooperative life office in which the insured themselves arethe insurers. Because of these aspects, it can be seen as a hybrid of the two. In the words ofthe Islamic Financial Services Board, “a typical takaful undertaking will consist of a two-tierstructure that is a hybrid of a mutual and a commercial form of company” (IFSB, 2006: 4).

In the context of takaful, what mutuality means is that a voluntary specific amount ofdonation is made among participants and managed by the takaful operator. The pooled fundis then utilized to help the unfortunate members. The spirit embodied in the arrangement isthat the participants are thinking not only of their own protection but they should also bethinking of helping other participants. Without the concept of donation, the transaction wouldsimply be that of buying and selling of insurance. In this case the risk is shared equally by theparticipants, and the takaful operator is not the owner of the fund but just its custodian.

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For the concept of takaful to be rendered operational, however, operating business modelsneed to be put in place – and there are in fact a number of alternatives in use – that maintainsegregated funds for policyholders and shareholders, and follow appropriate rules for thecollection, investment and distribution of funds as laid down by the Shariah advisors. AnIslamic insurance company should be established on the condition that its cooperative natureis made evident, with clear stipulations in the insurance contract to signify that the premiumspaid by the insured are grants to the company to be remitted to fellow contributors in need ofassistance. However, adopting a mutual corporate legal structure and embracing mutuality inthe form of a joint guarantee system is not in itself sufficient for takaful operations. Investmentsmust be in Islamically acceptable ventures, while riba, maysir, and gharar have to be avoided.Table 9.1 sets out some differences between mutual insurance, conventional proprietary, andtakaful insurance.

Table 9.1 Some features of mutual, conventional commercial, and takaful insurance

Mutual insurance Commercial insurance Takaful

Comprises cooperativeassociations, started byprovident societies, friendlysocieties, temperance unions,etc.

Comprises proprietarycompanies and Lloyd’sunderwriters

Comprises profit-oriented andnon-profit takafulcompanies

The individual members arethemselves the insurers aswell as the insured. Normallythe organization is anon-profit one

These enterprises are willing forpecuniary consideration (i.e.the premium), to take the riskof possible losses off theshoulders of others ontothemselves. They undertakesuch risks at a price and uponcalculations which, if welladjusted, will leave them,after providing against allcontingencies, a fair profit

Risk-sharing betweenparticipants throughta’awuni and tabarruconcepts

The insurer assesses thecontribution payable by eachmember to ensure that thefund is equitable andsufficient to meet expectedclaims. If the amount isinsufficient the insurer cancall for additional funds

For proprietary companies if theclaims were to exceed thefund available, the insurer (asthe risk-taker) must makegood any deficiency from itsown assets

Operator pays takaful benefitsfrom takaful fund. In theevent of deficiency in thetakaful fund, the operator isexpected to provide aninterest-free loan to the fund

The insurer in a mutualcompany may be consideredas the custodian (or treasurer)of the fund, as managementappointed by policyholders

In the case of proprietarycompanies the insurer is alsothe owner of the fund, andpremiums paid bypolicyholders (insured) areconsidered as income toinsurers

The function of operators islimited to beingintermediaries (orcustodians) and are onlyeligible for mudaraba profitshare or wakala fee or both

Investment avenues are notrestricted, except onprudential grounds, unless thesociety so deems

No restrictions on investmentsother than prudential

Assets of the takaful funds areinvested inShariah-compliantinstruments

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Irrespective of the business approach adopted, the following elements must exist in a takafulmodel

• cooperative risk-sharing for protection amongst participants;• incorporation of tabarru (donations) or waqf (endowment) concept to eliminate gharar;• avoidance of riba and maysir;• clear segregation of roles for participants and operators;• a separation of shareholder funds from those of participants;• commitment to distribute technical profits to participants;• all transactional aspects, including investment, to be in compliance with Shariah.

It is against this backdrop that it may be useful to draw a distinction between Islamic insuranceand takaful. When the system began, and for many years afterwards, the two were synonymous.Now the position is much more varied, and the profit-oriented and non-profit (e.g. the Sudanesecooperative structure) “pure” takaful operators have been joined by other supplies of “Islamicinsurance.” First, there are conventional insurance companies that operate within an Islamicsystem. In particular, in Iran, insurance companies operate on a conventional basis, but invest inShariah-compliant assets. Secondly, there are conventional insurance companies with takaful“windows”. For example, in Indonesia takaful products in 2008 were supplied by three “pure”takaful operators and 32 insurers (SwissRe, 2008). Under a window operation a notionaltakaful fund is set up within the conventional insurance fund. Assets are “ring fenced” withinthis notional fund. However, it is notional in that there is no legal separation of assets and in anywinding up it is doubtful that the assets in the takaful window are provided any protection fromthe liability of the other (conventional) policyholders. Moreover, in the Indonesian case, littleis known about the takaful business models employed. Finally, the picture is further blurredby the existence of retakaful (Islamic reinsurance) companies that also write conventionalbusiness.

If we confine ourselves to takaful products provided by companies set up as fully Islamic(“pure play”) institutions, in which the entire insurance operations are conducted in accordancewith Shariah, four business models operate. These are:

• mudaraba (profit-sharing)• wakala (agency)• hybrid model• waqf (endowment).

9.2.1 Mudaraba Model

The mudaraba model is essentially a profit-sharing arrangement. A mudaraba is a commercialrelationship between two parties: the entrepreneur (in this case the takaful company or operator)and the provider of capital (in this case the participants) who have agreed to conduct acommercial activity and share the profits at a pre-agreed ratio. When using this principle, thetakaful company undertakes to collect the contributions provided by the participants, managethe company, conduct the underwriting and paying of claims, etc., for a share of profits whichcome in the form of underwriting surplus and investment returns. Under the rules of mudaraba,any losses will be borne by the participants. Also, all direct expenses to the operations will bepaid off from the takaful fund (participants’ contributions).

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There are some variants with respect to the treatment of expenses. Under the ‘pure’mudaraba model all direct and indirect expenses are charged to the shareholders’ fund and theirshare of profits which come in the form of underwriting surplus and investment returns. Underthe modified mudaraba model all management expenses (direct or indirect) are charged to thetakaful fund. In addition, while the basic organizing principle is the mudaraba arrangement,with respect to the participants and company, the insurer may then enter into a musharakareinsurance arrangement on a profit-and-loss sharing basis.

Because mudaraba is the principle that underlies the relationship between an Islamic bankand its investing clients, at least on the liabilities side of the balance sheet, it was perhapsnatural that the arrangement would be used in takaful. For example, when Syarikat TakafulMalaysia (the first takaful operator in Malaysia and a subsidiary of Bank Islam MalaysiaBerhad, the first Islamic bank in Malaysia) was established in 1984, it adopted the mudarabamodel. The same was true of Etiqa Takaful Berhad (formerly MNI Takaful), establishedin 1993. In 2007/2008, they both moved from the mudaraba to the wakala model for newproducts.

Certainly, there are some questions about the mudaraba model, discussed in Wahab, Lewis,and Hassan (2007) and Hassan and Lewis (2011). In brief,

• Tabaru or mudaraba? Formally, the relationship between participants is one of tabarru(donation) not mudaraba (profit-sharing). A donation from participants cannot at the sametime be mudaraba capital.

• What are profits? A mudaraba contract allows for profit-sharing. However, profits frominvestment are not the same as surplus (excess of premiums and investment income overclaims, reserves and operating expenses). How valid is the practice of sharing the surplusrather than profits between shareholders and participants?

• Underwriting risks. Sharing of underwriting risk makes the contract analogous to conven-tional insurance, where shareholders become risk-takers and bear the risk of underwritingresults.

• Qard hasan. The practice of having the operator top up with an interest-free loan in thecase of a deficit is against the mudaraba principle in which the mudarib cannot be aguarantor.

9.2.2 Wakala Model

In this alternative model, the takaful company acts as an agent (wakil) on a fee-for-servicesbasis. Wakala is a contract of agency and the agent’s role in this case is to manage the affairs ofthe insurance pool for a defined fee. All risks remain with the fund and any operating surplusbelongs exclusively to the participants. As agent, the takaful operator does not share directlyin either the risk borne by the fund or any surplus/deficit of the fund from underwriting orinvestment profits. However, as under the mudaraba model, the agent has to provide an interest-free (qard hasan) loan to the takaful fund should it run into deficit. Instead of a profit-sharingremuneration, the operator receives a set fee called a wakala fee for managing the operationon the participants’ behalf, which is usually a pre-agreed percentage of the contributions paidby participants.6 In addition, there may also be a fee for management of the investment ofthe takaful fund. Finally, the operator’s remuneration may include a performance fee chargedagainst any surplus as an incentive structure.

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Despite the growing popularity of the wakala model, issues have been raised about certainfeatures. These are discussed in Wahab, Lewis, and Hassan (2007) and Hassan and Lewis(2011), and can be summarized as follows:

• Compensation. The tabarru is the property of participants and the donation becomes aconditional gift. As such, there are doubts about it becoming a basis of compensationthrough the deduction of a fee from the amounts donated.

• Fixed fee. The wakala operator fee is a fixed percentage of contributions. In an environmentin which bulk rates are negotiated with large customers, charging a fixed fee to the fundmay leave the fund with fewer funds to pay claims relative to risk undertaken.

• Generational issues. If contingency reserves are built up for future contingencies, thisis tantamount to an intergenerational transfer to future participants. Each generation ofmembers should contribute to deficits on a pro-rata basis.

• Qard hasan. The wakil should not be the guarantor of the participants who are representedon an agency basis.

9.2.3 Hybrid Model

This operating model is a combination of the mudaraba and wakala models. A wakala fee-based arrangement is used for the underwriting portion of the operations, and the mudarabaprofit-sharing principle is employed for the investment side of takaful operations. Bahrain,Saudi Arabia, and the United Arab Emirates are locations where takaful companies haveadopted a hybrid approach. Many regulatory agencies and international organizations (e.g.the Accounting and Auditing Organisation for Islamic Financial Institutions, AAOIFI) recom-mend this combination on incentive-compatibility grounds. Applying the mudaraba systemto investment activities is seen as mitigating principal-agent problems through the sharing ofprofits, while the use of wakala allows the operator to recover in an efficient way the admin-istrative costs of underwriting (SwissRe, 2008). Of course, the corollary is that the questionmarks raised above about both arrangements do not go away; indeed, they might be seen to bemagnified.

9.2.4 Waqf Model

This model has been suggested in the context of the concerns related to the wakala modelraised earlier, and a solution acceptable to Shariah scholars has been made in the form of awakala model with a separate legal entity of waqf interspersed (Wahab, Lewis, and Hassan,2007). The objective of the waqf (endowment) fund is to provide relief to participants againstdefined losses under the rules governing the waqf fund. The operating agent makes an initialcontribution to a waqf fund. Participants make additional contributions to the fund, which isthen used to settle claims. As under wakala, the operating agent earns a fixed underwritingfee, and for this reason the model is also sometimes called the wakala waqf model (SwissRe,2008).

In Pakistan, the model has been described as tabarru with waqf (Ernst & Young, 2009).While the wakala contract still applies between the takaful operator and the takaful fund,tabarru contributions are considered as a conditional gift, which are specifically to be usedto pay claims with any underwriting surplus still accruing to the tabarru contributors. Underthis assumption there is a concern that the transaction has the characteristic of a contract

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of compensation. With such conditions the underlying gharar would have invalidated thetransaction under Shariah. In order to avoid such doubts, the Shariah scholars proposed theuse of an Islamic trust fund, a waqf. Under a waqf, any lingering ownership by the participants(policyholders) to the tabarru contribution is legally severed. Ownership by the participants(as donors) would be lost as soon as they pay donations to the waqf fund, for the monies wouldbecome the property of the fund.

In effect, as Alhabshi and Razak (2009) argue, the main reason why the waqf element isintroduced into an otherwise pure wakala model is due to the nature of the tabarru fund whichhas a very specific use, namely to pay claims. The term tabarru itself implies that participantswho contribute have given up their right to any claim on their contributions. This concept isakin to the concept of waqf whereby once a person declares to give away a certain property forwaqf all ties to the property are severed. Immediately the property belongs to Allah and hencea trustee has to be set up to administer the property. A waqf , being a voluntary, permanent,irrevocable endowment of a portion of one’s wealth, makes this relationship clear.

9.3 PRODUCT DEVELOPMENT AND PROSPECTS

9.3.1 Products

The basic objective of takaful is to provide risk management protection for individuals andbusiness enterprises in Islamically acceptable ways. So far we have examined how the systemis structured with the aim of removing the elements of uncertainty and interest that are seen toexist in conventional insurance products, and which do not conform to Islamic beliefs. Whileone may quibble or take issue with some of the ways in which this is done, or even query towhat extent some are really necessary, the reality is that most of the major product lines ofconventional insurance protection are available in a Shariah compatible form. Table 9.2 liststhe major takaful products on offer in Malaysia.

Table 9.2 Some Takaful products in Malaysia

General TakafulMotor TakafulFire TakafulMarine, Aviation & Transit (MAT) TakafulMiscellaneous Takaful– Personal Accident– Engineering– Employer’s Liability– Contractor’s All Risk– Public Liability

Family TakafulMortgage Reducing Term TakafulGroup Term TakafulTakaful Education PlanInvestment Linked TakafulMedical TakafulAnnuity Retirement Takaful

Source: Ernst & Young, 2009

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Nevertheless, the system ought not to be viewed in terms of how well it is able to replicateconventional products. Islamicity extends not only to the ways in which insurance activitiesare organized and operated, but to the products themselves.

Consider, first, family takaful. As explained elsewhere (Lewis, 2005), this system is a veryingenious adaptation of the unit-linked policies that have proven to be so successful in the UKbut in this case to meet the special needs of the Islamic community worldwide. Both typesof policies deduct a proportion of the premiums paid and credit it into a separate account,i.e. a tabarru fund for the takaful policy and a special management fund for the unit-linkedpolicy, to cover the cost of any guarantees. Also, the sum assured for both policies depends onthe investment performance of the remaining portion of the premiums, subject to a minimumguaranteed sum assured on death.

There are also important differences. Most obviously, all the activities of takaful operatorsmust be in line with the Shariah principles and the investments and the implementationof takaful practices are strictly supervised religiously. Under unit-linked policies, only theremaining portion, which is put into a unit fund, is invested in a portfolio of assets, whereasunder takaful, both accounts, participant and tabarru funds, are invested in an Islamicallyacceptable way and in Islamically acceptable investment modes (screened equities, real estate,leasing and murabahas, participation accounts).

Another difference is in the way funds are segregated. Family takaful borrows from unit-linked policies the idea of separating premiums into tabarru and participant accounts, butgoes further than many unit-linked operators by maintaining a clear segregation betweenparticipant and operator. To this end, premiums paid by the participants are divided into atabarru account (TA) and participants’ investment portfolio accounts (PA). Insurance benefitsare paid from the tabarru fund, with the takaful company acting not as “insurer”, insuringthe participants, but simply handling matters of investment and administration. Participantsare entitled to reimbursements (of PA premiums and investment earnings and share of netsurplus) upon maturity, withdrawal (PA funds only) and, in some cases, upon disablement.Upon death of a participant, the heirs are entitled to benefits, along with PA funds, which arereimbursed according to the Islamic inheritance laws. As well as designating beneficiaries,a Muslim insured also appoints a nominee/assignee. After death of the insured, the nomineeacts as a trustee, receives investment returns and death benefits from the insurance company,and distributes them among the beneficiaries of the deceased according to the principles ofmirath (inheritance) and wasiyah (bequest).

In order to claim death benefits, only proof of death needs to be submitted to the insurer.The cause of death, whether natural, accidental, or unlawful, matters little in takaful insuranceas the death is deemed to be the will of Allah. Even in the event of suicide, the rights andclaims of the surviving family members may not be ignored. Some takaful insurers do notinclude a suicide clause in the contract.

When those insured survive to meet the target amount of savings determined at policyinception, they receive a refund of all the premiums paid for their individual account plustheir share of investment income from that account. In addition, their share of surplus willbe assessed from the special account. Takaful insurers also permit the insured to surrenderpolicies prematurely. When this option is exercised, they will get a refund of all the premiumspaid plus their share of surplus from the individual account (minus administrative expenses)until the date of surrender. However, no refund is usually given from the special account incase of policy surrenders. In a typical takaful insurance plan, it does not matter whether or

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not those insured surrender in a manner prescribed in their policy since all insureds are, inprinciple, partners of the insurance plan (Maysami and Kwon, 1999).

In general takaful, coverage is offered normally on an annual renewal basis for motorvehicle, fire, marine, workers’ compensation, and other such insurance lines. As in familytakaful, the premiums (contributions) are pooled into a takaful fund managed by eachinsurer. The insurer acts as trustee, invests the fund in Islamic ways, and channels theinvestment income, less investment expenses, back to the fund. Remuneration for this servicedepends on the particular operating model used. If, however, the sum of the premiums andinvestment income is insufficient to meet relevant claims, those insureds affected could beassessed for additional contributions. Accordingly, general takaful works similarly, albeit notexactly the same, as assessable mutual insurance arrangements in a conventional insurancecontext.

As in conventional insurance, general takaful operators use the principle of ‘insurableinterest’ to minimize moral hazard and separate insurance from gambling. Contracts can alsobe voided if there is material misrepresention, concealment, or a breach of warranty by theinsured. Nevertheless, there are important differences as well. Conventional insurers use a“valued policy” clause for certain types of properties where the insurer agrees, in the caseof total loss, to indemnify the value agreed at policy inception. For partial loss, the insurermay pay more (less) than the strict indemnity if the actual value of the property at the time ofloss falls below (increases above) the coverage limit. Such an arrangement is not permitted intakaful insurance (Ali, 1989). Also, no depreciation of the property value is permitted. Takafulinsurers are generally only willing to extend coverage following a proper valuation of theproperty to be insured. Further, a periodic follow-up valuation of the insured property is likelyto be conducted to eliminate any discrepancy between the existing insurance coverage and thecurrent market value of the property insured, with premiums adjusted accordingly (Ali, 1989).As a result of these valuation restrictions, property insurance is made on a replacement costbasis in order to satisfy Islamic principles.

There are also restrictions upon retakaful (Islamic reinsurance) contracts. Conventionalreinsurance is commonly classified into proportional and non-proportional arrangements. Inretakaful, non-proportional arrangements such as excess of loss or stop-loss arrangementsmay not be suitable because there exists uncertainty with respect to the assessment of losses inthose arrangements. Islamic principles require clearly defined joint responsibility throughoutthe coverage period. Hence, retakaful is likely to be arranged on a pro-rata basis, e.g. quotashare or surplus reinsurance, where the reinsurer becomes technically a coinsurer of the originalrisks. Should a non-proportional reinsurance arrangement be mandated, it could be based on astrict profit commission plan or on a reciprocal basis (Maysami and Kwon, 1999). At a practicallevel, however, the main limitation has come not so much from the contractual form but fromcapacity in the retakaful market, a situation that has forced some takaful operators to solicitjuristic acceptance of conventional reinsurance as a temporary solution. Recent developments,with some large conventional global reinsurers and regional firms entering the market, haveeased these capacity constraints.

9.3.2 Prospects

With Muslims accounting for one in four of the world’s population, totalling nearly 1.6billion of the world’s 6.8 billion people, the potential market for Islamic financial services

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is considerable. In 2007, the potential market for takaful in Muslim majority countries wasestimated at US $35–45 billion (SwissRe, 2008). This figure, while unrealistic in assumingthat all Muslims will switch to takaful, nevertheless contrasts with an actual market presenceof US $2 billion in terms of profit-oriented and non-profit takaful insurers, along with theta’awuni “co-operative” insurers in Saudi Arabia. In many of these Muslim majority countriesthe market presence of takaful vis-a-vis the total insurance market is low; the highest is Sudanwith 85% takaful, followed by Saudi Arabia with 20% of the market, Bahrain 12%, Malaysia6%, UAE 2%, and Indonesia 2%. However, it is also the case that one in five Muslims livesin a country in which Muslims are in a minority. The market for takaful amongst India’s 160million Muslims (13% of the population), China’s 40 million Muslims (3%), or Ethiopia’s 40million Muslims (48%) is virtually untapped. Admittedly, many of these minorities are poor,but then there are the 22 million Muslims living in the industrialized countries.

Consequently, the opportunities for growth of takaful come from the following elements:

• large “captive” population;• favourable demographics due to population growth;• strong market foundations and economic growth in Gulf and Malaysia, Singapore;• potential and strong markets in some Muslim minority countries;• Shariah scholars’ firm discountenance of conventional insurance;• expanding Islamic consciousness, resulting in a switch to Islamic insurance;• family takaful is relatively undeveloped relative to general insurance.

However, there are also some important challenges to be met.Market penetration. Takaful can be expected to expand in usage amongst Muslim commu-

nities vis-a-vis the conventional insurance market, but in most cases that market penetration isitself low. Expansion of the takaful industry is tantamount to one of raising the awareness of thevalue of insurance generally. Possible reasons for the low insurance density and penetration insome countries include a reliance on social welfare, the extended family system, and attitudesto risk.

Acceptability. Reinforcing these factors, it is also the case that for generations, Muslimsaround the world have grown up with the suspicion that insurance (life insurance especially)contravenes basic Islamic tenets and is against tawakkul (relying and depending totally on thewill of Allah). This perception overlooks the famous hadith of the Prophet Muhammad (tieyour camel, then depend on Allah). Taking precautions for one’s life is a financial transactionfor protecting widows, orphans, and other dependants, rather than leaving them needy andhaving to ask others for help.

Reward structure. Takaful rests on a clear segregation between participant and operator, butthe operator must be rewarded either on a profit-sharing (mudaraba) basis or on a fee-for-services (wakala) basis. As we have shown, there are issues with both in terms of using thedonations of participants for fee income or profit-sharing. Use of the waqf model seeks tosolve some of these ownership issues. However, the questions about compensation are merelycompounded in the hybrid model, which is mandated in some locations and encouraged inothers. Do these alternative operating models (and the distinction between “Islamic insurance”and takaful) hamper the development of the industry globally, or do they demonstrate thatdifferent interpretations can coexist and that diversity is an inherent and healthy feature inIslam?

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Shariah supervision. Certainly the diversity shows that the process of Shariah supervision is“alive and well”, and plays an integral and vital role in the development of takaful. Nevertheless,there are some problems. There is a shortage of qualified Shariah scholars at a global level, sothat many sit on a number of Shariah boards. There is also a shortage of insurance staff witha knowledge of both insurance and Shariah. Standardization of Shariah rulings at the nationallevel has sometimes widened the gap between Shariah solutions globally.

Supporting structures. A number of conditions need to be put in place to facilitate thedevelopment of takaful business in addition to Shariah advice. These include a cohesiveregulatory and legal framework, which emphasizes transparency and consumer protection,and uniform accounting standards. Financial reporting standards have not yet been developed,despite the setting up of IFSB and AAOIFI. As a result, Malaysian takaful operators, forexample, must conform with the Companies Act, Takaful Act, Bank Negara circulars andguidelines, and various national and international financial reporting standards (Ernst & Young,2009).

Governance issues. There are also various governance issues in terms of the relationshipsbetween the participants, the takaful operator, the board of directors, and the Shariah Board.Under an Islamic charter, in which shura (mutual consultation) is the watchword, the mostpressing issue is to develop a framework in which policyholders’ (participants’) interests canbe represented (Hassan and Lewis, 2011). As one example, under the mudaraba principle,takaful companies operate on the basis of ‘non-interference’ by the rabb al-mal in termsof portfolio selection. This feature differs from the conventional unit-linked policies for lifeinsurance under which provision for switching between mutual funds is a feature. As thetakaful market develops, such flexibility would add to product variety and give more controlto participants.

Product development. There are weaknesses at both ends of the takaful market. Giventhat many Muslim countries are among the poorest in the world, the insurance equivalentof microfinance – microtakaful – needs to be explored, with the aim of making insuranceprotection for things such as health and education affordable to low income households(Patel, 2002). These developments could draw upon the idea of microinsurance developed byconventional insurers (Allianz et al., 2006). At the other end, opportunities for takaful operatorsto penetrate the general insurance market for large corporate and commercial enterprises areheld back by a lack of resources and technical expertise in complex businesses such asaviation and energy. The existence of “statism” and longstanding arrangements between stateenterprises and state-owned insurers also limits opportunities. In general, the takaful industrycannot rely for growth solely upon the provision of Shariah-compliant insurance products, asprice, service, and insurance expertise play an important role.

Investment avenues. As well as product variety, one of the other difficulties facing takafulinsurance has been in finding riba-free investments. Avenues of investments must be inaccordance with Shariah principles and these can be limited. Growth of the sukuk markethas been an important innovation, but many issues have been oversubscribed, limiting theallocation, and there are problems of tradability. Some sukuk cannot be traded under Shariahrules, and others can be but are not traded frequently. Consequently, a further widening ofthe range of investment instruments and products that are Shariah acceptable remains a highpriority. Much Islamic investment money has flowed into real estate, but much of that financinghas proven to be illusory. A better focus would be in the area of Islamic project finance andbasic infrastructure financing, so important for Muslim countries.

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NOTES

1. Keynote address by Dato’ Muhammad bin Ibrahim, Assistant Governor, Central Bank ofMalaysia, at the International Takaful Summit, “Global Takaful Industry: Moving to theNext Level of Excellence”, Jumeirah Carlton Hotel London, 16 July 2008 cited in Alhabshiand Razak (2009), p. 82.

2. “Say: Who hath forbidden the beautiful (gifts) of God, which He hath produced for Hisservants, and the things, clean and pure, (which He hath provided) for sustenance?

Say: They are, in the life of this world, for those who believe, (and) purely for them onthe Day of Judgment. Thus do We explain the Signs in detail for those who understand”Al A’raf S7:32.

3. Cited in Visser (2009).4. “Help ye one another in righteousness and piety, but help ye not one another in sin and

rancour” Al Ma’idah, S5:2.5. In fact, there is a fourth form, employing what Marshall (1974) called the “mutuality

principle”, whereby insurance occurs by writing mutual indemnity contracts, in which thegainer compensates the loser. Such an arrangement, called the “hedge market”, operatedsuccessfully in Australia for many years, in terms of foreign currency positions when theforward foreign exchange market was restricted by regulation (Lewis and Wallace, 1985:380–5). However, in general, this form of insurance has been confounded by the existenceof moral hazard, with individuals putting themselves into the position of being losers.

6. Normally the wakala fee is stated explicitly in each takaful contract. In some Middle Eastmarkets, the fee is announced at the beginning of each operator’s financial year and fixedfor the duration of the year.

REFERENCES

Alhabshi, Syed O. and Razak, Shaikh Hamzah S.A. (2009) “Takaful insurance: concept, history,development and future challenges”, in Proceedings of the Symposium Islamic Banking and Fi-nance: Global Perspective on Ethics and Financial Practices, M. Ariff, C.J. Mews, A. Saeed, M.J.Skully (eds), National Centre of Excellence for Islamic Studies, Melbourne, pp. 65–84.

Ali, Kasi Md. Mortuza (1989) “Principles and practices of insurance under Islamic framework”, Insur-ance Journal, December, 29–38.

Allianz AG, GTZ and UNDP (2006) Public Private Partnership, Microinsurance – Demand and MarketProspects, Indonesia.

Billah, M.M. (2001) Principles & Practices of Takaful and Insurance Compared, GECD Printing SdnBhd: Malaysia.

Dhareer, Al Siddiq Mohammad Al-Ameen (1997) Al-Gharar in Contracts and its Effects on Contempo-rary Transactions, Islamic Development Bank, Islamic Research and Training Institute: Jeddah.

El Gamal, Mahmoud A. (2006) Islamic Finance, Law, Economics, and Practice, Cambridge UniversityPress: New York.

Ernst & Young (2009) Financial Reporting for Islamic Based Transactions, Malaysian AccountingStandards Board Conference: Accounting Challenges in Turbulent Times, Securities CommissionMalaysia, 29 April .

Hassan, M. Kabir, and Lewis, M.K. (2011) “Corporate governance in Islamic insurance (Takaful)” inHandbook of Islamic Auditing and Corporate Governance, R. Haniffa and M. Hubaid (eds), EdwardElgar: Cheltenham UK and Northampton, MA.

IFSB (2006) Issues in Regulation and Supervision of takaful (Islamic insurance), The Joint WorkingGroup: Islamic Financial Services Board and International Association of Insurance Supervisors,August.

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Iqbal, Zafar and Lewis, M.K. (2009) An Islamic Perspective on Governance, Edward Elgar, Cheltenham,UK and Northampton, MA.

Lewis, M.K. (2005) “Wealth creation through takaful (Islamic insurance)” in Islamic Perspectives onWealth Creation, M. Iqbal and R. Wilson (eds), Edinburgh University Press: Edinburgh, pp. 67–87.

Lewis, M.K., and Algaoud, L.M. (2001) Islamic Banking, Edward Elgar: Cheltenham, UK and Northamp-ton, MA.

Lewis, M.K., and Wallace, R.H. (1985) Australia’s Financial Institutions and Markets, LongmanCheshire, Melbourne.

Marshall, J.M. (1974) “Insurance theory: reserves versus mutuality”, Economic Inquiry, 12(4), 476–92.Maysami, Ramin Cooper, and Kwon, W. Jean (1999) “An analysis of Islamic Takaful insurance – a

cooperative insurance mechanism”, Journal of Insurance Regulation, 18(1), 109–32.Patel, Sabbir (2002) “Takaful and poverty alleviation” ICMIF, Cheshire, UK. www.ikcmif.org/takaful.Salahi, Adil (2003) “Scholar of renown: Professor Mustafa Al-Zarqa” Arab News, 19 May, www.

arabnews.com.Siddiqi, M.N. (1985) Insurance in an Islamic Economy, The Islamic Foundation: Leicester.Siddiqui, S.A. and Al Athmey, A.-A.A.R.A. (2007) “Resolving controversial issues and setting goals

for Islamic insurance: an evaluation of Takaful companies of Brunei”, Journal of Islamic Economics,Banking and Finance, 3(2), 129–58.

SwissRe (2008) Insurance in the emerging markets: overview and prospects for Islamic insurance, Sigma,5/2008, 19–49.

Visser, Hans (2009) Islamic Finance. Principles and Practice, Edward Elgar: Cheltenham, UK andNorthampton, MA.

Wahab, Abdul Rahim Abdul, Lewis, M.K., and Hassan, M. Kabir (2007) “Islamic Takaful: businessmodels, Shari’a concerns and proposed solutions”, Thunderbird International Business Review,49(3), 371–97.

Wahib, Rusil Bin (1999) “Islamic Takaful Insurance”, New Horizon, Part 1, 86, 10–12; Part 2, 87, 16–17;Part 3, 88, 10–12.

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10

A New Model for Options in Islamic Law

Valentino Cattelan

10.1 LOOKING FOR ISLAMIC DERIVATIVES:A LEGAL OXYMORON?

In the last decade, the admissibility of derivative contracts has represented one of the mostcontentious topics in Islamic finance: their acceptability, in fact, has been opposed to anideal performance of the divine Message, perpetuating a contrast between theory and practicewhich has constantly affected the evolution of the sector. Moreover, although derivativesare undoubtedly problematic for Shariah law, the issue has perhaps been worsened by aninappropriate approach, aimed simply at replicating in Islamic finance Western legal products,to the detriment of original Muslim categories.

As is well known, derivative contracts imply future exchanges of cash flows which arenot related to the transfer of real properties, but are merely dependent on the fluctuations ofprices (of stocks, commodities, bonds, equities . . .) or variables (currency rates, interest rates,indices . . .). In fact, in a derivative transaction, the contracting parties do not seek to exchangetangible goods, but to hedge risks (Board, 2000: 156) or to take advantage of the volatility ofthe market (Valdez, 2007: 309–68): in summary, derivatives are risk management instrumentsaimed at hedging or speculation. Because of their function, they hold an intrinsic value thatmakes them tradable on the market independently from the underlying assets (Hudson, 2006:12–13; Kolb, 2007; James, 1999).

From a Shariah perspective, both the structure and dual (hedging/speculation) functionsof financial derivatives raise fundamental issues, which make their admissibility particularlycontroversial:

1. Inexistence of the contract: the lack of any tangible good (mal) to be traded makes derivativecontracts inexistent (bat.il), being the constant reference to tangible assets a key cornerstoneof the logic of Islamic contract law: in fact, “the promise of the counter-party to pay moneyin the event that the price moves in the opposite direction is not ‘property’, and, accordingly,cannot save the contract from the perspective of Muslim jurists” (Fadel, 2002: 84);

2. Lack of actual ownership: derivatives allow profit to be made through the fictive transferof underlying assets, which are sold/bought in order to hedge/speculate on respectivepositions, and are not necessarily owned by the seller. Being profit in conflict with theprinciple al-kharaj bil-d. aman (“profit follows responsibility”) and the sunna (it is recordedthat the Prophet said: “Do not sell what you do not have”), the sale is invalid;


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3. Lack of delivery: in a derivative transaction the reciprocal positions are cleared by thenominal exchange of cash flows, while the taking of possession (qabd. ) of the underliers isnot only merely eventual, but even undesirable. Thus, since the principle of the certainty ofdelivery is violated (Usmani, 1996: 10), the transaction becomes unlawful;

4. Prohibitions of riba (illegitimate increase), gharar (uncertainty), maysir (gambling) andspeculative function: derivatives are likely to produce riba due to the disequilibrium inthe distribution of legal entitlements (h. uquq al-‘aqd), determining an unbalanced, andtherefore invalid, contract (‘aqd) (Cattelan, 2009). Moreover, since the final distribution ofentitlements is always unknown at present, derivatives are affected by elements of ghararand maysir, especially in the case of short-time selling, which makes the transaction purelyspeculative;

5. Illegitimacy of derivative trading: according to Mufti Usmani, a derivative contract “is notsomething tangible which can be bought or sold” (Usmani, 2000). Thus, due to the nominalcharacter of its value and the absence of any tangible good (mal) to be traded, the contractcannot be sold, pledged, or be an independent value in an investment portfolio.

Despite these anomalies in the light of Islamic law, the substantial need for hedginginstruments has led scholars to sentences of permissibility on the basis of the general benefit(mas. lah. a) for the Muslim community (Kamali, 2000: 206; Al-Amine, 2008: 24–8). Thus,bay’ al-salam has been proposed as equivalent to futures contracts; the use of the unilateralpromise (wa’d) for swaps; the institutes of khiyar ash-shart. and bay‘ al-‘urbun as equivalentsto options; and so on. In any case, contesting this tendency to “liberalize” Islamic law in thelight of social welfare, the current attempt to replicate derivatives in Islamic finance has alsobeen depicted as the result of a “form-above-substance approach”, linked to a “peculiar formof regulatory arbitrage that is best characterized as Sharı’a arbitrage” (El-Gamal, 2006: 20).

How can these conflicting tendencies in Islamic finance be judged?To a certain extent, forcing a worldly adaptation of Islamic law towards market practice

has implicitly made lex mercatoria overrule the authentic divine Message. In particular, orig-inal Islamic categories have been increasingly contaminated with the logic of Western law,producing, as a final outcome, a sort of “legal oxymoron”, responsible for mixing practicalrationalities which are, in reality, alternatives to one another (MacIntyre, 1988). In fact, whilecontractual freedom in Western law allows derivatives to be shaped as nominal structuresaimed at purposes of risk management, in Islamic law the necessity of a tangible object forthe validity of the contract (‘aqd) raises decisive contradictions in the attempt to “translate”derivative contracts into the realm of fiqh, highlighting the inefficiency of the Shariah arbitrageapproach.

Given these preliminary remarks, the following pages will try to overcome this legal oxy-moron by searching for a financial option model which adheres to the logic of fiqh.

More precisely, considering option contracts as Western law products, this chapter willpropose not an analogue but a substitute to Western options, shaped within the logic ofIslamic justice. In this way, the object of financial options (the future transfer of an asset ifthe purchase is convenient for the option holder, with a profit for the option writer, whichfulfils both hedging and speculative strategies) will be alternatively modelled in Islamic lawthrough an ijara wa-hiba structure (payment of rent for the usufruct of the underlying asset,instead of the initial option premium, and eventual transfer through donation with contextualcompensation), and a function limited to the mitigation of risk.

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A New Model for Options in Islamic Law 203

10.2 OPTIONS, WESTERN LAW, AND ISLAMIC JUSTICE

Within the realm of derivative contracts, options are agreements which convey the right, butnot the obligation, to buy or sell an asset by a certain date for a certain price. In comparison toforwards, futures, and swaps, they offer major flexibility, since they give the holder the right,but not the obligation, to buy or sell; this facility has a cost, and in fact the option holder hasto pay an up-front price, the so-called option premium. In relation to the right of buying orselling, two basic types of options are distinguished: call and put; with regard to the timing ofexercise, we have European and American options. In a nutshell:

A call option gives the holder the right to buy an asset by a certain date for a certain price. A putoption gives the holder the right to sell an asset by a certain date for a certain price. The price inthe contract is known as the exercise price or the strike price; the date in the contract is known asthe expiration date or the maturity date. A European option can be exercised only on the maturitydate; an American option can be exercised at any time during its life. (Hull, 2008: 6)

Depending on the underlying entity, there are commodity/stock options, currency op-tions, index or futures options, and so on. Like any other derivative, options can be tradedautonomously, since they hold an economic value (expressed by the option premium).

The specific purpose of the present paragraph is to evaluate the compatibility of optioncontracts with the logic of Islamic contract law. As has already been said, like any otherderivative contract, financial options may be considered as Western law products, both in theirstructure and function. More precisely, the Western legal tradition has historically codified theobject of option contracts (i.e. the future transfer of an asset if the purchase is convenient forthe option holder, with a profit for the option writer) through a legal model which embraces

1. a derivative reference to the underlier(s);2. the payment of a premium, “which is the unconditional amount that the optionee must pay

upfront in order to acquire the right to exercise the option” (Katz, 2004: 2205);3. the duration of this right for a certain period (option life);4. the fixed price of the exchange (exercise or strike price), which will be paid by the option

holder if the transfer is considered profitable in relation to the volatility of the market;5. a risk management purpose, for hedging or speculation.

To what extent is this Western codification compatible with Islamic justice? In other words,is the attempt to forge an “Islamic analogue” to option contracts reasonable or not?

The search for an Islamic analogue to option contracts is fruitless for the following reasons:

1. As previously underlined, the derivative structure, in general, does not comply with thelogic of fiqh, and results in strong criticism on the permissibility not only of options, butalso of forwards, futures, and swaps.

2. In particular, the fundamental difficulty for options lies in the payment of the premiumwithout any transfer at present, which gives rise to riba. Moreover, since “to keep a promise(wa‘d) is religiously binding (mulzim diyanatan) though not enforceable legally (qad. a’an)”(Vogel, 1997: 38; in the same way, Chehata, 1969: 150–1), no reward can be sought for anact whose execution depends only on a voluntary choice by the promisor.

3. As far as the duration of the offer is concerned, the topic is usually related by scholarshipto the waqt al-khiyar, i.e. the period of life of khiyar ash-shart. .

4. Once again, the dependence of the transfer on the optionee’s choice is linked to thelogic of khiyar ash-shart. , which corresponds, in fact, to a “condition suspensive purement

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potestative” (Linant de Bellefonds, 1965: 312), i.e. a whimsical condition. But criticism ofthe last two points will be shown in the next paragraph.

5. As already seen in relation to derivatives as traded securities, the artificiality of the derivativevalue makes option contracts inexistent (bat.il) as mal, due to the lack of the object whichis an essential element (rukn) of any ‘aqd.

10.3 Khiyar ash-shart. AND al-‘urbun AS ISLAMIC ANALOGUES TOOPTIONS: CRITICAL ELEMENTS

Despite the oxymoron inherent in the translation of option contracts in the context of fiqh, twolegal structures have been suggested as Islamic equivalents to financial options: the institutionof the “conventional option”, khiyar ash-shart. , and the contract of bay‘ al-‘urbun (“sale withadvance payment”).

The khiyar ash-shart. , “stipulated” or “conditional” option, belongs to the broader categoryof al-khiyarat. It constitutes an additional clause to the contract, which provides the beneficiarywith the power to cancel or ratify the agreement for a defined period of time. It is recognizedby all the Schools on the basis of the h. adıth: “The Prophet said to Habban al-Ans.arı, who wascomplaining of being cheated in his transactions: When you buy or sell, at the moment of salemake a declaration to the effect ‘that there shall be no cheating (la khilaba) and I reserve formyself the option for three days’ ” (Linant de Bellefonds, 1965: 312; Rayner, 1991: 309). Theterm of three days is strictly imposed by H. anafıs and Shafi‘ıs, while the H. anbalıs admit anyterm, provided that the parties express clearly in the contract the duration of the option; theMalikıs make the validity of the option dependent on the needs of the parties and the natureof the object (Linant de Bellefonds, 1965: 316–17). Since the effectiveness of the contractis subordinated solely to the choice of the beneficiary, the khiyar ash-shart. appears to be awhimsical condition.

On this topic, relevant elements can be found in AbuSulayman (1992), Kamali (1997; 2000),Vogel and Hayes (1998), Obaidullah (1998), Bacha (1999) and, more recently, Jobst (2007)and Al-Amine (2008). In particular, referring to “amalıyat ash-shart. ıya al-ajila” (lit. “deferredconditional transactions”), Kamali considers khiyar ash-shart. as a viable model for optionsin Islamic law, but at the same time he genuinely underscores that “the basic concept of anoption which occurs in the sunna and the juristic manuals of fiqh was intended, not so much tocreate a new trading formula or risk-management tool but to ensure propriety and fairness, aswell as to protect the integrity of consent in the completion of contracts” (Kamali, 1997: 25).

The contradictions of “Islamic options” as legal oxymoron emerge where Kamali notesthat:

• as recognized by the OIC Fiqh Academy, Decision 65/1/7, Seventh Session, “the conven-tional discourse in fiqh envisaged al-khiyarat as an aspect of the contract of sale, an ancillaryor incidental aspect of that contract, but not as a contract in its own” (Kamali, 1997: 26);

• AbuSulayman considers the Western financial option as a contract which cannot be traded inIslamic law since “the subject matter of option is a right (h. aqq) and a right pure and simple(al-h. aqq al-mujarrad) is neither a tangible commodity nor usufruct; it cannot therefore bea proper subject matter of contract” (AbuSulayman, 1992: 32–3); moreover,

. . . neither the price nor the subject matter (al-thaman wa al-muthman) is taken into possessionas they are both absent at the time of contract and this turns the contract into bay‘ al-kali’ bial-kali’ (a sale of one debt for another). To validate a sale of this kind it is necessary that at least

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one of the counter-values is prompt and the other which is deferred is accurately described soas to prevent disputes (AbuSulayman, 1992, p. 33);

• according to Vogel, “an option requires payment for something that is a mere intangible(h. aqq), not property (mal) in the usual sense (i.e., a tangible good or a utility taken from atangible good). . . [thus] the option price is ‘unearned’ ” (Vogel and Hayes, 1998, p. 164).The problem is the charge of a fee (the option premium) for granting the right to cancel orratifying the contract, which is not a valid property in Islamic fiqh. Taking argument fromthe H. anbalı doctrine, Kamali contests that “the option premium is paid in exchange for aright/privilege that is granted to the option holder, and there is nothing objectionable inthis” (Kamali, 1997: 31), since “if the seller is entitled to stipulate for a security depositor a pawn, then it is a mere extension of the same logic that he may charge the buyerand impose a fee or compensation in respect of such options and stipulations that are tothe latter’s advantage” (Kamali, 1997: 30). But the very last position is difficult to agreewith: on the one hand, the H. anbalı School, although admitting broader contractual freedomin comparison to the other madhahıb, does not accept exceptions to the materiality of thecontractual object (mal); on the other hand, the analogy (qiyas) with the contracts of depositand pawn is incorrect, since the cases do not share the same reason (‘illa).

In the end, it has to be concluded that “the stipulated option [khiyar ash-shart.] has littleapparent significance in and of itself for the creation of Islamic valid derivatives, if onlybecause the party giving the option cannot be compensated for doing so; the option right itselfis not paid for” (Vogel and Hayes, 1998: 156).

The second institution which is commonly recalled to replicate Western financial option isthe contract of al-‘urbun (also rendered as al-‘urban or al-‘arbun), lit. “earnest money” or“advance payment”. This is a down-payment sale, where, if the buyer decides to complete thesale, the advance payment (‘urbun) is discounted from the total price; otherwise, if the buyerdoes not execute the sale, he forfeits the down payment. Being functionally equivalent to anon-refundable deposit, aimed at penalizing a cancelling buyer and protecting the seller fromthe sale that will not be concluded, al-‘urbun cannot be compared to an option contract, sincethe initial deposit will be discounted from the final price and is not intended as a premium.

Moreover, its validity is seriously challenged by the classical madhahıb. For instance, ah. adıth reports that the Prophet forbade the contract (Ibn ‘Abbas; Malik; Ibn Madja):

Arbun makes a gift conditional on a sale, and therefore offends a principle against combininggratuitous contracts with onerous ones. It adds to the standard sale contract more than oneadditional term (shart.), which a h. adıth forbids. It partakes of gambling. The seller gets theadvance for nothing, and is unjustly enriched (akl al-mal bi-al-bat.il). Finally, the buyer needs notto fix a time limit for the option, so the contract is fatally indefinite. (Vogel and Hayes, 1998:156–7)

With specific reference to the Malikıs, Santillana reports that the prohibition of al-‘urbunby the Prophet is already quoted in the Muwat.t.a by Imam Malik, and the founder of the Schooldefines it bat.il, inexistent. The nullity derives from two reasons: the condition is uncertain,and therefore void per se; it results in an unlawful enrichment of the seller to the detrimentof the buyer, when the contract is not concluded (Santillana, 1938: 57–8). Only the H. anbalısuphold the contract. In fact, Ibn H. anbal deems the h. adıth on the prohibition of al-‘urbun tobe weak, and upholds the validity of the contract on the grounds of another h. adıth, reported

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by al-Bukharı and supported by a narration of ‘Umar Ibn al-Khattab. On this ground, the OICAcademy (Eight Session, 1993) has endorsed ‘arbun, but only if the time is specified:

. . . they cite a story from the time of the Caliph ‘Umar, in which an official purchased a house fora prison, giving an advance to hold the house pending Caliph ‘Umar’s approval. Another h. adıthrecounts a famous early judge’s approval of an individual’s reserving a lease on an animal in acaravan and promising to pay a penalty if he failed to take it. Some H. anbalıs require a time to beset for the option, but most do not. (Vogel and Hayes, 1998: 157)

More recently, in any case, not only the H. anbalıs but contemporary jurists of most Schools

argued that down-payment sales had become very common and provided some compensation tothe seller for waiting, in case the buyer decides not to execute the sale. Moreover, contemporaryjurists argued, there are weak Prophetic traditions that provide support either for permissionor for prohibition. Hence, the Fiqh Academy of the Organization of Islamic Conference (themost prestigious international juristic body) ruled at its eighth session in Brunei in 1993 thatdown-payment sales are permissible. (El-Gamal, 2006: 92)

The contract of al-‘urbun raises fundamental doubts above its correspondence to Westernfinancial options. From the point of view of the structure, it might be considered similar toa call option, where the payment of the premium is substituted by a non-refundable deposit;but, even in this case, the discount of the price eliminates the reward of the option premiumfor the seller, transforming his promise into a gratuitous firm offer. Furthermore, the faculty tosell embedded in a put option has no correspondence in al-‘urbun structure, to the extent thatVogel and Hayes suggest as equivalent to a put option not al-‘urbun but a third-party guarantee(Vogel and Hayes, 1998: 227).

A fortiori, from a functional perspective, “the basic purpose behind the two transactions isso different that drawing an analogy between them becomes totally superfluous; therefore, inthe final analysis, such an analogy will be more than a discrepant analogy (qiyas ma‘ al-fariq),which is invalid” (Kamali, 1997: 27).

10.4 IN SEARCH OF A SHARIAH-BASED SUBSTITUTE:THE ijara wa-hiba STRUCTURE

In the attempt to replicate Western financial options little attention has been paid to thealternative logics of Western and Islamic laws: thus, in the al-‘urbun model a non-refundabledeposit has been considered equivalent to an option contract; in the case of the khiyar ash-shart. structure, a conditional term has been claimed correspondent to an autonomous contract,actually unknown in Islamic law. Both cases represent applications of a Shariah arbitrageapproach, supported by the idea that contractual schemes are universal and neutral, hencereplicable in any legal context (Zweigert and Kotz, 1977: 25).

On the contrary, recognizing the option contract as a peculiar expression of Western lawmay suggest the proper framework for a feasible model of Shariah-compliant financial options.

If we assume, in fact, that both the structure and the function of financial options areculturally affected, specifically codified by Western law, our attention should be directed,preliminarily, towards what financial options represent, i.e. the future transfer of an asset, ifthe purchase is convenient for the option holder, with a reward for the option writer. Giventhis object, our aim becomes to recodify it in compliance with Islamic contract law, and inparticular to model

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(A) a non-definitive transfer for a fixed price, subject to the choice of the “option” holder;(B) to be concluded within a determined period;(C) with a certain and immediate reward for the other party, the “option” writer;(D) where both the transfer and the reward have to relate to the same tangible property (mal).

The certain and immediate reward (C) for the option writer cannot be conceived in Islamicfiqh as the price of a promise, since its immateriality prevents it from being mal (D); at the sametime, the premium doesn’t hold any counter-value at present to maintain the equilibrium ofthe transaction. Thus, given a valid ‘ayn property as subject matter (existent at the time of thecontract, capable of immediate possession, licit and clearly determined: Linant de Bellefonds,1965: 185), a recompense for the option writer may be structured, instead, as the price for thesale of its usufruct (manfa‘a), i.e. the wage (ajr) related to a contract of hire or lease, ijara.

Given the specified commodity (indexes, interest rates, or mere variables, in fact, cannotbe admitted as mal (D): Al-Amine, 2008: 10), (B) the option life is substituted by the periodof rent of the ijara contract; the quantitative and qualitative equilibrium required by Islamiclaw is satisfied by the synallagmatic structure, where the reward of the option writer isequilibrated by the benefits that the option holder may derive from the rented commodity,and the specification of the subject matter. Remarkably, while in the conventional financialoption the premium is determined according to the value of the underlier, in the case of ijarathe reference value becomes its utility (manfa‘a); moreover, the ijara model may replicateEuropean and American options, in determining, respectively, the expiration at a defineddeadline, or according to periodical renovations of the lease.

If a Shariah-compliant remuneration for the option writer may be modelled as the wage of anijara contract, the structuring of a non-definitive transfer (A) appears to be more problematic,when referred to synallagmatic contracts in Islamic law. Despite the possibility of fixing adetermined price, as strike price, the mere probability of the sale (bay’) of the underlier, infact, would determine the censure of the model due to the presence of gharar in relation to theuncertainty of the transfer.

If the reference to synallagmatic contracts (mu‘awad. at) seems to be fated to impracticality,a suitable path may be found, instead, in the field of liberal contracts (tabarru‘at), and, moreprecisely, in the rules on donation, hiba. In Islamic law, the donation is defined as a gratuitoustransfer of ownership, concluded with an intention not exclusively charitable, since the purposeof the donor is a worldly benefit, differently from alms, S. adaqa, which is done “in order toplease God and to deserve His recompense” (Linant de Bellefonds, 1935: 18). In fact, thehiba is the transfer of any valid mal, either raqaba or manfa‘a, according to a liberal, but notnecessarily charitable, scheme, which does not prevent the donor from asking a counter-value(‘iwad. ):

Affirming that the donation is gratuitous means that the donation is perfect, without the exigencyof any counter-value, but does not mean that the absence of counter-value (‘iwad. ) is a necessarycondition for its conclusion . . . as [the counter-value is necessary] in the case of the sale, wherethe counter-value is an essential condition for its validity, to the extent that if it is not stipulated,the sale is null. (Linant de Bellefonds, 1973: 317)

In particular, Linant de Bellefonds underlines the conceptualization of the donation as autilitarian transaction by the H. anafıs, namely in the Mabsut. by Sarakhsı and the Hidaya byMarghınanı, while in the other madhahıb this character is much less manifest in favour of asincere charitable intent:

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According to them [the H. anafıs], we have the impression that it is less in the interest of the donee,than in his own, that the donor donates – which signifies that he hopes, through his liberal gesture,to receive some advantages in return, not necessarily, by the way, a financial gain: it may be afavour, a legal ruse, an honour. From that, the popular saying: “The gifts are nothing more thanloans”. The scholars, anyway, do not exclude the possibility – but it appears to them exceptional –of a veritable animus donandi, in the donor, that leads him to look only for the benefit of the done.(Linant de Bellefonds, 1973: 317)

This scheme provides further explanation on the peculiar structure of the hiba in the H. anafıdoctrine.

For the H. anafı School, the hiba is a contract, ‘aqd, requiring for its valid formation mutualconsent (taradı). But the mutual consent does not determine the immediate transfer of thesubject matter, due to the lack of an equilibrium of counter-values at present: the transfer ofthe ownership requires the taking of possession (qabd. ):

[A]ll the Schools agree on a point: the agreement of the parties, the ıjab and the qabul, eitherconceived as a simple platonic step towards the taking of possession or qabd. (H. anafı-Shafi‘ı law)or creating the obligation to transfer the possession (Malikı law) does not transfer the ownership,differently from the sale that determines, in Islamic law, the immediate transfer of the ownership.The H. anbalı law departs from this quasi general principle . . . For the choses de genre [dayn] onlythe traditio produces the transfer of ownership; for all the other properties [ayn], the transfer isdetermined by the exchange of the consents through ıjab and qabul. (Linant de Bellefonds, 1973:323)

Since an equilibrium at present does not exist, the donation is intrinsically revocable inIslamic law, despite the existence of divergences among the madhahıb:

[T]he Schools are divided in two groups whose thesis are diametrically opposite. On the one side,the H. anafı assert that the donor has . . . the right to revoke his donation, except when the doneeis his consort or a relative within the grade where the marriage is prohibited; and, on the otherside, the three Schools, Shafi‘ı, Malikı and H. anbalı, which decide that the donation is, on thecontrary, irrevocable as a principle, apart from precisely when the donor is the father or the motherof the donee (Malikı and H. anbalı doctrine) or one of his descendants (Shafi’ı doctrine), in whichcase he is allowed to take back what he gave to his descendant. [. . .] Ibn Qudama underlines thisantithesis in a lapidary manner: “For us, only the parents revoke, and for them (the H. anafıs) onlythe strangers (to the family).” (Linant de Bellefonds, 1973: 388)

On the faculty of repeal, El-Gamal quotes the Prophetic tradition according to which “ ‘thedonor is more worthy of keeping his property, as long as he was not compensated for it’. Inother words, a gift promise is not binding if the donor had not received compensation, andbinding if he had” (El-Gamal, 2006: 112). The intention to revoke must be expressed in theclearest way and cannot be subject to any term of condition (which makes the repeal invalid).Moreover, differently from the other Schools, which make the revocation dependent only onthe donor’s will, the H. anafıs contemplates two alternative procedures for the revocation: theagreement of the donor and the donee and the eventual intervention by a judge (qad. ı), who canbe replaced by an arbitrator (h. akam) appointed by the parties (arbitration, tah. kım). In otherwords, if the repeal by mutual consent (i.e. the annulment of the contract, faskh) is not possible,due to the opposition of the donee, the donor has the possibility to invoke the intervention ofa judge.

In both cases, the repeal does not determine a second transfer of ownership, but it annulsex tunc the original donation: the hiba is conceived as never having come into existence. For

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this reason, the taking of possession back to the donor, i.e. the re-possession, is not necessaryfor the validity of the repeal, since the donor is presumed to have been, continuously, theproprietor of the object.

As already pointed out, for the H. anafıs the donor can always revoke his donation (unlessthe donee is a member of the family), but the repeal is not admitted in the case of the paymentof compensation (thawab) to the donor.

Since the donation in Islamic law is basically a gratuitous but not charitable contract, thestipulation of a compensation, that can be equivalent or even superior to the value of thedonation, does not give rise to any contradiction. For this reason all the Schools admit“the onerous donation, indicated by the phrase hiba bi-shart. al-‘iwad. , that is to say, donationwith a clause of compensation, or alternatively hiba li-thawab, donation for a compensation,[which] is the donation where a counter-value is stipulated at the donor’s expense” (Linant deBellefonds, 1973: 374).

At all events, while for the Shafı’is, Malikıs, and H. anbalıs, the onerous donation is, fromany aspect, equivalent to a sale, bay’, for the H. anafıs the hiba li-thawab enjoys a hybridnature: it is a liberal act with regard to its formation, but it becomes a sale in relation tothe regulation of its effects, like any other synallagmatic contract (mu‘awad. a). The turningpoint is the double taking of possession by the donee (of the donation) and by the donor (ofthe compensation), which prevents both parties from repealing (Linant de Bellefonds, 1973:377); differently from the sale, therefore, the hiba bi-shart al-’iwad. is not completely effectivewith mutual consent but with the double appropriation, respectively, of the object and of thecompensation. Moreover, according to the doctrinal configuration of the compensation aimedat cancelling the faculty of repeal, all the rules regarding the hiba, but not those of the sale, areapplied: in particular, the value of the ex post thawab (/iwad. ) does not necessarily have to beequivalent to the value of the original donation, but, according to the purposes of the parties, itmay be minimal or even superior to it. The donee must specify that the offered compensationis expressly directed to make the received donation irrevocable; at any rate, the iwad. must beaccepted by the donor as compensation for his own hiba, since he is not obliged to renouncehis faculty of repeal, even if the compensation has a greater value than his own gift.

The previous investigation of the H. anafı rules on the hiba bi-shart. al-’iwad. may givevaluable suggestions for the structure of a Shariah-compliant non-definitive transfer (A). Infact, as already remarked, a commutative contract like bay‘ does not provide any viable means,due to the instantaneity of the exchange. On the contrary, the reference to the donation withcompensation may provide a feasible model for both the call and put options, where thecompensation is substituted the strike price of conventional options.

In summary, and bearing in mind the provisions on ijara as a reward for the optionwriter previously described, the model for Shariah-compliant financial options may be asfollows:

◦ CALL OPTION: the option to buy may be structured in Islamic fiqh with the combinationof a sale of the manfa’a (ijara) by the option writer (and owner of the underlier) with thedonation of the substance (raqaba) of the same underlier to the option holder subject tothe payment of a iwad. , according to H. anafı law. The option writer receives a reward forthe period conceded for the eventual conclusion of the transaction. The initial donationremains revocable for the option writer till the payment of the compensation, according tothe rules on hiba bi-shart. al-’iwad. ; the value of the iwad. corresponds to the strike exerciseof conventional options;

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◦ PUT OPTION: the option to sell may seem more complex to structure, since it requires theprovision of a reward for the person who is not the original owner of the underlier. Here,in fact, the option holder enjoys the right to sell the asset and has to remunerate the writerfor this facility; but the writer, of course, is not the owner of the asset. This issue, in anyevent, finds a solution if we admit that the eventual seller initially donates the underlier tothe potential buyer, and contemporaneously the latter transfers the manfa’a to the former:the donation, subject to compensation, is not definitive and can be revoked by the seller atany time during the lease period; of course, during the same time, the seller may accept theiwad. offered by the buyer, making the transfer of the raqaba definitive.

The ijara wa-hiba structure requires some comments.First of all, it must be noted that the structure seems to combine ijara and hiba into a

singular transaction, violating the prohibition of combination of contractual schemes whichall the Schools (with some exceptions for the H. anbalıs) endorse. But, in reality, the structuredistinguishes the manfa‘a and the raqaba of the underlier as independent objects of twodifferent contracts, which are concluded at the same time, but autonomously, since the subjectmatter is different in each case. Thus, the structure appears tenable.

Moreover, since the liberal acts are not subject to the prohibition of riba, there are noobjections on the ground of possible increases in the value of the underlier in the market; and,because of the clear determination of the iwad. there are no issues related to the presence ofgharar.

The ijara wa-hiba differs from another structure, already known in the practice of Islamicfinance, which is hire-purchase, ijara wa-iqtina’, as a form of financial lease:

[M]odern Islamic finance often combines leasing with purchase in a single contract called hire-purchase, or ijara wa-iqtina’. Under such a contract the tenant pays, in addition to lease, asum which goes toward buying the leased property. Properly the tenant is given credit for hispayments by becoming in ever-increasing degree the owner of the property, with the result that theproportion of his payments that goes for rent also continually reduces. The result is not dissimilarto a mortgage. (Vogel and Hayes, 1998: 144)

In the ijara wa-iqtina’ model we find the combination of a lease with a sale, which determinesthe contextual variation of the rent, while the ownership is progressively transferred; in theijara wa-hiba, instead, the two contracts are completely independent of one another, even ifinserted in the same structure.

Finally, the non-definitiveness of the transfer at present (since the donation is intrinsicallyrevocable in H. anafı law) may raise criticism on the basis of the presence of gharar in themodel, but the prohibition of gharar ‘occurs in the context of commutative contracts (‘uqudal-mu‘awad. at al-maliyyah), thus precluding tabarru’at’ (Kamali, 1999: 201). More precisely,Saleh underlies that

for the Malikıs [with specific reference to Ibn Rushd], gharar has no effect on donations; it is validto donate objects whose sale would be invalid . . . [But] this is not what the Shafi’ıs and the otherSunni Schools teach: for them, gharar impairs all contracts, whether a price is involved or not,with minor exceptions as regards gratuitous transactions . . . H. anafıs require that the subject-matterof a donation be known and determined . . . Under H. anbalı teaching, although the donation ofwhat is unknown (majhul) . . . is invalid, in some circumstances such as when the properties oftwo persons are intermingled in a way which makes their separate identification impossible, oneof these persons may donate his property to the other. (Saleh, 1992: 70–1)

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As is evident, the attention of all the madhahıb, and particularly that of the H. anafıs, forthe absence of gharar in tabarru‘at focuses on the existence and the clear determination ofthe subject matter, which the ijara wa-hiba structure fully satisfies, both with reference to theunderlier and the amount of the compensation to make the transfer irrevocable.

The ijara wa-hiba model, finally, cannot be criticized as a form of gambling (maysir): theconstant reference to a material underlier, the clear knowledge of the iwad. , as well as thepresence of a reward for the option writer based on the sale of usufruct, prevent any censureof illegitimate profit.

10.5 TRADING ijara wa-hiba OPTIONS? CLEARING HOUSE,ISSUANCE OF S. ukuk al-manfa‘a, AND LACK OF SPECULATION

To conclude the examination of ijara wa-hiba options (briefly, IWH), it is useful to discuss thepossibility of their trade. More precisely, considering that IWH options base their existenceon the transfer of the ownership/possession of the underlier(s), may we admit an IWH market,where IWH options are traded as unbundled commodities?

In this regard, Kamali claims the admissibility of the option market on the ground that

option trading does not proceed on charging of fixed interest, nor does it involve unwarrantedrisk taking and uncertainty (gharar). Option trading has a logic of its own, which is dominatedby the idea of risk reduction and hedging against excessively large positions in its underlyingassets. From the perspective of Islamic law this aspect of options is attractive and hence . . . Imake the case for the legality of options . . . options trading cannot be equated with gambling orover-indulgence in financial speculation, as it is basically designed to minimize speculative risktaking and for the most part operates as an antidote to gambling. (Kamali, 1997: 17–18)

But the argument of the admissibility of option markets in Islamic law, on the basis ofrisk reduction and hedging, is not satisfactory, since (1) the structure of conventional optionsintrinsically permits an opposite speculative function that cannot be separated from hedging;and (2) the trading of options as unbundled commodities has no valuable mal as its object.

In this regard, (1) the validity of conventional options in Islamic law has already beenfully excluded, in favour of the more feasible IWH structure; but (2) even with reference toIWH options, the issue of the tradability of mere contracts cannot be resolved with a positivejudgment in Islamic fiqh. IWH options cannot be traded, since this would represent the sale ofa mere right (to buy or to sell) and “a right pure and simple (al-h. aqq al-mujarrad) is neither atangible commodity nor usufruct; it cannot therefore be a proper subject matter of contract”,as seen above (AbuSulayman, 1992: 32–3).

What may be legitimately traded, instead, are certificates representing the usufruct ofthe underliers involved in the transactions (S. ukuk al-manfa‘a). The direct reference to theownership of usufructs, as valuable mal, constitutes the fundamental requirement for thevalidity of this trade, since it implies a corresponding risk of property loss for the ownerhimself (see, on the point, for instance, AAOIFI Resolution, 13–14 February 2008, Bahrain).

As far as their price is concerned, valuable suggestions may be found in Jobst – as we shallsee in the next paragraph – according to whom Islamic finance property-based transactions“re-characterize interest through the attribution of economic benefits from the (temporary)use and original ownership of an existing or future (contractible) asset” (Jobst, 2007: 8).Accordingly, the price of S. ukuk al-manfa‘a certificates may be intended as “the fair market

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value of each rental or lease payment in debt- and asset-based contracts of the period pay-outin equity-based Islamic transactions at each time period t” (Jobst, 2007: 15).

Moreover, the usufruct certificates may be gathered into a pooled investment and managedby a clearing house (according to a wakala mandate), which may also be in charge of thesettlement of mutual positions related to IWH options. More precisely, the clearing house (aswakıl) would be in charge of the management of the collective ownership (shirkat al-milk) ofthe members. The collective ownership would be divided into usufruct shares, represented bytradable S. ukuk al-manfa‘a certificates. According to this framework, in the Malikı doctrine,each of the co-owners (shuraka’, lit. “partners”) holds an undivided portion (h. iS. S. a musha‘a)of the collective, overall usufruct-property (res plurium communis pro partibus indivisis)(Santillana, 1926: 307–8); moreover, each partner can freely dispose of his portion, withoutany previous division (qisma), which may eventually occur either by agreement (qisma murad. aor qismat al-wifaq) or by decision of a judge or an arbitrator. Again, this role may be performedby the clearing house. In the same way, the H. anafıs recognize the co-ownership as “propertypartnership”, sharika amlak, and the free disposal of the h. iS. S. a musha’a by each co-owner,according to the authority of Shaybanı and T. ah. awı:

[T]he ownership of each co-owner is . . . entirely distinguished from that of the others, despite thestate of non-division that characterizes each of them . . . [thus] each of the co-owners can disposeof his portion, before the division. The sale of an undivided portion is recognized expressly valid.Being the right to dispose an essential prerogative of the proprietor, it is here completely enjoyedby the co-owner – who can, therefore, be considered as a veritable owner. (Chehata, 1973: 176–7)

Since the transfer of undivided shares is likely to occur among the members of the clearinghouse, the property is immediately reinvested in the same shirkat al-milk. In this way, the finaloutcome would be, in practical terms, an increase of the liquidity available in the market. Therequest of division (qisma) determines the end of the co-ownership, and the conversion of theundivided usufruct into physical and identified usufruct shares:

[W]hen financial assets as usufruct certificates are converted into physical usufruct, a process ofidentification of previously unidentified shares in the overall usufruct of the property is required. Inthis context, the Ottoman Majalla . . . Art. 1114, defined property division (qisma) as “specifyingportions of a jointly owned property for ownership by each partners, i.e., separating the sharesthrough measurement by size weight, or volume”. In this regard, it is easy to define timeshareunits in terms of the number of certificates necessary for conversion into weekly usufruct ofeach specific unit, and then assign the shares on a first-come first-served basis. Since those rulesfor converting the abstract shares in usufruct represented by S. ukuk al-manfa‘a can be listed incertificate documents, all conversions of certificates into actual usufruct of specific units duringspecific time periods are deemed to take place by mutual consent of all certificate holders (partnersin overall usufruct). (El-Gamal, 2006: 114)

In conclusion, the establishment of a clearing house for the trade of S. ukuk al-manfa‘a andfor the settlement of the IWH options may serve the following tasks:

• the regulation of the transfers of possession;• the registration of the acceptance of compensations (making the donations irrevocable);• the resolution of eventual controversies as arbitrator (h. akam) (H. anafı law);• the pooling of all IWH positions related to the market of S. ukuk al-manfa‘a;• the issuance and trading management of S. ukuk al-manfa‘a;

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• the eventual creation of a system of mutual guarantee, according to a takaful model, for theprotection of the members in case of default;

• easier access to information, which reduces lack of knowledge (gharar) in the exchange;• greater liquidity, thanks to the trading of S. ukuk al-manfa‘a, as a by-product of the market.

Moreover, a clearing house arrangement offers further benefits:

• A large clearing house with access to information can aggregate risks and reduce themthrough diversification better than a sole intermediary can.

• Collateral mechanisms and access to government funds in case of emergency reduces therisks of individual contracts.

• Derivatives are highly leveraged; a clearing house can limit the total leverage of eachunderlying asset by establishing a maximum number of contracts per unit of underlyingasset, resulting in greater market stability.

• The presence of brokers between customers and clearing house creates competition thatbrings the costs of contracts to their fair prices, resulting in a more efficient market.

• An organization of traders, perhaps licensed, can adopt through cooperative means measuresthat could not be validly imposed through individual contracts (Vogel and Hayes, 1998:260).

With reference to the leverage linked to the speculative function of conventional options(i.e. the possibility to magnify the positive/negative outcome of an investment in comparisonwith standard payoffs), the level of gearing allowed by IWH options is quite minimal. In fact,while the number of exchanges may be increased thanks to the trade of S. ukuk al-manfa‘a,with the settlement by the clearing house and greater liquidity as a by-product of the system,the ownership of usufruct certificates does not provide per se the right to conclude the transferof the raqaba of the underlier, which is, on the contrary, subject to the full payment of thecompensation for the initial donation.

As a consequence, the “option holder” cannot speculate on the variations of price of theunderlier thanks to leverage strategies as happens with conventional options (Krefetz, 1986;Chew, 1996), since for IWH options there are no artificial financial values under trading(trade admitted, on the contrary, only for S. ukuk al-manfa‘a). Thus, the speculative function ishighly limited, making the IWH structure compliant with the Islamic rejection of any form ofuncertainty (gharar), exploitation, and gambling (maysir), while fostering hedging purposesadmitted by the Shariah.

10.6 PRICING S. ukuk al-manfa‘a IN RELATION TO THE RENTALRATE OF RETURN

As already noted in the previous paragraph, while IWH options cannot be autonomously traded,what can be legitimately traded are the S. ukuk al-manfa‘a. But how to determine the “price”of the single S. akk al-manfa‘a, replacing the idea of the “price of the promise” embedded inthe option premium?

As is well known, the conventional option premium is calculated through statistical tech-niques, considering the behaviour of the underlier price for a certain period in the past, sayover the last six months, and project this forward; at the same time the calculus considersthe exercise price, the current market price, and the option life, and use the past behaviour todetermine a fair value for the premium (Valdez, 2007: 317). These statistical techniques were

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developed in May 1973 by Fischer Black and Myron Scholes, assisted by Robert Merton,and the Black-Scholes model (as it is commonly known) is still today the most widely usedto calculate premiums (Black and Scholes: 1973). The model, strictly speaking, is applicableonly to European options; another major advance in option pricing was made by John C. Cox,Stephen Ross, and Mark E. Rubinstein in 1979, with the development of the famous binomialmodel, which deals also with the possibility of early exercise, and can be consequently usedfor the valuation of American options (Cox, Ross, and Rubinstein, 1979). These models takeinto consideration five factors affecting the price of a stock option: (1) the current stock price,S0; (2) the strike price, K; (3) the time to expiration, T; (4) the volatility of the stock price, σ

(supposed normally distributed); (5) the risk-free interest rate, r.A full explanation of the mentioned models goes far beyond the scope of this work, and

proper discussion can be found in textbooks of finance theory (Hull, 2008). What is rele-vant for this study is that, taking these models into consideration, Jobst demonstrates howIslamic finance property-based transactions “re-characterize conventional interest throughthe attribution of economic benefits from the (temporary) use and original ownership of anexisting or future (contractible) asset” (Jobst, 2007: 8): thus, the implicit rate of lending canbe characterized in relation to periodical rental payments (Jobst, 2007: 11). For instance,

[I]n asset-based Islamic finance for investment or trade, the borrower leases from the lender one ormore assets A valued at S, which have previously been acquired from either the borrower or a thirdparty. The lender entitles the borrower to (re)gain ownership of A at time T by writing a call option–c(E) with time-invariant strike price E subject to the promise of full repayment of E (via a putoption +p(E)) plus an agreed premium in the form of rental payments over the investment period.This arrangement amounts a secured loan with fully collateralized principal (i.e. full recourse).[. . .] The combination of a put and call option on the same strike price represents a series ofindividual (and periodically extendible) forward contracts on asset value S over a sequence ofrental payment dates t. (Jobst 2007: 8–9)

Reinterpreting the ijara contract as a sequence of (implicit) extendible forward contracts(unrelated to the variation of the interest rate, cash-neutral), Jobst applies the BSM (Black-Scholes-Merton) framework to derive the market price of Islamic transactions, characterizing“the implicit interest rate of Islamic lending as a result of the premium payments (i.e., periodicrental or lease payments) received by the lender in return for the call position on assets heldby the borrower in Islamic finance” (Jobst, 2007: 12). Finally, through the adaptation ofthe BSM framework to the logic of Islamic finance (where the interest rate is replaced byrental premiums), Jobst demonstrates that the value of the call option on future repaymentE represents “the fair market value of each rental or lease payment in debt- and asset-basedcontracts of the period pay-out in equity-based Islamic transactions at each time period t”(Jobst, 2007: 15).

Jobst’s reasoning is certainly apt to suggest a price formula for S. ukuk al-manfa‘a, whichshould be related in the IWH structure

• to the possibility that the donated or leased-back property ceases to produce usufruct, since“unlike standard pricing based on credit-risk models, the callability in this case relatesalso to operational risk factors. In general, pricing Islamic finance instruments becomesincreasingly difficult because of its characteristic bundling of multiple risk factors” (El-Gamal, 2006: 22);

• to the agreed value of the iwad. , which affects the price of IWH options in the same way ofK (strike price).

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Despite further research still being necessary on the matter, Jobst’s position provides pre-liminary insights into the pricing of Islamic finance products. First and foremost, a majordeparture from conventional finance is the lack of reference to interest rate (r), replaced byperiodic rental or lease payments. Secondly, the asset-based pricing formula replicates animplicit forward model with a periodically extendable sequence (according to the renewal ofthe payment of the rent). This matches with the proposed ijara wa-hiba structure for Shariah-compliant option contracts: option contracts (in the form of American options), in fact, can beseen as a sequence of forward contract, where the possibility to conclude the transfer can bepostponed according to the will of the option holder.

10.7 ijara wa-hiba OPTIONS AND THE PATHTOWARDS LEGITIMACY

As seen, one of the fundamental features of the IWH structure is to guarantee the constantreference of the transaction to tangible property as valid mal for the ijara and the hiba contracts,according to the logic of Islamic law.

This may raise doubts on the classification of IWH options as a kind of derivative, sincethey avoid any volatility from underlying assets. The result, in any case, does not seem tome to be contradictory: being derivative contracts, an expression of Western law, there is noincongruity in admitting an alternative “codification” of the same object (the future transfer ofan asset, if the purchase is convenient for the option holder, with a reward for the option writer),according to the practical rationality governing Islamic fiqh. Thus, as a “promise to pay” isnot valuable property (mal) in Shariah law, the suggested model refers to the combinationof a lease (rectius, sale of usufruct) and a donation in order to re-codify the same object of(Western) options according to Islamic justice.

Indeed, alternative codifications of the same object in different legal traditions (an “option”derivative contract, having hedging and speculative functions in Western law; a “lease anddonation” structure with a function limited to hedging in Islamic law) should not be unexpected.On the contrary, they reflect the attempt to overcome the shortcomings of the Shariah arbitrageapproach (El-Gamal, 2006), in favour of the recognition of a legal pluralism able to promoteindependent solutions and alternative juridical sensibilities (Menski, 2006).

It is this legal pluralism that constitutes, in my mind, the only viable path towards strongerlegitimacy for Islamic finance. A legitimacy that will contribute indirectly to the future strength-ening of the market, to the benefit of both Muslims and non-Muslim investors.

REFERENCES

AAOIFI Resolution,13–14 February 2008, Bahrain, available online at www.aaoifi.com. Accessed 8March 2010.

AbuSulayman, I. (1992) Al-ikhtiyarat: dirasa fiqhıya tahlilıya muqarana, Majalla al-Buhuth al-Fiqhiyyaal-Mu‘asara (Options: a comparative legal analysis), n. 15, pp. 32–3.

Al-Amine, M. (2008) Risk Management in Islamic Finance: An Analysis of Derivatives Instruments inCommodity Markets, Brill’s Arab and Islamic Laws Series, Leiden, p. 10; pp. 24–8.

Bacha, O.I. (1999) Derivative instruments and Islamic finance: some thoughts for a reconsideration,International Journal of Islamic Financial Services, 1(1), available online at http://www.iiibf.org/journals/journal1/art2.pdf. Accessed 8 March 2010.

Black, F. and Scholes, M. (1973) The pricing of options and corporate liabilities, Journal of PoliticalEconomy, 81, 637–59.

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Board, J. (2000) The economic consequences of derivatives, A. Hudson (ed.), Modern Financial Tech-niques. Derivatives and Law, Kluwer Law International, p. 156.

Cattelan, V. (2009) From the concept of h. aqq to the prohibitions of riba, gharar and maysir in Islamicfinance, International Journal of Monetary Economics and Finance, 2(3/4), 384–97.

Chehata, C. (1969) Theorie generale de l’obligation en droit musulman hanefite. Les sujets del’obligation, Editions Syrey: Paris, pp. 150–1.

Chehata, C. (1973) Etudes de droit musulman. 2/La notion de responsabilite contractuelle. Le conceptde propriete, Presses Universitaire de France: Paris, pp. 176–7.

Chew, L. (1996) Managing Derivative Risks: The Use and Abuse of Leverage, John Wiley & Sons.Cox, J.C., Ross, S.A., and Rubinstein, M. (1979) Option pricing: a simplified approach, Journal of

Financial Economics, 7, 229–63.El-Gamal, M.A. (2006) Islamic Finance. Law, Economics, and Practice, Cambridge University Press,

pp. 20, 22, 92, 112, 114.Fadel, M. (2002) “The regulation of risk in Islamic law, the common law, and federal regulatory law”

in Proceedings of the Fourth Harvard University Forum on Islamic Finance, Harvard University,Cambridge, MA, 30 September–1 October 2000, p. 84.

Hudson, A. (2006) The Law of Financial Derivatives, 6th edn, Sweet & Maxwell: London, pp. 12–13.Hull, J.C. (2008) Fundamentals of Futures and Options Market, 6th edn, Pearson Prentice Hall: New

Jersey, p. 6.James, S. (1999) The Law of Derivatives, London.Jobst, A.A. (2007) Derivatives in Islamic Finance, Paper presented at the International Conference on

Islamic Capital Markets, Jakarta, Indonesia, 27–29 August, pp. 8–9; 11–12; 15.Kamali, M.H. (1997) Islamic commercial law: an analysis of options, The American Journal of Islamic

Social Sciences, 14(3), 17–18, 25, 26, 27, 30, 31.Kamali, M.H. (1999) Uncertainty and risk-taking (gharar) in Islamic law, IIUM Law Journal, 7(2),

201.Kamali, M.H. (2000) Islamic Commercial Law. An analysis of futures and options, Islamic Texts Society,

p. 206.Katz, A.W. (2004) The option element in contracting, Virginia Law Review, 90(8) 2205.Kolb, R.W. (2007) Futures, Options and Swaps, 5th edn, Blackwell.Krefetz, G. (1986) Leverage: The Key to Multiplying Money, Wiley.Linant de Bellefonds, Y. (1935) Des donations en droit musulman, Recuil Sirey: Paris, p. 18.Linant de Bellefonds, Y. (1965) Traite de droit musulman compare, 3 Vols, Vol. 1, Theorie generale de

l’acte juridique, Mouton & Co.: Paris, Le Haye, pp. 185, 316–17.Linant de Bellefonds, Y. (1973) Traite de droit musulman compare, 3 Vols, Vol. 3, Filiation, incapacites,

liberalites entre vifs, Mouton & Co.: Paris, La Haye, pp. 317, 323, 374, 377, 388.MacIntyre, A. (1988) Whose Justice? Which Rationality? Duckworth, London.Menski, W. (2006), Comparative Law in a Global Context. The legal systems of Asia and Africa, 2nd

edn, Cambridge University Press: Cambridge.Obaidullah, M. (1998) Financial engineering with Islamic options, Islamic Economic Studies, 6(1)

73–103.Rayner, S.E. (1991) The Theory of Contracts in Islamic Law: A Comparative Analysis with Reference

to the Modern Legislation in Kuwait, Bahrain and the United Arab Emirates, Arab and Islamic LawsSeries, 1st edn, Graham & Trotman: London/Dordrecht/Boston, p. 309.

Saleh, N. (1992) Unlawful Gain and Legitimate Profit in Islamic Law. Riba, gharar and Islamic Banking,2nd edn, Graham & Trotman: London, pp. 70–1.

Santillana, D. (1926) Istituzioni di diritto musulmano malichita con riguardo anche al sistema sciafiita,Vol. I, IPO, Roma, pp. 307–8.

Santillana, D. (1938) Istituzioni di diritto musulmano malichita con riguardo anche al sistema sciafiita,Vol. II, IPO, Roma, pp. 57–8.

Usmani, M.T. (1996) Futures, options, swaps and equity investments, New Horizon, Institute of IslamicBanking and Insurance, No. 59, p. 10.

Usmani, M.T. (2000) Fatwa regarding the conditions for trading stocks and stock options, quoted in J.Smolarski, M. Schapek, and M.I. Tahir Permissibility and use of options for hedging purposes inIslamic finance, in Thunderbird International Business Review, Vol. 48, pp. 425–43.

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Valdez, S. (2007) An Introduction to Global Financial Markets, 5th edn, Palgrave Macmillan, pp. 309–68.Vogel, F.E. (1997) “Contract Law of Islam and the Arab Middle East” in International Encyclopaedia of

Comparative Law, Vol. VII, Contracts in general, Chapter 7, Mohr Siebeck: Tubingen and MartinusNijhoff Publishers: Dordrecht, Boston, Lancaster, p. 38.

Vogel, E.F., and Hayes, S.L. (1998) Islamic Law and Finance: Religion, Risk and Return, Arab andIslamic Law Series, Kluwer Law International, The Hague, London, Boston, pp. 144, 156–7, 164,227, 260.

Zweigert, K., and Kotz, H. (1977) An Introduction to Comparative Law, I The Framework, North-HollandPublishing Company, p. 25.

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Part III

National and Regional Experiences

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11

Building up an Islamic Capital Market:The Malaysian Example

A. Usama DeLorenzo

11.1 INTRODUCTION

Malaysia has perhaps the best example today of a comprehensive capital market in Shariah-based services and products. This “Islamic capital market”, which works in parallel with theconventional capital market on a common infrastructure, features a host of participants, a broadrange of products and service providers, and a more comprehensive regulatory framework thanany other jurisdiction to date.

Malaysia is a useful case-study of how government and regulatory policy initiatives cancomplement commercial and community interests in the private sector to create a high-growth and thriving market environment. The Malaysian Islamic capital market is founded oncommunity beliefs in the need for the availability of investments that are not contrary to theteachings of Islam and the need for regulatory and policy-driven interventions to facilitate acontrolled environment in which Islamic instruments can flourish.

A coordinated approach to policy, regulation, and participation of market participants helpsto mitigate the higher costs associated with doing Islamic business in comparison to otherjurisdictions. This stems directly from the fact that the infrastructure in Malaysia for theIslamic capital market has been built on policy-driven initiatives and the fact that one of theobjectives of the Securities Commission Malaysia (SC) is to promote market development.The SC is the only regulator with a dedicated Islamic Capital Market Department, which willbe explored further in this chapter.

This chapter will also delve into the liberalization efforts by the Malaysian government forthe Islamic capital market, which forced down the costs of doing business and the barriers toentry. These elements inevitably create the potential in the market to open up further and thiscontributes to Malaysia being a very attractive destination for the Islamic financial servicesindustry.

For Malaysia, the growth of the Islamic capital market has exceeded the initial expectationsof simply meeting the needs of its Muslim community. The common goal of institutionsand government in growing the Islamic industry was supported by policy and governmentinitiatives that led to sustainable growth within the industry and left the country with a strongfoundation in Islamic finance. Pro-active policies and strong collaboration between regulatorsand the market have provided the country with a strong competency in Islamic finance andhave placed the Islamic capital market as the country’s main competitive advantage.


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11.2 THE BEGINNINGS OF SHARIAH-BASED FINANCEIN MALAYSIA

Modern Islamic finance in Malaysia began almost 50 years ago. The National Pilgrims FundBoard, known by its Malay name Lembaga Tabung Haji (Tabung Haji), was established in1963 to help Muslims accumulate enough savings to perform the hajj, or pilgrimage to Mecca.1

Tabung Haji’s missions include that they are to empower Muslims economically, to activelysearch for strategic global and local investments, to mobilize capital on behalf of and enrichinvestors, and to provide competitive returns that are halal. Since then Tabung Haji has growninto one of the biggest Malaysian institutional investors with a mandate to invest only in aShariah-compliant manner.

Tabung Haji became very successful in mobilizing the savings of the Muslim community inMalaysia. Investing in a Shariah-compliant manner put Tabung Haji in a role that exposed thenature of Islamic finance to the rest of Malaysia’s business community and interest in financecompliant with the Shariah started burgeoning.

In 1981, the government established a National Steering Committee to develop policy onIslamic transactions and financial services activities. The focus of the steering committeewas to study the legal, religious, and operational aspects of setting up an Islamic bank withthe aim of broadening the range of Shariah-compliant financial services in Malaysia. Twoyears later, Bank Islam Malaysia Berhad (Bank Islam) was established, following the IslamicBanking Act 1983 by Parliament. Shortly after, the first Takaful (Shariah-compliant insurance)operator, Syarikat Takaful Malaysia, began operating in 1984, following the Takaful Act1984.

The demand for Shariah-compliant capital market instruments grew over time as the needfor Islamic financial institutions to find solutions to manage liquidity and to make investmentsalso grew. The introduction of Shariah-compliant instruments into the market meant thatthe issue of Shariah compliance would need to be addressed. The same necessary elements,such as transparency, disclosure, and meeting regulatory guidelines and policy, that provideconfidence to investors in conventional instruments, needed to be there for investors inShariah-compliant instruments. In addition, when it came to Shariah-compliant instrumentsthere was the added responsibility of providing assurance to Muslim investors that theseinstruments and their underlying assets were in compliance with Shariah requirements. Lastly,the cost of issuing these instruments had also to be competitive relative to conventionalinstruments.

Challenges to do with securities regulation and with Shariah compliance began to mountand this provided the impetus for policy makers to advocate the establishment of a securitiesregulator.

11.2.1 The Securities Commission Malaysia

In 1993, the SC was founded and given authority by the Securities Commission Act 1993 asa self-funding statutory body with investigative and enforcement powers. The SC reports tothe Minister of Finance and the Commission’s accounts are tabled in Parliament annually.The SC has a mandate not only to regulate securities markets and activities but also topromote their development. Prior to the establishment of the SC, supervisory powers wereshared between industry organizations like the stock exchange and government institutions.

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Building up an Islamic Capital Market: The Malaysian Example 223

The SC is the sole authority responsible for the registration of prospectuses of corporations(other than unlisted recreational clubs); for the approval of corporate bond issuances, licensing,and supervising all licensed persons; and for supervising the exchange, clearing houses, andcentral depositories. In addition, the SC is responsible for encouraging self-regulation, ensuringproper conduct among market participants, and regulating all matters relating to securities andfutures contracts, take-overs, and mergers of companies and unit trust schemes. Underpinningall these functions is the SC’s ultimate responsibility of protecting the investor. Apart fromdischarging its regulatory functions, the SC is also obliged by statute to encourage and promotethe development of the securities and futures markets in Malaysia. Additionally, the SC isresponsible for advising the Minister of Finance on all matters relating to the securities andfutures markets. This gives the SC a significant role in making policy recommendations,including those related to the Islamic capital market.

The SC comprises nine members2 appointed by the Minister of Finance, including indi-viduals from both private and government entities. Divisions, departments, and units performdifferent activities yet complement one another’s functions in a synergistic relationship makeup the rest of the SC.

The undertaking of development in the Islamic capital market occurred in the formativeyears of the SC. The SC set up an Islamic capital market department, clearly indicating thedevelopment of an Islamic capital market as a priority. Three years after its establishment,the SC set up a national Shariah Advisory Council (SAC) for the capital market (1996) toadvise on matters related to the Islamic capital market and to serve as a point of reference onall Shariah issues to do with securities. This was a significant development in that the SACwas to play an important role in the future in providing the necessary clarity and certainty oninterpretations of the Shariah to the market place.

11.2.2 The Shariah Advisory Council (SAC)

Compliance with Shariah principles is a fundamental precept of Islamic finance. To mitigatethe risk of there being confusion in the market place about rulings of independent scholars,thus potentially negatively affecting the market, Malaysia set up an SAC at the national level.Individuals from varying backgrounds with expertise in both the Shariah and in finance wereselected to ensure that transparency, consistency, and scholarly depth are part of the processwhen coming to Shariah interpretations. These interpretations are required to provide stabilityand lessen the risk of confusion arising from differing Shariah interpretations in the market.

Since its establishment, the SAC have played a critical role in facilitating the development ofthe many Islamic capital market instruments and intermediation activities. The SAC resolutionsare reviewed periodically and are currently in their second edition. The resolutions are a body ofreference for issues to do with Shariah relating to the Islamic capital market. These resolutionshave attracted worldwide attention to the extent that a compilation of the SAC resolutions hasbeen translated into several languages.

In their deliberations, the members of the SAC accept all sources and manhaj (method-ologies) of Islamic jurists from all of the four schools of Islamic thought in relation tofiqh muamalat (Islamic commercial transactions); namely the Shafi’i, Hanafi, Maliki, andHanbali. This was based on the view that the inclusion of all sources lent themselves to a morecomprehensive analysis of the issues in order to fully utilize the richness of the Shariah. Themembers of the SAC pursue continuous dialogue and discussion with scholars from all overthe world to ensure a greater understanding and appreciation of differing views.

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To ensure compliance with resolutions issued by the SAC, the SC publishes these resolutionsand guidelines directly pertaining to the Islamic capital market. This effort is carried out toensure compliance, as well as to promote transparency, and to ensure that the resolutions ofthe SAC are universally understood.

Recently, a provision was included in the Capital Market and Services Act that empowers theSAC to advise any person on any Shariah issue pertaining to Islamic capital market businessand transaction. The SAC has also been given authority to provide ruling on the Shariahcompliance of any Islamic capital market issues raised in cases brought before a court orarbitrators. The provisions state that the SAC’s rulings on matters of Shariah compliance arebinding and should there be any inconsistency between rulings given by a registered Shariahadviser and the rulings by the SAC, the latter’s rulings shall prevail.

Guidelines for the Islamic Capital Market

The SC has issued a total of seven guidelines for the Islamic capital market. The approachthe SC had in putting together guidelines is that they were either additions to existingguidelines or that they were separate and stand-alone. These guidelines can be categorizedinto two parts; one to regulate products and the other to regulate services.3

The guidelines, however, are not entirely stand-alone; they cannot be read disjunctively.Fulfilling the requirements within one guideline will not fully qualify an entity for doingthe type of business desired. These guidelines are in place as an addendum to securitiespolicy, frameworks, and other existing guidelines. If an entity is interested in issuing Islamicproduct into the market, the entity would have to follow the guidelines for the conventionalsecurities and would then seek to satisfy the Islamic requirements found in the respectiveIslamic guidelines. The guidelines in use for Islamic securities are an added measure toensure that Shariah compliance, transparency, accountability, and compliance are all partof the issuance and investment process. Furthermore, it is useful to understand that oneof the focal points when writing these guidelines was that any given product application,Islamic or conventional, should not be in conflict with any of the generic guidelines issuedby the commission; that the generic guidelines apply universally. This is to ensure thatthere is no compromise in the level of protection and transparency provided to investors byway of adherence to SC rules and regulation.

In July of 2004, the SC issued the Guidelines for the Offering of Islamic Securities4

whose aim is to provide clarity to any person issuing Islamic securities. The Guidelinesstipulate the criteria that must be met for any issue, offer, or invitation to subscribe toany Islamic security regulated by the SC. Consultation of the Islamic guidelines, however,must be complemented by a reference to the set of guidelines that correlates to the type ofsecurity being offered. For instance, if it is an asset backed security that an entity wishes tooffer, the Guidelines for Asset Backed Securities must be referenced and satisfied beforereferring to the Islamic guidelines.

Following the issuance of the Guidelines for Islamic Securities, in November 2005,came the issuance of the Guidelines for Islamic Real Estate Investment Trusts (IREITS).The Guidelines for Islamic Real Estate Investment Trusts must be read together with theGuidelines for Real Estate Investment Trusts and cover the areas of rental of real estate,tenancy, financing, insurance, and currency hedging.

The Guidelines on the Offering of Structured Product, issued in April 2007, outline theprocedures and define the eligible parties for the offering of structured product. Islamic

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structured product follows the same check-list as conventional structured product with theadded requirement of furnishing proof of Shariah compliance as per a Shariah advisor5

and the construct6 of the product must be one that has been approved by the SAC ofthe SC.

The Guidelines on Islamic Fund Management were issued by the SC in the December of2007. These guidelines set out the requirements for carrying on an Islamic fund managementbusiness whether that fund manager is a stand-alone entity or a window of an Islamic bankor financial institution. The Guidelines for Islamic Fund Management contain both a listof Shariah principles and concepts,7 and requirements for Shariah advisors that are non-residents8 of Malaysia. The Guidelines for Islamic Fund Management must be read withthe Guidelines on Compliance Function for Fund Managers, the Guidelines on Unit TrustFunds, and all relevant materials, depending on the nature of the fund, pursuant to theCapital Market Services Act and the Licensing Handbook.

The Guidelines and Best Practices on Islamic Venture Capital were issued in May 2008,and cover two broad areas; guidelines and best practices. The guidelines cover the areaof core requirements, while best practices cover the responsibility of Shariah advisors,disclosure and declaration by Shariah advisors, compliance, portfolio management, andthe maintenance of accounts. This set of guidelines contains two appendices geared atShariah compliance in that in Appendix 1, acceptable Shariah Principles and Concepts arestated and in Appendix 2, the appointment of a Shariah advisor is stated.

The Guidelines on Wholesale Funds were issued in February 2009, and replaced theGuidelines on Restricted Investment Schemes as well as the requirements for wholesalefunds within the Guidelines on Unit Trust Funds that were issued in March 2008. Fundmanagers who wish to offer wholesale funds are also required to comply with other relevantguidelines that are applicable to the products on offer. The Guidelines on Wholesale Fundsare comprehensive in their approach and detail requirements and guidance on the roleand duties of both fund managers and trustees, fees and charges, liquidity, risk disclosure,marketing, disclaimers, internal monitoring, valuation, and fees.

The Registration of Shariah Advisers Guidelines is the latest of the published guidelinespertinent to the Islamic capital market that have been issued; and they were issued inAugust of 2009. According to the guidelines, a Shariah advisor can be an individual or acorporation and can be domestic or foreign. These guidelines cover the criteria a Shariahadvisor must satisfy in order to register, and renew registration, with the SC. The guidelinesalso set forth the procedures for registration and deregistration and address the issue ofcontinuing professional development.

11.3 THE ISLAMIC CAPITAL MARKET IN MALAYSIA

11.3.1 The Capital Market Master Plan

A significant developmental milestone for the capital market in Malaysia, which included theIslamic capital market, was the development of a comprehensive plan for orderly growth. TheIslamic capital market formed one of the six key strategic initiatives of the 10-year CapitalMarket Master Plan (CMP). Based on the strategic initiative of establishing Malaysia as aninternational Islamic capital market centre, several policy initiatives were identified. First,the plan set out to facilitate the development of the Islamic capital market by facilitating thedevelopment of a wide range of competitive products and services within the Islamic capital

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PHASE 1

PHASE 2

PHASE 3

Strengthen domestic capacity; developstrategic nascent sectors

Strengthen key sectors and gradualliberalization

Strengthen market processes and infrastructureand enhance international positioning

Figure 11.1 The three phases of the Capital Market Master Plan (2001–2010)

market. Secondly, the SC envisioned a viable market for the effective mobilization of Islamicfunds and wanted to ensure that there was a comprehensive accounting, tax, and regulatoryframework in place to aid in the growth of the Islamic capital market. Lastly, one of the majorcomponents of the plan was to enhance the visibility of the value Malaysia added to the Islamicindustry internationally (see Figure 11.1).

11.3.2 The Current State

The current financial landscape for Islamic institutions in Malaysia is quite different fromwhat it was when it began in the late 1960s. What has been surprising has been the speedand extent of the transformation in the market from the mid-1990s until today, as the Islamiccapital market is one of the fastest-growing segments of the capital market in Malaysia. Whatis on offer today has gone beyond trade financing needs into equity financing, infrastructurefinancing, and a broad range of debt and investment products.

Today, the Islamic capital market offers a broad range of investments including Shariah-compliant equities, sukuk, Islamic unit trust funds, Islamic ETFs, Islamic REITS, Islamicstructured products and derivatives. Malaysia’s Islamic capital market is uniquely positionedin that it offers the same level of investor protection for Islamic products as is availablefor conventional products. The various regulations and guidelines available cover a broadrange of intermediation services and products to ensure Shariah compliance while providinga level of comfort to investors about issues to do with their protection. Islamic products andservice providers benefit from a range of tax incentives that ensure highly competitive pricingand a broad investor base comprising both Muslim and non-Muslim investors. Malaysia hasa critical mass made up of a diverse segment of market intermediaries consisting of localand international investment banks, Islamic banks, Takaful operators, stockbrokers, and fundmanagers that actively participate in the market.

11.3.3 Malaysian Sukuk

There is no doubt that Malaysia’s contributions to the Islamic finance industry have beennumerous. Though there has been a lot of growth in many areas of the Islamic capital marketover the last few decades in Malaysia, there is one segment of the market where Malaysia’sefforts have paved the way for the global Islamic finance industry and that is sukuk. Malaysia isresponsible for many firsts in the sukuk market as referenced in Table 11.1. The key milestonefor the Malaysian sukuk market was when the SC imposed a regulatory intervention that clearlyintroduced the concept of sukuk, decoupling it from the concept of debentures.

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Table 11.1 Notable Malaysian sukuk issuances

Issuer Sum raised Year Transaction highlightsTenor(years)

Shell MDS RM125m(US$33m)

1990 World’s first ringgit sukuk issueby foreign owned, non-Islamiccompany

-

Kumpulan Guthrie Bhd US$150m 2001 World’s first global corporatesukuk

8

Government of Malaysia US$ 600m 2002 World’s first global sovereignsukuk

5

International FinanceCorporation (WorldBank)

RM500m(US$132m)

2004 First ringgit sukuk issue by asupranational agency

3

Cagamas MBS Bhd RM2.05b(US$540m)

2005 World’s first Islamic residentialmortgage-backed security

13

Khazanah Nasional(Rafflesia Capital Ltd)

US$750m 2006 World’s first exchangeable sukuk 5

Nucleus Avenue(MalakoffCorporation)

RM8b(US$2.5b)

2007 First hybrid sukuk in the world 50

Maybank Berhad US$300m 2007 World’s first internationalsubordinated sukuk

10

Binariang GSM RM15.35b(US$4.8b)

2007 Largest-ever sukuk issue in theworld

20

Source: International Islamic Financial Market (IIFM) Sukuk Report 2010

In 1990, Shell MDS was responsible for issuing the world’s first sukuk issue by a foreignowned, non-Islamic company and the issue was denominated in ringgit. The next sukuk issuein Malaysia was to be in 2001, 11 years later by Kumpulan Guthrie Berhad (Guthrie), theplantation manager, for US$150 million. This was the world’s first global sukuk and had atenor of eight years.

In 2002, the Government of Malaysia issued the world’s first sovereign sukuk, which wasfollowed by an International Finance Corporation sukuk two years later in 2004. The IFCsukuk was the first ringgit-denominated sukuk issued by a supranational agency. One yearlater, in 2005, Cagamas Berhad, the Malaysian national mortgage corporation, issued theworld’s first Islamic mortgage-backed security that was backed with residential mortgages.The Cagamas issuance had a tenor of 13 years and raised over two billion ringgit. The followingyear, the world’s first exchangeable sukuk was issued by Khazanah Nasional, and a year afterthat Nucleus Avenue (now known as Malakoff Corporation) issued the world’s first hybridsukuk. Later on in 2007, Maybank Berhad issued the first international subordinated sukukand Binariang GSM issued the largest sukuk issue in the world to date raising just under US$5billion.

11.3.4 Malaysian Shariah-Compliant Equities and Fund Management

What continues to provide impetus to the Malaysian Islamic capital market is strength in theShariah-compliant portion of the equity market, including the funds that investors rely on for adiversified exposure to the equity market of Kuala Lumpur. Fund management has developedsignificantly since the beginnings of the Islamic market in Malaysia. Presently, there are 157

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funds on offer in Malaysia which operate on a mandate compliant with the Shariah. Thisnumber is larger than in any one jurisdiction in the world. The net asset value of these fundsranks at number two in the world at approximately RM23 billion with Saudi Arabia being thejurisdiction having the greatest concentration of managed assets in Islamic funds. Malaysiahas, with the largest range of investments and greatest number of funds in the world, createda strong fund management industry through a base of strong investable Shariah-compliantequities and recent liberalizations. Kuala Lumpur has become the destination of choice for topIslamic fund managers and to date eight foreign fund managers have acquired licences andhave established operations in the city.9

The Islamic fund management industry, however, could not have developed without thefundamental elements of a robust equity market atop a framework facilitative of Shariah com-pliance and the issues found therein. In 1997, the SC started officially screening listed equitiesbased on a criterion ensuring universality in Shariah compliance. The criterion focuses onevaluating the core activities of companies to ensure that they are not haram, or impermissibleaccording to Islamic law, and to test the financial data of companies for haram revenues, useof leverage, and interest income through the usage of ratios on each company’s accountingdata. In reviewing the companies, the SAC is also mindful to apply the concepts of maslahah(common good) and umum balwa (common plight) to help in the process of determiningwhether a company is deemed Shariah-compliant. The introduction of this official screeningprocess by the SC, rather than third-party vendors offering screening, enabled the commissionto ensure that it was doing all in its power to reduce ambiguity in the market as to what wasShariah-compliant and what was not and to reduce the costs to market participants of doingbusiness. Currently, the proportion of Shariah-compliant equities to non-compliant equities isabout 88% (see Figure 11.2).

In addition to screening the listed companies, the SC, upon the request of a company filingfor an initial public offering, can pre-screen a company prior to its listing. This is employed by

Figure 11.2 Relative numbers of Shariah and non-Shariah-compliant public listed companies inMalaysia.

Source: SC Malaysia

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some companies to attract assets by mentioning their Shariah-compliant status in subscriptiondocumentation.

The SAC list of Shariah-compliant equities provided a boost to the growth of the Islamic fundmanagement industry in Malaysia. Moreover, it also provided incentive for listed companiesthat were not Shariah-compliant to work towards compliance as that would allow them accessto a greater pool of investors and broaden their investor base. Based on these equities, BursaMalaysia has launched indices with the FTSE Group (FTSE) and with Dow Jones Indexes.The Dow Jones Islamic Market Index created for Malaysia was later used for the launch ofAsia’s first Islamic ETF, the MyETF.

Malaysia’s Islamic fund management industry has matured considerably in the last decade,adding, on average, about nine funds per year since 1993; in 1993 there were just two Shariah-compliant unit trust funds.

11.3.5 Government, Regulation, and Taxation

High-level government support and facilitative policies were essential elements in drivingthe rapid growth of the Islamic capital market in Malaysia. The SC placed emphasis ontwo important principles to ensure comprehensive regulation. First, there was this notion ofregulatory parity which required that all market participants engaging in a particular activityshould be regulated in the same manner to ensure consistent protection and fair treatment ofinvestors. To underscore this, the Islamic Capital Market Task Force, set up by the InternationalOrganization of Securities Commissions (IOSCO) was chaired by the SC and its aim was toreview developments in Islamic capital markets worldwide. The taskforce’s Islamic CapitalMarket Fact Finding Report concluded that the principles of securities regulation must alsoapply to Shariah-compliant products. Secondly, the SC realized that there must be investorconfidence in the Shariah compliance process and that this would be achieved through ensuringthat Islamic products are true to label. The key feature of Malaysia’s Islamic capital marketregulatory approach was to ensure that the Islamic capital market was regulated in a mannerthat ensured that it could co-exist with the conventional financial system and provide allparticipants the same degree of clarity, certainty, and protection. This established regulatoryframework guided and supported the progressive, systematic, and consistent development ofthe Islamic capital market. However, in order to level the playing field for the Islamic side ofthe market and to incentivize Islamic issuances, the government has announced a number ofliberalizations in recent years.

Sukuk issuances are now permitted in foreign currencies and are not limited to ringgit. Thetax treatment of the SPV in the sukuk market has been changed so that the SPV is exemptedfrom its income tax liability as it is recognized as a vehicle solely designed to channel funds.Furthermore, the company that issues the SPV is given a deduction on the cost of the issuanceof the sukuk incurred by the SPV. For three years, until 2010, there was also an extensionon the deduction of expenses, for the issuer, for sukuk issued under certain types of Islamiccontracts (Musharaka, Mudharabah, Ijarah, and Isntisna’a).

For the investor, a few benefits were put into place. Profit paid or credited to any individual,unit trust, listed closed end fund, and non-resident company (RM-denominated sukuk only)that has been approved by the SC is exempt from income tax liability. In addition, profit paidor credited to any person on non-ringgit sukuk that is originated in Malaysia is also exemptfrom income tax. Lastly, the issue of tax neutrality of Islamic instruments with respect toconventional instruments is addressed in the Income Tax Act and the Stamp Act by way of

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eliminating additional tax or duty for Islamic products and there is a possibility of specifictreatment of an issuance as long as the SAC and the SC have approved the issuance.

Between 2006 and 2010, the government also allowed for expenses of setting up an Islamicbrokerage business to be tax deductible. This was subject to the company opening doors forbusiness within a period of two years from the date of approval from the SC.

In 2008, conventional fund management companies, whether local or foreign owned andwith local or foreign investors, were given income tax relief on all fees received from managingIslamic funds; and this incentive will be in effect until 2016. For Islamic fund managementcompanies, however, the liberalizations opened up more possibilities and incentives. Islamicfund management companies are now allowed to be foreign owned in totality, are permitted toinvest all assets abroad with no restriction and have potential access to a total of RM7 billionthat has been designated Shariah-compliant by the Employee Provident Fund (EPF).

11.3.6 Promoting International Linkages

Malaysia continues to open up avenues via which foreign entities in the area of broking,fund management, and the advisory industries can operate with more ease and confidence andMalaysia’s intermediaries are also expanding internationally, either individually or throughpartnerships. Malaysia welcomes foreign companies to raise funds or list products in its marketand has an established and tested regulatory framework that caters to both Shariah and legalrequirements. In addition to there being a framework of support in Malaysia, the SC and BankNegara collaborate actively and very closely with the Malaysian International Islamic FinanceCentre (MIFC, founded 2006) to aid the MIFC with its objective of promoting Malaysia asthe global hub of Islamic finance.

To date, Malaysia has signed Mutual Recognition Agreements (MRA) with the DubaiInternational Financial Centre and with the Hong Kong Securities and Futures Commission tofacilitate cross-border offerings of Islamic funds and the SC actively explores opportunities tosign MRAs in order to align with other jurisdictions that have similar goals within the Islamicspace. These linkages help expand the breadth of the Islamic capital market worldwide andpromote transparency and the understanding of products within the global Islamic capitalmarket.

Each year, to help keep abreast of the development within the global Islamic capital marketand to raise the level of understanding, both in Malaysia about developments in other markets,as well as outside Malaysia about developments domestically, the SC annually hosts twoprogrammes specific to the Islamic capital market. The Islamic Markets Programme (IMP),organized by the Securities Industry Development Corporation (SIDC), is now in its fifth yearand draws participants from regulators and practitioners to scholars and students from all overthe world to learn from and to share with the SC the broader issues relating to the Islamiccapital market. The International Islamic Capital Market Forum, which is now in its fourthyear, has a slightly more focused approach. Each year, this programme focuses on a theme thatis topical in the market and explores the details of that theme in depth, encompassing withinit the views of regulators, practitioners, and scholars. The participants of this programmeare comprised of an internationally diverse group of people including regulators, scholars,students, and market participants, many of whom are international organizations.

In an effort to enhance the proposition of the Malaysian Islamic capital market both locallyand globally, the SC recently added an international scholar to the SAC for the purposes ofdiversifying its inputs and rulings. Furthermore, the SC always encourages its Shariah scholars

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to sit on international boards to be able to deepen and broaden the experience the scholarsmay have. The inclusive nature of the attitude of and resolutions by the SAC, keeping inmind jurisdictional differences within the factions of scholarship in the Shariah, has been areal strength for the Islamic capital market in Kuala Lumpur. The openness and readiness toincorporate the norms, rulings, and views of international scholars and international standardsetting bodies, such as AAOIFI10 and the IFSB,11 in the resolution process has been a powerfuldriver in the growth of the Islamic market in Kuala Lumpur.

11.3.7 Development of Skills in the Islamic Capital Market

Given that there is a shortage of experts who know both finance and Islamic law, developingskill sets in the industry continues to be a significant part of the SC’s efforts. Over the years,Malaysia has invested a considerable amount of resources to develop skills in the industry andto build up a pool of knowledgeable people in Islamic finance so as to expand the supply oftalent available for Islamic market participants. The approach has been to focus on education,training, and research and today there are various institutions in existence that provide anavenue for development in this area.

The SIDC, the training arm of the SC, works in collaboration with the Capital Market Devel-opment Fund (CMDF) to provide short-duration educational and training courses, workshops,and conferences to expand the pool of Shariah advisors and professionals. It is also leadinginitiatives for the compilation of rulings/fatawa and the launch of an Islamic capital marketbook series.

Together with the SC, the SIDC developed a programme to help address the need to develophuman capital within the Islamic capital market. In early 2009, SIDC launched the IslamicCapital Market Graduate Training Scheme (ICMGTS) with the intention of adding to the poolof talent required to grow the Islamic capital market in Malaysia. Emphasis in this programmeis placed on producing forward thinking professionals with good communication and technicalskills. The programme aims to do this by employing a variety of teaching methods includinglectures, cases, and simulations that help broaden the skill sets and knowledge base of recentgraduates who are moving toward working in the Islamic capital market. The Islamic Bankingand Finance Institute Malaysia (IBFIM) provides short-duration training courses, consultancy,and advisory services in Islamic finance. The International Centre for Leadership in Finance(ICLIF) provides leadership training programmes including specialized programmes inIslamic financial services for senior management of Islamic financial institutions worldwide.The International Centre for Education in Islamic Finance (INCEIF) has been set up as afully-fledged university providing professional certification, post-graduate, and doctorate pro-grammes in Islamic finance. The International Shariah Research Academy for Islamic Finance(ISRA) promotes applied research in the area of Shariah and Islamic finance. It also acts asa repository of knowledge for Shariah views or fatawa and undertakes studies on contempo-rary issues in the Islamic financial industry with a view to providing a platform for greaterengagement amongst practitioners, scholars, regulators, and academicians via research andintellectual dialogues, both domestically and internationally.

11.4 CONCLUSION

Malaysia, through time and experience, has managed to develop an example of a locallystimulated and sustained Islamic capital market that is increasingly becoming integrated within

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the larger ecosystem of global finance. The contribution of Malaysia to each asset class inIslamic finance has been significant and no other jurisdiction in the world has been ableto rival the volume or sophistication found within Malaysia’s shores. Kuala Lumpur is alsoan undisputed hub of Islamic finance that continues to contribute a great deal to innovationand to building capacity in the Islamic markets on many fronts including human resourcedevelopment.

Malaysia has been developing a steady stream of Islamic financial products, institutions,and thinkers and the role of the regulator has never been as important as it is today. Malaysiacan lend a great deal to nations who wish to develop Islamic finance in their own marketsand who are looking for exposure to the nature of Islamic markets, be they banking or capitalmarkets. Furthermore, Malaysia has done a great deal to ensure that queries coming from otherjurisdictions who wish to learn from Malaysia and its experiences can do so with relative ease.The aforementioned programmes and consultations speak to this point.

Asset management seems to be the growing niche in Islamic finance in Kuala Lumpur; thenumber of funds and assets under management on the Islamic side of asset management bothcontinue to grow. Kuala Lumpur has a wide network of banks and financial intermediariesthat support Islamic finance activity and comprises a structure of knowledgeable support anda structured web of relationships that asset managers can use to their advantage.

Kuala Lumpur and its Islamic markets stand as a tribute to the people who built them and tothose who strive to build Islamic markets further. The history, the practical examples, and thedesire for continued innovation all exist here simultaneously. Kuala Lumpur is arguably thebest destination for those who wish to study or gain experience in Islamic finance, and mostcertainly in the Islamic capital market.

NOTES

1. Hajj is one of the five sacred duties incumbent of every Muslim. The other four arethe profession of faith (Shahadah), prayer (Salat), fasting (Sawm), and alms-giving(Zakat).

2. According to law, the SC shall have a Chairman, a Deputy Chief Executive, four repre-sentatives from the Government, and three other individuals.

3. Products would include, but would not be limited to, Islamic securities, unit trusts,REITS, and structured products. Services would include but would not be limited to,fund management, venture capital, and Shariah supervision.

4. These guidelines were a breakthrough for sukuk as they were the first set of guidelinesto stipulate the criterion the regulator would want fulfilled in order for an entity to issuesukuk.

5. A definition of Shariah advisor is available in Section 2.04 of the Guidelines on theOffering of Structured Product.

6. An approved list of Islamic principles used in Shariah-compliant constructs for structuredproduct is written into the Guidelines on the Offering of Structured Product in Appendix2 titled “Approved Shariah Concepts and Principles for the Purpose of Structuring, Doc-umenting and Trading of Islamic Securities”.

7. An approved list of Islamic principles and concepts is written into the Guidelines forIslamic Fund Management in Appendix 1 titled “Shariah Principles and Concepts”.

8. Information regarding non-resident Shariah advisors is set out the Guidelines for IslamicFund Management in Appendix 2 titled “Information Required on Shariah Advisers”.

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9. Kuwait Finance House (Malaysia), Asian Islamic Investment Management, AberdeenIslamic Asset Management, BNP Paribas Islamic Asset Management, Reliance AssetManagement, Global Investment House, Saturna Capital, and Nomura Islamic AssetManagement.

10. AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions.11. IFSB – Islamic Finance Services Board.

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234

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12

Islamic Finance in Germany: Trends,Opportunities, and Potential

Azadeh Farhoush and Nicolas Schmidt

12.1 INTRODUCTION AND BACKGROUND

According to most of the existing research, Islamic finance boasts an expansion rate in thedouble digits and thus is among the fastest growing economic sectors today – even duringthe financial crisis. Some researchers even estimate “Islamic Finance” to be one of the lastremaining growth segments within the financial sector. Unsurprisingly, Islamic finance hasbecome highly en vogue for researchers in theory and practice over the past years.

12.1.1 Brief Background on Islamic Finance

Islamic finance describes the attempt to build financial services complying with the Shariah,the religious commandments and prohibitions in Islam. For Muslims, the Shariah definesthe normative basis of all aspects of life. It explains and regulates the obligations of everyindividual regarding religious practices as well as decisions and actions in everyday life.

In order to meet the demands of a Shariah-compliant method of financing, certain principlesmust be considered. Some of the more important principles are the following:1

• Prohibition against the generation of surplus money through investment: money is only tobe used as a medium of exchange and not as a commodity or product. However, if moneyis traded for money, the profit or loss should be equal on both sides. Taking interest istherefore forbidden.

• Prohibition against making profit without any risk: the predetermined gain of investedcapital from a purely financial transaction is prohibited. As a result, conventional banks andmost of their products are generally prohibited.

• Prohibition of speculation (gharar): for this reason, options, future, and forward contractsas well as conventional insurances are prohibited.

• Avoidance of business with forbidden actions and products (haram), e.g. sectors dealingwith alcohol. Investments in these sectors and any trade with them are strictly forbidden.Only products that are legitimate according to Islamic thought (halal) are sustainable.

When trying to comply with all these parameters, the necessity of an appropriate bankingsystem with specially developed products that enables economic trade while following theprinciples of Islam becomes obvious. Normally,2 the products and financing possibilities have


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to be scrutinized by a Shariah board, a commission of Islamic jurists and scholars. In practice,there are a great number of Shariah boards in each country and in general a financial institutecan choose the Shariah board with which it wants to cooperate.

12.1.2 Development and Market Potential of Islamic Finance

With the establishment of the Islamic Development Bank in 1970 through the Organizationof the Islamic Conference, a foundation was laid to support the economic development andthe social advancement of Islamic communities with regards to the principles of Shariah.After the foundation of the first Islamic banks in the 1970s, it took 15 to 20 years beforeconventional banks started to enter the market through subsidiaries offering Shariah-compliantproducts. Subsequently, more institutions were built to create standards for Islamic Bankingand Finance, e.g. the Accounting and Auditing Organization for Islamic Financial Institutionsin 1990 and the Islamic Financial Services Board in 2002. Today there are approximately 300Islamic financial institutions in 65 countries. Since there is neither international nor nationalofficial data available, there are no official indicators for the size of the market or for the volumeof Islamic finance and Shariah-compliant managed assets. However, there are a number ofestimates. First, total assets of Islamic banks reached about US$500 billion by the end of2008.3 Second, Booz & Company estimated that about US$487 billion in assets complyingwith Shariah were managed in 2008.4 Ernst & Young even estimated the market at aboutUS$763 billion, growing approximately 20% p.a. and reaching US$1000 billion by the end of2010.5

Even in the aftermath of the financial crisis, experts expect growth rates above 10% p.a.According to some experts, growth in Islamic finance could even accelerate, since interestin Islamic finance has increased – also because some Islamic Financial Institutions haveovercome the crisis much more successfully than conventional institutions due to risk andfinancial leverage restrictions.6

Of course, the major potential is located in regions and countries that have a large Muslimpopulation. While Muslims are found on all five inhabited continents, more than 60% of theapproximately 1.6 billion Muslim population worldwide lives in Asia, and about 20% in theMiddle East and North Africa. Altogether, more than about 20% of Muslims live in countriesand regions where Muslims are the minority. The countries with the largest number of Muslimsare Indonesia, Pakistan, India, and Bangladesh (see Figure 12.1).7

As the most important financial centres for Islamic Finance and Banking Kuala Lumpur,Bahrain, Dubai, and Kuwait can be named. But beyond the Orient and the Middle East, thereis a demand for Islamic finance instruments as well.

With about 38 million Muslims living across Europe (including Russia and other ex-Sovietcountries), Muslims make up the second largest religious group after Christians (see Table12.1). Due to a lack of official data, the exact number of Muslims in Western Europeancountries is not known, but can be estimated at around 15 million. Though Muslims havebeen living for centuries in Baltic and Balkan countries, as well as the Iberian peninsula,Cyprus, and Sicily, the majority immigrated as foreign workers in the 1960s and 1990s.8 Themost important countries of origin are Maghreb, Turkey, and India/Pakistan. However, theorigins of the Muslims differ widely in the European countries according to historic colonialties. While the majority of Muslims in the UK come from Pakistan, India, and Bangladesh,most French Muslims immigrated from Maghreb countries. The Muslim community in Spain

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Islamic Finance in Germany: Trends, Opportunities, and Potential 237

Countries with the Largest Number of Muslims Muslim population by region

Asia-Pacific

972,5 Mio 61,9%

Middle East -

North Africa

315,3 Mio 20,1%

Europe

38,1 Mio 2,4%Sub-Saharan

Africa

240,6 Mio15,3%

Americas

4,6 Mio 0,3% Country Estimated 2009 Muslim Population

Percentage of Population that is Muslim

Percentage of World Muslim Population

12.9% 88.2% 202.867.000 Indonesia

11.1% 96.3% 174.082.000 Pakistan

10.3% 13.4% 160.945.000 India

9.3% 89.6% 145.312.000 Bangladesh

5.0% 94.6% 78.513.000 Egypt

5.0% 50.4% 78.056.000 Nigeria

4.7% 99.4% 73.777.000 Iran

4.7% <98% 73.619.000 Turkey

2.2% 98.0% 34.199.000 Algeria

<2% <99% 31.993.000 Morocco

Figure 12.1 Muslim populations

Source: Pew Research Center’s Forum on Religion & Public Life, Mapping the Global Muslim Population, October2009

Table 12.1 Countries in Europe with the largest number of Muslims

CountryEstimated 2009

Muslim Population

Percentage ofPopulation that is

MuslimPercentage of WorldMuslim Population

Russia 16.482.000 11.7% 1.0%Germany 4.026.000 <5% <1.0%France 3.554.000 <6% <1.0%Albania 2.522.000 79.9% 0.2%Kosovo 1.999.000 89.6% 0.1%United Kingdom 1.647.000 2.7% 0.1%Bosnia-Herzeg. 1.522.000 <40% <1.0%Netherlands 946.000 5.7% 0.1%Bulgaria 920.000 12.2% 0.1%Macedonia 680.000 33.3% <0.1%Rest of region 3.814.000 1.1% 0.2%Regional Total 38.112.000 5.2% 2.4%World Total 1.571.198.000 22.9% 100.0%


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originated primarily from Morocco and North Africa. Muslims living in the Netherlands andGermany, in contrast, predominantly have their roots in Turkey.

There are two main reasons for choosing the German market for research into trends andopportunities of Islamic finance in Europe: economic relevance in Europe and the size of theMuslim community in Germany.

12.1.3 Economic Relevance of Germany

With a population of just over 80 million, Germany is Europe’s most populous country afterFrance and the UK and is a key member of the European Union and its economic, political,and defence organizations. The German economy is the fifth largest economy in the world inPPP terms, and with a GDP of €2,495 billion Europe’s largest economy (approx. 20% of GDPof the European Union) in 2008.

In regard to financial services, there are four main reasons for the relevance of Germany.Germany has the highest savings rate in the European Union: in 2008 households in Germanysaved about 17.2% of GDP.9 Furthermore, Germany carries the second largest stock marketcapitalization after UK and also ranks second in terms of financial assets of €4500 billion.When looking at the market and the demand for mutual funds, it has to be taken into accountthat some funds are domiciled abroad but are primarily sold in the home country of theprovider. Thus, Germany has the second largest mutual funds market in Europe after France.10

In addition to the key macroeconomic and financial data of Germany, Frankfurt belongsglobally to the most important financial centres. Frankfurt serves as the headquarters of theEuropean Central Bank as well as many German and international financial institutions and isa centre of financial product innovation.

The second reason for analysing the German market is the size of its Muslim communityand thus the potential for Islamic finance.

12.1.4 Immigrants and the Muslim Community in Germany

According to recent studies, there is no European country with a greater Muslim populationthan Germany.11 Since there is no differentiated governmental recording by religious affiliation,official data is not available.12 However, several surveys estimate the number of Muslims livingin Germany to range between 3.513 and 4.314 million. With an estimate of 4 million by PewResearch (2009), Germany has the tenth largest population of Muslims living as minorities inthe world, and is the only country in the EU within this top ten (see Table 12.2).

A closer look at the number of foreigners living in Germany by nationality reveals relevantinformation: about 25% of the approximately 7.2 million foreigners living in Germany (8.8% ofGermany’s total population)15 have their origin in Turkey. According to the government studyMuslim Life in Germany 2008, the Muslim community in Germany is strongly heterogeneousin regards to origin. Though the Muslim population in Germany has emigrated from over 40nations, 63% have Turkish roots, the rest predominantly hailing from the Balkans, the MiddleEast, North Africa, and Asia (see Figure 12.2).16

Financial considerations also indicate a need to establish Islamic finance in Germany:while the average income of households with Turkish roots is lower than that of equiv-alent German households, the savings rate is significantly higher than that of Germans.17

In 2004, Gassner estimated the sales potential for financial products within the TurkishMuslim community at around €2.7 billion and the assets deposited in German bank accounts

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Table 12.2 Countries with the largest number of Muslims living as minorities

CountryEstimated 2009

Muslim Population

Percentage ofPopulation that is

MuslimPercentage of WorldMuslim Population

India 160.945.000 13.4% 10.3%Ethiopia 28.063.000 33.9% 1.8%China 21.667.000 1.6% 1.4%Russia 16.482.000 11.7% 1.0%Tanzania 13.218.000 30.2% 0.8%Ivory Coast 7.745.000 36.7% 0.5%Mozambique 5.224.000 22.8% 0.3%Philippines 4.654.000 5.1% 0.3%Germany 4.026.000 <5% <1.0%


between€15 and 25 billion.18 Experts estimate the amounts saved at approximately€1.5 billionyearly.19

Furthermore, the number of Germans converting to Islam has continuously increased overthe past years. According to a study financed by the Federal Ministry of the Interior, thenumber of converts between 2004 and 2005 increased by 400%.20

Due to this approximated data concerning the Muslim community in Germany and especiallythe large Turkish Muslim community, providers in different sectors have already visiblystarted Muslim-focused “ethno-marketing” and are even offering special goods and servicesto Muslims.

12.1.5 Products and Services Focused on the Muslim Community in Germany

The first stage in addressing the Muslim community is a target-oriented marketing approachfor existing products and services. This involves using languages spoken by the Muslim

Turkey25,1%

EU-nationals (ex Italy, Greece, Poland)17,3%

Others31,3%

Greece4,3%

Serbia and Montenegro

5,2%

Poland5,8%

Italy7,7%

Croatia3,3%

Turkey63,2%

Other Africa1,5%

Central Asia / GUS0,4%

S-SO-Asia4,6%

North Africa6,9%

Middle East8,1%

Southeastern Europe13,6%

Iran1,7%

Figure 12.2 Foreigners and Muslims in Germany

Source: Statistisches Bundesamt, Auslanderzentralregister in Auslanderzahlen 2008, Bundesamt fur Migration undFluchtlinge Study: “Muslim Life in Germany”, 2008

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community in marketing campaigns and informational literature. Thus, many providers indifferent sectors offer materials in Turkish.

The second stage consists of the creation and offering of target-oriented contents and ser-vices. Even this is already widespread in some sectors. One example is the telecommunicationssector: one of the largest German mobile phone providers, E-Plus, launched a product linefocusing on Turks living in Germany with specific fees for mobile services within Germanyand from Germany to Turkey.21

In several regions, e.g. Berlin or the Ruhr, elder care facilities focusing on Muslims have beenfounded with services adhering to Muslim customs and requirements.22 The funeral industryhas also been impacted, as many German federal states have changed their law to allowcemeteries to adjust burial procedures in order to comply with the requirements of Islam.23

Insurance companies have even created insurance packages for Islam-compliant funerals.24

Germany has also been home to the first Muslim counselling centre for conflicts in marriage,family, or with children.25 Swimming pools with certain timeframes for Muslim women26 orspecific TV programmes and TV shows for Muslims27 have become more common.

Since Islamic finance is the main objective of this chapter, a closer examination of the statusquo of financial services for Muslims in Germany is necessary.

12.1.6 Status Quo of Islamic Finance and Shariah-Compliant Products in Germany

Banks and financial institutions have recognized the potential of the Turkish and/or Muslimcommunity in Germany and handled the first stage by offering information and advice inTurkish. For example, Deutsche Bank has founded its so-called Bankamiz branches that notonly offer consulting in Turkish, but also special products such as free money transfers toTurkey, as well as Muslim motifs on credit and debit cards.28 However, Shariah-compliantproducts are not offered so far.29

HypoVereinsbank (HVB) and the Turkish bank within the UniCredit Group – YapiKredi– serve customers with roots in Turkey.30 The German insurance company Helvetia in-troduced – along with materials in Turkish – Turkish speaking advisors and a Turkishspeaking customer hotline.31 Also the insurer Allianz approaches the target group directlywith Turkish speaking personnel.32 Another example is the American mutual fund companyFidelity, which provides information on retirement and investments through its German websitein Turkish.33

However, the next stage – offering a broad range of products and services for this targetgroup – has not yet been reached. In other European markets, especially in the UK, financialinstitutions have reacted faster and have begun to offer Shariah-compliant financial productsto meet the demand.34 The Islamic Bank of Britain, founded in 2003 in UK, was the firstIslamic Bank in Europe to receive an FSA licence.35 Since then the regulatory frameworkhas improved steadily: according to S&P research, by now, there are five Islamic banks, oneIslamic insurance company, and about 20 conventional banks (e.g. HSBC or Lloyds TSB)with Islamic banking units operating in London and offering Shariah-compliant accounts,financing, and investments.36 And other banks in Europe have started to participate in thismarket as well. Furthermore, experienced financial institutions in the Middle East showedinterest in entering the European market.37

France is also considering ways to adjust its regulatory framework to fit Islamicfinance.38 Even some German financial institutions have followed the trend and created

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Shariah-compliant products, but primarily for Muslims living in the fast growing marketsof Muslim countries.

12.1.7 One Clear Objective is to Attract Major Muslim Investors

In summer 2004, the German state “Saxony-Anhalt” set up a Shariah-compliant bond, a sukuk,and raised about €100 million from Arabic investors for refinancing.39 However, in GermanyShariah-compliant products for the Muslim or Turkish community are not yet offered.40 Thefirst branch of a real Islamic bank opened in mid-2010 in Mannheim. The Kuveyt Turk Bank,a Turkish-Kuwaiti bank, received a restricted banking licence from the German financialauthority (BaFin) and will offer Shariah-compliant products.41 Kuveyt Turk also plans furtherbranches in other German cities.42 With this move, other Islamic banks are expected tofollow.43

However, the two bank institutes Bankamiz and YapiKredi both state that they have notreceived major demand for Shariah-compliant investments.44 A reason could be a bad ex-perience in the past known as the Islamic Holding Scandal: in the 1990s several Turkishinstitutions, including Kombassan, Yimpash, and Jet-Pa, attracted about 200–300 000 TurkishGermans to invest approximately DM5 billion in Shariah-compliant investments. Theseinvested assets were defalcated and the majority lost its money.

This, as well as insufficient marketing activities, might have caused a low demand forShariah-compliant mutual funds in Germany. The first German company, cominvest, intro-duced the Shariah-compliant equity fund Al Sukoor in 2000. This fund, however, did notdevelop adequately, not even reaching a volume of €5 million and was terminated in 2006.45

Nonetheless, other German or European mutual fund companies, e.g. DWS Investments,followed the attempt and also introduced Shariah-compliant mutual funds. In 2008, severalShariah-compliant ETFs were approved by Deutsche Borse, e.g. db x-trackers S&P Europe350 Sharia ETF or db x-trackers S&P 500 Shariah ETF.46

Based on more than 60 different Islamic indices or supported by individual Shariahboards, today more than 350 Shariah-compliant mutual funds are provided through morethan 100 fund managers worldwide. See Table 12.3 for some examples of international assetmanagers.

From this universe of Shariah-compliant mutual funds, however, only a small part is avail-able to investors in Germany. Based on MorningStar category Islamic Funds, not even15 Shariah-compliant funds are available for public sale – and most of these have lowvolumes.

To sum up, the German market might offer high potential for Islamic finance due to itseconomic relevance and the size of its Muslim community. Though the first stage in addressingthis target group has been attempted, a broad range of Islamic products is still missing.47

The main question remains whether there really exists a demand for Shariah-compliantproducts within the Muslim community in Germany and which measures can be taken tosatisfy the needs. This chapter seeks answers to these questions and is organized as follows.In Section 12.2 we will give a brief overview on the existing research – both academicand populist – and will derive remaining questions that have not been answered sufficiently.In Section 12.3 we introduce and report key findings of an empirical study conducted on theattitudes of Muslims living in Germany towards money and investment. Section 12.4 concludesand draws implications for financial institutions in Germany.

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Table 12.3 Examples of international asset managers (ex Islamic Finance institutions) offeringShariah-compliant equity mutual funds

Active Asset Managers Product examples

Allianz Global Investors Allianz RCM Islamic Global Equity Opportunities; AllianzRCM Islamic Global Emerging Markets Equity

Alliance Unit Trust Management Alliance Dana Adib, Alliance Dana AlifCiti Islamic Portfolios SA Citi Islamic Global Equity Portfolio A, Citi Islamic Global

Equity Portfolio BCredit Suisse Asset Management CS Sicav One (Lux) Equity Al-Buraq B, CS Sicav One (Lux)

Equity Al-Buraq IDWS Investments DWS Noor Asia-Pacific Equity, DWS Noor China Equity Fund,

DWS Noor Global Equity Select FundFortis Investments Fortis Equitra Amanah, Fortis Persona AmanahHSBC Amanah Investment Funds Amanah GCC Equity (Ex-Saudi), HSBC Amanah Americas

Equity Fund; HSBC Amanah Asia Pacific Equity Fund, HSBCAmanah Pan European Equity (PPF)

ING Funds ING Ekuiti IslamOld Mutual Asset Managers Old Mutual Al Saqr FundPictet Asset Management Al Dar-World EquititiesScottish Widows Investment

Partnership Ltd.SW Islamic Global Equity Fund

SEI Investment Management SEI Islamic Emerging Markets Equity Fund, SEI IslamicEuropean Equity Fund, SEI Islamic US Equity Fund

UBS Islamic Fund Management UBS (Lux) Islamic Global EquitiesWellington Management Co. Chahine Islamic Stars Europe, Hegira Global Equity Fund

Passive Asset Managers (ETF) Product examples

Daiwa Asset Management Daiwa FTSE Shariah Japan 100DB-X-Trackers S&P Europe 350 Sharia, S&P Japan 500 Sharia, S&P 500 ShariaiShares MSCI World Islamic, MSCI Emerging Markets Islamic, MSCI

USA IslamicEasyETF DJIM Titans 100

Source: Murat Unal (2008), Sharia Investments: sicher in der Warteschleife, dpn, November/Dezember 2008

12.2 RESEARCH AND STUDIES ON THE MUSLIMPOPULATION IN GERMANY

This section aims to give a rough overview of previous research, studies, and literature, bothacademic and non-scientific, about Muslims and their relation to financial products in generaland about Islamic finance with a focus on Germany in particular. Although Germany has ahuge Muslim population, the needs and attitudes of that population have only recently begunbeing analysed. The following makes no claim to be complete.

Finally, some 40 years after the first foreign workers came to Germany, Germany has realizedthat it is important to deal more closely with its Muslim population and analyse its structureand needs, especially after 11 September 2001, and an increasing negative presentation ofIslam in the media. In September 2006 an important step was taken by establishing theGerman Conference of Islam (Deutsche Islam Konferenz DIK) through the former FederalMinister of Interior Dr Wolfgang Schauble. The DIK was created to provide a nationalplatform for dialogue between the German state and representatives of the Muslim population

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in Germany. Since there was a lack of information about the Muslim population in Germany,a first representative study was commissioned in 2007 which should give a first impressionand overview of life and religious practice. This nationwide representative study with about6,000 Muslim interviewees from 49 countries of origin was presented by the Federal Officefor Migration and Refugees. The study found a larger than expected Muslim population,heterogeneous in nature. Citizens of Turkish descent form the largest group. The study alsofound varied attitudes towards religious practice, and, in the Turkish community, distinctionsbetween Muslims and non-Muslims.

In education, challenges of structural integration come to the fore. Islamic lessons are inhigh demand. However, even as rates of higher education increase, most Muslim children stilldo not graduate from high school. According to the studies, Muslims have integrated into theGerman culture. For example, more than 50% belong to a German club, e.g. a sports club, andmost Muslim children take part in co-ed swim lessons. Only 10% refuse to take part in schooltrips. Furthermore, there are no signs of separation in terms of everyday social contacts, andMuslim associations represent a minority of the Muslims in Germany. The most well-knownassociation among Muslims is the Turkish-Islamic Union for Religious Affairs (DITIB), fol-lowed by the Central Council of Muslims in Germany (Zentralrat der Muslime in DeutschlandZMD), the Association of Islamic Cultural Centres (Verein Islamischer Kulturzentren VIKZ),and the Alevi Movement in Germany (Alevitische Gemeinde in Deutschland AABF). Onlya minority of the interviewees had heard of the Council on Islam for the Federal Republic ofGermany (Islamrat fur die Bundesrepublik Deutschland IRD) or the Coordinating Council ofMuslims in Germany (Koordinationsrat der Muslime in Deutschland KRM).48

Other research – regarding general relationships between Muslims and Christians in Ger-many – deals with the process of assimilation of Muslim and Christian immigrants on the basisof language, culture, social integration, history of migration, and ethical self-identification.The main results are that Christians assimilate faster than Muslims, especially in comparisonto female Muslims. Female immigrants and those who have completed an education in theircountry of origin are more closely connected to the country of origin than others.49

A study by Constant et al. reveals trends in integration. The degree of integration in Germansociety has a differential effect on citizenship acquisition. While a longer residence in Germanyhas a negative influence on actual or future naturalization, arriving at a younger age and havingclose German friends are strong indicators of a positive proclivity to citizenship acquisition.Likewise, ethnic origins and religion also influence these decisions. Muslim immigrants inGermany are more willing to become German citizens than non-Muslim immigrants, but thereare also fewer German citizens among Muslims than among non-Muslims.50

As previously stated, the German Government has only recently begun to pay attentionto its Muslim population, particularly in terms of needs. However, there are several separatestudies and papers concerning the behaviour of Muslims, e.g. the crime rate and also aboutthe way Germans think about Muslims. The study “Islam in Germany” for example dealswith religiousness, connection and attitude towards religious institutions, education, religiouseducation, attitude towards the state, and experience with Germans.51 A study by the Universityof Hamburg Faculty for Law Institute of Criminal Science, Department of Criminology, state-aided through the Federal Ministry of Interior in 2007, deals with integration, integrationbarriers, religion and attitudes towards democracy, rule of law, and political-religious motivatedcrime of Muslims in Germany.52

Professor Heiner Bielefeldt’s essay about attitudes of Christian Germans concerning Mus-lims reveals strong prejudices towards Muslims resulting in social exclusion.53 ElisabethNoelle and Thomas Petersen indicate that these prejudices are on the rise.54

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Studies of immigration in toto suggest that to some degree, the Muslim experience is notexceptional.55 The study Zuwanderer in Deutschland 2009 of the Allensbach Institute forOpinion Polls shows that most of the immigrants feel comfortable in Germany and want tostay there, but do not feel that the German state and Germans in general accept them, and theybelieve that children of migrants do not have the same chances that German children have.

Great Britain and France, for example, have dealt more with this subject, and have con-ducted more research. However, these nations have different historical reasons to deal withtheir Muslim population (e.g. colonialism) and have entirely different Muslim populations,emigrating from past colonial ties.

A study on Muslims in the European Union in 2006 shows that there is generally a lack ofofficial statistical information about Muslims in Europe. It underlines the fact that there is agreat deal of prejudice against Muslims and that they are often victims of negative generaliza-tion. Therefore many Muslims have restricted possibilities because of their religion.56

12.2.1 Research and Studies on Financial Services and Islamic Finance

The aim of this part is to give an overview about research and studies in the field of Islamicfinance worldwide, in Europe and in Germany. There is substantial academic literature onIslamic finance and banking, critical as well as uncritical. This area of research has risenespecially in recent years and therefore it is en vogue in politics, practice, and science, butfundamental questions remain. The following outline makes also no claim to be complete butshows several selected surveys.

Since the financial crisis, there have been more and more articles, lectures, and conferencesabout Islamic banking and finance. There is a wide range of information about Islamic bankingand finance and much discussion as to whether Islamic Banking and Finance might offera solution to the current crisis-ridden system. Such literature describes the basics of thesystem, including its general performance, its similarities to and differences from conventionalbanking, and its advantages and disadvantages. Here a plethora of books and articles can befound, e.g. “handbooks” of Islamic banking and finance. The following is a sample of otherliterature which deals with the regulatory framework and basic aspects of economics andfinance according to the principles of Islam worldwide: Chapra (1982), Khan (1968a), Nasib(2008) and Rifaat and Archer (2002).

Some works which demonstrate how certain conventional products can be made Shariah-compliant or how new and innovative products can have the Shariah as their basis are:Batchvarov and Gakwaya (2006), Global Investment House (2007), Jobst (2007a,b), andKamali (2001, 2007). Jobst (2007a) presents a valuation model that helps to illustrate Shariah-compliant synthetication of conventional finance through an implicit derivative arrangement.

Furthermore, there is much academic literature about Shariah-compliant funds, e.g. aboutfunds in selected countries such as Indonesia, Malaysia, USA, or Egypt. They include the anal-ysis of Shariah-compliant benchmarks, characteristics of risk and return, and the performanceof Shariah-compliant funds. An example is the article of Bose and McGee (2008), Islamicinvestment funds, in which different kinds of Islamic funds are presented and analysed. Otherpapers within this research topic include the following:

• Abdullah, Mohammed, and Hassan (2007) analyse differences in terms of performancebetween Islamic and conventional mutual fund in the context of the Malaysian capitalmarket.57

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• Annuar, Shamsher, and Ngu (1997) examine the performance of 31 Malaysian mutual fundsover the period 1990 to 1995. Many of these funds are Islamic and thus provide a roughproxy for Islamic fund performance. They find empirical evidence that these Malaysianfunds did outperform their Kuala Lumpur Composite Index benchmark.58

• Hayat and Kraussl’s empirical study about the performance and risk-return characteristics of145 IEFs over the period January 2000 to February 2009 analyses the effect of the currentfinancial crisis (2008–09), as well as the effect of a previous bear market year (2002).In addition, they study the downside risk of IEFs. They show that that IEFs are relativeunderperformers compared to the Islamic market. Moreover, this underperformance seemedto have increased during the current financial crisis, during which IEFs also underperformedconventional benchmarks.59

• Shakahan (2007) Islamic Funds outperforming, www.maxfunds.com.

In addition, some research investigates Islamic finance in specific countries (e.g. Saudi Arabia,Iran, and Malaysia) analysing the possible advantages of Islamic banking in these nations. Thequestion of a possible adaptation to the West and how Islamic banks can be established in aconventional banking system is often discussed:

• Man (1988) “Islamic Banking: The Malaysian Experience”.• Sole (2007) describes the main phases in the process of establishing Islamic banks and the

challenges a country will face when developing Islamic banking alongside conventionalinstitutions.60

• Toutounchian (2004) reasons that economic problems and difficulties of many nations havebecome so complicated that capitalistic economics, as admitted by Western economists,cannot possibly respond accordingly. A scientific approach to Islamic Banking has beenapproached in recent years to heal the institutionalized problems faced by capitalism. Theseshort-term solutions may act to pacify the wounds inflicted on the system. Toutounchianwrites that “it takes a theory to kill a theory” and that “the remedy cannot be anything butthat offered by Islamic economics”. Muslim scientists should use their thinking capacity,and the capacity of their interaction with one another, and through avoiding mixing thecontent of capitalism with that of Islam, they can present mankind an alternative route.61

• Aburime (2008) draws some useful insights on Islamic banking in Nigeria and says that anemergence of fully-fledged Islamic banks in Nigeria should be expected in the near future.62

• Bashir (2000) writes about the experience in the Middle East.63

• Khan and Mirakhor (1989) write about Islamic banking in Iran and Pakistan,64 Maeda(2008) about Islamic finance in Japan,65 and Salim (2007) in China.66

Most of the literature about Islamic finance in Europe deals with the situation in the UK.London has become a centre for Islamic finance. One reason is that the UK has changed itstax policy and regulative framework and has encouraged the development of Islamic bankingand finance. Therefore, a number of large international banks have opened Islamic bankingfacilities in London.

Ainley et al. (2007) give a regulatory perspective about the UK as a global hub for Islamicfinance, the role of the Financial Services Authority (FSA) and risks and challenges faced byIslamic firms in UK in the retail and wholesale market. The existence of a single regulatorybody, the FSA, and its policies provide a suitable environment for the registration of Islamicbanks.67

Dar (2004) writes that there is no huge demand for Islamic finance at present but thatit is growing and that it is expected to further increase if correct marketing measures are

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adopted. He outlines that the factors of south-north divide, income, educational attainment,and occupation affect the demand for Islamic finance in the UK.68

Academic research about Islamic finance in Germany can hardly be found. A study on behalfof the Ministry for Food, Agriculture and Consumer Protection (BMELV) analysed immigrantsand financial services in 2005. Gleisner et al. (2009) analysed the bank nationality choice offoreign-born retail banking customers among 1000 Turkish immigrants in Germany. The keyfindings have been that product differentiation explains the choice of a home nation bank andthat ethnic origin in itself provides the strongest comparative advantage for the foreign bank.69

A study by Booz & Company in 2008 found that there is a market potential of about €1.2billion a year in Germany and that most of the Muslims would like to have Islamic constructionand consumer financing and insurances although many Muslims were once deceived (in theIslamic Holding Scandal). But German financial institutions are hesitant.70

Therefore, there still remain many unanswered questions, especially concerning Germany,some of which we will answer through our survey in Section 12.3.

12.3 ANALYSIS OF THE ATTITUDES AND PREFERENCES OFTHE MUSLIM POPULATION IN GERMANY TOWARDS

FINANCIAL PRODUCTS

12.3.1 Research Questions and Assumptions

As we have shown, Germany has a large and long established Muslim community of whichthe largest is the Turkish community and among which the number of young people is veryhigh. Therefore, there is a huge potential for Islamic finance in Germany, but many questionshave not yet been adequately analysed.

This section analyses the attitudes and preferences of the Muslim population in Germanytowards financial products and aims to provide solutions to the following list of concerns thatmust be addressed before establishing a Shariah-compliant financial system:

• Is there a real demand for Shariah-compliant products in Germany?• Which products are most in demand?• What is the composition of the target group?• What are the attitudes of the Muslim population in Germany towards investments, retirement

arrangements, and financial institutions in general?• What impact does religiosity have on attitudes towards finance-related issues?• What knowledge do Muslims have in the field of banking and finance in general, and in the

field of Shariah-compliant financing in particular? What is the impact of knowledge?

12.3.2 Methodology and Approach

To provide answers to these questions, several steps were taken.At first a qualitative preliminary survey was conducted by interviewing 28 Muslims (practis-

ing and non-practising) in Cologne, which has an immigrant population of 19%.71 Interviewswith the target group allow a fuller picture than can be derived from statistics alone. All thepractising interviewees expressed huge demand for mortgaging. They suffer from the deficitof living a life according to the rules of Islam in an environment where Islam is not popu-lar. Therefore they resorted to searching for alternatives or even keep their money at home.This is true of non-practising Muslims as well. Muslims in Germany feel that they are not

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understood by the German state and think that Germany is not ready for the establishment ofShariah-compliant financing and investment as is the UK, for example. To better understandthe situation, a questionnaire with three qualitative questions and more than 50 quantitativequestions with standardized answer scales was generated as the basis for an online survey.This questionnaire took the findings of the preliminary survey into account.

A pre-test was conducted to prove the comprehensibility and clarity of the questions. Only afew adjustments had to be made. The participants were recruited with the help and cooperationof several institutes like the Institute for Islamology Amir Zaidan (Islamologisches InstitutAmir Zaidan). Other institutions and associations were also asked to help.72

Potential participants were asked via email to take part and to forward the link to ensure ahigh and representative number of participants.

12.3.3 Description of the Dataset

The online survey was opened and viewed by 781 visitors, 151 of whom just opened the linkbut did not participate. From the remaining 630 who started the survey, 257 stopped answeringthe survey questions at some point; 373 completed the questionnaire. In all, 47.8% of thosewho opened the survey completed it, an above average rate that demonstrates the high qualityof visitors addressed (see Table 12.4). On average the completion of the questionnaire tookabout 20 minutes; the median time to complete was 17.5 minutes.

Among the participants the proportion of females was slightly higher with around 58% asagainst 42% male participants. Two-thirds of the participants were between 21 and 30 with anaverage age of 30.5 and a median age of 29 years. Those aged between 25 and 30, comprisingone-third of the respondents, formed the largest group in terms of age range. Only 4% of theparticipants were aged below 20, so the vast majority were of age. At 93%, the overwhelmingmajority of the participants were Muslim – 75% by birth, and 25% being converts.

While the converts mainly originated in Germany, the participants who were Muslim by birthhad their origin in Turkey (30.3%), Morocco (16.5%), and Iran (ca. 5%). However, regardlessof the country of origin, 71% of the participants were born in Germany. Consequently, about70% have been living in Germany for more than 10 years and almost 60% have been living inGermany for over 20 years. The majority were born and raised in Germany, and almost 80%of the participants have German citizenship. Half of the participants plan to stay and live inGermany in the long term; while about 9% of the participants plan to return to their countryof origin, some 18% have not thought about future location.

The participants were very well educated, with 62.5% having a high school diploma andeither a university or university of applied science degree. Only 13% of the participants donot have any kind of degree. About three-quarters of the participants are currently working –either full- or part-time. Thus, a large proportion of participants have disposable income: 27%

Table 12.4 Survey completion statistics

Questionnaire. . . No. %

. . . opened and viewed 781 100.0%

. . . started 630 80.7%

. . . started and stopped/broke up 257 32.9%

. . . completed 373 47.8%

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of the participants state that after deducting all costs from income, less than €500 remain fordisposition such as saving or investing. However, 30% state that their money for free disposalis up to €1000 and another 30% have up to €2000 every month.

Figure 12.3 provides an overview of key statistics.Another important description of the dataset in the context of this analysis is the religiousness

of the survey participants. Approximately 70% of the participants stated they were veryreligious practising Muslims. This includes praying as instructed in Islam and obeying therestrictions and conventions for eating and drinking. Almost 80% of the participants stated thatthey fast during Ramadan and 40% of the participants reported going to the Mosque regularly.Almost 70% of the participants stated that religion guides all their decisions (see Figure 12.4).

The survey results correspond well with established research, with, for example, a perfectcorrespondence between survey results regarding country of origin and larger populationstudies. The survey successfully reached the target group of likely investors – those who willstay in Germany.

One possible bias could be the educational level of the participants, which seems intuitivelyto be above average. However, as more second and third generation Muslims enter the schoolsystem, we can expect an analogous increase in educational levels. The same applies to thehigh rate of employment and high level of disposable income.

Another problem could be the high religiousness of the participants, which might resultfrom cooperating with Muslim associations and also from having almost 25% of participantsbeing converts, who are usually above average in religiousness.

12.3.4 Quantitative Results

The quantitative results reveal some interesting information on attitudes regarding banks,financial products, and financial knowledge as well as the use of banking and financial productsby Muslims living in Germany.

12.3.4.1 Banking

As expected, 98.4% – almost all – of the participants have at least one account with a Germanbank, which is very reasonable since the participants are predominantly employed and employ-ers require a German bank account. In keeping with statistics regarding the German populationin toto, more than half of the participants use the “Sparkasse” – a German savings bank.

Unfortunately we cannot measure the effect that the financial crisis has had on trust inconventional banks. More than 50% of the participants have greater trust in banks and financialinstitutions that follow the principles of Islam, than in banks and institutions that do not actin accordance with Islam. Even more participants state that it is important for them that theirbank in Germany adheres to Islamic rules. Only 18% answer to the contrary (see Figure 12.5).

As a large proportion of the participants has some kind of employment and disposableincome, the use of the money is relevant. About a third of the participants saves monthly eithertraditionally at home or in a savings account. This corresponds to the finding that Turks livingin Germany save on average more than Germans.73 Surprisingly, only 16% of the participantsreport transferring money to support the family in their country of origin. Furthermore, only6% report investing in their country of origin – on the one hand this can be explained throughthe high percentage of participants that plan to remain in Germany in the long run. On theother hand, only 19% of the participants report investing in Germany.

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Country of birth

Country of origin

Overview on participants statistics

22.5%Germany

30.3%Turkey

Morocco

Iran

Tunesia

Syria

Bosnia

Pakistan

India

Iraq

Others

16.6%

4.6%

3.2%

2.9%

1.1%

0.8%

0.3%

0.3%

17.4%

Answer categories

5.9%Others0.5%Tunesia0.5%Syria0.5%Serbia0.5%Poland0.5%Lebanon0.5%France0.8%Afghanistan1.6%Egypt3.5%Iran6.2%Turkey7.0%Morocco

71.8%Germany

Answer categories

Years living in Germany

Highest educationdegree

26.0%n.a.0.8%< 5 years

3.8%> 5 years12.3%> 10 years

39.1%> 20 years18.0%> 30 years

Answer categories

Vocational programme (Ausbildung)

Traineeship (Lehre)

No degree

22.5%

2.7%

13.1%

University of AppliedScience 20.6%

41.0%University

Answer categories

Planned return to country of origin

49.6%No, I plan to stay in Germany in the long-run.

8.5%Yes, I plan to return to my country of origin in the long

I will shuttle between the countries.

In the long-run, I want to move to another country.

I have not thought about it so far.

16.5%

7.4%

18.0%

Answer categories

Money for free disposalafter deducting all costs

Variable Attribute No. Share

57.9% 216 Female Sex

42.1% 157 Male

by age range

<20 4.3%

21-25 23.3%

25-30 32.4%

30-35 21.7%

35-40 8.0%

Age

Average: 30.5

Median: 29.0

>40 10.2%

52.0% 194 Yes, full-time employed

12.9% 48 Yes, part-time employed

11.5% 43 Yes, mini-job

Employment (yes/no)

23.6% 88 No, not employed

Yes 347 93.0% Muslim

(yes/no) No 26 7.0%

24.4% 91 Yes

68.6% 256 No Converted Muslim (yes/no)

7.0% 26 n.a.

Blue-collar worker 17 4.6%

White-collar worker 155 41.6%

Public officer 8 2.1%

Self-employed/freelancer 39 10.5%

Trainee 10 2.7%

Student 92 24.7%

Retired person 1 0.3%

Housewife/-man 24 6.4%

Unemployed 8 2.1%

Social situation

Others 19 5.1%

High school graduation 233 62.5% Highest schooldegree

Vocational diploma 58 15.5%

CSE 23 6.2%

9.1%> 2500 EUR4.3%2001 EUR - 2500 EUR

10.2%1501 EUR - 2000 EUR19.3%1001 EUR - 1500 EUR

30.6%501 EUR - 1000 EUR26.5%< 500 EUR

Answer categories

Figure 12.3 Overview of key statistics

P1: TIX



34.0%35.1%I am very religious

7.0%29.2%40.8%I am a practitioning Muslim.

7.0%16.9%51.2%I pray as instructed by Islam.

7.0%10.2%67.8%I fast during Ramadan.

7.0%14.5%45.8%I am planning the Hadj within the next 10 years.

7.0%17.2%24.7%I am going to Mosque regularly.

7.0%21.2%53.6%I strictly obey food restrictions.

7.0%5.9%74.0%I strictly obey the prohibition of alcohol.

7.0%

7.0%

41.3%The religion is the guide for all my decisions.

n.a.6

26.8%

432 51

Answer Scales (1=Agree …. 6=Disagree)

Figure 12.4 Statements on religiousness

Based on the dataset one can infer that the higher the level of religiousness, the more likelythat saving takes place in a traditional Islam-compliant way. This thesis can be confirmed: theproportion of the participants reporting that they save money in a traditional way at home ishigher for the participants who also evaluate themselves as very religious than for participantswho do not see themselves as religious. This relation – only the other way around – applies toinvesting in Germany. The support of family or saving in a savings account is not influencedby religiousness (see Figure 12.6).

12.3.4.2 Financial Products and Investments

To be able to save and invest, it is essential to have the necessary financial knowledge. However,similarly to equivalent surveys on the total population, financial literacy in general is very low.Just 14% of the participants assess their knowledge to be broad. Two-thirds instead evaluatetheir knowledge to be between low and very low. Considering the above-average educationallevel of the participants, this indicates that the financial literacy amongst the lower educationallevel must be even lower, and thus inadequate.

Though self-assessed financial literacy is low, the majority of the participants know or haveat least predominantly heard of “savings accounts”, “stocks”, and “real estate” as a financialproduct or investment. Almost two-thirds have heard of “mutual funds”. The use of theseproducts, however, is lower. Only 50% use a savings account in Germany; 15% own stocks orreal estate and 22% use mutual funds in some way (especially for retirement savings). Almost athird of the participants use no financial products. The use of financial products in their countryof origin is even lower, again suggesting that Germany is the basis of living for the participants.

Even though the participants in the survey report being very religious and also have greatknowledge of Islam, the knowledge specifically on the handling of money and investments inIslam is also very low: only about 15% of the participants evaluate their knowledge as broad.This low level of knowledge explains why less than 30% of the participants know or haveheard of certain Islamic financial products such as Musharakah, Mudarabah and so on (seeFigure 12.7).

P1: TIX


Att

itu

de

on

ban

ks in

Ger

man

y N

amed

Ger

man

ban

ks f

or

acco

un

t

13.9

%C

omm

erzb

ank

/ Dre

sdne

r B

ank

18.3

%D

euts

che

Ban

k12

.8%

Gen

osse

nsch

afts

bank

/ V

olks

bank

51.8

%S

park

asse

Pos

tban

kC

itiba

nkS

onst

ige

15.3

%2.

5%19

.9%

0.0%

12.1

%5.

9%23

.6%

30.8

%

0.0%

12.6

%5.

4%17

.2%

44.2

%

n.a.

65

43

21

Ans

wer

Sca

les

(1=

Agr

ee …

. 6=

Dis

agre

e)

I tru

st in

ban

ks a

nd fi

nanc

ial i

nstit

utio

ns m

ore,

that

follo

w Is

lam

ic p

rinci

ples

, tha

n ba

nks

and

finan

cial

inst

itutio

ns, t

hat d

o N

OT

follo

w th

e pr

inci

ples

.

For

me,

it is

impo

rtan

t tha

t my

bank

in G

erm

any

adhe

res

rule

s an

d pr

inci

ples

of I

slam

.

Fig

ure

12.5

Atti

tude

sto

bank

ing

251

P1: TIX


Use

of

dis

po

sab

le in

com

e af

ter

ded

uct

ing

all

cost

s…

… b

y re

ligio

usn

ess

… in

gen

eral

30.8

%T

here

is n

o re

sidu

al

Sen

d to

cou

ntry

of o

rigin

to s

uppo

rt th

e fa

mily

32.4

%S

avin

g (a

t hom

e)

33.0

%

5.9%

Sav

ing

(in a

sav

ings

acc

ount

)

16.4

%

18.5

%In

vest

in G

erm

any

Inve

st in

cou

ntry

of o

rigin

Ans

wer

cat

egor

ies

7.7%10

.0%

I rat

her

disa

gree

33.3

%I r

athe

r ag

ree

33.6

%I a

gree

42.0

%I a

bsol

utel

y ag

ree

I abs

olut

ely

disa

gree

I dis

agre

e

7.7%

“I a

m v

ery

relig

iou

s”S

avin

g (

at h

om

e)

30.8

%

35.0

%

33.3

%

32.0

%

29.8

% 38.5

%

Sav

ing

(o

n a

sav

ing

sac

cou

nt)

38.5

%

35.0

%

16.7

%

17.6

%

13.7

%

15.4

%

Inve

st in

Ger

man

y

23.1

%

5.0%

28.6

%

17.6

%

13.7

%

15.4

%

Sen

d to

cou

ntry

of o

rigi

n to

su

ppor

t the

fam

ily

Fig

ure

12.6

Use

ofdi

spos

able

inco

me

252

P1: TIX



Self-assessment of knowledge on financial products and handling of money and investment in Islam

Known financial and investment products

Answer categories

28.7%

2.9%

27.6%

31.9%

4.3%

Very broad knowledge

Broad knowledge

Some knowledge

3.5%4.3%

9.9%11.3%

19.8%20.6%

Little knowledge

Insufficient knowledge

No knowledge

35.1%

… handling of money and investment in Islam

… on financial products in general

5.9%

59.0%Commodities (Gold)83.9%Real estate / mortgages

65.4%Mutual Funds

86.3%Stocks95.7%Savings accounts

None of the named products

Others

1.6%

Answer categories

Knowledge of Islamic financial products Use of financial products ….

… in country of origin

… in Germany

13.4%49.1%Savings accounts

4.8%15.3%Stocks

5.6%22.0%Mutual Funds

11.3%15.5%Real estate / mortgages

4.8%9.7%Commodities (Gold)

50.9%31.6%

None of the named products1.9%

5.1%Others

Answer categories

30.3%Musharakah

22.0%Mudarabah

27.6%Murabaha

23.1%Qard al-hasanah

22.0%Sukuk

20.9%Ijarah

Answers

Figure 12.7 Financial knowledge and use of financial products

Surprisingly, the Imam of the mosque is named as a key monetary advisor by only 5% of theparticipants. For 40% of the participants, the bank advisor is named as an important advisoron financial and investment issues, and independent advisors have been named as importantby 25% of the participants. Family and friends however are not only named as importantadvisors by around 40%, they are also named as the most trusted. Bank advisors in contrastare only trusted by 18% of the participants. This illustrates the necessity of building trust (seeFigure 12.8).

Some important parameters for advising are investment objectives and risk attitudes. Hereour participants report similar needs to those of the general population who might prefer con-ventional banking. The most often named objectives are the creation of wealth and retirementsavings. Short-term gains are named by only 12% of the participants. Furthermore, financingof religious activities is an objective for about 22% of the participants – mainly those who arevery religious and are planning the Hadj within the next 10 years. In terms of risk attitudes,the participants are predominantly risk averse: only 20% would evaluate themselves as riskseekers. To concretize: almost half of the participants are unwilling to take any loss on invest-ments, about 30% would accept up to 10% loss, and the rest are willing to accept higher losspercentages (see Figure 12.8).

12.3.4.3 Obeying Islamic Principles and Shariah Compliance

Regarding the focus of this analysis, the most interesting question concerns the importance ofadherence to Islamic rules for financing and investments. The results are clear: Islamic rules andprinciples definitely matter. More than 70% of the participants state that compliance with theprohibition of interest and speculation is very important. The same applies with regard to invest-ing: for these 70% it is also important to act in compliance with Shariah. In order to be Shariah-compliant, these participants are even willing to receive lower returns (see Figure 12.9).

P1: TIX


Ris

k at

titu

des

In

vest

men

t o

bje

ctiv

es/m

oti

vati

on

F

inan

cial

ad

viso

rs

Ans

wer

cat

egor

ies

5.4%

19.3

%

33.2

%

10.5

%

20.9

%

Ban

k ad

viso

r

Inde

pend

ent F

inan

cial

A

dvis

or (

IFA

)

Fam

ily

39.9

%18

.2%

26.5

%23

.6%

42.9

%45

.8%

Frie

nds

Imam

in M

osqu

e

Oth

ers

38.6

%

… m

ost t

rust

ed

… m

ost u

sed

for

a

dvis

ory

9.4%

Oth

ers

Fin

anci

ng o

f rel

igio

us p

lans

12.1

%R

etur

n

40.2

%

7.5%

Wea

lth c

reat

ion

22.0

%

35.7

%R

etire

men

t pla

nnin

g

No

obje

ctiv

e

Ans

wer

cat

egor

ies

25.5

%H

igh

risk-

aver

sion

55.0

%R

isk-

aver

sion

15.5

%R

isk-

seek

ing

4.0%

Hig

h ris

k-se

ekin

g

Ans

wer

cat

egor

ies

Fig

ure

12.8

Atti

tude

sto

finan

cial

advi

sors

254

P1: TIX



3.8% 12.3%15.8%56.8%

4.0% 9.7%17.4%54.4%

13.7%3.2%17.2%53.6%

654321


It is very important to me, to obey prohibition of interest.

It is very important to me, to obey prohibition of speculation.

It is very important to me, to follow rules and principles of Sharia regarding investments.

Figure 12.9 Relevance of Shariah compliance and adherence of Islamic principles

Looking at these important attitudes towards investing, two points become obvious:

• The higher the knowledge of laws regarding the treatment of money and investment inIslam, the higher the importance of obeying the rules of Islam regarding investing.

• The higher the level of religiousness, the higher the importance of living in a Shariah-compliant way.

The results of this survey can confirm both points. With decreasing knowledge of moneyand investing in Islam, the proportion of participants not affirming the importance of obeyingthe prohibition of interest and speculation, as well as Shariah-compliance and willingness toreceive lower returns, increases. The same applies to religiousness. The affirmation of theprohibition of interest, speculation, and compliance with the rules of Shariah is lower forparticipants with lower levels of religiousness (see Figure 12.10).

12.3.4.4 Market Potential for Shariah-Compliant Products in Germany

Having seen the preferences and attitudes and thus the willingness to be Shariah-compliant,the next step is to analyse the relevant products. The following overview of the purchasewillingness of certain conventional financial products, versus purchase willingness for thesame products rendered Shariah-compliant, provides details. About 46% of the participantsare generally willing to use a savings account; this proportion increases to almost 75% ifthe savings account were to be Shariah-compliant. The same effect applies for stocks, wherethe proportion of participants willing to buy stocks increases from 25% to 50% if Shariah-compliant and for mutual funds from 25% to 52% (see Figure 12.11).

For a proper estimation of the potential of Shariah-compliant products in the Germanmarket, it might be of interest to differentiate the intentions and willingness in relation to thefuture plans of the participant. The following graph illustrates that for the participants planningto remain in Germany long term, Shariah-compliant products are of interest, especially forsavings accounts, real estate, and mutual funds: participants are more likely to use products thatare Shariah-compliant. For example, 23.4% of the participants wanting to remain in Germanyare willing to buy stocks. However, if the stocks are Shariah-compliant, the proportion doubles.The same holds true for mutual funds: 52% of the participants who want to remain in Germanyin the long run are willing to buy funds if they are Shariah-compliant (see Figure 12.12).

When asked for which products they have a need for Shariah compliance, participants mostoften name financing (loans) and real estate financing/mortgaging. But still, more than 50%of the participants state a need of Shariah compliance for retirement savings and insurances.

P1: TIX



Relevance of Shariah compliance along self-assessed knowledge of handling money and

investment in Islam

No knowledge 68.8%12.5%

Insufficient knowledge 47.1% 16.0%

Little knowledge 59.2% 6.8%

Some knowledge 71.4% 9.1%

Broad knowledge 64.3% 2.4%

Very broad knowledge 68.8% 6.3%

Self-assessment of knowledge on handlung of money and investment in Islam


43.8%18.8%

46.2% 13.4%

55.3% 5.8%

61.0% 6.5%

71.4% 2.4%

68.8% 6.3%


47.1%

68.8%0.0%

17.6%

8.7%55.3%

64.9% 9.1%

61.9% 4.8%

68.8% 6.3%


93.8%6.3%

34.5%65.5%

79.6% 20.4%

26.0%74.0%

83.3% 16.7%

75.0% 25.0%

Willingness to receive lowerreturns for Sharia-compliance

Relevance of Shariah compliance along religiousness

No knowledge 68.8%12.5%

Insufficient knowledge 47.1% 16.0%

Little knowledge 59.2% 6.8%

Some knowledge 71.4% 9.1%

Broad knowledge 64.3% 2.4%

Very broad knowledge 68.8% 6.3%

Self-assessment of knowledge on handlung of money and investment in Islam


43.8%18.8%

46.2% 13.4%

55.3% 5.8%

61.0% 6.5%

71.4% 2.4%

68.8% 6.3%


47.1%

68.8%0.0%

17.6%

8.7%55.3%

64.9% 9.1%

61.9% 4.8%

68.8% 6.3%


93.8%6.3%

34.5%65.5%

79.6% 20.4%

26.0%74.0%

83.3% 16.7%

75.0% 25.0%

Willingness to receive lowerreturns for Sharia-compliance

Figure 12.10 Relevance of Shariah compliance

23.1%23.1%Savings account, in general

12.6%24.7%48.5%Savings account, if sharia-compliant

38.1%15.8%8.6%Stocks, in general

25.2%16.1%33.5%Stocks, if sharia-compliant

34.6%15.0%10.7%Mutual funds, in general

24.1%19.0%33.0%Mutual funds, if sharia-compliant

21.4%22.0%30.6%Real estate / mortages, in general

10.5%18.2%55.2%Real estate / mortages, if sharia-compliant

24.4%22.0%21.2%Commodities (Gold), in general

25.2%

19.6%41.0%Commodities (Gold), if sharia-compliant

6

17.4%

432 51


Figure 12.11 Willingness to purchase or to buy financial products “in general” vs. “if Shariah-compliant”

P1: TIX


Yes

, I p

lan

to r

etur

n to

my

coun

try

of o

rigin

in th

e lo

ng-r

un.

No,

I pl

an to

sta

y in

Ger

man

y in

the

long

-run

.

I will

shu

ttle

betw

een

the

coun

trie

s.

In th

e lo

ng-r

un, I

wan

t to

mov

e to

ano

ther

cou

ntry

.

I hav

e no

t tho

ught

abo

ut it

so

far.

80.4

%49

.0%

76.2

%38

.1%

68.1

%61

.7%75

.2%

43.3

%62.5

%37

.5%

whe

n sh

aria

-com

plia

nt

Con

vent

iona

l, no

t sha

ria-c

ompl

iant

Sav

ings

acc

ount

Sto

cks

56.9

%21

.6%

57.1

%19

.0%

55.3

%31

.9%

48.2

%23

.4%

50.0

%25

.0%

Rea

l est

ate

72.5

%41

.2%

66.7

%52

.4%70

.2%

57.4

%77.3

%51

.8%70

.8%

58.3

%

Mut

ual f

unds

58.8

%21

.6%

52.4

%14

.3%

46.8

%25

.5%

51.8

%25

.5%

54.2

%33

.3%

Com

mod

ities

60.8

%41

.2%

61.9

%42

.9%53

.2%

46.8

%63.1

%39

.0%54

.2%

41.7

%

Fig

ure

12.1

2W

illin

gnes

sto

purc

hase

orto

buy

finan

cial

prod

ucts

“in

gene

ral”

vs.“

ifSh

aria

h-co

mpl

iant

”in

plan

ned

futu

re

257

P1: TIX



About a third of the participants also name mutual funds. This is particularly the case withparticipants who have a greater knowledge of the handling of money and investments in Islam.To sum up, the higher the knowledge on rules of Islam concerning money and investments,the stronger is the need for investment solutions (see Figure 12.13).

For conventional financial institutions, the main question is whether Muslims that are inter-ested in Shariah-compliant products are also willing to buy or use these products from conven-tional institutions, generally do not act according to the rules of Islam. Figure 12.14 illustratesthe result. More than half of the participants are willing to use or buy Shariah-compliantproducts from a conventional institution. This percentage is even higher for participants forwhom the compliance of Shariah is very important.

The only requirement is that the Shariah compliance is certified and ensured by a trustedinstitution.

Table 12.5 provides an in-depth description of the participants who may consider buyingShariah-compliant products from conventional banks or institutions and of the participantswho are not willing to use savings accounts, stocks, mutual funds, and insurances unless theyare Shariah-compliant.

In addition, three qualitative questions about the need for Shariah-compliant products andfurther development were asked.

12.3.4.5 Qualitative Results on Future Development

The qualitative results show that most of the descendants of foreign workers want to live andinvest in Germany. The answers of the interviewees indicate a huge demand, mostly in thefield of mortgaging, followed by loans (consumer loans, loans for start-ups, student loans etc.),retirement provisions, and money investments (investment funds, stocks). Basically there isa need for Shariah compliance in every aspect of retail banking (e.g. solutions for Shariah-compliant accounts, savings books) and in every kind of financing (e.g. car financing). Manyinterviewees said that Muslims are waiting to be offered a variety of serious Shariah-compliantgoods and are not investing but hoarding their money until such products are available: “I hopethat Germany is able to work out a deliberate offer of Shariah-compliant financial possibilities.They have already hesitated too long.”

Respondents indicated that the financial crisis has made them more leery of conventionalinvestments, and more comfortable with Shariah-compliant investments, which they see as lessrisky. Many mentioned that the use of Shariah-compliant products should not be restricted toMuslims alone, but rather be made available to non-Muslims as well, although many Muslimsdoubt the tolerance in Germany: “Germany shows low interest in its Muslim population whichis not only seen in the financial sector.” “The Germans would be annoyed. Never endingdebates would be the result.” Additionally, the “predominantly Islam hostile tenor in mediaand politics” is seen as a barrier to acceptance among the German population. But if safeinvestments were achieved through Shariah compliance, the Shariah aspect would be toleratedand the offers would increase. Talking about ethical products in the first place and then aboutShariah or Islamic products could be a method of achieving long-term success.

But the opinion is that there has to be certification because with a rise in offers, hypocriticalinstitutions will also increase. Additionally – to avoid defalcation – an offer of Shariah-compliant products should be combined with education, consulting, and efficient marketingmethods, e.g. in the Turkish media (television, newspapers, etc.). It is important that theproducts are offered by Muslims in order to regain the trust of Muslims, who have often

P1: TIX


Dem

and

for

Sh

aria

hco

mp

lian

ce fo

r …

. D

eman

d fo

r S

har

iah

co

mp

lian

ce fo

r se

vera

l pro

du

cts

alo

ng

sel

f-as

sess

ed k

no

wle

dg

e o

n h

and

ling

of

mo

ney

an

d in

vest

men

t in

Isla

m

54.7

%

43.7

%U

nive

rsity

/ co

llege

fina

ncin

g

67.8

%M

orta

ges

/ rea

l est

ate

finan

cing

33.8

%M

utua

l Fun

ds

71.6

%F

inan

cing

/ lo

ans

12.3

%O

ther

s

Ret

irem

ent p

lann

ing

59.0

%In

sura

nces

Ans

wer

s

69.7

%

77.7

%Li

ttle

know

ledg

e

70.1

%S

ome

know

ledg

e

76.2

%B

road

kno

wle

dge

75.0

%V

ery

broa

d kn

owle

dge

No

know

ledg

e

Insu

ffici

ent k

now

ledg

e

37.5

%

Sel

f-as

sess

men

t o

f kn

ow

led

ge

on

han

dlin

g o

f m

on

ey a

nd

inve

stm

ent

in Is

lam

Dem

and

for

Sh

aria

com

plia

nce

for

fin

anci

ng

/ lo

ans

26.9

%

34.0

%

42.9

%

33.3

%

62.5

%

12.5

%

Dem

and

for

Sh

aria

com

plia

nce

for

mu

tual

fun

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259

P1: TIX



59.5%13.9%

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654321


I am planning to purchase stocks within the next 12 months.

I am planning to purchase mutual funds within thenext 12 months.

I could imagine to buy sharia-compliant products,that are offered by a conventional institute.

Figure 12.14 Purchase intention and willingness to use cooperation of conventional institutions forShariah-compliant products

been deceived. “You have to be careful not to give the Muslims the feeling of putting themat a disadvantage and just making profit out of their need.” Therefore it is important to makesure that the products will be developed together with Shariah scholars and experts and notpeople who have no knowledge about Islam. Furthermore the products should be positionedseparately from conventional products because otherwise Muslim customers could assumefraud.

Regarding the development in Germany most of the interviewees remain pessimistic aboutthe next three years. They think that little or no success will be achieved. Perhaps conventionalbanks will establish “Islamic windows” to gain experience, but nothing more. However, theyare more optimistic about the next 10 years and think that Germany cannot avoid offeringShariah-compliant products or establishing Islamic banks. Basically, there is the opinion thatGermany has to emulate the UK by creating a legal framework and conditions as well asproviding education. At the same time clear definitions and laws in Germany should be putinto writing so as to properly inform the people. It is necessary for definitions and fundamentalsto be clear and documented.

The demand is so huge. Most Muslims would terminate the agreement with their bank andswitch to an Islamic bank. There is a huge market gap in Germany.

12.4 CONCLUSION AND PRACTICAL IMPLICATIONS FORFINANCIAL INSTITUTIONS IN GERMANY

The main question posed in Section 12.1 of this chapter, whether there is a demand and thusmarket potential for Shariah-compliant products in Germany, can be answered thus: “Yes,there is a huge demand.” The Muslim community in Germany is an attractive target group forfinancial institutions and it is hardly possible to underestimate the gain in long-term customersatisfaction in the Muslim community. Most of the Muslims do not plan to return to theircountries of origin, but rather plan to stay in Germany and, therefore, predominantly state ademand to invest in real estate, self-employment, and education.

One important finding is that Muslims in Germany have higher trust in Islamic institutionsthan in conventional institutions. There is a high relevance of Shariah compliance, especiallyfor those with a higher level of religiousness. Additionally, bank advisors are relevant sourcesbut not the persons most trusted. Persons of trust are mainly family members or Muslimsin general. Another key finding is the low knowledge on financial matters in general and onmoney and investment affairs in Islam.

P1: TIX


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P1: TIX



Therefore there is the need for action in several fields to cover this demand successfully. TheGerman state and the financial institutions have to realize these given facts and react properly.The attempts made hitherto by some financial institutions were not successful possibly becausesome important aspects were not considered.

12.4.1 An Offer of Shariah-Compliant Products According to Needs

The attitudes and behaviour regarding the use of financial products and services of Muslimsare different from those of non-Muslim customers, e.g. the different way of saving. The maindifferences and needs have been pointed out in this chapter but nevertheless every institutionhas to find out the special needs of its own customers and act according to these needs. Animportant step would be to work closely together with Muslim organizations. When doing soit is necessary to keep the different culture and way of thinking in mind.

12.4.2 Improvement of Financial Education and Consultancy

The majority of Muslims in Germany do not have enough knowledge about finances. In orderto sell financial products within this target group, it is necessary to increase that knowledge.The financial institutions have to provide more information, e.g. in the form of multilin-gual brochures which many providers in different sectors have already realized, as shown inSection 12.1.

Furthermore, financial institutions have to work with scholars who are experts in Islamin order to gain the trust of Muslims because the confidence of the Muslim population inGermany has to be restored. At the same time there has to be a culture- and nationality-specific consultancy with native-speakers and Muslims as persons of trust. An offer of lecturesor speeches and consultancy in groups could also be useful to begin with, because the basicneeds of some population strata are certainly similar, especially in the early stages. Generally,institutions have to act very carefully so that their Muslim customers do not feel that they arebeing taken advantage of because of their needs. In this context, it is vital to remember thatMuslim communities are tight-knit, and positive word-of-mouth is extremely important.

Moreover, it is important to mention that conventional institutions have to educate their ownemployees regarding cultural aspects and handling of this special customer group.

12.4.3 Elaboration of Marketing Activities

A main reason for the failure of offered products until now might be the inappropriate useof media and marketing. It will take an intelligent sales and marketing effort to introducethese products. To become successful it is important to use efficient marketing methods, e.g.advertisement in Turkish newspapers or commercials during Turkish television programmes.It is also important to change the negative images of Islam in Germany because otherwise thenon-Muslim population could feel uncomfortable when they realize that conventional financialinstitutions offer Shariah-compliant products. The positive aspects of these products have tobe explained to the non-Muslim customers and it has to be clarified that these products can beused by them as well. At first, the word “ethical” can be used instead of “Shariah-compliant”.

But all this cannot work properly without the cooperation of the German state itself. Oneissue is the regulatory framework in Germany. For example, due to regulations, Shariah-compliant mortgage rates are double those of conventional mortgages. In this context the UK

P1: TIX



can serve as a model. Furthermore actions to prevent swindles and victimization are veryimportant.

Germany is at the very beginning of the development of offering Shariah-compliant productsand services. The demand and market potential is there. It is now up to the financial institutionsand the German state to overcome hurdles and offer the right combination of regulatoryframework, education, and confidence building.

NOTES

1. Cf. Farhoush (2007), p. 51.2. An exception is for example Iran, where an Islamic law for Banking and Finance exists.3. Cf. Stocker (2008).4. Cf. Beecken (2009).5. Cf. Weissenborn and Prange (2009).6. Cf. Volkery (2009).7. Cf. Miller (2009).8. Cf. EUMC (2006).9. Source: Savings rate 2008 according to Eurostat Data and central banks.

10. Source: Data Assets end 2008 taking into account funds domiciled abroad and promotedby national providers in their own country, the foreign-domiciled funds promoted byforeign providers in each country, and the home-domiciled funds sold abroad, cf. EFAMAfact Book, 7th edition (2009), p. 40.

11. Cf. Pauly (2009).12. Cf. Bundesamt fur Migration und Fluchtlinge.13. http://www.remid.de.14. Cf. zeit online (2009), Carstens (2009).15. Cf. Bundesamt fur Migration und Fluchtlinge.16. http://www.bamf.de/cln 101/nn 442016/SharedDocs/Anlagen/DE/Migration/Publikation

en/Forschung/Forschungsberichte/fb6-muslimisches-leben.html? nnn=true andhttp://www.bamf.de/SharedDocs/Anlagen/DE/Migration/Publikationen/Forschung/Forschungsberichte/fb6-muslimisches-leben,templateId=raw,property=publicationFile.pdf/fb6-muslimisches-leben.pdf.

17. Cf. Middendorf (2008).18. Cf. Gassner (2004).19. Cf. Knappmann (2008).20. http://www.spiegel.de/politik/deutschland/0,1518,459544,00.html.21. http://www.spiegel.de/wirtschaft/0,1518,419477,00.html.22. Cf. Bernau (2009), welt online (2008).23. Cf. Unknown author (2009).24. http://www.handelsblatt.com/unternehmen/banken-versicherungen/man-spricht-

tuerkisch;1229010.25. Cf. Wildemar (2009).26. Cf. welt online (2008).27. Cf. Exo (2007).28. http://www.wdr.de/themen/politik/nrw02/integration/ethnomarketing/index1.jhtml.29. Cf. Middendorf (2008).30. http://www.pressbot.net/article l,1,i,83840.html.

P1: TIX



31. http://www.foonds.com/article/3014.32. http://www.allianzdeutschland.de/presse/news/news 2009-10-08.html.33. http://www.holtzbrinck-schule.de/pshbs/fn/holtzbrinckschule/sfn/bp/nv/46/bk/372/index.

html.34. Cf. Beecken (2009).35. Cf. Gassner (2004).36. Cf. Beecken (2009), Weissenborn and Prange (2009).37. Cf. Booz & Company (2008).38. Cf. Fehr (2008).39. Cf. Knappmann (2008).40. Cf. Pauly (2009).41. http://www.n-tv.de/wirtschaft/Scharia-Bank-eroeffnet-Filiale-article551846.html.42. Cf. Pauly (2009).43. Cf. Middendorf (2008).44. Cf. Seibel (2009).45. Cf. Knappmann (2008).46. Cf. Gansneder (2008).47. Cf. Gassner (2004).48. Cf. Federal Office for Migration and Refugees (2006).49. Cf. Constant et al. (2006).50. Cf. Constant et al. (2007).51. Cf. Sen and Sauer (2006).52. Cf. Brettfeld and Wetzels (2007).53. Cf. Bielefeldt (2006).54. Cf. Noelle and Petersen (2006), S. 5.55. Cf. Constant et al. (2006).56. Cf. EUMC (2006).57. Cf. Abdullah et al. (2007).58. Cf. Annuar, Shamsher, and Ngu (1997).59. Cf. Hayat and Kraussl (2009).60. Cf. Sole (2007).61. Cf. Toutounchian (2004).62. Cf. Aburime (2008).63. Cf. Bashir (2000).64. Cf. Khan and Mirakhor (1989).65. Cf. Maeda (2008).66. Cf. Salim (2007).67. Cf. Ainley et al. (2007).68. Cf. Dar (2004).69. Cf. Gleisner, Hackethal, and Rauch (2009).70. Cf. Booz & Company (2008).71. http://www.koeln-nachrichten.de/neues-aus-nrw/statistik/koeln auslaender einwohner

statistik.html.72. E.g. VIKZ, IGMG, DITIB, Haus des Islam, VDM ev., ATIB, DIMS Dusseldorf, deutsche

muslim-liga hamburg, deutsche muslim-liga bonn, Herr Dr Ibrahim Ruschoff – IASE,Islamische Gemeinde Saarland e. V. (IGS), Islamisches Zentrum Munchen, Islamisches

P1: TIX



Zentrum Hamburg e.V., Islamisches Zentrum Aachen (Bilal Moschee) e.V., Institut furIslamfragen.

73. Cf. Middendorf (2008).

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Aburime, T.U. (2008) Islamic banking theories, practices and insights for Nigeria, International Reviewof Business Research Papers, 5(1), 321–39.

Ainley, M., Mashayekhi, A., Hicks, R., Rahman, A. and Ravalia, A. (2007) Islamic Finance in the UK:Regulation and Challenges, FSA.

Annuar, M.N., Shamsher, M. and Ngu, M.H. (1997) Selectivity and timing: evidence from the perfor-mance of Malaysian unit trusts, Pertanika Journal of Social Science and Humanities, Vol. 5.

Archer, S. and Rifaat, R.A. (2002) Islamic Finance: Innovation and Growth, Euromoney InstitutionalInvestor PLC.

Bashir, A.-H. (2000) “Assessing the Performance of Islamic Banks: Some Evidence from the MiddleEast”, in American Economic Association Annual Meeting, New Orleans, Louisiana.

Batchvarov, A. and Gakwaya, N. (2006) Principles and structures of Islamic finance, Merrill Lynch,European Structured Finance – ABS (8 September) London.

Beecken, G. (2009) Das letzte große Wachstumsfeld, Manager Magazin, 8 July 2009.Bernau, V. (2009) Krankenbett auf Turkisch, Sueddeutsche.de, 17.07.2009.Bielefeldt, H. (2006) Das Islambild in Deutschland, Deutsches Institut fur Menschenrechte.Bose, S. and McGee, R.W. (2008) Islamic Investment Funds: An Analysis of Risks and Returns, Florida

International University Chapman Graduate School of Business, working paper, 2 December.Brettfeld, K. and Wetzels, P. (2007) Muslime in Deutschland: Integration, Integrationsbarrieren, Religion

sowie Einstellungen zu Demokratie, Rechtsstaat und politisch-religios motivierter Gewalt.Booz & Company (2008) Pressemitteilung, 22.07.2008.Carstens, P. (2009) Viel mehr Muslime als gedacht, Frankfurter Allgemeine Zeitung vom 24 June 2009.Chapra, M.U. (1982) “Money and Banking in an Islamic Economy”, in Ariff, M. (ed.) Monetary and

Fiscal Economics of Islam, Jeddah: International Centre for Research in Islamic Economics.Constant, A., Gataullina, L., Zimmermann, K.F. and Zimmermann, L. (2006) Clash of Cultures: Muslims

and Christians in the Ethnosizing Process.Constant, A.F., Gataullina, L. and Zimmermann, K.F. (2007) Naturalization Proclivities, Ethnicity and

Integration.Dar, H. (2004) Demand for Islamic Financial Services in the UK: Chasing a Mirage?EFAMA (2009) Fact Book 2009 Trends in European Investment Funds, 7th edn, October 2009.EUMC (2006) Muslims in the European Union – Discrimination and Islamophobia.Exo (2007) ZDF startet Angebot speziell fur Muslime, welt online, 6 July 2007.Farhoush, A. (2007) Leasing als Shariakonformes Finanzierungsinstrument, Leasing- Wissenschaft &

Praxis, Nr 2.Federal Office for Migration and Refugees (2006) Muslim Life in Germany.Federal Office for Migration and Refugees: Auslanderzahlen 2008.Fehr, B. (2008) Islamische Finanzprodukte haben viel Zulauf, 23 July 2008.Gansneder, T. (2008) Deutsche Borse lasst Sharia-konforme ETFs zu, 28.08.2008.Gassner, M. (2004) Der weltweite Markt fur Islamic Finance, in: Die Bank 11/2004.Gleisner, F, Hackethal, A. and Rauch, Ch. (2009) Migration and the Retail Banking Industry: an

examination of immigrants’ bank nationality choice in Germany.Global Investment House (2007) Sukuks – A dawn of a new financial era.Jobst, A.A. (2007a) Derivatives in Islamic finance, Islamic Economic Studies, 15(1).Jobst, A.A. (2007b) The Economics of Islamic Finance and Securitization, Journal of Structured Finance,

13(1), 1–12.Kamali, M.H. (2001) Islamic Commercial Law – An Analysis of Futures and Options, Cambridge, UK:

Islamic Texts Society, Ch. 10.

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Khan, M.A. (1968a) Theory of Employment in Islam, in Islamic Literature, XIV (4), 5–16.Khan, M.S. and Mirakhor, A. (1989) IB as Experienced in Iran and Pakistan.Knappmann, L. (2006) Islamic Banking: Rendite ohne Zinsen, Manager Magazin, 20 February 2006.Kraussl, R. and Hayat, R. (2008) Risk and Return Characteristics of Islamic Equity Funds.Maeda, T. (2008) The Dawn of Islamic Finance in Japan.Man, Z. (1988) “Islamic Banking: The Malaysian Experience”, in Ariff, M. (ed.), Monetary and Fiscal

Economics of Islam, Jeddah: International Centre for Research in Islamic Economics.Middendorf, S. (2008) Halal statt Haram, in: Zeit Online, 10 May 2008.Miller, T. (2009) Mapping the Global Muslim Population: A Report on the Size and Distribution

of the World’s Muslim Population, Pew Research Center, http://pewforum.org/newassets/images/reports/Muslimpopulation/Muslimpopulation.pdf, retrieved 2009-10-08.

Nasib, H. (2008) Islamic Finance – A Global Proposition, in Capco Institute Bulletin, 26 June.Noelle, E. and Petersen, T. (2006) Eine fremde, bedrohliche Welt, Frankfurter Allgemeine Zeitung.Pauly, Ch. (2009) Gewinne in Gottes Namen, Spiegel 43/2009, 19.10.2009.Salim, N. (2007) China’s Scope for Islamic Finance, published in Islamic Finance News, 4(4).Seibel, K. (2009) Finanzaufsicht lockt Islam-Banken, 30 October 2009.Sen, F. and Sauer, M. (2006) Islam in Deutschland – Einstellungen der turkischstammigen Muslime,

ZfT-aktuell, Nr. 115.Shakahan (2007) Islamic Funds outperforming, www.maxfunds.com.Sole, J. (2007) Introducing Islamic Banks into Conventional Banking Systems.Stocker, F. (2008) Der Koran verandert die Finanzindustrie auch außerhalb muslimischer Lander, 13

January 2008.Toutounchian, I. (2004) Islamic Banking: A Last Ditch to Save Capitalism.Unknown author (2009) Mit dem Gesicht gen Mekka – Muslimische Bestattungen in Deutschland,

12.09.2009.Volkery, C. (2009) Islambanken: Mit Allahs Hilfe durch die Finanzkrise, 02.05.2009.Weissenborn, Ch. and Prange, S. (2009) Islamic Banking wachst deutlich, Handelsblatt, 04.06.2009.welt online (2008) Spezielle Angebote fur Muslime, 3. August 2008.Wildemar (2009) Weltweit erste muslimische Seelsorge, dw-world.de, 04.09.2009.zeit online (2009) Mehr Muslime in Deutschland als bekannt, 23. Juni, 2009.

Websites accessed in January and February 2010:http://www.allianzdeutschland.de/presse/news/news 2009-10-08.html.http://www.foonds.com/article/3014.http://www.handelsblatt.com/unternehmen/banken-versicherungen/man-spricht-tuerkisch;1229010.http://www.holtzbrinck-schule.de/pshbs/fn/holtzbrinckschule/sfn/bp/nv/46/bk/372/index.html.http://www.integration-in-deutschland.de/nn 282926/SubSites/Integration.http://www.koeln-nachrichten.de/neues-aus-nrw/statistik/koeln auslaender einwohner statistik.html.http://www.n-tv.de/wirtschaft/Scharia-Bank-eroeffnet-Filiale-article551846.html.http://www.pressbot.net/article l,1,i,83840.html.http://www.remid.de.http://www.spiegel.de/politik/deutschland/0,1518,459544,00.html.http://www.spiegel.de/wirtschaft/0,1518,419477,00.html.

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13

Islamic Finance in France: An EmergingMarket?

Ibrahim-Zeyyad Cekici and Laurent Weill

France is often considered as potentially the most important market for Islamic financeactivities in Europe. This is motivated by two main reasons. On the one hand, France hasthe greatest Muslim community in Europe. On the other hand, the good relationships betweenthis country and governments from Middle East and North African (MENA) countries areexpected to favour the establishment of financial institutions originating from these countries.

As we will see in this chapter, these prejudices are partly true but must nevertheless be setagainst the economic and legal aspects of Islamic finance issues in France. The first section ofthis chapter develops the legal acts which are fundamental to appraise the evolution of Islamicfinance in France. The second section is then devoted to the development of economic aspectsfor the expansion of Islamic finance in France. In doing so, we stress the key elements on thedemand side and on the supply side.

13.1 LEGAL ASPECTS

French law has already had some connections with Islamic law. We can notably cite theexamples of “contrats de commodat” which are close to moudaraba, “contrats d’aval” (aval)(hawala), or even “vente a remere” (inah sale) (Affaki, 2009).

The major issue is the fact that, even if interest is legally used in France, Islamic law stillprohibits its application. However, some authors argue that Islamic law can compromise withthe practice of interest as “giving less importance to the psychological investigation of theacting person, Muslim law seems to have been less stringent in the prosecution of usuriousactivities” (Richard, 2005: 38). They prolong this argument by arguing that French law hasintroduced the mohatara technique thanks to Islamic legal rules. It is a “vente a remere” which,for instance, allows A to sell forward a good for 1500 to B, while B resells it for a cash priceof 1000.

This instrument was condemned by the Church in 1679. We are then inclined to comparethis mohatara to the inah sale (Bay al Inah) which is prohibited by all madhab. In line withthis, the loan with interest could also be covered by the incorporation of a company (sharikat)where the income of partners was fixed ex ante without a real participation in profits and losses.

This shows that a substantial part of the French doctrine is aware of the practice of Islamicfinancial institutions (Cekici, 2008; Saint Marc, 2008). However, we can observe that theseinstitutions are still not present in France and that, since the recent decision of the Constitutional


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Council which we will comment upon later, no legislative reform has been implemented. For alarge share of the population living in France, French law is devoid of any religious element inits respect for the principle of secularism. Its interpretation is however related to the politicalclimate. Depending on political power, secularism can be considered in its active form, itspassive form, or in the form of secularism-neutrality. We prefer to adopt this latter view,which is in line with what has been adopted by the French Republic in its relations with theChurch. This is shared with Islamic finance protagonists, while the French legal system hasundergone a small revolution by including the terms mourabaha and sukuk in tax conventions.This revolution was initiated by the Financial Market Authority in 2007 when issuing a noteon Islamic mutual funds and also in 2008 on sukuk.

An attempt to change the “Code napoleonien” was expected to allow the methods for sukukstructuring by the adoption by the French Parliament of several paragraphs changing the legalstatus of “fiducie” (the French version of a “trust”, i.e. an arrangement whereby propertyis managed by one person for the benefit of another). It was blocked by the ConstitutionalCouncil in October 2009. We will now present the positions of public authorities and the likelylegal evolution for Islamic finance in France.

13.1.1 The Positions of Public Authorities

13.1.1.1 Islamic Finance and the French Parliament

The French Parliament is composed of the National Assembly and the Senate. Both are infavour of the emergence of a legal framework for Islamic finance. Following the organizationof two round tables on Islamic finance in the Senate, a report was published referring to theposition of members of Parliament and other participants. It demonstrates that the willingnessto welcome Islamic financial institutions as “a growing interest for this economic system” exists(Rapport d’Information du Senat, 2008: 7). The French legislator nevertheless mentioned that“this round table has allowed us to stress the paradoxical situation of France regarding Islamicfinance: the existence of a certain national inactivity while the development of Islamic financewould not come up against an obstacle”. More precisely, “the participants to both round tableshave considered that no insurmountable legal or fiscal obstacle to the development of Islamicfinance on the national territory exists”.

After a short period, the adoption of legal arrangements was expected to legally secure thestructuring of several Islamic financial products. Unfortunately, legislative debates have beenfocused only on sukuk.

Indeed, article 66 B of the Bill of 16 March 2009 on the simplification of the law was setaside as a more thorough analysis was needed. This article was about to establish some specificcharacteristics of an Islamic type for the “fiducie” status newly included in French law. Sixteennew paragraphs were to have been included in the law including article 2014 according towhich “[t]he ‘fiduciaire’(settler) acting for the ‘fiducie’ can, in an agreement with the trustees,issue financial instruments which represent the ownership of assets included in the holdingsof the ‘fiducie’ ”.

Besides, the parliament archives give us a very interesting position of the commissionwhich has adopted a legal status for the improvement of the newly adopted French trust called“fiducie”: “we propose here to adapt the ‘fiducie’, which results from a law in February 2007[. . .]. The ‘fiducie’ can be the vehicle for issuances of bonds compliant with the principleof so-called Islamic finance. After all, there is no reason for all these operations to take

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Islamic Finance in France: An Emerging Market? 269

place elsewhere than Paris, notably London where, for more than ten years, the requiredregulatory, legislative, tax adjustments have been implemented to allow the emergence and thedevelopment of this field.”1

We must however specify that sukuk structuring can also be done through other legalarrangements. We notably think of securitization funds replacing the former “fonds communsde creance” (debt mutual funds). Those funds could invest in receivables and in all kindsof debt.

From this point on, the Constitutional Council stopped the legislative process.

13.1.1.2 Islamic Finance and the Juridical Power

The Constitutional Council has cancelled article 16 which was included in the text of the billadopted at first reading by the Senate on 9 June 2009. The motivation of this decision was thatthis article was contrary to the Constitution because it is considered to have no link – evenindirect – with the arrangements included in the bill which aim to favour the access to creditof small and medium-sized companies.2

As a consequence, this decision was only motivated by a legal flaw. Article 16 was adoptedto complete article 2011 of the Civil Code with a more general arrangement. It would haveallowed the structuring of sukuk thanks to the arrangements of the French law.

We must also stress a decision of the French Supreme Court of Judicature (“Cour deCassation”). This court gave a judgment on 3 May 2007 in favour of an Islamic bank accused bya publication of belonging to a terrorist network. It considered this information to be libellous.

13.1.1.3 Islamic Finance and Executive Power

After the establishment of an “Islamic Finance” Commission in Europlace, some proposalsfor the adaptation of the legal framework have been implemented. This was first demonstratedby the publication of doctrinal forms, and then by the publication of tax instructions on 25February 2009 and on 23 July 2010 in order to clarify mourabaha, tawarruq, istisna, ijara andsukuk legal and tax frameworks in France (Cekici, 2009).

Thus, the operations backed by mourabaha and sukuk currently benefit from tax neutrality.According to these texts, sukuk are securities which represent for their holder a debt securityor a participating security for which the return and the capital are indexed on the performanceof one or several assets held by the issuer, which are allocated to the payment of the returnand the repayment of sukuk. Their holders benefit from an indirect right to joint ownership onthese assets that they can exercise in case of bankruptcy of the issuer. The assets are tangibleassets or the usufruct of these assets.

For the tax administration, sukuk are considered as debt instruments which benefit fromtax-deductible interests.

This scheme respects the French tax rationale devoted also to operations backed bymourabaha. This latter operation is considered as a sale contract according to which a sellersells an asset to an Islamic financer (an Islamic bank or an ad hoc subsidiary established by thebank or by a third party to the investor) who resells it to the investor in exchange for a price(which includes a mark-up covering, notably, the financial cost for the financial intermediary,which is paid later).

This tax scheme exempts mourabaha operations from taxation on the mark-up when fiveconditions are met. These conditions are those required by Islamic law to recognize the Islamic

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legality of operations backed by mourabaha, such as operations on securities or on the LondonMetal Exchange.

13.1.1.4 Islamic Finance and the Regulatory Body

The Comite des etablissements de credit et des entreprises d’investissement (CECEI) gives theagreement for practising banking activities in France. In the Senate Report, it has particularlystressed the ability of the company to realize its development objectives in a way which iscompliant with the safety of customers and the banking system. It appeared clearly in 2008that the CECEI is not familiar with all the specific characteristics of Islamic banks so that itsposition may be influenced by prejudices – it assumed that Islamic banks do not have riskmanagement departments and it required that the mechanism for the prevention of moneylaundering and terrorism financing must be subjected to particular care.

This institution has repeated that Islamic banks must respect the legal rules of French lawand the Monetary and Financial Code by stressing the internal control which must guaranteeboth French and Islamic compliance. This supposes a double legality when Islamic bankspropose their products to their customers.

This double legality creates certain problems for the CECEI as it considers “the articulationbetween the role of the Shariah Board and that of the governance and internal control unitboards” but also decides that “the existence of the Shariah Board in charge of controlling thecompliance of financial products with Islamic principles comes under the internal free decisionof the institution, following the example of institutions which propose products of sociallyresponsible investment. However its role will have to be limited to this task for controlling andcertifying Islamic products. It can not be extended further and can not interfere with generalgovernance of the bank and its terms for internal functioning.”

In fact the CECEI regards with suspicion the influence of the Shariah Board on managers ofan Islamic bank. This could lead to a conflict of interest between those managers looking foreconomic viability and profits, and the Shariah Board using its reputation to keep decisionscompliant with Islamic law but economically unprofitable. Indeed, the moral influence ofthe Board is a guarantee of the Islamic legality of banking products, but its fatwas havethe disadvantage of submitting managers to factors which are not economic but social ortheological.

Conversely, the Shariah Board could also be influenced, which has led the Islamic FinancialServices Board to enact Islamic governance standards which should be taken up by the Frenchbanking regulator (Islamic Financial Services Board, 2008).

Furthermore, the CECEI requires that Islamic banks are continuously able to respect pru-dential rules.

The “Autorite des marches financiers” (AMF) is in charge of financial markets. It can givethe agreement to Islamic funds and can supervise the sukuk in a regulated French financialmarket. On 2 July 2008 it published a note allowing the listing of sukuk on a French regulatedmarket. It attempts to define sukuk by considering a summa divisio according to which asak can be an asset-backed security or an asset-based security. Thus, the AMF has been onestep ahead of the legislator on this issue. This is not as surprising as it may first appear, asthis institution has contributed to discussions of the International Organization of SecuritiesCommissions (2008) on sukuk.

Information requirements are particularly important. If a new security like sukuk does notcorrespond to a specific category of securities, additional information is required.

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According to Michel Storck (2008), the issuance of sukuk under French law can take theform of participating securities regulated by article L. 228-17 of the Commercial Law, or elsesubordinated bonds regulated by article L. 228-97.

In the report of the Senate, the deputy general secretary of the AMF (Bruno Gizard)mentioned that an Islamic fund can offer its products in France: “We have recently agreed toa mutual fund mentioning in its documents that it respected criteria decided by a committeecomposed of French bishops and was compliant with catholic religion. Similarly, we hadthe opportunity in November 2006 to agree a first mutual fund created by BNP ParibasAsset Management: Easy ETF DJ Islamic Market Titans 100. This mutual fund [. . .] aims atreplicating the performance of the Dow Jones Islamic Markets Titans 100 index, this indexbeing composed of 100 stocks of the world’s largest world companies respecting Shariahprinciples” (Rapport d’Information du Senat, 2008: 47).

Indeed, the AMF published a note on 17 July 2007 with the more general suggestion that itsdeputy general secretary implicitly meant to give a signal to managers and trustees of Islamicfunds. This note develops the requirements of the regulatory authority and relates Islamicmutual funds to ethical funds.

Among the requirements, the management company must preserve its autonomy with theShariah Board. While the company carries out the selection of securities, the latter can onlygive an opinion. This selection must then be compliant with legal arrangements. Islamic fundscannot make a selection based for instance on discrimination according to the religion ofmanagers of companies issuing the securities.

Another specific aspect of Islamic funds is however permitted in French law: the redis-tribution of a share of revenues considered as impure to a charitable organization for thepurification of those revenues. This is possible when the brochure makes mention of the bene-ficiary which must however have the status of an officially recognized non-profit organization(“un organisme reconnu d’utilite publique”).

13.1.2 The Trends

Regarding the trends in Islamic finance, we must stress from a legal perspective on the onehand that reforms will continue and on the other hand that a new concept deserves to berecognized by the authorities.

The Finance Minister again announced during a conference in Paris on 3 November 2009that tax instructions would be published in order to eliminate all tax obstacles for operationsbased on ijara, istisna, and mousharaka.

All protagonists are impatient for France to proceed with reforms. In order to placate thesecularist lobby, we put forward an idea according to which Islamic banks could undertakecredit operations thanks to a legal framework which is already in force, and which only requireslegal clarifications.

No textbook of Islamic law (fiqh) provides a general theory of credits. This loophole inIslamic law is the consequence of the absence of a state-level or even an international-levellegal framework. However, we may question whether it is the role of France to provide a legalbasis for this concept. France may benefit by taking opportunity, especially when consideringthe fact that it has the largest Muslim population in Europe.

In France, banking operations are defined by articles L. 311-1 and L. 311-2 of theMonetary and Financial Code. They are: (1) deposit operations, (2) credit operations,

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(3) operations of management of means of payment, (4) connected banking operations(exchange, consulting . . .).

If we only consider credit operations, it is surprising that the French legal framework canaccommodate Islamic credit operations without the need for any change in the law.

Articles 1874 and following of the Civil Code develop the legal regime of loans. It followsfrom these articles that the loan is free in principle, i.e. it is not intended to produce income,which allows us point out a similarity with qard hassen. However, article 1905 permits thestipulation of interest, but only as an exception. This exception has of course become theprinciple for bank credit. It thus results from a legal investigation that interest is not an elementdefining credit, nor a method of remuneration of the banker that can be ignored. It is onlyan execution procedure of the credit contract. However, article L. 313-1 of the Monetary andFinancial Code acknowledges that credit is costly but does not explicitly require the stipulationof interest.

Following doctrine and case law, participating earnings are acceptable as long as partiesfreely assent. Stoufflet (2007) recalls that parties involved in a credit contract have freedomin the choice of the mode of earnings, which can be fixed or variable, or even random butdeterminable as it is the result of a return on investment.

For this reason we can imagine an Islamic credit operation based on the participating loanruled by article L. 313-13 of the Monetary and Financial Code. This constitutes financialassistance to companies which can be granted by the State or by banks. This assistanceis considered as equity and is paid with fixed interest which can be increased by a profitparticipation clause.

The participating loan is in fact a hybrid form of credit under Islamic and French laws. Itcan be the legal basis for Islamic finance operations based on moudaraba, mousharaka anda mix between declining mousharaka and ijara. Thus, as pointed out by Serhal (2007), thereis nothing in French law preventing an interest rate set at zero, and payment of the Islamicbanker based on the principle of profit and loss sharing is feasible.

Moreover, mourabaha is now considered as an operation of Islamic credit in French law bythe tax authorities because of the granting of a repayment period in accordance with case lawfrom the Court of Justice of the European Union.

We would also mention that French law recognizes that the credit operation is the provisionof funds in exchange for the manufacturing or the supply of a good or a service at a later date.The issue here is to offer a legal vehicle for operations such as ijara, istisna, or salam, whichis provided by article L. 311-20 of the Consumer Code which regulates allocated credits.

There is also an issue regarding the obligation to inform the customer of the total cost ofIslamic credit. Article L. 313-2 of the Consumer Code requires that each loan contract mentionsthe global effective rate (including interest, fees, etc.). As observed by Serhal and Cekici (2009),Islamic credit will have to respect this requirement for information and transparency. Thereis no text prohibiting a zero interest rate, which could be replaced by a return resulting fromfinancial results or by the specification of a mark-up, or finally by a mixture of both Islamicmethods.

13.2 ECONOMIC DIMENSIONS

In spite of the efforts of the French authorities and of the willingness of a few Islamic banksfrom the Middle East, there is no Islamic bank established in France with activities in Franceas of the beginning of 2010.

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The analysis of Islamic finance in France can thus focus on the description of the industryin this country, but rather on the perspectives of this industry. To this end, our aim is to presentthe key factors for the expansion of Islamic finance in France by considering separately thedemand side and the supply side.

13.2.1 The Demand Side

As observed by Visser (2009), “there is a demand for Islamic financial products, otherwisethere would be no Islamic financial institution”. A similar reasoning allows us to considerthat the willingness of some Islamic banks to enter the French market supports the existenceof a demand for Islamic financial products. However, two questions emerge. First, we maywonder whether observers or potential entrants do not overestimate the effective demand forIslamic financial products. Secondly, the question is to know whether this demand exists notonly for wholesale activities but also for retail activities. To address these issues, we presentthe available elements and interpretations for both markets.

Wholesale markets concern large companies and government entities. Several argumentssuggest the existence of a demand for Islamic financial products on these markets. For theState, a key argument in favour of a demand is the large level of debt. As of end 2009, the debtof the French State amounted to €1,489 billion. The amount in itself is not an indication of theimportance of the indebtedness. However, the ratio of public debt to GDP was 77.6% at end2009. Forecast figures at end 2009 even predict an increase to 87.1% for 2012. Therefore, thehigh level of public debt in France has as its main consequence that the French State must takecare of finding funds to finance its debt. This element, in addition to competition from otherindebted European states looking for funds, is a driving force favouring the development ofIslamic financial products like sukuk.

For government entities, the demand can be expected to increase in the near future for twobasic reasons. The first is the fact that the French Government is currently delegating more andmore prerogatives to local entities (“regions”, “departements”). The second is the crowding-out effect resulting from the high level of public debt. As a consequence, increasing needs forand decreasing access to funds with the assistance of the State should favour increased demandof governmental entities for financial products such as Islamic financial products, which allowfunds to be obtained from a new class of investors.

For companies, at first glance, the use of Islamic loans and of sukuk can be an alternativemeans for companies to have access to funds. One can nevertheless question the demand forsukuk in France by observing the limited development of bond markets in comparison withother countries such as the US. Indeed, French companies are well known to make less useof bonds than US companies. World Bank data show that the ratio of private bond marketcapitalization to GDP was 48.5% in France as compared with 125.1% in the US for 2007 (Beck,Demirguc-Kunt, and Levine, 2000). This point suggests qualifying the optimistic expansionof sukuk issued by French companies.

The demand for Islamic financial products on retail markets is a subject of controversy inFrance. This can be explained by the difficulties in obtaining clear information on this issuein the absence of some experience in the market. The claim that there is a high demand forIslamic financial products may also be the result of an attempt on the part of Islamic banksto promote such products. Indeed the existence of a strong demand for retail Islamic financialproducts would be a key argument in favour of the entry of Islamic banks with a view tofavouring the access to credit for a part of the French population. The argument is that some

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French people would be reluctant to use conventional financial activities which would thendeny them access to credit (notably mortgage loans and professional loans) for them. Thesepeople would then suffer from credit rationing and would not be able to have access to realestate property.

The key argument in favour of the existence of a demand for retail Islamic financial productsis the large Muslim population in France. Indeed France is the Western European country withthe largest Muslim population. The French Senate notably mentioned in 2008 that “Francehas the first Muslim community in Europe with about 5.5 million people in comparison with2.5 million in the UK” (Rapport d’Information du Senat, 2008: 10). Therefore, the underlyingidea is that a very substantial share of this population would be willing to consume Islamicfinancial products. While we can agree with the intuitive idea of a positive relationship betweenthe Muslim population and the use of Islamic financial products, this argument however suffersfrom several limitations.

First, even if the figures of a Muslim population in France of between 5 and 6 million arewidely cited in publications, including the official ones, they are based on a rule of thumb.Indeed it is impossible to have a precise idea of the Muslim community in France as statisticsbased on religion are totally prohibited. It is interesting to note that the above-mentioned“Rapport d’Information du Senat” (2008) mentioning the Muslim population in France doesnot cite any reference. Interestingly the demographer Michele Tribalat suggests a lower figureof 3.7 million having made estimates based on the number of immigrants and their descendants.Next to the issue of the population, a key question concerns the religiosity of people consideredas Muslim. There is no obvious reason why people with family links with the MENA countriesor Africa would all be religious. One must bear in mind that even in countries with a majorityof Muslims Islamic banks have far from a 100% exclusive market share. So Muslims are notall reluctant to use conventional financial products and we cannot assume that every Muslimliving in France will become a user of Islamic finance.

Those who support the existence of a significant demand for Islamic retail financial prod-ucts in France mention the argument of the size of the Muslim population in the coun-try but they also cite some studies or anecdotal evidence supporting this view. A surveywas done in 2008 by the survey institute IFOP for the Aidimm (“Association d’innovationpour le developpement economique et immobilier”) and the consulting firm Ifaas (IslamicFinance Advisory and Assurance Services). The conclusions were positive as to the exis-tence of a retail market as the survey concludes that “more than 500 000 potential customerswould be attracted by this supply of ethical people” and that “more than 55% of FrenchMuslim people are interested by a banking supply compliant with their religious or ethicalbeliefs”.

Furthermore, several experts maintain that this demand exists. Among others, a consultantinterviewed by the Senate Commission, Zoubeir Ben Terdeyet, argues that “many Muslims,even if they have a bank account, do not wish to open an interest-earning deposit to respect forSharia principles” (Rapport d’Information du Senat, 2008: 32). He furthermore stresses thataccording to his experience “a strong demand of the Muslim community exists for Sharia-compliant products allowing access to real estate property” (Rapport d’Information du Senat,2008: 34).

It is of interest to observe that anecdotal evidence from bankers shows the existence ofconsumers requesting non-interest deposits in French banks for religious reasons. There isthen some evidence to suggest the existence of a demand for Islamic retail financial productsin France.

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This opinion is however not unanimous. Several experts do not believe in the existenceof a demand for retail products. A representative from the French Banking Federation, Jean-Francois Pons, notably claims in the Senate Report that “for retail there is no significantdemand for Islamic financial services” (Rapport d’Information du Senat, 2008: 27).

A recent survey conducted by the consulting firm Equinox Consulting in 2010 corroboratesthis view. The major conclusion of this survey is that demand would be small. It notablystresses the fact that only one quarter of the Muslims living in France would be practising.

The argument according to which the greater Muslim population in France than in theUK should lead to a greater market for Islamic retail financial products is contradicted bytwo elements. First, the potential customers in France have not been familiar with an Islamicfinancial system in their country of origin, in contrast to the Muslims in the UK, who come fromAsia and notably from Pakistan and India where Islamic banking appeared several decadesago. So the French potential customers may not be as used to Islamic banking as the Britishones. It must furthermore be stressed that the countries of origin of French Muslims do notreally welcome Islamic finance, which can also contribute to limiting the support of FrenchMuslims for Islamic financial products. Secondly, according to Jean-Francois Pons (Rapportd’Information du Senat, 2008: 27), the ratio of financial inclusion is lower in the UK thanin France (about 98%). It weakens the argument according to which some people would bereluctant to use the services of conventional banking in France.

Thus, we can conclude this section on the demand for Islamic financial products in Franceby observing that, while there is consensus for a demand for wholesale Islamic banking,evidence is mixed for retail Islamic banking. These factors can explain the reluctance on thesupply side to enter into Islamic banking activities in France.

13.2.2 The Supply Side

A few Islamic banks have indicated their willingness to enter the French banking market byasking for the required licence to perform banking activities. As information on these issuesis not public, we can have only limited information. These institutions are unlikely to benumerous and will probably come from Middle Eastern countries rather than from Asia. Theyare likely to focus first on wholesale banking with a limited geographic presence in France.

These banks may not be inclined to undertake retail activities because these latter activitiesrequire the presence of a network of branches to have access to a wide number of customers.The creation of a network of bank branches ex nihilo is very difficult notably because ofthe existence of switching costs for customers which make it hard and very costly for a newcompetitor to enter the retail banking markets. This is of course particularly the case on theFrench banking market with a high level of banking development.

Islamic finance could nevertheless reach the retail markets if the Islamic financial productswere to be sold through branches of a major existing French bank. Indeed the existence ofeconomies of scope in the banking industry favours the possibility for a bank to sell differentproducts as was demonstrated with the development of “bankinsurance” (i.e. the sale ofinsurance products in bank branches).

This raises two fundamental questions: are French banks willing to sell Islamic financialproducts developed by Islamic foreign banks? And more directly why, after all, do Frenchbanks not sell Islamic financial products which are developed by them?

This latter point leads to a major observation. At first glance, one can consider that Frenchbanks do not have the same know-how in relation to these specific financial products in

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comparison with Islamic banks from MENA or Asia. However, this is in contradiction withthe fact that French banks already have some activities in Islamic finance, and these activitieshave actually existed for over 20 years. For example, BNP Paribas has carried out Islamicfinance activities since the 1980s. However, French banks mainly develop Islamic financeactivities in Middle Eastern countries.

A surprising consequence is thus that, in spite of their know-how in Islamic finance, Frenchbanks do not seem willing to propose Islamic financial products. Indeed, only Islamic banksfrom abroad are nowadays preparing their supply of Islamic financial products.

French banks involved in Islamic finance include BNP Paribas, Calyon (now Credit AgricoleCorporate and Investment Bank), and Societe Generale. BNP Paribas notably provides awide range of Shariah-compliant services such as murabaha financing, sukuk, and Islamicsyndicated loans with its subsidiary BNP Paribas Najmah, established in Bahrain in 2003.These banks are important players in the Islamic finance industry as can be shown by the roleof BNP Paribas in the sukuk issuances.

French banks have nevertheless launched some Islamic finance products in France but ona negligible scale. Banque Francaise Commerciale Ocean Indien, a subsidiary of the majorFrench bank Societe Generale, has launched two Islamic savings products in 2008 on ReunionIsland, an overseas French department in the Indian Ocean. It was an experiment for themetropolitan market, as the share of Muslim population is quite similar. The minimal amountto be invested was €10 000. No capital loss was possible for any product. The most successfulproduct was a short-term one based on murabaha contracts. The bank has collected more than€15 million on these products. The products were stopped in April 2009 because of the lowreturn during the period of crisis and all subscribers were repaid.

The Banques Populaires Group, a major group of cooperative banks, has also launchedan Islamic savings product, this time in metropolitan France in September 2009: “KaramaEthique”. Offered by the Paris subsidiary of the group (BRED), this product is riskier than theones proposed by Societe Generale as a capital loss is possible. It is a mutual fund based onShariah-compliant stocks.

Several reasons can explain the fact that French banks are reluctant to propose Islamicfinance products in their own country. The first relates to the “reputation risk” for the bank.The supply of such products can be perceived as a support for “communautarism” and anattack on secularism in France which would result in a loss of clients for the bank. Thus, thebenefits can be lower than the costs. In another area, a fast-food chain which recently decidedto propose only halal products in some restaurants suffered a great deal of criticism. Thisexample may reinforce the banks’ view of risk for their clientele.

The second reason is based on the uncertainties of this market. We mentioned above thecontroversial debate regarding the existence of a demand for retail products. As a consequence,French banks may be willing to wait and see how the performance of foreign Islamic banksdevelops before entering into this specific market.

Finally, the third reason can be related to the lack of knowledge in Islamic finance foremployees. The absence of skilled employees in this strand of finance can act as a bottleneckfor banks. Education in Islamic finance is very recent in France. The first diploma from auniversity in Islamic finance was created in January 2009 in the EM Strasbourg BusinessSchool. This experiment was extended by the creation of a similar diploma in Paris a fewmonths later.

To conclude this chapter, we must finally mention some very recent news regarding theestablishment of a partnership between a French bank and a foreign Islamic bank to create a

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joint venture to supply Shariah-compliant financial products in France. This partnership wasofficially announced during the 5th Finance and Investment in Qatar Forum taking place inParis at the end of March 2010. The French bank is Banque Populaire-Caisse d’Epargne whichwas recently created after the merger of two large cooperative banks. The foreign Islamic bankis Qatar Islamic Bank. Therefore, in the forthcoming months, Islamic finance products shouldbe provided in France not only by Islamic foreign banks but also by this joint venture.

NOTES

1. Assemblee nationale, 9 June 2009. All debates are available on the website of the NationalAssembly.

2. Conseil constitutionnel, 14 octobre 2009, Decision n◦ 2009-589 DC, http://www.conseil-constitutionnel.fr/conseil-constitutionnel/francais/les-decisions/acces-par-date/decisions-2009/2009-589-dc/decision-n-2009-589-dc-du-14-octobre-2009.45861.html.

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Beck, T., Demirguc-Kunt, A., and Levine, R. (2000) A new database on financial development andstructure, World Bank Economic Review 14, 597–605 (2009 edition).

Cekici, I.Z. (2008) La prohibition islamique de l’interet et les operations de credit islamiques en France,Revue Lamy Droit des Affaires, octobre 2008.

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Islamic Financial Services Board (2008) Guiding Principles on Sharı’ah Governance System, December2008.

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Serhal, J.C. (2007) Les prets participatifs a l’heure de la finance islamique, Banque Strategie, novembre2007.

Serhal, J.C. and Cekici, I.Z. (2009) L’application du taux effectif global aux contrats de financementsislamiques, Banque et Droit, n◦ 126, Juillet–Aout 2009, p. 3.

Storck, M. (2008) Conditions d’agrement d’un OPCVM islamique et conditions d’admission a lanegociation des obligations islamique (sukuk) sur un marche reglemente francais, RTDcom.,Chronique Droit des marches financiers, octobre/decembre 2008, p. 809.

Stoufflet, J. (2007) Le cout du credit: encadrement ou liberte? Table ronde introduite et animee par AnnieBac, in dossier �Remuneration du credit en Europe�, Revue de Droit Bancaire et Financier, p.84–5.

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14

Islamic Finance in the United States

Blake Goud and M. Kabir Hassan

14.1 INTRODUCTION

The Islamic finance industry in the United States has been developing in several areas over thepast 25 years. Much of the attention paid to this development has focused on the development ofretail financial products like mutual funds and Shariah-compliant alternatives to conventionalmortgage products. Far less attention has been paid to the areas of Islamic finance in theUnited States that deal with wholesale investments – investments designed for the needsof institutional investors. The wholesale investment market has largely, but not exclusively,been developed to provide Shariah-compliant investment opportunities for global investors,particularly those in the Gulf Cooperation Council (GCC) countries in the Middle East.

The development of Shariah-compliant investments using money from the Middle Eastbegan almost completely under the radar with individual deals structured so that investorswere not engaging in any non-Shariah-compliant investments. Only later were investmentfunds created to provide broader diversification for investors. More recently, two US-basedcompanies entered the sukuk market as a way to diversify their funding sources and both didso for financial, not religious, reasons.

Alongside this growth in the Islamic finance industry, several domestic companies emerged,some as subsidiaries of Gulf-based Islamic banks and some as stand-alone companies, toprovide structuring advice, Shariah advice, investment screening, and investment advice forthe Islamic finance industry, on both a retail level and an institutional level.

This chapter will provide a comprehensive overview of the wholesale market for Islamicfinance in the United States as well as an overview of the capital markets activity – sukuk,mutual funds, and exchange-traded funds – that have accompanied the wholesale Islamicfinance business.

In section 14.2, we will provide a summary of the history of the capital inflows fromglobal investors into the United States using Shariah-compliant investment structures. Theseinvestments were primarily into real estate, although there are a few notable exceptions wherethe US served as the destination for Shariah-compliant private equity and venture capital. Insection 14.3, we will give an overview of the companies that have entered the Islamic financemarket from within the United States. Many of these companies cater to the needs of investorsfrom outside the United States, although a few focus specifically on domestic investors makingShariah-compliant investments within the US. Section 14.4 provides a summary of the retailinvestment products available in the US that have Shariah-compliant mandates. In section14.5 we review the legal, regulatory, and taxation issues that Islamic finance faces in the


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United States. Section 14.6 describes the two sukuk issued by US-based companies. Finally,we conclude with a few thoughts about what the future might hold for Islamic finance withinthe United States.

14.2 THE UNITED STATES AS A DESTINATION FORSHARIAH-COMPLIANT INVESTMENT

The Islamic finance industry in the United States is best known for Shariah-compliant homefinance products and the development of mutual funds. The US is home to the Amana MutualFunds, whose Income and Growth funds are the two largest Islamic mutual funds in theworld according to Failaka. However, the more significant area of Islamic finance in the UShas largely flown beneath the radar. During the past several decades, a number of Musliminvestors, primarily from the Middle East, have looked to the United States as a destinationfor investing their surplus (mostly petrodollar-related) capital and a portion of this has beeninvested in Shariah-compliant investments.

These investments have been largely, but not exclusively, in real estate. There are individualproject investments, investment funds, and wholly-owned subsidiaries of Middle Easternbanks. In addition to these real estate investments, there have been several subsidiaries ofMiddle Eastern Islamic banks set up to operate in the private equity and venture capital areaswithin the United States. Although these different investments have stretched back severaldecades, like the Islamic financial industry, the breadth has expanded rapidly in the pastdecade.

14.2.1 The Development of an Ijara-Istisna’a Contract for Real Estate Construction

Before providing a history of the inflow of capital into the United States from the Middle East inIslamic financial transactions, we will describe two transactions that stand out as particularlysignificant in the development of Shariah-compliant real estate construction finance. Thetwo transactions, which were used to finance residential apartment construction in Texasand Maryland, provided a structure that has been used extensively within the United Statesand internationally.1 The two projects were the Maconda Park Apartments in Austin, Texas,financed in June 2000 and the Truman Park Apartments in Largo, financed in April 2001. Bothused an ijara-istisna’a structure, although there were slight differences in the two transactions.

The basic structure of the transaction involves an investor approaching a bank for thefinancing of a new construction project. The equity investors form an investment vehicle whichpurchases the land on which the construction will occur, often with an equity contribution fromthe developer, which acts as a general partner (in a limited partnership) or managing member(in a limited liability company (LLC)). The investors are either limited partners (in a limitedpartnership) or non-managing members (in an LLC).

The investors use a combination of ijara and istisna’a to incorporate a Shariah-compliantdebt-equivalent, although the same structure could be used with conventional interest-baseddebt using an identical structure.2 One of the projects, the Truman Park Apartments, used anijara-istisna’a structure modified to accommodate the use of American Institute of Architectsdocuments with the general contractor. The structure combines a leasing transaction betweenthe equity investors and the funding SPV with an istisna’a (construction) transaction betweenthe funding SPV and the general contractor.

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Islamic Finance in the United States 281

In the Maconda Park Apartment construction, Gulf Investment House (GIH) and Key GlobalCapital entered as limited partners into the limited partnership, Maconda Park, LP and thedeveloper on the project Fairfield Residential, LLC invested and served as the general partner.The financing entity received Shariah-compliant debt-equivalent financing from an affiliate ofKeyBank, NA, a large US bank and the parent company of Key Global Capital. The fundingSPV entered into a site lease over the property on which the apartments will be constructedand made lease payments to Maconda Park, LP. In contrast to a conventional site lease, all ofthe liabilities remain with the lessor, including environmental liabilities.3

The funding SPV, using specifications provided by the investors for the project, enteredinto an istisna’a agreement with the general contractor, FF Development, LP, a subsidiary ofFairfield Residential. The istisna’a agreement provides specific descriptions for the projectconstruction and also has a fixed payment; any changes must be specifically agreed to.The istisna’a contract allows for flexible payment and so the payments to the general con-tractor are structured to mirror the disbursement schedule of the debt from the KeyBankaffiliate.

At the time the contracts were signed for the site lease, the debt-equivalent financing, andthe istisna’a agreement, Maconda Park signed an ijara contract with the funding SPV, whichis acting as the owner of the properties being built on the land owned by Maconda Park.The lease covers both the underlying land (subleased to Maconda Park) and the propertiesbuilt. One feature that was included that is specific to the Shariah-compliant structure isthat Maconda Park acts as the managing contractor for the funding SPV because under theijara, the funding SPV cannot pass the responsibilities for maintenance and insurance toMaconda Park.

Structuring the lease payments for Maconda Park leasing the property from the fundingSPV does raise some difficult Shariah compliance issues. McMillen describes:

The Lease (Ijara) was executed at the same time as the other financing documents, but cannotbecome fully effective at such time due to a Shariah principle that prohibits the payment of rentfor an asset until that asset has sufficient economic value and sufficiency for Shariah purposes –i.e., until the asset can be, and is, put to the intended use. [. . .] Property becomes subject to theLease (Ijara) on a continuous on-going basis as construction is completed and each Project isinspected and accepted by the relevant Managing Contractor.

Maconda Park begins leasing the properties when there is sufficient completion as theconstruction is completed. In order to fund the lease payments, Maconda Park will rely on therent payments from the apartment tenants. The lease between Maconda Park and the fundingSPV is structured so that the payments mirror, to the greatest extent possible, the repaymentschedule on the debt-equivalent owed by the funding SPV to KeyBank.

In addition to this basic structure, two features were inserted to make the transactionmore similar to a traditional construction loan: a put and call option between Maconda Parkand the funding SPV. The call option provides Maconda Park with the option to make avoluntary prepayment of the debts owed on the Shariah-compliant debt-equivalent and isstructured as a purchase because the acceleration of payments cannot be structured withinthe ijara contract. The put option provides the bank with the ability to enforce mandatoryprepayment in the case of a default through a sale of the property from the funding SPV toMaconda Park.

The structure of the Truman Park Apartments in Largo, Maryland, was nearly identical tothe Maconda Park Apartments and with identical players except that The Dolbin Company was

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the developer and Bovis Lend Lease, Inc. was the general contractor. Also, the investing entity,Truman Park LLC, was already established for a conventional transaction, which was convertedinto a Shariah-compliant one. The main difference in the transactions was that the generalcontractor used only the standard construction documents, which were not Shariah-compliant –an extra layer had to be added between the funding SPV and the general contractor.

Instead of the funding SPV directly engaging in an istisna’a contract with the generalcontractor, it instead used an “orphan” SPV acting as the mustasne’ (with the funding SPV asthe sane’). The orphan SPV then engaged in the conventional construction contract with thesame specifications provided by the developer.

The development of the ijara-istisna’a structure for the Maconda Park and Truman Parkapartment projects added significantly to the ability of Middle Eastern investors to invest in theUS using debt financing (either conventional or Islamic), while retaining the same tax benefitsas they would have through a straight conventionally financed project.

14.2.2 The First Entrants

The Maconda and Truman Park apartment projects described above represent the opening ofthe floodgates of Shariah-compliant investment funds into the United States. However, a fewfunds did invest in the United States prior to 2000. The most notable early entrant, and oneof the first, was the Danah Real Estate Portfolio offered by Kuwait Finance House in 1994.4

This fund initially invested $50 million in three residential projects in the southeastern UnitedStates in 1995.5

The IIBU Fund II PLC was launched by the United Bank of Kuwait, now a part of AhliUnited Bank, which offered operating leases on equipment to US companies through itssubsidiary, the International Islamic Banking Unit (IIBU). The IIBU also managed the RBEIjara Fund PLC for Saudi Islamic bank Riyad Bank, which was launched in 1997.6 Thesetwo leasing funds originated equipment operating leases to US companies and in some casespurchased leases originated by other US-based companies. These leasing funds were followedby a $40 million KFH Lease Fund, which Kuwait Finance House launched in 1998 to makeinvestments in leases in the US.7 Many of the leasing funds organized for Islamic investorsinternationally with operating leases in the US were organized by banks like Citicorp, J.P.Morgan Chase, and BNP-Paribas, as well as US-based companies like the Wafra InvestmentAdvisory Group, a subsidiary of the Public Institution for Social Security – Kuwait.8 In theyears following the first leasing fund, Wafra has launched several other funds, including aseries of ijara funds that were offered by the National Bank of Kuwait.

The following year, Investcorp, a Bahraini alternative investments firm, launched its USResidential Properties II Portfolio, which bought eight multi-family apartment buildings for$195 million. The fund was comprised of both conventional and Islamic tranches, with theShariah-compliant portion using ijara to provide investors with operating cash flows from theproperties as well as capital gains on any building sales. During the next eight years, Investcorplaunched five funds and one stand-alone project in the US structured to be Shariah-compliant.The funds were primarily diversified funds, not focused on any specific type of property. In2007, the fifth fund, the US Retail III fund was launched by Dubai Islamic Bank but managedby Investcorp, which invested in eight shopping malls across the United States using an ijarastructure to separate the equity investment from the debt used to finance the purchase of theproperties.9

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14.2.3 The Entry of Private Equity

While the real estate and ijara fund side of the inflows of capital continued to grow slowlyin the US in the late 1990s, a new source of funds began to enter the United States withthe launch of Crescent Capital Investments, Inc. in Atlanta, Georgia, which was a sub-sidiary of the - then recently formed First Islamic Invesment Bank based in Bahrain. Cres-cent Capital Investments is now known as Arcapita following a rebranding of the companyin 2005.10

Arcapita’s investments focus on real estate as well as private equity, asset-based investments,and venture capital. The initial focus of Arcapita was in the private equity area and the firstinvestment they made was in a kayak manufacturer, Watermark Paddlesports, Inc. which itpurchased for $40 million in June 1998. In August 2001, Watermark bought Yakima, a companythat manufactures roof racks for cars, for $173.1 million which it still owns. Later that month,Watermark sold the kayak part of its business to Confluence Holdings Corporation.11

Like other private equity firms, Arcapita uses a combination of debt and equity to finance thetransactions to acquire companies that become a part of its portfolio. However, the financinghas to be done with Shariah-compliant financing. Based on the total transaction sizes, as wellas Arcapita’s reported assets under management, roughly 40% of every deal is equity, with theremainder in debt.12

In the years following the first investment in Watermark, Arcapita has expanded its privateequity transactions in the size of deals. In 2000, it began offering real estate investmentsthrough several funds, most of which were in the United States. The first two funds weremulti-family residential buildings, in which it invested $251 million in 2000 and which wereexited in 2005 for $300 million at a total return of 40%.13

Following the multi-family residential funds, Arcapita invested $603.5 million in industrialdistribution properties through three funds in partnership with ProLogis. The 80% sharesowned by Arcapita in the three funds were purchased by ProLogis in January 2006 for$259.2 million in cash and $435.9 million in assumption of debt and other liabilities.14 The

Table 14.1 Arcapita investments by type and year

Corporate Real Estate Asset-Based Venture Capital Total

1998 $40.0 – – – $40.01999 $241.9 – – – $241.92000 $351.6 $251.0 – – $602.62001 $438.2 $603.5 – – $1,041.72002 $104.1 $412.5 – – $516.62003 $162.7 $417.4 – – $580.12004 $774.4 $182.0 – – $956.42005 $513.0 $1,173.6 $100.4 – $1,787.02006 $956.0 $839.4 – $45.6 $1,841.02007 $852.8 – – $31.5 $884.32008 $30.6 – $924.8 $28.4 $983.82009 – – – $8.2 $8.2Total $4,465.3 $3,879.4 $1,025.2 $113.7

Source: Arcapita. Annual Report 2009. Manama: Arcapita; Arcapita. Annual Report 2008. Manama: Arcap-ita; Arcapita. Annual Report 2007. Manama: Arcapita. Available from http://arcapita.com/about/fininfo/annualreports.html.

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Table 14.2 Arcapita real estate funds

Fund Name Transaction Size ($) Entry Date Exit Date

Multifamily I $107.3 Apr-00 May-05Multifamily II $143.7 Jun-00 May-05ProLogis I $242.6 Apr-01 Jan-06ProLogis II $215.4 Jun-01 Jan-06ProLogis III $145.5 Sep-01 Jan-06US Senior Living Yielding I $203.4 Mar-02 Sep-06US Senior Living Yielding II $209.1 Nov-02 Sep-06US Senior Living Yielding III $417.4 Sep-03US Residential Development I $182.0 Oct-04US Residential Development II $245.0 Jun-05US Senior Living Yielding IV $493.5 Jul-05US Residential Development III $435.1 Oct-05US Retail Yielding I $150.0 Jul-06International Luxury Residential Development I $689.4 Aug-06

Source: Arcapita. Annual Report 2009. Manama: Arcapita. The International Luxury Residential Development IFund includes investments both within the US and internationally.

other funds that Arcapita has launched have been focused on residential development andsenior living facilities, with Sunrise Senior Living, Inc., a provider of senior living services.

In 2006, Arcapita began two different types of funds, a $150 million income-focusedretail fund with Prescott Capital Management LLC, and a $689.4 million international luxuryresidential fund, which includes two development projects in Aspen and Steamboat Springs,Colorado.

The two remaining areas – asset-based investment and venture capital – are more recentadditions to Arcapita’s investment strategy. The asset-based investment area is primarilyinternationally focused with only three investments in the United States, while the venturecapital segment is entirely focused within the United States. Arcapita describes the outlookfor investing in infrastructure in the US:

The United States hasn’t initiated a national infrastructure plan since the 1950s, when interstatehighway construction began. Today, the country’s challenges appear more complex and daunting,and many systems are either obsolete or crumbling and require rebuilding and reinvention. [. . .]The positive opportunities for investment in North America have been offset by the ongoingchallenges in the credit markets and limited activity from traditional strategic investors and privateequity institutions. However, there are positive signs in the second half of 2009, as M&A activityincreases and access to the capital markets steadily improves.15

This impediment and the growth of opportunities for infrastructure projects outside theUnited States which fit the sector focus of Arcapita’s investments (energy, transportation, andwater) have led the asset-based investment segment to focus on international investments inthe UK, Europe, Asia, and the Middle East.

In contrast to the asset-based investments, Arcapita’s venture capital investments are entirelywithin the United States. The $200 million venture capital fund, Arcapita Ventures I, waslaunched in 2006 and has invested $113.7 million so far in eight companies, one of which,Navini, was exited in 2007 through a sale to Cisco Systems, Inc. The investment focus ofthe Arcapita venture capital segment is in companies operating in the healthcare, information

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Table 14.3 Arcapita Ventures I investments by year

Company Sector 2006 2007 2008 2009 Total

Alloptic, Inc. Technology $12.5 $7.5 $4.0 $2.8 $26.8Aspen Aerogels, Inc. Indust. Tech. $10.0 $10.0CardioMEMS, Inc. Healthcare $11.3 $7.5 $5.0 $1.0 $24.8Fidelis SeniorCare, Inc. Healthcare $10.0 $0.8 $0.6 $11.4FrameMax, Inc. Technology $8.0 $8.0Intelleflex Corporation Indust. Tech. $6.5 $0.6 $3.0 $10.1Navini Networks, Inc. Technology $12.8 – $12.8Prenova, Inc. Technology $9.1 – $0.9 $9.9

$45.6 $31.5 $28.4 $8.2 $113.7

Source: Various Arcapita Annual Reports.

technology, and industrial technology industries. Unlike the investments in other segments,for which most of the investments are over $100 million, the venture capital investments beginwith an investment of $5 million to $12 million with follow-on investments up to a totalmaximum investment of $30 million.

Arcapita is the largest of the Islamic private equity firms in the United States, but it is notthe only one. In 2004, Unicorn Investment Bank was founded in Bahrain with a subsidiary,UIB Capital, based in Chicago, Illinois. Unlike Arcapita, UIB Capital is solely focused onprivate equity. It focuses its acquisitions on healthcare, technology, manufacturing, businessservices, consumer products, and oil and gas companies. Its transactions sometimes use somedebt, which is structured as murabaha or ijara. The growth began slowly with $10 million inassets in the United States in 2004 growing to $30 million in 2006.16

In 2006, Unicorn Investment Bank launched the Global Private Equity Fund, which was ini-tially closed for $150 million. This five-year, closed end fund is focused on global acquisitionssimilar to UIB Capital, which manages all of Unicorn’s private equity business. The globalmandate expanded the entire private equity business for Unicorn and also led to continuedgrowth for UIB Capital as well with assets rising to over $130 million in 2007 and $185 millionin 2008.

This growth is particularly significant due to the recession in the US during 2008, althoughthe bank did take writedowns of $31.8 million on some of its private equity holdings at theend of 2008. The specific companies or locations of investments of these writedowns was notdisclosed in the Annual Report however. The one impact measurable is the revenue and income

Table 14.4 UIB Capital investments

Company Industry Entry Exit IRR

Sun Well Service, Inc. Oil & Gas Services 2008Open-Silicon Technology 2007Victron, Inc. Technology 2007Precision Time Consumer Services 2006Ellington Leather Consumer Products 2006The Gardens Residential Community Healthcare Real Estate 2004 2007 21%

Source: UIB Capital website (www.uibcapital.com).

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of the Victron, Inc. acquisition, which is broken down separately on financial statements. It sawrevenue grow from $64.9 million in the nine months to 30 September 2008 to $68.4 millionin the same period during 2009. However, profits measured by revenue minus expenses forVictron were $7.3 million in the first nine months of 2008 compared with $6.2 million in thesame period in 2009.17

14.2.4 Growth Accelerates

The Maconda Park and Truman Park projects, financed in 2000 and 2001, respectively, coin-cided with the beginning of the expansion of investment flows into the US through Shariah-compliant structures. While these two transactions provided both the development of a flexiblestructure for ijara-istisna’a de novo real estate construction projects, there were other factorsthat contributed to the growth in the Islamic finance industry in the US. In 1999, Dow JonesIndexes launched the first indices in what has become one of the most recognizable Shariahindex families. In addition, with rising oil prices contributing to wealth creation in the GCCcountries, the broader Islamic financial industry began growing more rapidly worldwide in theearly years of the 2000s.

In 2000, a GCC-based bank, the Abu Dhabi Islamic Bank, entered the US market withthe ADIB Leasing Fund, which raised $50 million to invest in equipment leases targeted atinvestment-grade US companies. The fund was wound up in 2006 with an average incomeyield of 7%.18 This fund was followed by the ADIB-Sentinel Multi-Family Housing Fund,which was launched the following year. This fund invested in real estate properties in Texas,Florida, and Arizona with the goal of providing regular income to investors. It was wound upin 2005 returning 17% to investors. The early liquidation of the fund was due to the boomingcondominium market at that time, particularly in the regions in which the properties werelocated, which motivated significant condominium conversions.19

One of the established international Islamic finance companies, Kuwait Finance House,added another real estate fund, the Al-Soor Real Estate Leasing Portfolio in 2001 in conjunctionwith Citigroup. It used $115 million in equity to purchase eight income generating residentialproperties for $378 million, which it sold for $511 million in 2005.20 Since the launch ofa handful of funds in the late 1990s and 2000, Kuwait Finance House launched a numberof funds investing in US real estate in the first half of this decade, all of which it exitedbefore the financial crisis of 2008. These funds spanned a wide range of different propertytypes and geographical regions within the United States including industrial, multi-familyhousing, healthcare facilities, real estate leasing, luxury developments, senior housing, andundeveloped land.

The Gulf Investment House, the investor in the Maconda Park and Truman Park projects,viewed those investments as “pilot investments” to test whether the ijara-istisna’a structurewould be acceptable to the US banks providing debt financing, to the investors in terms ofthe tax efficiency of the transaction, and to the Shariah Board of Gulf Investment House. In2001, Gulf Investment House expanded their scope of investments in the United States byestablishing TransOcean Capital, Inc. TransOcean Group is a private equity company thatfocuses on industrial manufacturing, branded consumer products, and healthcare services andmedical devices. According to the company’s website and Gulf Investment House annualreports, it has made just two acquisitions.21

The first acquisition was made in 2001 when TransOcean Capital acquired Halcore Group,Inc., the largest manufacturer of ambulances in North America with manufacturing facilities

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Table 14.5 Kuwait Finance House Funds and projects in the United States

Fund/Project Name Partner Organization Date Launched Equity Size ($M)

Danah Real Estate Portfolio None 1995 $50Lease Fund for the US None 1998 $40Deera Investment Fund None 2000 $50Prime Industrial Fund I First Industrial Realty

Trust, Inc.2001 n/a

Alliance Real Estate Fund None 2003 $520Net Lease Fund First Industrial Realty

Trust, Inc.2003 $420

Prime Industrial Fund II First Industrial RealtyTrust, Inc.

2003 n/a

Care Fund None 2005 $164Grand Peninsula Project Global Securities

House2005 n/a

Net Lease (Al-Mumayaz)Industrial Real Estate Fund

None 2006 n/a

Pacific Heights Development Global SecuritiesHouse

2007 n/a

Multifamily BuildingJoint-Venture

UDR 2009 $450∗

Michigan Street (Chicago)Apartments

Prism Company 2009 $242∗

∗ Project size is listed because the size of the equity component is not known.Source: Various news articles and Kuwait Finance House-related websites and annual reports.

in Ohio, North Carolina, and California. The Halcore Group is made up of five separate com-panies with some integration in their manufacturing: Horton Emergency Vehicles, AmericanEmergency Vehicles, Leader Emergency Vehicles, Horton Rescue, and Interfleet. The secondacquisition was of Stronghaven, Inc. in 2003. Stronghaven is a corrugated packaging companybased in the southeastern United States.

Contemporaneously with the private equity investments through TransOcean Capital, GulfInvestment House continued its development of real estate investments in the United Stateswith the launch in 2001 of the Bunyan Fund, which invested $26.95 million of equity in theconstruction of four Class A multi-family apartments valued at $123 million. The fund wasexited in 2005 with an IRR of 12.5%.

In 2004, Gulf Investment House formalized the process of generating new real estateinvestments in the United States with the formation of Innovest Capital, Inc. Innovest isprimarily responsible for originating investments on behalf of Gulf Investment House andprimarily invests through equity investments in projects developed by other developers. Duringthe past few years it has invested in a number of projects including hotels, multi-familyresidential projects, and medical care facilities.

Some of these investments have been individual projects originated for Gulf InvestmentHouse, but there have also been several funds launched with specific focuses like medicalcare facilities, condo-conversions, multi-family housing, and condominiums. The structure ofGulf Investment House’s investments through Innovest Capital are very similar to the structuredeveloped for the Maconda Park Apartments where Innovest invests equity as a limited partnerin the project and is separated from the project-level debt using a lease.

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Table 14.6 Gulf Investment House funds and projects in the United States

Fund/Project Name Partner Organization Date Launched Equity Size ($MM)

US Real Estate Fund None 2000 n/aMaconda Park Apartments None 2000 n/aTruman Park Apartments None 2001 n/aTransocean Capital Group,

Ltd.None 2001 n/a

The Bunyan Fund None 2001 $123Overland Capital Group, Inc. None 2002 n/aCondo-Conversion Fund-US

Residential CondominiumPortfolio

None 2005 n/a

US Residential CondominiumFund

None 2005 n/a

Care Fund I Innovest Capital 2005 $33Care Fund II Innovest Capital 2006 $40US Residential Condominium

Fund IINone 2006 n/a

US Diversified Fund I Innovest Capital 2008 $60Care Fund III None 2009 n/a

Source: Various news articles and Gulf Investment House-related websites and annual reports.

In August of 2001, the Islamic Investment Company of the Gulf Ltd, a subsidiary of DarAl-Mal Al-Islami, which also owns Shamil Bank of Bahrain through its investment in IthmaarBank, invested $8 million in a real estate development, Castle Pines Village, near Denver,Colorado.22 In October 2001, James Godec, the managing director at Key Global Capital, Inc.,who worked on the project, as well as the Maconda Park and Truman Park Apartments, leftKey Global Capital to start a new company, Overland Capital Group.

Overland Capital has a range of activities, but within the Islamic finance area, the twoprimary activities it focuses on are leasing and real estate. During the first few years of itsexistence, Overland Capital worked with Shamil Bank on two real estate funds in the UnitedStates. The first, the Shamil US Real Estate Portfolio, was launched in 2003 with equity of$40 million to acquire $200 million in multi-family real estate in Texas and Florida.23

Like most of the other real estate funds in the US, the equity is contributed into a mudarabafund managed by Shamil Bank with Overland Capital Group serving as strategic advisor.The equity invested in the fund is then invested in real estate projects, but separated fromeach property’s debt through an ijara. The second, the US Development Opportunities FundI, was launched in December 2005 with equity of $48.4 million that was used to fund thecompletion of two condominium development projects, one in suburban Washington, DC andone in Florida.24 The fund was partially exited in May 2007.

Following the launch of the two funds by Shamil Bank with Overland Capital Group,Overland Capital participated in the launch of First Leasing Bank in Bahrain in 2005 alongsideGulf Finance House, Ithmaar Bank, and Gulf Investment House. The ownership was shuffledslightly with Ithmaar buying out Gulf Investment House’s investment and with an additionalcontribution from Abu Dhabi Investment House.

First Leasing bank raised additional capital through a private placement in 2006. The fundsfrom the private placement were used to acquire assets to lease to companies primarily in the

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Gulf Cooperation Council, with Overland Capital Group serving as the investment advisor.25

The business plan outlined in the private placement memorandum anticipated First LeasingBank raising debt financing to leverage the balance sheet, as well as offering leases to non-GCC, primarily US-based, companies.

However, these plans were delayed and at the end of 2008, the debt had not been arrangedand there was only one lease to a US-based company for $12.6 million during 2008. Thiscompany entered Chapter 11 bankruptcy in the first quarter of 2009 due to liquidity con-cerns, although First Leasing Bank does not believe it will need to take a provision againstthis because the orderly liquidation value of the equipment backing the lease is valued at$15.9 million.26

In 2002, another global financial institution with significant business in the Islamic financeindustry, HSBC Amanah, offered products that invested in the United States. HSBC Amanahhas been active globally in Islamic finance and had a brief presence offering Islamic homefinance in the United States in 2002, although they left the US market in 2006 citing insufficientdemand.27 The first fund offered by HSBC Amanah in 2002 was the HSBC Amanah GlobalProperties Income Fund. Although the fund is global, 70% of the fund was invested in propertiesin the United States, primarily those properties leased by a single tenant which allowed thefinancing for the fund to be based on the credit rating of the tenant rather than on the qualitiesof the building. The fund is managed by HDG Mansur, a US-based real estate investmentmanagement company.28

The HSBC Amanah Global Properties Income Fund was followed in 2005 by the HSBCAmanah Aqar Income Fund. In contrast to the Global Properties Income Fund, the AqarIncome Fund was entirely invested in properties in the US. The investment strategy is in singletenant properties as well as those leased by state and federal government entities and a smallportion into development projects. Unlike the Global Properties Income Fund, which onlyused one investment manager, the Aqar Income Fund used two managers: Falcon Real EstateInvestment Company, Ltd and NGP Capital Partners III, LLC.29

The investment management company for the Global Properties Income Fund, HDGMansur, announced in June 2007 that it was planning to list the first publicly traded Shariah-compliant real estate investment fund on the London Stock Exchange and the Dubai Inter-national Financial Exchange (now NASDAQ Dubai). The fund focused on an internationalportfolio of properties, with 16 purchased when the announcement was made, all in the UnitedStates.30 The fund was delayed until later in 2007, but has not yet launched, likely due to theglobal economic and property markets downturn that began that year.

Another global financial company, UBS, through its UBS Noriba subsidiary, launched itsown real estate fund in October 2003. The UBS Noriba US Commercial Properties Fundinvested in five commercial properties in New Jersey and Missouri. It was much smaller thanthe HSBC Amanah funds with $30 million in capital that was used to purchase $121.3 millionin property. The fund was liquidated in less than two years in March 2005 with an IRR of18.2%.

In 2004, the number of international Islamic financial institutions with real estate investmentsand operations within the United States increased further when the internationally-focusedShariah-compliant subsidiary of The Securities House of Kuwait. Global Securities Housewas established in San Francisco, California, in 1998 primarily focused on screening publiccompany equities for Shariah compliance. This mandate was shifted to real estate followingthe tech crash in the early 2000s with the headquarters moved to Kuwait, while keeping anoffice in San Francisco. In 2004, they offered a Shariah-compliant investment in the Transpoint

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Building in Washington, DC. The building is the headquarters for the US Coast Guard. Theinvestment in the building was reasonably short with an exit realized at the end of 2006 withan IRR of 33%, exceeding its targeted return of 15%. Following the Transpoint Buildingacquisition, the Global Securities House also invested in a few other buildings in the UnitedStates.

In 2005, Global Securities House invested in a planned community, the Grand PeninsulaProject, in the Dallas/Ft Worth, Texas, area with Kuwait Finance House. In addition to thatproject, Global Securities House also invested in a government building in Washington, DC,the Columbia Building, which is leased to a District of Columbia government agency, theChild and Family Services Agency.

In the same year, Global Securities House became the Shariah advisor to a new real estatefund, the Shmael Fund, which purchased six office buildings in the US valued at $100 million.31

The involvement followed the Securities House purchase of Al-Shall Consulting and Invest-ment Company in April 2005.32 The fund was launched by Injazzat Real Estate Companywith participation from Legg Mason Real Estate Services and Grosvenor, a large US-basedproperty company.

The growth into the real estate fund area continued for the Global Securities House in2007 when it launched the Bronco Fund, which invested $140 million in office and industrialproperties in the United States. This fund was launched in partnership with the Shariah-compliant, UK-based subsidiary of the Arab Banking Corporation, ABC International BankIslamic Asset Management Limited, and the Broe Companies in the United States.33

With the collapse of US real estate which began in 2007 with the onset of the sub-primemortgage crisis, the investment flow from international investors slowed to a standstill. Thelargest source of investments, Kuwait Finance House, had largely exited the US market priorto the sub-prime and financial crisis.34 However, in August 2009, they re-entered the marketthrough a joint venture with the Colorado-based apartment real estate investment trust UDR,Inc. The joint venture will invest in $450 million in properties with equity of $180 millioncontributed by Kuwait Finance House and $54 million from UDR. As of 30 September 2009,the joint-venture had not acquired any properties.35

Subsequently, Kuwait Finance House expanded its investments into US real estate witha $242 million investment in the 40-storey building currently under construction by PrismCompany, which owns the 5% of the project not owned by Kuwait Finance House. The projectis expected to be completed in 2011.36

14.2.5 Conclusion

Investments into the United States from investors requiring Shariah compliance have flownunder the radar for much of the past 15 years. Much of these investments occurred followingthe 9/11 attacks which led to anything “Islamic” being viewed with extra scrutiny. However,despite this sentiment and widely reported repatriation of capital back to the Middle East,there has continued to be significant growth in the area of Shariah-compliant investments withfunds from the Middle East.

Much of the attention within Islamic finance in the United States has focused on the retailindustry, in particular the growth of Shariah-compliant alternatives for American Muslimsto purchase a home. However, it is likely that the Shariah-compliant investment funds fromabroad that invest in the United States are larger than the domestic Islamic finance industry.

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Many of these funds were focused on commercial, industrial, and multi-family real estate.All sectors within real estate have seen valuations diminished, sales decrease, and vacanciesincrease as the United States entered a severe recession accompanied by a significant financialmarket crisis and the beginning of what is likely to be a prolonged period of deleveraging.

It remains to be seen how resilient the Islamic funds will be in what is commonly referredto as the “new normal”. Many Islamic real estate funds used significant leverage to finance thedevelopment or purchase of the assets held by the funds. The structure used for the funds hasbeen developed to use either conventional or Shariah-compliant debt, but both areas are likelyto be more difficult to access as banks are hesitant to increase their exposure to the US realestate market.

That being said, the entry of Kuwait Finance House back into the US real estate marketcould lead other companies that have been involved in the past to re-enter the market as well.Unless the real estate markets resume their deterioration, the next year or two could be a periodof new growth for Islamic real estate funds in the US.

14.3 WHOLESALE ISLAMIC FINANCE WITHINTHE UNITED STATES

The Islamic finance industry has been growing internationally for much of the past decade. Thegeographical concentration of Islamic financial institutions has been largely in the countriesof the Gulf Cooperation Council (GCC) and in Malaysia. These institutions have soughtgeographical diversification in their Shariah-compliant investments, which has led to themany Shariah-compliant real estate and private equity funds described above.

For the most part the investments have been inbound into the United States. There has beenfar less growth in Islamic finance domestically, particularly outside the retail banking area.Although small, there are a few companies – many of which were started only in the past fewyears – that have provided Shariah and financial advisory services. Some of these companiesprovide services to domestic investors looking to offer Shariah-compliant financial productsin the United States. However, most are based in the United States looking abroad for eithercapital or investment opportunities.

One of the earliest wholesale financial institutions in the United States was Shariah Capital,based in Connecticut, which was founded by Eric Meyer with the initial goal of creatinga Shariah-compliant platform for hedge funds that use both long-only as well as long-shortstrategies. His work began in 2001 and the development process took several years to completeand receive approval. In 2007, Shariah Capital launched the Al Safi platform, which providesa system for investment managers to launch Shariah-compliant hedge funds. Shariah Capital,through a subsidiary in the Cayman Islands, provides the Shariah screening and, through itspartnership with Barclays, offers a Shariah-compliant short sale using arboon.

The arboon short-selling product, which uses Barclays Capital Prime Brokerage as the primebroker, has attracted some criticism, although Shariah Capital has released a more thoroughdescription of how it works and why they use the arboon method, rather than alternatives suchas wa’d or salam. The criticisms centre around the prohibitions of selling something that onedoes not own, something which the arboon method avoids by transferring title to the securitieswhen a down payment is made.

The arboon structure replicates a short sale, but does not identically replicate it. In someways, the arboon structure is similar to an option, because it has a fixed length of time beforethe transaction concludes, 60 days in the description of arboon provided by Shariah Capital.37

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Before describing the specifics of the Shariah Capital arboon short sale, we will provide abasic description of an arboon sale.

In an arboon contract, the buyer specifies a good for purchase and makes a down paymentto the seller. The buyer makes the remainder of the payment at a future date and if he decidesnot to purchase the good, the seller reclaims title to the good and keeps the down payment. Thecontract did not necessarily have a set end date for the buyer to either pay the remaining price orwalk away. However, the Organization for the Islamic Council (OIF) Fiqh Academy requiredthat the contract include a specified date by which the transaction must be completed.38

Returning to the Shariah Capital arboon contract, instead of denoting a physical asset, astock is the asset involved. The prime broker acts as the agent via which the transaction occursand the fund manager wishing to short-sell the stock pays a portion of the value of the stockequal to the margin requirement in a conventional short sale and receives title to the stock anda fixed period in which to replace the total shares minus the down payment. The fund managerthen sells the stock to another buyer at the current market price. At the end of the fixed period,the fund manager purchases the remaining shares owed and returns them to the lender.

The risk and return profile from the transaction is similar to a conventional short sale to thefund manager with the prime broker taking on a similar amount of counterparty risk as in aconventional short sale.

Trade Date + 60

Trade Date + 1 If Price Declines If Price Rises

Price of Stock $10 $9 $11Proceeds from Sale (10 shares) $100Down Payment (1 share) $10Cost to Purchase Shares Owed $81 $99Profit/(Loss) $9 −$9

Shariah Capital used the arboon short sale to attract external managers of several fundsit launched through its Al Safi Trust. In 2008, Shariah Capital formed a joint-venture DubaiShariah Asset Management with the Dubai Multi Commodities Centre Authority (DMCCA)with DMCCA also buying a 4.99% stake in Shariah Capital. Within the Dubai Shariah AssetManagement joint venture, there are four commodity funds (and one fund of funds with equalinvestments in each of the four funds) under the DSAM Kauthar name. The four funds focuson different segments of the commodity industry: gold, energy, natural resources, and globalresources and mining. Each fund is a long-short equity fund investing in companies associatedwith the specific area targeted and managed by a different fund manager.39

In addition to the funds directly managed by DSAM Kauthar, Barclay’s Wealth offers itsclients access to a basket of hedge funds in the Al Safi Trust through its Alternative FocusAl Fajr Sub-Trust. These investments are made by private banking clients of Barclay’s inan actively managed portfolio of hedge funds. Although there are only a limited number offunds available, there is a planned expansion into hedge funds with a focus on technology andhealthcare.

With the launch of the first four hedge funds, as well as the fund-of-funds, DSAM Kautharlaunched an index of Shariah-compliant hedge funds in early 2009. The index, the DubaiShariah Hedge Fund Index, tracks the value of the DSAM Kauthar Commodity Fund, Ltd,which is the fund-of-funds invested equally in the four commodity hedge funds.

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Shariah Capital is primarily focused on creating Shariah-compliant hedge funds that usethe arboon short sale, but in 2009, the Dubai Gold Securities was launched. The Dubai GoldSecurities is an ETF similar to the GLD available in the US, but is slightly altered to beShariah-compliant. Shariah Capital acts as the Shariah advisor to the Dubai Gold Securities.

During the years in which Shariah Capital was developing their arboon short sale product,several other financial institutions entered the Islamic finance market. One of the first wasSHAPE Financial Corp., based in a Washington, DC suburb in Virginia. SHAPE is focusedon providing structuring advice and was responsible for the products offered by UniversityIslamic Financial Corp in Ann Arbor, Michigan. The products, called mortgage alternatives(MALT), use ijara and murabaha structures within the United States. In addition to the homefinancing products, SHAPE financial developed a profit-sharing investment account which isoffered by University Islamic and includes FDIC insurance. The University Islamic depositproduct invests deposits in the ijara home financing products offered by the bank, providingdepositors with a Shariah-compliant return based on the performance of those investments.

Another financial company, Anchor Finance Group, which is based near New York City,was launched in 2005. Anchor provides financial and management consulting for structuredfinance, syndication, product development, and trade finance. Several of the projects it hasworked on are real estate investments in Pakistan. In most cases, Anchor Finance Group workswith other financial institutions to develop investments that are then funded and arranged bytheir partner financial institutions.

The following year, in 2006, another company, IdealRatings, was founded with the launchof its product in 2007. Based in San Francisco, California, IdealRatings provides a technologyplatform to Shariah-compliant fund managers to assist in the screening of investments toensure they are and remain Shariah-compliant. In addition to Shariah-compliant investments,IdealRatings also allows screening using other ethical and socially responsible screens.

IdealRatings uses the information provided through Reuters and other information providersto provide up-to-date information on Shariah-compliance, coupled with some additional reviewof questionable companies. The information provides subscribers with the ability to screenexisting portfolios, find new investments, create Shariah-compliant indices, and calculatenecessary purification for non-compliant earnings by portfolio companies. IdealRatings doesnot have its own Shariah Board but instead relies upon its clients’ Shariah Boards to approvethe standards used by its technology, which supports multiple rule books. In 2009, ThomasWeisel announced an alliance with IdealRatings to provide screening for investment fundsand separately managed accounts. San Francisco-based Thomas Weisel Asset Managementfocuses on US small- and mid-cap growth stocks.

During 2007, another firm offering Shariah-compliant financial advisory services wasfounded, Zeus Capital Advisers. Among the services offered by Zeus Capital Advisers that isunique is advice for investors interested in starting a de novo Shariah-compliant communitybank. This is provided alongside its advisory services focused on new product development.Zeus Capital Advisers is currently advising Crescent Bancshares, a new corporation currentlyraising $15 million to acquire a bank in the Chicago, Illinois, area. The bank acquisition isanticipated to close in early-to-mid 2010.40 The bank will be an Islamic bank offering Islamicbanking products and providing a model for a national network of Islamic community banks.41

In addition to working on the new community bank, Zeus Capital Advisers advises on thestructuring of Shariah-compliant real estate transactions and other investments.

Another new firm, Zayan Finance, which launched in 2007, provides commercial real estatefinancing using a musharaka mutanaqisa (diminishing musharaka). In contrast to the Islamic

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home finance providers, which are generally limited to providing less than $417 000, ZawyanFinance provides commercial real estate financing between $400 000 and $50 million. It hasoffices in three cities, New York, Chicago, and Los Angeles, and provides financing acrossthe United States. The financing used in the transactions is sourced from major financialinstitutions.

In 2008, Codexa Capital began operations offering Shariah-compliant structuring services,although a related firm, Calyx Financial, had been offering similar services since 2002 along-side its conventional financial advisory services. The split of Calyx Financial into CodexaCapital and Calyx Offshore was done to offer specialized investment banking services sepa-rately from non-Shariah-compliant activities.

The services offered by Codexa Capital are relatively interlinked with the product structuringfocusing on Shariah-compliant investment vehicles and funds. The other services – assetadvisory and investment research – tie into the product structuring by providing research andadvisory services to the funds and investment vehicles on which whey provide structuringadvice.

While much of the Islamic finance business on the wholesale side has involved structuringShariah-compliant transactions, often in real estate, there have been a few other areas whichIslamic finance has innovated in the United States with other types of Islamic financial services.In 2008, two Islamic ethicists, Taha Abdul Basser and Faraz Rabbani, started the StraightWayEthical Advisory, a Shariah advisory firm modelled on a law firm in that it provides Shariahadvisory services with several Shariah scholars. One of the principals, Ustadh Abdul Basser,provides Shariah advisory services to the first Islamic exchange traded fund (ETF) in theUnited States, the Javelin JETS Islamic Market International Index Fund.

The other three companies that have entered the Islamic financial industry in the UnitedStates in 2009 remain at an early stage, but they demonstrate several underserved areas in theUnited States. One of these is StoneCross Capital, which has created a longevity asset-basedproduct, which the company describes on its website as accomplished by “pooling longevityassets and coupling them with a standard Shari’ah-compliant asset”.42

Conventional longevity assets represent a pool of life insurance policies purchased at avalue lower than their maturity benefit but at a price greater than their cash surrender value.The return on the assets represents the aggregate difference between the maturity benefit andthe premiums paid from purchase to maturity. In the most basic form, they would not beShariah-compliant because they involve non-mutual, conventional insurance. However, thereare few ways that they could be structured to be Shariah-compliant; the actual method is notdescribed publicly by Stone Cross Capital.

One way would be to create a Shariah-compliant swap using wa’d, although certainapplications of this structure have been criticized by Shariah scholars including Sheikh YusufDeLorenzo who serves as one of Stone Cross Capital’s Shariah advisors. His criticism of thatapplication of a wa’d-based swap was that funding of the non-Shariah-compliant investmentswas provided by the funds placed in the investment. Specifically, he differentiated betweenputting a Shariah wrap on non-Shariah-compliant returns and the use of LIBOR as a pricingbenchmark:

The means of delivery, a wa’d or promise, is widely seen to comply with Shariah norms. Since itis compliant, at least to the letter of the law, some Shariah scholars have approved products thatuse a wa’d to deliver returns from non-compliant investments. By doing so, however, they havefailed to consider the purpose of the transaction, they have failed to consider the movement of

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the cash and, most importantly, they have failed to consider the ramifications for the industry asa whole. At a very fundamental level, the reason for these failings is that they have not discernedthe difference between the use of LIBOR as a benchmark for pricing and the use of non-Shariahcompliant assets as a determinant for returns.43

Based on this criticism, it is unlikely that Sheikh DeLorenzo would approve a similarproduct and therefore it is more likely an asset used to create identical cash flows to a syntheticlongevity asset.44 One such structure could be a parallel commodity murabaha similar to aprofit rate swap. One murabaha would be a fixed rate murabaha which makes instalmentpayments for a fixed premium amount, while the other is a floating rate murabaha with theinstalment payments based on a longevity index as a benchmark for establishing a series ofunconnected murabaha transactions across the duration of the fixed rate murabaha.45

In the second half of 2009, the trade finance firm Delphi Trade, announced that it wouldlaunch a Shariah-compliant trade finance fund with $100 million in investments and an initialtarget $1 billion on 30 September and an expectation that the planned size of the fund wouldrise from $2 billion to $3 billion shortly thereafter.46 The president and CEO of Delphi Trade,Dr Craig Allen, describes the methodology they use:

For example, we might make a payment of 30% of the invoice value to a manufacturer when apurchase order is received from a qualifying buyer, we might take that to a level of 70% of theinvoice when the goods are shipped, and we would then make a final payment of the balanceowing on the invoice, less our trade margin, when we receive final payment from the importer.47

This is similar to the murabaha used by other Islamic trade finance firms, including the Inter-national Islamic Trade Finance Corporation, a member of the Islamic Development Group.48

Thus, while the product being used is not unique, the use of funds from US investors, arrangedby a US-based company, is. One of the areas where Delphi Trade anticipates using this tradefinance fund is to create a Shariah-compliant commercial paper market that would provideshorter-term maturity instruments, which would help Islamic banks match the maturity profileof their assets and liabilities.

During 2009, a proposal was made for a large Islamic financial investment in the autoindustry, which was never completed. The proposal, made by Rasameel Structured Finance,KSCC, a Kuwaiti Islamic investment bank, would have created a musharaka with cash contri-butions from the US government and equity investors and in-kind investments from domesticand foreign automakers. The musharaka planned the issuance of up to $50 billion in Shariah-compliant debt financing to finance the restructuring of the auto industry over a 10-yearperiod.49

The domestic wholesale Islamic finance industry has developed significantly over the pastdecade, although much of the activity is still focused on investments involving internationalinvestors. However, as the industry matures over the next decade, there are likely to bean increasing number of US-based Islamic finance firms that raise money domestically forinvestments both within the US and globally.

14.4 MUTUAL FUNDS AND EXCHANGE TRADED FUNDS

Of the areas of Islamic finance in the United States covered in this chapter, the retail financialinvestment products, are probably the most widely known. The development of Islamic mutualfunds has occurred during the past 25 years, but remains a small part of the total mutual funduniverse. Exchange-traded funds (ETFs) represent an even smaller area within the Islamic

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Table 14.7 Islamic mutual funds and ETFs

Fund Date

NetAssets

($)

% oftotal

assets DateNet Assets

($)

% oftotal

assets

Amana Income Fund 8/31/09 647.9 37.8% 12/30/09 991.8 39.7%Amana Growth Fund 8/31/09 1025.9 59.9% 12/30/09 1460.0 58.4%Amana Developing

World Fund8/31/09 0.0 0.0% 12/30/09 4.0 0.2%

Azzad EthicalMid-Cap Fund

9/30/09 8.1 0.5% 12/30/09 9.2 0.4%

Iman Fund 8/31/09 26.6 1.6% 12/30/09 30.4 1.2%Javelin International

Islamic ETF9/30/09 4.7 0.2% 12/30/09 5.0 0.2%

Total 1713.2 2500.4

Source: Various SEC filings. Data from 31 December 2009 was compiled from Morningstar.com.

finance industry, although both ETFs and mutual funds have grown rapidly and represent asignificant portion of the overall Islamic finance industry in the United States.

The two largest mutual funds by net assets in the world according to Failaka are the AmanaGrowth Fund and Amana Income Fund. The two funds are also the oldest in the United States,and have net assets of $1.46 billion and $991 million, respectively, as of 31 December 2009.These two funds also dominate the US market for mutual funds managed in accordance withShariah guidelines. The two funds manage 98.1% of the total net assets in Islamic mutualfunds and ETFs in the United States.

Despite the size of the two largest Amana Funds (there is also a Developing World fund,which launched in the fourth quarter of 2009), they are a very small part of the mutual funduniverse in the United States. According to data from the Investment Company Institute, atthe end of November, US mutual funds totalled $10.958 trillion in assets and equity mutualfunds had assets of $4.825 trillion, 44% of the total fund assets.50

The development of the Islamic mutual fund industry in the United States, and the AmanaFunds in particular, began with a small investment pool formed by Muslims in the Indianapolis,Indiana, area in 1984. The investment pool soon grew too large to be managed by its memberswho then approached Nicholas Kaiser, a local fund manager, with whom they started theAmana Income Fund in 1987 with $3.2 million.51 In 1994, the Amana Growth Fund waslaunched to expand the offering of Islamic mutual funds to two.

Following the launch of the Amana Growth Fund, there were no additional funds createduntil after the launch of the Dow Jones Islamic Market Indexes in 1998, when the Dow JonesIslamic Fund, which is now called the Iman Fund, was launched by Allied Asset Advisors in2000. Allied Asset Advisors is owned by the North American Islamic Trust, a waqf servingNorth American Muslims.

The same year, another fund manager, Azzad Asset Management, launched two Azzadfunds, the Ethical Income Fund and the Mid-Cap Fund. The two funds grew slowly during the2000s and as a result Azzad lowered the expenses on the Mid-Cap Fund and eliminated theEthical Income Fund altogether in June 2009.52

In 2009, Amana launched its third mutual fund, the Amana Developing World Fund, whichinvests in emerging market companies. The launch occurred at the end of the third quarter of

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2009. Azzad Asset Management, which manages the Azzad Mid-Cap Fund, filed a registrationstatement for a new fund, the Wise Capital Fund, which has an investment policy similar to abond or money market mutual fund. The fund has not yet been launched and Azzad has notprovided an expected launch date.

The exchange traded funds market, which grew rapidly in the 2000s for the conventionalinvestment industry, was not penetrated until 2009, when the Javelin Exchange Traded Serieswas launched with the first offering, an ETF which tracks the Dow Jones Islamic InternationalTitans 100 Index. This offering will be supplemented by a new series of Islamic ETFs managedby Florentez Investment Management, which is currently awaiting approval from the Securitiesand Exchange Commission. These ETFs, which will be called the ShariahShares, are expectedto be launched in the first quarter of 2010.53

14.5 LEGAL, TAX, AND REGULATORY ISSUESIN ISLAMIC FINANCE

The Islamic finance industry has developed globally within the context of legal, tax, andregulatory systems designed for conventional, interest-based financial products. Although theproducts have been designed to be Shariah-compliant, they are also designed to function withinsecular legal systems. In the United States, the Islamic finance industry followed this trend.This has created several issues in some areas of Islamic finance, while not being burdensomein others.

In general, the Islamic finance products described in other parts of this chapter can be dividedinto three groups for discussing the impact of the US legal, tax, and regulatory environment:investments in assets in the US by international investors, mutual funds, and sukuk. Thissection will highlight some of the most important areas where Islamic finance interacts withthe US legal system and will not provide a comprehensive overview of all the legal issuespertaining to Islamic financial products in the United States.

As described above, there has been significant investment in US assets, primarily real estate,by international investors that have been structured to be Shariah-compliant. In this area, theprimary concern by investors is that they are not disadvantaged in the tax treatment of theirinvestments compared with conventional investors making similar investments.

The most common structure used in Islamic finance transactions for new constructionprojects in the US is the ijara-istisna’a structure as described above for the Maconda Park andTruman Park Apartment projects. A variant of this structure is used by investors purchasingproperties in the United States that uses an ijara to separate investors from the debt usedin property acquisitions. The important consideration in both the ijara-istisna’a structureand the ijara-based acquisition is the structure of the lease and its tax consequences. Beforedescribing these implications, we will describe the ijara-based acquisition structure used formany investments.

A typical property investment fund is organized by a bank in the market where the investorsare located and invests in several properties in the United States, which it can then sell onto investors through a fund. The bank locates properties and establishes the fund with equitythat is at least equivalent to the size of the down payments on acquired properties. The bankproviding financing and the investment fund agree to the financing terms and a neutral SPVis formed. The SPV is neutral in that it is neither owned nor controlled by the bank or theinvestment fund; it is usually owned by a charitable trust or corporate service company.

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The SPV receives a rent advance from the fund equivalent to the down payment on thepurchase of the properties and receives a loan (either conventional or Shariah-compliant) fromthe bank to make up the remainder of the purchase price. The investment fund then leasesthe properties from the SPV with the rent payment mirroring the repayment schedule of thedebt owed by the SPV to the bank. As with the ijara-stisna’a structure, the lease agreementbetween the SPV and the investment fund is supplemented with a call option to allow for earlypre-payment by the investment fund and a put option that the SPV can exercise in cases ofdefault.

The structure used in these types of financing transactions requires that the lessor (theSPV in the case above) retain all of the rights and responsibilities of ownership to complywith Shariah restrictions governing ijara transactions. This is problematic for many banksthat would prefer to transfer those responsibilities to the investment fund, something whichis not permissible in an ijara transaction. In order to comply with Shariah restrictions, thetransactions usually contain an additional agreement where the lessee performs maintenanceand the other responsibilities held by the SPV with the costs being borne by the SPV. Theexpected costs are incorporated into the rent paid by the investment fund.54

One important distinction for US tax law is whether the investment fund is the owner of theproperties it leases from the SPV. If it is the owner it must assume the responsibilities (e.g.maintenance) that it does not assume under an ijara lease except under the supplementaryagreement to act on behalf of the SPV. This structure is used to comply with both the Shariahrestrictions governing leases as well as US tax laws that view it (as opposed to the SPV) asbeing the owner of the property. By being viewed as the owner of the property, rather than alessee, it is able to take advantage of federal tax benefits that would not be available to theinvestors as lessees.

Another similar type of tax issue would arise if foreign investors were leasing equipmentor property within the US. In general, foreign lessors receive more favourable tax treatmentfor “financing” leases compared with “operating” leases. This is because in a financing lease,the lease payments are treated identically to payments made on a loan comprising principaland interest and these payments are generally not subject to taxation. The classification ofthe transaction as an operating lease, in contrast, would expose the investors to US taxationbecause they would be viewed as conducting business in the US. As Robert W. Toan describes:

In this event, the lessor will be subject to U.S. taxation on its net income at regular corporatetax rates (assuming that the lessor is a corporation) of up to 35%. The foreign lessor will receivethe benefit of depreciation to help offset its taxable income from rent, but this depreciation willgenerally be “recaptured” upon a sale of the property, the gain from which will also be subject tonet income taxation.55

The tax implications of using ijara rather than conventional financing are indicative ofone of the primary challenges for Islamic financial products, particularly those that serve asalternatives to interest-based financing. Robert Toan describes the US tax code as being interest-biased because it provides tax advantages to debt financing over other types of financing. Thishas, as described above, created some challenges in structuring Islamic finance transactions inthe United States that are both tax advantageous and compliant with Shariah.

The second area where Islamic finance products must be concerned with US regulationsis for mutual funds. In general, mutual funds which invest in US equities but are organizedoutside the United States are exempt from the Investment Company Act of 1940, which createdthe regulations of mutual funds.56 This exemption requires that the funds not be available to

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investors in the United States. Investment funds available within the US must be registeredunder the Investment Company Act unless they are exempt under another section of the law.One of these other exemptions is for private investment funds, more commonly known ashedge funds.

Mutual funds offered in the US, whether conventional or Islamic, are required to be registeredunder the Investment Company Act, and there is no distinction made between conventionaland Islamic funds. The Investment Company Act primarily deals with investor protection anddoes not have a significant impact on Islamic mutual funds compared to their conventionalalternatives.

The third area where regulations may impact Islamic finance products is in the area of sukuk.The impact of regulations on sukuk issuers is not significantly different from conventionalfinancial products issued by global investors. The primary concern faced by sukuk issuers whencreating the offering documents with regard to the regulatory environment is the applicabilityof US securities laws, which can significantly increase the cost if the sukuk must be registeredunder the Securities Act of 1933. In general, sukuk issuers have two options: register the sukukunder the Securities Act or use one of the two “safe harbour” exemptions, Regulation S orRule 144A.57

In general, most sukuk issuers opt for the Regulation S safe harbour exemption. Thisprovides an exemption for investment products offered by offshore issuers and sold exclusivelyto offshore investors. Ayman Abdel-Khaleq summarizes the restrictions:

Two general conditions apply to the safe harbours provided by Regulation S: first, the offer andsale must be an offshore transaction, which generally means the buyer is not someone in (or aresident of) the US; and secondly there are to be no directed selling efforts, which generally meansthat there should be no conditioning the market for the securities, in the US.58

In most cases, the Regulation S exemption is used because there is sufficient interest fromnon-US-based investors that the issuer can avoid the costs associated with registering the sukukunder the Securities Act or using the Rule 144A exemption.

The 144A exemption, on the other hand, offers a way for certain US investors to investin sukuk issued in compliance with Rule 144A of the Securities Act of 1933. Rule 144Aspecifically exempts private transactions where securities are reoffered or resold to qualifiedinstitutional buyers (QIBs) and are not listed on any public market within the United States.Despite the prospects of tapping the capital markets in the United States by issuing sukuk thatcomply with Rule 144A, only four issuers have opted to take this route.

In general, the legal, tax, and regulatory environment in the United States is friendly toIslamic financial products. The US regulatory environment makes no distinction betweenconventional and Islamic financial products. This provides flexibility for financial institutionsoffering products which have the same economic outcome as conventional products. However,

Table 14.8 Rule 144A-compliant sukuk

Issuer Size Year Issued Year Due Coupon

Loehmann’s $110 million 2004 2011 n/aDP World $1.5 billion 2007 2017 6.25%Republic of Indonesia $650 million 2009 2014 8.80%Petronas $1.5 billion 2009 2014 4.25%

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the lack of familiarity with Islamic finance in the US financial markets and the strict regulatoryenvironment of the US have combined to limit the demand for Islamic financial products. Thislack of demand coupled with significant demand in other parts of the world has limited theneed for issuers to incur the extra expense associated with complying with regulatory ruleslike 144A.

The issuance by Petronas and the Republic of Indonesia of sukuk which comply with Rule144A may mark a turning point in this regard. Those two issues which both occurred in 2009were larger than all other 144A-compliant sukuk issued prior to this year. As the global capitalmarkets continue to be constrained in the aftermath of the financial crisis, the Dubai debtcrisis, and the continuing global recession, more issuers may deem it beneficial to structuresukuk so they are available to US-based investors, even if this availability is limited to QIBs.

14.6 SUKUK ISSUED BY US-BASED COMPANIES

The Islamic finance industry in the United States has a significant divergence between the retailproducts like home finance aimed at US clients and wholesale products, which are primarilyfinanced by international investors. The sukuk market is one area – still in its nascent stagein the United States – that bridges the divide in some ways between international investorsand domestic clients. There have only been two sukuk issued by US-based companies andboth were issued using the exemption from registration provided by Regulation S and thus notavailable to US-based investors. There is also a third sukuk that has remained in the pipelinefor nearly three years, which is the securitization of a Venezuelan oil company owned by aNew York Stock Exchange-listed oil and gas company.59

The two sukuk – East Cameron Partners and GE Capital – each have unique qualities thatprovide interesting case studies for how sukuk can be structured and each is described below.The East Cameron Partners sukuk, besides being the first sukuk issued by a US-based company,has the dubious distinction of being one of the first sukuk to see its issuer proceed through thebankruptcy process. While an unfortunate occurrence for the investors in that sukuk, it doesprovide an interesting precedent for how some of the structures used in sukuk will function, atleast in a US bankruptcy court.

The East Cameron sukuk received a significant amount of attention because it was the firstissue from a US-based company. The size of the transaction, $165.67 million, was at the lowend for sukuk. The issuer was East Cameron Partners, a small wildcatter oil and gas companywith two properties off the coast of the US state of Louisiana. The sukuk was a musharakasukuk with the proceeds used to buy out an equity stake held by Macquerie Bank, which hadprovided conventional financing to East Cameron, as well as the development of other drillingon the properties.

Before covering the structure of the sukuk, we provide a brief overview of the underlyingasset. The lands offshore of the United States where oil and gas exploration occurs are ownedby the US Government and managed by the Minerals Management Service (MMS), a divisionof the US Department of the Interior. These are properties on which exploration is governedby a lease from the MMS. The asset backing the sukuk, in turn, was an overriding royaltyinterest (ORRI) which provides the sukuk investors with a share of total gas production in theproperties up to a certain volume of gas. The unique feature of ORRIs offshore of Louisiana isthat they are recognized as real property and were therefore judged to be a Shariah-compliantasset on which the sukuk could be based.

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The musharaka sukuk was structured using two special purpose vehicles (SPVs), one onshore(Louisiana Offshore Holdings, or LOH) and one domiciled in the Cayman Islands (EastCameron Gas Company or ECGC) for tax reasons. The offshore SPV, ECGC, issued sukukto investors to raise the money to purchase part of the ORRI which comprises the assets ofthe musharaka. The remaining part of the ORRI is contributed in kind from East CameronPartners. The value of the contributed capital and in-kind ORRI determined the percentageallocation between LOH and East Cameron Partners, which was roughly 90% and 10%,respectively.

Following the issue of the sukuk and the musharaka agreement, ECGC entered into threeShariah-compliant hedges for a portion of the future gas production to reduce the impact ofprice fluctuations in natural gas. During the first year of the sukuk, the periodic payments weremade to the sukuk based on the entire principal of the sukuk. In subsequent years, the periodicpayments are calculated based on the value of the unredeemed sukuk. During each quarterfollowing the first year grace period, a portion of the revenue from the sale of gas produced anddelivered to LOH is used to redeem a portion of the sukuk based on the actual gas production.The periodic payment amounts were smoothed through the use of a reserve account.

The East Cameron sukuk ran into trouble in October 2008 when the issuer, East CameronPartners, filed for Chapter 11 bankruptcy. The bankruptcy case, which is still ongoing, provideda key test for one of the key aspects of the sukuk structure used by the East Cameron sukuk,as well as many others. At issue was whether the sale of the ORRI by East Cameron Partnersto ECGC was a “true sale” as the lawyers for LOH claimed or a disguised financing, as EastCameron Partners claimed.

The distinction is significant for investors in the sukuk. If the bankruptcy court had foundthat the sale of the ORRI to LOH was not in fact a “true sale”, it would have brought the assets(the ORRI) into the bankruptcy estate of East Cameron Partners, which would have providedother creditors with recourse against those assets. This is an important outcome for Islamicfinance because it upholds the structure used by many sukuk issuers (at least those that willin the future be subject to US courts), which should provide some reassurance to investorsat least where sukuk are asset-backed and not asset-based. In the former case, the structureprovides sukuk investors with direct recourse to the assets backing the sukuk, which so longas the SPV structure is not collapsed into the bankruptcy estate, will be separated from claimsby the issuer’s other creditors.

In contrast to the East Cameron sukuk, the sukuk issued by GE Capital is significantly largerand less likely to run into the problems faced by investors in the initially CCC+ rated EastCameron sukuk. The GE Capital sukuk for $500 million was structured around several aircraftleases already originated by GE Capital. The leases underlying the GE Capital sukuk wereconventional financial leases and contained aspects which were not Shariah-compliant.

In order to take the portfolio of non-Shariah-compliant leases and make it Shariah-compliant,GE Capital, acting through an SPV, enters an agency agreement with the issuer SPV to servicethe lease portfolio. Any payments made by non-compliant clauses in the underlying leases aresegregated and paid to charity and the remaining lease payments are used to make periodicpayments at 3.875% to sukuk certificateholders. The sukuk also makes use of reserve accountsto smooth the payments to sukuk investors but are also used to generate a return throughcommodity murabaha transactions with the lease servicer, which is a subsidiary of GE Capital.

In contrast with the East Cameron sukuk, in which investors were provided with an assetthat secured the sukuk, the GE Capital sukuk is an asset-based sukuk with the aircraft leasesserving as the asset generating cash flows until the sukuk matures. At maturity, however, the

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sukuk are redeemed through a purchase and sale agreement with the entities that sold the leasesto the issuer SPV at the outset.

The first two sukuk issued by US-based companies provide examples of two unique struc-tures that represent the dichotomy in sukuk structures between those that are asset-backedand those that are asset-based. The East Cameron sukuk provided information for issuersand investors alike about the robustness of the legal structure in cases of default or issuerbankruptcy. The GE Capital sukuk demonstrated the potential for non-Shariah-compliant con-tracts to be unwrapped with their non-compliant cash flows stripped out and the remainderused for structuring an asset-based sukuk.

The paucity of issues from US-based companies highlights the underdevelopment of thesukuk market as a funding source for US-based companies. Following the credit crisis, whichhas severely restricted the financing markets for many businesses, particularly those which relyupon bank financing and without access to the debt markets in the US, a sukuk could providean alternative. However, in the near term, this remains unlikely with the majority of new sukukissues coming from well established companies and sovereign or multilateral issuers.

14.7 CONCLUSION

The Islamic finance industry in the United States has developed relatively slowly, both inthe wholesale area and the retail areas. However, several institutions based in the Gulf havefootholds within this market and appear to be re-entering with new investments following thefinancial crisis that began in 2007. Several institutions with the largest footprints across theUnited States are either maintaining their investments or, in the case of Kuwait Finance House,re-entering the market with new investments in real estate. In addition, a domestic firm, StellaCapital, is anticipated to launch a Shariah-compliant investment fund to invest in distressedoffice properties in January 2010.

However, despite the continued presence of several Gulf-based banks and domestic com-panies, there remain significant gaps in the industry. One of the largest is the near total lackof Shariah-compliant investment opportunities targeting US-based institutional investors. Thetwo sukuk that have been issued by US-based companies were both closed to US investorsto enable them to take advantage of the Regulation S exemption from registration under theSecurities Act of 1933.

This could indicate that there is not sufficient demand from within the US to warrant issuingproducts under the Rule 144A exemption. However, there have been several sukuk issuedglobally that have used Rule 144A instead of Regulation S, including two during 2009. Thiscould indicate that we should expect sukuk issuance from other US-based companies, but feware expected in the near term. This could be a sign that the concept of a sukuk is viewed as aforeign concept that intrigues institutional investors sufficiently for them to invest in foreign-issued sukuk, but is not viewed as mature enough to create a reliable source of demand amonginstitutional investors within the United States.

There may also be some feedback from the small retail Islamic finance industry that limitsdemand for sukuk. Some of the largest investors in sukuk globally are takaful companies andIslamic banks, both searching for Shariah-compliant fixed income alternatives to hold on theirbalance sheet alongside their other assets. The UK, in contrast to the United States, has fiveIslamic banks: one retail bank and four wholesale banks. In the US, there is one retail bank (asubsidiary of a conventional bank) but no wholesale banks. There is one provider of takaful,AIG, and its Islamic finance business is headquartered outside the United States. Other large

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banks in the United States are also involved with Islamic finance, but those activities are basedout of regions of the world with larger domestic Islamic finance industries.

The consequences of this may be relatively benign for the Islamic finance that does occurin the US where the interaction with Islamic finance is either done overseas or in a passiveway as a destination for Shariah-compliant investments. However, it is likely that the lack ofinfrastructure for Islamic finance within the United States will limit the role the US can playin the Islamic finance industry as a whole. The role of Western capital of Islamic finance,at least for the time being, seems likely to be London, Singapore, or Hong Kong instead ofNew York.

One area where this could have a significant impact is on the retail investment prospectsfor the five to seven million Muslims living in the United States. As we have described, oneof the areas where retail Islamic finance has intersected with the capital markets is in mutualfunds and exchange-traded funds. These funds, however, have been entirely equity funds.For many Muslims saving for retirement using Shariah-compliant investments, an entire assetclass is non-existent. With so few options for engaging with the Shariah-compliant financialsystem available, there is little natural demand created by the limited familiarity that exists incountries like the UK for the types of institutions that will encourage a deepening wholesaleIslamic finance industry to develop.

NOTES

1. Michael J.T. McMillen (2000) Special US Report: Briefing: Islamic Finance: Breakingthe Mould, Middle East Economic Digest, 44(38), 28–9.

2. Michael J.T. McMillen (2008) “Shariah-compliant infrastructure and project finance” inHenry A. Davis (ed.), Infrastructure Finance: Trends and Techniques, p. 383.

3. Michael J.T. McMillen (2001) Islamic Shariah-compliant project finance: collateral secu-rity and project finance structural case studies, Fordham International Law Journal, 48,May 2001.

4. Kuwait Finance House (1994) Annual Report, Kuwait Finance House: Kuwait City.5. Kuwait Finance House (1995) Annual Report, Kuwait Finance House: Kuwait City.6. Riyad Bank, RBE London Limited and RBE Ijara Fund PLC v Ahli United Bank (UK)

PLC [2005] EWHC 279 (Comm). Available from http://www.hmcourts-service.gov.uk/judgmentsfiles/j3123/riyadbank-v-ahli united bank.htm.

7. Kuwait Finance House (1998) Annual Report, Kuwait Finance House: Kuwait City.8. Abdulkader Thomas (2002) The state of the art: converging trends, ABANA Review, XIX(2)

Fall 2002, 3–5.9. John Foster (2007) New kids on the block, Islamic Business & Finance, 19 June

2007. Available from: http://www.cpifinancial.net/v2/Magazine.aspx?v=1&aid=980&cat=IBF&in=19.

10. Mushtak Parker (2005) First Islamic changes its name, Arab News, 28 February. Availablefrom: http://www.arabnews.com/?page=6&section=0&article=59689&d=28&m=2&y=2005&pix=business.jpg&category=Business.

11. Ben Delaney, Yakima bought by Watermark, a top water sports company, Bicycle Retailer,1 August 2001.

12. The equity portion is estimated by taking the reported assets under management as of 30June 2009 multiplied by the reported percentage within the United States. This is dividedby the total transaction value of all acquisitions between 1998 and 2009 of companies

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within the United States, less the transaction values that were exited prior to 30 June 2009.The debt portion is calculated as one minus the equity portion.

13. Arcapita (2005) Annual Report 2005, Manama: Arcapita.14. Prologis (2006) Annual Report Form 10-K, Note 21 to Financial Statements,

filed 16 March 2006. Available from: http://edgar.sec.gov/Archives/edgar/data/899881/000095013406005249/d33907e10vk.htm.

15. Arcapita. Annual Report 2009, Manama: Arcapita, p. 40.16. Unicorn Investment Bank. Annual Report 2004. Bahrain: Unicorn Investment Bank.

Annual Report 2006. Bahrain: Unicorn Investment Bank. Available from: http://www.unicorninvestmentbank.com/en/category/financials/annual-reports/.

17. Unicorn Investment Bank. Interim Consolidated Financial Statements. 30 September2009.

18. Abu Dhabi Islamic Bank (2006) Base Prospectus from ADIB Sukuk Company Ltd, 1December 2006.

19. Robin Wigglesworth (2006) Investment banking insights, Islamic Business & Finance,Issue 11, September 2006. Available from http://www.cpifinancial.net/v2/print.aspx?pg=magazine&aid=2.

20. Kuwait Finance House. Annual Report 2005, Kuwait Finance House: Kuwait City, p. 16.21. TransOcean Capital, Inc. “Portfolio”. Accessed 19 December 2009. Available from

http://www.transoceancapital.com/portfolio/index.html; Gulf Investment House. AnnualReport 2008. Kuwait City: Gulf Investment House.

22. Erin Johansen (2001) Key enters Denver market on behalf of Saudi investors, DenverBusiness Journal, 10 August 2001. Available from: http://denver.bizjournals.com/denver/stories/2001/08/13/story8.html.

23. Shamil US Real Estate Portfolio (2003) Principal Terms Memorandum, 10 February.24. Shamil US Development Opportunities Fund I, Private Placement Memorandum.

November 2005.25. First Leasing Bank, Investment Overview, 21 August 2006; First Leasing Bank, Private

Placement Memorandum, 21 August 2006.26. First Leasing Bank, Quarterly Report 2009 Q1, Manama: Bahrain. Available from

http://www.1stleasingbank.com/financial.htm.27. Blake Goud (2009) Islamic Finance in North America, Yasaar Media: Dubai, p. 22. Avail-

able from http://yasaarmedia.com/Yasaar Media Islamic Finance in North America2009.pdf.

28. HSBC Amanah, Global Properties Income Fund Fact Sheet, September 2002.29. HSBC Amanah, Aqar Income Fund Fact Sheet, January 2005.30. HDG Mansur, “HDG Mansur to list first Shariah-compliant global real estate company

on DIFX and LSE” Press Release, 4 June 2007.31. Grosvenor, Annual Report 2008, Grosvenor: San Francisco.32. The Securities House. “Acquisition of Al-Shall Consulting and Investment Company

and changing its name to Al-Aman Investment Company” Press Release, 15 May 2005.Available from http://www.sh.com.kw/press 200515.htm.

33. Arab Banking Corporation. “Successful launch of US Islamic Commercial Real EstateFund” Press Release, 18 May 2007. Available from http://www.arabbanking.com/En/AboutABC/Media/Press/Pages/SuccessfulLaunchofUSIslamicCommercialRealEstateFund.aspx.

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34. John Irish and Eman Goma, “Kuwait Finance, UDR to set up U.S. prop-erty J.V.” Reuters, 15 August 2009. Available from http://www.reuters.com/article/idUSTRE57E0IJ20090815.

35. UDR, Inc. (2009) Quarterly Report Form 10-Q for Period Ending September 30, 2009.Filed with the Securities and Exchange Commission, 3 November 2009. Available fromhttp://edgar.sec.gov/Archives/edgar/data/74208/000095012309056760/c91753e10vq.htm

36. Staff Writer. “KFH signs direct real estate investment in Chicago worth $242 million”CPI Financial, 27 December 2009. Available from http://www.cpifinancial.net/v2/News.aspx?v=1&aid=3996&sec=Wealth%20Management.

37. Shariah Capital. “The Shariah-compliant Arboon short sale” Presentation accessed 27December 2009. Available from http://www.shariahfunds.com/pubs/shariah/arboonexplained.pdf. DeLorenzo, Shaykh Yusuf (2008) “The Arboon Short Sale: A Shariah-compliant alternative to selling short with borrowed securities” accessed 27 December2009. Available from http://www.shariahfunds.com/pubs/shariah/the arboon saleenglish.pdf

38. Frank E. Vogel, and Samuel L. Hayes (1998) Islamic Law and Finance: Religion, Riskand Return, Kluwer Law International: The Hague and Boston, pp. 156–7.

39. The gold fund is managed by Tocqueville Asset Management, LP: the energy fund by LucasCapital Management, LLC, the natural resources fund by Zweig-DiMenna InternationalManagers, Inc., and the global resources and mining by BlackRock Capital Management,Inc.

40. Zeus Capital Advisers, “Crescent Bancshares to raise $15m for bank acquisition inChicago” Press Release, 11 December 2009. Available from http://www.openpr.com/news/111632/Crescent-Bancshares-to-raise-15m-for-bank-acquisition-in-Chicago.html. Crescent Bancshares, “Crescent Bancshares Corporation to acquire a bank inthe Chicago market” Press Release, 23 December 2009. Available from http://www.crescentbancshares.com/infocenter.html.

41. Blake Goud (2009) Islamic Finance in North America, Yasaar Media: Dubai, p. 51.42. Stone Cross Capital, “Platform”, accessed 30 December 2009. Available from http://

stonecrosscap.com/platform.htm.43. Sheikh Yusuf DeLorenzo (2007) The Total Returns Swap and “Shari’ah Conversion

Technology” Stratagem. Manuscript. Emphasis added.44. For more information on synthetic longevity-linked assets, see Jonathan T. Sadowsky

and Matthew C. Browndorf (2009) “Synthetic Longevity-Linked Assets – A Primer” inVishaal B. Bhuyan, (ed.), Life Markets: Trading Mortality and Longevity Risk with LifeSettlements and Linked Securities, John Wiley & Sons, Inc.: Hoboken, NJ.

45. Authors’ note: this is just one possibility for how a Shariah-compliant longevity-linked product could be constructed and does not necessarily represent the actualstructure used by Stone Cross Capital. For more information on profit rate swaps,see Andreas A. Jobst (2009) “Risk Management and Islamic Financial Instruments”Qatar Finance – The Ultimate Resource (“Qfinance”), Bloomsbury Publishing, London.Available from http://www.qfinance.com/financial-risk-management-best-practice/risk-management-of-islamic-finance-instruments?page=1.

46. Joseph A. Giannone, “New fund helps hard-hit US firms finance ex-ports” Reuters, 21 September 2009. Available from http://www.reuters.com/article/idUSN216663820090921.

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47. GTR, “New trade finance fund to launch in the US” GTR magazine, 24 September 2009.Available from http://www.gtreview.com/global-trade-review-news/2009/September/New-trade-finance-fund-to-launch-in-US- 7618/.

48. International Islamic Trade Finance Corporation, “Modes of Financing”, accessed 31December 2009. Available from http://www.itfc-idb.org/node/122.

49. Blake Goud (2009) Driving force, Islamic Business & Finance, Issue 41, April. Availablefrom http://www.cpifinancial.net/v2/Magazine.aspx?v=1&aid=1975&cat=IBF&in=41.

50. Investment Company Institute, “Trends in Mutual Fund Investing, November 2009” PressRelease, 30 December 2009. Available from http://www.ici.org/research/stats/trends/trends 11 09.

51. Blake Goud (2009) Islamic Finance in North America, Yasaar Media: Dubai.52. Ibid., p. 18.53. Liau Y-Sing (2009) “U.S. fund manager plans Islamic ETF in Q1 2010” Reuters, 5 October

2009. Available from http://in.reuters.com/article/fundsNews/idINKLR46690420091005.54. Isam Salah (2009) “Legal issues arising in Islamic finance transactions in the United

States” in Islamic Finance in North America, Yasaar Media: Dubai.55. Robert W. Toan (2009) “Cross-border ijara: a case study in the U.S. taxation of Islamic

finance”, in Harvard Islamic Finance Project (ed.), Islamic Finance: Local Challenges,Global Opportunities: Proceedings of the Third Harvard University Forum on IslamicFinance, Harvard University: Cambridge, MA, p. 193.

56. 15 USCS § 80a-7(d). Available from http://www.law.uc.edu/CCL/InvCoAct/sec7.html.57. Ayman H. Abdel-Khaleq (2005) “Offering Islamic funds in the US and Europe”

International Financial Law Review, Supplement on Islamic Finance, 24 May 2005.Available from http://www.iflr.com/Article/1984847/Offering-Islamic-funds-in-the-US-and-Europe.html.

58. Ibid.59. Siraj Capital, “Capital Markets”. Accessed 3 January 2010. Available from http://

sirajcapital.com/capital markets.htm.

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15

An Analysis of Global Trends andRegional Pockets in the Application ofIslamic Financial Contracts in Malaysia

and the Gulf Cooperation Council

Anne-Sophie Gintzburger

In essence, Shariah-compliant finance supports activities in the financial system that are inline with the principles for transactions and contracts detailed in Islamic commercial law. Ithas a clear set of approaches in contractual structures and product structures for financingoperations. These financing operations share the same economic objectives as those of theconventional financial system yet do so with different underlying structures and customer-institution interactions. In Sheikh DeLorenzo’s words, “while the economics are the same,the mechanics are different”.1 Islamic finance in its applications has adapted to regionalcircumstances beyond the overarching prohibitions against riba, gharar, and maysir in Shariah-compliant transactions. A sign of this adaptability is the spectrum of perspectives on thepermissibility of the implementation of some key Islamic transaction contracts. This variationhas been the source of debates among practitioners in the industry, particularly and mostnotably recent debates around the permissibility of the tawarruq arrangement and certainsukuk structures.

Within the diverse cultural and socio-economic contexts in which Islam is practised, andbeyond regions where Islam is the predominant religion, the ways in which Shariah-compliantfinance is practised varies around key yet narrow areas. True to the characteristics of adaptabil-ity reflected in the diversity of regions that Islam is practised in, Islamic finance, consideredin the realm of secondary matters in which a variety of opinions is permissible, arguablyreflects a corresponding capacity for adaptation to regions as diverse as the Middle East andSouth East Asia. The consequence of this adaptability is that a variety of interpretations areneeded to suit and mediate between specific environments in which Shariah-compliant financeis practised and between interpretations of what should or ought to be done in different partsof the world by various groups of Shariah scholars. Some would argue that the ways in whichIslamic finance is practised reflects and demonstrates a dynamic adaptation to distinct localnorms and local regulatory environments.

The development of the application of Islamic principles to the contemporary financ-ing needs of Muslims across diverse regions is increasingly significant in the internationalfinancial landscape. Since the implementation of the Napoleonic code in most states of the


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Middle East, financing needs were met through conventional (Western) financial institutions.Conventional financial institutions gradually replaced the Islamic commercial contracts thatwere applied for financing purposes, and particularly to trade, in the region. Similar circum-stances applied to the Indian subcontinent through the influence of British law. Subsequently,Islamic finance, or Shariah-compliant finance, emerged as an intellectual offshoot of pro-independence movements like the Muslim Brotherhood, originating in Egypt. These politicalmovements were partially motivated as a response to colonial disregard for local Islamic idealsand aspired to develop socio-economic and political systems that drew their significance fromIslamic values.2 From the early stages at the periphery of the global financial system, Shariah-compliant finance is increasingly recognized and integrating into the broader internationalfinancial system.

Beyond regions where Islam is the predominant religion, start-ups in Islamic financesprouted across Western states. These pilot projects are reflected in initiatives such as theIslamic Bank of Britain, Germany’s Saxony-Anhalt sukuk al ijara (Islamic fixed incomesecurity), the opening of a subsidiary of Kuwait Finance House through Malaysia in Australia,and the Muslim Community Co-operative (Australia). Conventional banks, headquartered inWestern states, have also opened Islamic divisions. These include BNP Paribas Najmah, HSBCAmanah, and Standard Chartered Saadiq. Additional evidence of a growing integration intothe international financial system is the existence of the Dow Jones Islamic Market Index(DJIM) and the FTSE Global Islamic Index Series (GIIS), both indicative that Islamic financeis increasingly recognized in leading international financial centres.

In economies such as that of Malaysia, where Islamic finance is well supported basedon the Government’s lead in its development, its application offers an insight into strategiesfor financial modernization advanced by an economy belonging to the Organization of theIslamic Conference (OIC),3 particularly significant as the organization strives to develop andprotect the interests of the Muslim world. True to the characteristics of adaptability reflectedin the diversity of regions in which Islam is practised, Islamic finance reflects a correspondingcapacity for adaptation to regions as diverse as South East Asia and the Middle East. Reflectiveof a divergence – in certain areas of the Islamic financial sector – in the application of Islamictransactional contracts that demonstrates adaptation to distinct local norms, Islamic financehas adapted to what could be qualified as regional circumstances beyond the overarchingprohibitions against riba (financial interest), gharar (ambiguity), and maysir (gambling) infinancial transactions.4 A sign of this adaptation to local contexts is apparent in the applicationof certain Islamic finance contracts, resulting in divergence of opinion. This divergence ofopinion has on some occasions led to debates among members of the Shariah Boards5 acrossregions.

These variations in opinions on contracts may be attributed to a diversity of backgrounds, toschools of jurisprudence, as well as to the regional context and national regulatory environmentin which the members of the Shariah Boards function. These varieties in the contexts in whichthey operate and their individual backgrounds lead Shariah Board members to diverge in theiropinions on the permissibility of the implementation of certain Islamic financial products.Some of these Islamic financial products may qualify as traditional and are directly linked toclassical commercial contracts. Other financial products are innovative and require in-depthtechnical interpretations of both the sources of Islamic law and of conventional finance in orderto offer alternatives to the conventional financial system while respecting the requirements forShariah compliance. A recent example of an innovative product is Shariah-compliant short-selling which is a relatively new concept based on the contract of bai’ al arboon (a deposit

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An Analysis of Global Trends and Regional Pockets in the Application 309

secured sale) and which was developed and deemed Shariah-compliant by a team of leadinginternational Shariah Board members.6

Some implementations of Islamic finance contracts are local and present in primarily limitedregional contexts whereas others are transnational in their application. This latter point isreflected in the divergence of opinions between some Islamic finance practitioners in Malaysiaand others in the Arab monarchies of the Gulf Cooperation Council. This diversity, at timessubtle, in the application of Islamic commercial laws to financing exposes a dimension ofIslam usually ignored in mainstream Western conceptions of Islam. These tend to presentIslam as a static and unitary system. Yet Islamic finance and its practice through Islamicfinancial institutions (IFIs)7 demonstrates a capacity for innovation. It has the potential to shiftWestern perceptions of Islam beyond the rigidity with which it has been portrayed, to that ofa dynamic system which adapts to the needs of modern societies, a dynamism exposed by theemergence of Islamic finance.8

Beyond similar economic objectives to those of the conventional system, what distin-guishes Islamic finance from conventional finance is its contractual underpinnings. Theseunderpinnings rely on transactional structures that facilitate transactions that conform toIslamic commercial laws and that are primarily equity-based, asset-based, and asset-backed.9

This is a contrast to the methods of the conventional financial system where underlying assetsare not a requirement and money may be created out of pre-existing money rather than outof tangible assets. In theory, Islamic finance relies on equity participation or the sharing ofprofit and loss by parties to a transaction.10 In order to fulfil the theory of equity participation– the system is still developing – equity financing is yet to develop globally. The Islamicfinance industry, in a practical or pragmatic implementation of the theoretical underpinningsof Islamic economics, has predominantly relied on the contracts of exchange (such as ijara,murabaha, istisna’, and salam). It has done so at the cost of the equity-financing contracts, orcontracts of participation, in the banking sector (such as musharaka and mudaraba) due to therisks involved.11 In the capital markets, sukuk structures based on the contracts of musharakaand mudaraba were regularly applied until a pronouncement by the Shariah Board of theAccounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) inFebruary 2008 shifted this trend.

15.1 REGIONAL POCKETS AND GLOBAL TRENDS

Studies of the Shariah-compliant financial system have presented the system as a whole whileneglecting to understand certain pockets of divergence within the field. Such neglect does notfacilitate a clear understanding of the underlying structures of the sector in the transactionalstructures. Nor does it facilitate an understanding of the human and regional dynamics of thesector through the involvement of the members of the Shariah Boards of differing backgrounds.Occasional mention in newspaper articles regarding regional differences surrounding thepermissibility of the use of the Islamic contracts of bai’ al ina (bipartite same item sale) and bai’al dayn (sale of debt not at par value) led to developing an interest in understanding differencesof a regional nature, especially when mention of the need for “Shariah-convergence” wasalluded to on numerous occasions in newspapers and business articles.12 Although the term“Shariah convergence”13 is not an accurate term as there is recognition for all Islamic schools ofjurisprudence for commercial matters and among Shariah Board members of Islamic financialinstitutions, the term was a trigger for the research.

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The potential that the contemporary forms of Islamic financing offer for the development ofMuslim economies and its recent growth14 – estimated at an average annually of 15–20%15 –makes it an area that should be further understood. It is in this contemporary context thatthis chapter seeks to address the underlying principles of Shariah-compliant finance and thecomplexities and particularities of the system as it is practised in its most profitable forms inMalaysia and the Arab monarchies of the Gulf. It is a comparative analysis of Islamic financecontracts applied by IFIs and their links to members of the Shariah Boards, pertaining to thesecontracts on a global scale. Although the coverage of the research is limited to Malaysia andthe Gulf Cooperation Council (GCC), these two regions cover a major portion of the totalmarket share of global Islamic finance. Hence what is observed of Islamic finance in the tworegions may be representative of broader global trends. This chapter analyses potential factorscontributing to the observed inter-regional contrasts in the permissibility and implementationof Islamic transaction contracts and seeks to further understand the permissibility of keyIslamic contracts which are applied across the banking sector, Takaful, and the Islamic capitalmarkets.

15.2 THE INFLUENCE OF THE SHARIAH FRAMEWORK

Islamic finance is applied in regions as diverse as South East Asia and the Middle East. Withsuch a variety in the contexts in which it is practised and implemented, it is to be expected thatthere will be variations at the level of the use of Islamic finance contracts. It is to be expectedtoo that there will be disagreements and a divergence of perspectives on the permissibility ofcontracts based on the context and the time at which Shariah pronouncements or fatawa aremade. The variety in regions reflects a variety in needs, a variety in socio-economic and politicalcontexts as well as differing economies and regulatory environments, to which Islamic financewas adapted at a particular point in time in the evolution of the sector. Shariah Board memberswho are predominantly experts in fiqh al muamalat have played a key role in this process ofadaptation as the contemporary financing needs of Muslims are as diverse as the regionsthey are based in. Additionally, the financing needs of Muslims have required interpretationsbeyond the classical contracts pre-existing the implementation of conventional finance inthe Arabian Peninsula and the Indian subcontinent and this interpretive process has requiredShariah Board members to exercise interpretation. With interpretations come variations anddivergence of opinions and this divergence is respected in subsidiary matters in Islam. Thesesubsidiary commercial matters are not core to the faith such as the tenets of the faith and itsrituals. Secondary matters or subsidiary matters, such as those covered by Islamic commerciallaw, allow for this wealth and divergence in perspectives.

Throughout a study on regional differences in Islamic finance,16 the Shariah Boards ofinstitutions offering particular Islamic financial products showed a distinctive pattern basedon the nationalities and backgrounds of Shariah Board members of the type of products likelyto be permitted. An analysis of the regions of origin and regions of training of Shariah Boardmembers revealed that a significant portion of the Malaysian members of the Shariah Boardshave studied in the Middle East, and as such that they would be familiar with the opinionsof members of the Shariah Boards in the GCC. As such the regional differences could not belinked only to the states of origin of the Shariah Board members. A reflection on the regulatorystructures at the level of the formal and the informal Shariah framework indicated that thedifference in the centralized approach to guiding Shariah interpretations in a jurisdiction,as in the case of Malaysia, and the decentralized approach in the GCC states, contributed

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most significantly to the regional variations observed. The Malaysian Shariah framework isbroader and more encompassing of the perspectives of the GCC Shariah Board membersthan the converse. Malaysia-specific applications of contracts such as bai’ al ina and bai aldayn are likely to remain localized to Malaysia and more steps are taken for Middle Easterninterpretations to be integrated to the local market by welcoming GCC-based Islamic financialinstitutions into Malaysia.

15.3 THE FUNCTION OF SHARIAH BOARDS

The purpose of including a Shariah Board in the governance structure of an Islamic financialinstitution is to enable the institution, its shareholders, stakeholders, and clients, and to someextent the local financial authorities to be ensured of the Shariah compliance of its internal andexternal operations. In Shariah-compliant financing, members of the Shariah Boards – Muslimjurists specialized in fiqh al mu’amalat (Islamic commercial laws) and other areas of relevantexpertise, in some cases economics and conventional law – form the nucleus of Islamic financemechanisms. This organ within the operation of the Islamic financial institution is responsiblefor interpreting and assuring – in light of the interpretations of Islamic commercial laws –Shariah compliance of transactions implemented by the IFI as well as Shariah compliance ofthe proposed structure of new Islamic financial products. The manner in which the jurists areinvolved at the level of the Islamic financial institution in the jurisdictions of Malaysia and theGCC states is addressed. This dimension is believed to have a direct impact on some of theregional variations identified.

Shariah scholars may, in some jurisdictions and in particular international standard-settingbodies, be involved in developing policies for a jurisdiction’s Shariah framework or forjurisdictions at an international level. Such is the case in jurisdictions where there is a nationalShariah Board at the level of the financial authorities. At a supranational level, Muslim juristsmay be involved in international standard-setting bodies. Adherence by IFIs to the interpre-tations of Islamic commercial laws set by these international bodies – such as those by theShariah Board of the Accounting and Auditing Organisation for Islamic Financial Institutions(AAOIFI) or the Islamic Fiqh Academy – is voluntary. In many instances, the Shariah inter-pretations by these international bodies may be used as guidelines for various jurisdictions inwhich IFIs operate. In such supranational contexts, scholars – that is, Shariah Board mem-bers of numerous institutions, internationally – meet to discuss interpretations of the Shariahfor particular financial products and for new products, resulting in new interpretations or inthe consolidation of past interpretations, which can then be guidelines for Shariah Boardsinternationally.

Members of the Shariah Boards have a direct involvement in the legal and contractualmatters relating to an IFI’s transactions. Their priority is to endorse the Shariah compliance ofproducts or operations. In cases where there are no pre-existing opinions or cases, they theninterpret, approve, and review Islamic finance contracts and underlying product structures.This interpretation, for new products, is done through the process of ijtihad in which Muslimjurists, with a specialization in fiqh al muamalat, interpret the sources of the Shariah that guidecommercial matters. The interpretive process of the Shariah that analyses the textual sourcesof the Quran and the Sunna is known as ijtihad, meaning independent reasoning, and theend product of this interpretive process is known as the fiqh. Clearly stating the importance ofhuman reasoning in interpreting the guidelines in the sources of Islamic law, Mohd Daud Bakaremphasizes that fiqh, from which rulings for Islamic transactions are made, is the product of

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human understanding: fiqh which literally means intelligence, is a result of an independentexercise of reasoning in deciding a point of law.17 This emphasizes the potentially fluid natureof interpretations for new Islamic financial products, until interpretations are consolidated.18

This may provide a potential explanation as to why some Islamic financial products may beinterpreted as Shariah-compliant in some parts of the world, and may not be interpreted assuch in other regions or by different IFIs’ Shariah Boards. There is however a distinctionbetween the fatawa issued and the organization and procedures of the Shariah Boards. TheIslamic Financial Services Board (IFSB) is concerned only with the organization and procedureof the Shariah Boards and not with the fatawa as the AAOIFI is. Both the fatawa and thesystems of Shariah governance can vary between, and sometimes even within, jurisdictionsbut they are not necessarily related to each other. In most cases, only the Shariah governancesystems are determined by the legislative and regulatory environment whereas in Malaysia,this additionally includes the pronouncement of fatawa.

In the 1970s and early 1980s, when Islamic finance was emerging, the appointment of aShariah Board was not an obligation for the overall functioning and reputation of an Islamicfinancial institution, in particular for Islamic banks which were existent before other formsof Islamic financial institutions developed, such as Takaful operators, Islamic subsidiaries ofIslamic banks, and Islamic windows of conventional banks.19 The contemporary trend forIslamic financial institutions, be they Islamic windows, subsidiaries, or fully-fledged Islamicinstitutions, is to function under the guidance of a Shariah Board. Other terms also employedto refer to a Shariah Board are Shariah advisory council, Shariah advisory committee, fatawaand guidance committee, or Shariah Supervisory Board based on the jurisdictions in whichthe financial institution operates.

Even though this applies to the current and contemporary Islamic financial sector, oneolder study (Michel Galloux’s) on Islamic banking presents the role of Shariah scholars as asymbolic one rather than one directly contributing to the evolution of the sector. In MichelGalloux’s study of Islamic finance, with a case study on Egypt in the late 1990s and avariety of banks across Middle Eastern states, rather than having an operational role, theShariah scholars in Islamic finance were considered by him as having a much more symbolicfunction at the heart of Islamic banks.20 From the perspective of his study, their role was togive an Islamic legitimacy to the operations of the bank.21 This could have been due to thelimited specialization in fiqh al muamalat for Shariah scholars at the time and the limitedknowledge of conventional finance which has inspired Shariah-compliant financial products.Even though the impact on the reputation of the institution could be perceived as equivalentto a form of symbolism in terms of the institutions’ Islamic legitimacy, contemporary Muslimjurists are involved in the technical development of Shariah-compliant financial instrumentsdue to their growing understanding of the financing needs of Muslims and of the ways inwhich the economic objectives supported by the conventional financial sector can be met in aShariah-compliant fashion. Their role in this decade is more than symbolic, it is also technical:“. . . they do have a very significant role in the contemporary practice of Islamic banking, muchmore than what we noted . . . in the context of the early days of the Islamic economic project.But their role is rather technical.”22

An incident reported to have contributed to the progressive incorporation of Shariah Boardsas part of the operations of Islamic banks occurred in Dubai Islamic Bank in the 1990s. Thebank’s reputation was damaged owing to embezzlement.23 In order to avoid the recurrenceof such an event, the setting-up of an independent Shariah Supervisory Board to avoid therepetition of such a situation was sought. Sheikh Hussein Hamed Hassan, a prominent Shariah

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scholar from Egypt and based in the GCC, has headed Dubai Islamic Bank’s Shariah Boardfor several years. Similarly, decades after the first experiments in Islamic banking in Egypt,Jordan, and the United Arab Emirates’ emirate of Dubai, Islamic financial institutions made itmandatory to include the opinions of independent scholars on the permissibility of financialproducts offered. Early and significant fatawa have been reported back to Dubai Islamic Bank,Kuwait Finance House, and the Sudanese Faisal Islamic Bank. In the 1990s, significant fatawacan be traced back to Dar al Mal al Islami, Al-Baraka, and Jordan Islamic Bank.24

As an industry that builds its reputation on the credibility of the Muslim jurists it ap-points, they may be regarded as guardians or custodians of the ethics and dependability of theindustry, having a responsibility for the evolution of Islamic finance.25 In addition to the roleof jurists, the regulatory authorities of the jurisdictions in which IFIs function have a salientrole in ensuring the financial regulation of Islamic financial institutions. In jurisdictions inwhich there is a national Shariah Board, the financial authorities collaborate with a desig-nated team of reputable Shariah scholars to create a Shariah framework which all IFIs arerequired to follow. Additionally and more recently, there has been the development of cor-porate entities that offer the services of Shariah scholars, generally regrouping internationaland renowned Shariah Board members independent of the jurisdictions in which these cor-porations are based. They offer the services of these groups of Shariah scholars and formShariah advisory firms;26 examples of such institutions include Yasaar Ltd, Amanie BusinessSolution, and Dar al Istithmar. Combining groups of renowned Shariah Board members, theyare developed to cater to the needs of Islamic financial institutions across numerous jurisdic-tions, as the scholars participating in these are generally specialized in several jurisdictions.For instance, the Shariah Board of Amanie Business Solutions has Shariah Board membersfrom Malaysia, Kuwait, Saudi Arabia, and Qatar,27 all of which additionally work on variousShariah Boards of IFIs across the jurisdictions of each of their countries of origin as well asinternationally.

Islamic finance evolved separately in Malaysia and the Middle East. It is believed to bein the early 1980s that the respective Islamic finance sectors started interacting across theborders of these diverse regions. Practices as such developed separately and Shariah scholarsof the two regions approved core financial structures without interacting with jurists involvedin the development of Islamic finance in other regions. Even though they may have studiedIslamic commercial law in similar parts of the world, the practice of Islamic finance seemed tohave been done within a relatively insulated context of their respective regions. Whereas theinitial experiments in Islamic finance and banking in Malaysia developed through Tabung Haji,which was a pilgrims’ fund to save for performing the Hajj, in the Middle East, it developedthrough the bank in the town of Mit Ghamr in Egypt, followed by the development of the firstIslamic bank in the Gulf, Dubai Islamic Bank.28

Mahathir’s call for ijtihad and innovation, especially for the development of the IslamicCapital Market in Malaysia, is a direct example of the importance of the process of ijtihad forthe Islamic financial sector.29 With the contemporary financial system, ijtihad is required asmany of the products and transactions necessary have not been addressed in primary sources ofthe Shariah.30 The commercial transactions, especially in banking and financial issues, belongto an area of the law that is unfixed and as such ijtihad may be applied in those.31 There is anunderstanding that in Islamic law, the law is given not ready-made “to be passively receivedand applied”, but rather it is to be actively constructed on the basis of those sacred texts.32

Whereas Islamic law is fixed in certain areas, contemporary circumstances require adaptationsor interpretations (not necessarily equivalent to interpretations in the English sense of the

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terms as they need to be based on textual evidence for Sunni jurists as opposed to the role thatintuition may play in deriving or extracting laws for Shi’i scholars).33 Ijtihad is crucial forinnovations in Islamic finance and is believed to be at the core of some of the divergence inopinions across regions. According to one Kuala Lumpur-based Pakistani Shariah scholar34

working on the harmonization of Islamic law in Islamic finance, the crux of the regionaldifferences, those that are pertinent to the permissibility of instruments, is a direct result ofijtihad. It is a direct result of the differences in interpretation of Shariah injunctions. Withinmethods for ijtihad, there are differences among the schools of jurisprudence. For instance,the Hanafi consider irregular the literal methods of proving the hukm but these are practisedby the other schools of jurisprudence.35 These differences in methodology could potentiallyalso contribute to divergence in opinions on the permissibility of financial products.

For Islamic financial products and issues referring to non-ritual matters, eclecticism ispermitted. Due to the nature of the application of Islamic law to an area that is contemporary,the general trend is that a certain eclecticism of views from existing schools of jurisprudence isapplied to support the approval of particular transactions. Fatawa may be derived from a varietyof existing opinions from different schools of jurisprudence. Sheikh Yusuf Talal DeLorenzosupports this view when referring to what he qualifies as the revival of jurisprudence forcommerce and trade, which is a recent phenomenon: “in many cases, the sources they referredto were of their own particular legal schools of thought . . . though there appears to havebeen, early in this process, a general understanding among most scholars that considerationcould be given to the opinions and methodologies of at least the four main legal schools”.36

At times, a product is initially approved, and then, due to new information presented toShariah scholars, or a greater understanding on their part of the financial mechanisms of aproduct structure, the product which was previously permitted is forbidden, or one which waspreviously prohibited is allowed. An example of this is the shift in the sukuk market due to theAAOIFI’s February 2008 announcement, rejecting 80–85% of existing sukuk as non-Shariah-compliant.

15.4 THE ROLE OF SHARIAH BOARDS IN MALAYSIA

In some states, such as Pakistan and Malaysia, there are central Shariah Boards organizedby the Central Banks.37 For Malaysia, there are two central Shariah Boards, one for theSecurities Commission and another for Bank Negara Malaysia (BNM).38 In other states, theBoards may be independent of the central bank and Islamic institutions may set up theirown Shariah Boards independently from any centralized opinion. These approaches havean impact on the resulting diverging opinions within the countries and national boundariesand at an international level. As of 2001, according to Tarek Zaher and M. Kabir Hassan, asample of countries in which Islamic financial institutions have Shariah Boards independentof their central banks are Jordan, Kuwait, Bahrain, Gambia, Indonesia, Qatar, the United ArabEmirates, and Yemen. In Pakistan, the concept of a Shariah Board for Islamic institutions didnot exist in 2001. In more recent information, for Malaysia and Sudan, it has an overarchingShariah Board at the level of the central bank where rulings are then implemented at a localbank level by individual banks’ Shariah Boards. It does not seem to be a requirement in Iranto have Shariah Boards. Although Pakistan and Malaysia have pioneered a central ShariahBoard, in Pakistan, it includes, in addition to specialists in fiqh al muamalat, bankers, lawyers,accountants, and economists.39

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The Shariah advisory council of the central bank, Bank Negara Malaysia, was establishedunder the Central Bank of Malaysia Act 1958 as the authority to decide on Shariah matters onIslamic banking and financial business under the central bank’s authority.40 The Shariah Advi-sory Council (SAC) resolutions serve as the reference for Shariah ruling in court proceedingson Islamic banking and finance cases. It is additionally the reference body and advisor to BNMon all Shariah compliancy matters and also responsible for validating all Islamic banking andTakaful products to ensure their compatibility with Islamic commercial laws. Islamic banks inMalaysia have an additional individual Shariah Board that ensures that the rulings by the SACare adhered to. In the context of capital markets, Malaysia has established a Shariah Board topromote the development of Islamic capital market instruments.

There are two recognized approaches that reflect the role and functions of Shariah Boardmembers in Malaysia and the GCC. The first approach is that the implementation of thenational and centralized Shariah Supervisory Board which has been explained earlier. Thisapproach is practised in Malaysia, Pakistan and Sudan. The second approach is where theShariah Supervisory Board represents private IFIs. This latter approach is seen as affected by,and belonging to, market forces rather than to regulatory influences. In Malaysia, both the SACin the Central Bank and the SC have set the standard for any Shariah matters and governancefor the operations of the IFIs. In this case all matters involving the Shariah compliance aspect inrespective IFIs must adhere to the standards that had been formulated by the central authorities.The authorities have a monitoring system to vet the activities of the licensed IFIs so that mattersof Shariah compliance and governance are fully adhered to in order to protect the interest of theShariah framework, the shareholders and stakeholders of the IFIs as well as their customers.For instance, the IFIs need to receive approval from the financial authorities to appoint anyShariah scholars as Shariah Board members.

As for the Islamic capital market, the IFIs in Malaysia can only appoint the scholars thathave been licensed by the Securities Commission (SC). This approach is seen as a qualitativemeasure to control the market in protecting the respective parties involved. The pertinentfeatures of the Shariah compliance process are inclusive of fulfilment of all Shariah require-ments or fatawa, in particular contract structures. The Shariah compliance exercise under theresponsibility of Shariah Board members across jurisdictions – be it in Malaysia or the GCC –covers the whole spectrum of the Islamic banking and finance activities such as product design,product structures, legal documentation, accounting treatment, system process, and risk man-agement. In Malaysia, these are exercised under the scrutiny of the financial authorities. Failureto comply with the Shariah requirements in any of these exercises may result in revocation ofthe Islamic banking licence by law, as stated in the Malaysian Islamic Banking Act 1983.

In summary, the function and role of Shariah scholars in Malaysia is more towards makingsure that all matters that have been laid out earlier by the central authorities’ Shariah Boardare implemented. This in a way can provide more security and soundness to new fatawa orproducts that could otherwise create financial instability in the jurisdiction or market. However,this structure may slow down the process of new product development that may facilitate thegrowth in the said jurisdiction or market. Should there be a new product introduced in themarket, it will need to go through the Shariah Advisory Council’s approval for it to thenbe applied in the market. Two classical examples of this process are the products based onthe contract of musharaka mutanaqisa which was introduced by CITI Group (Malaysia) andtawarruq financing. Both of these concepts or contracts were earlier not in the approved listbut after being recommended by the private IFIs, they were studied and approved by the SACto be approved and applied in the Malaysian market.41

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15.5 THE ROLE AND FUNCTION OF SHARIAHBOARDS IN THE GCC

In the emirates of Dubai and Abu Dhabi in the United Arab Emirates, and in Kuwait, Bahrain,Saudi Arabia, and Qatar, the Shariah Boards are not centralized in the way that the SAC ofthe SC and BNM are in Malaysia. Some have a centralized board but it does not function inthe same way as the SAC of BNM and the SC. As mentioned in relation to the Malaysianmodel, most of the GCC countries have their own legislation with regard to Islamic bankingand finance operations, and the authorities give freedom to the IFIs and other industry playersto decide on the activities and process relating to Shariah matters in Islamic finance. Yetthe establishment of the AAOIFI and Islamic Fiqh Academy has created an influence in theGCC market. These two organizations are standard-setting bodies for the market to have somebenchmark in operating and executing fatawa relating to Islamic finance operations. Havingsaid that, the approaches and methodology of Shariah compliance and Shariah governanceunder the respective Shariah framework – even though the process and areas of coverage aresimilar to the Malaysian market – are done privately by the individual IFIs. In this sense, itgives authority and influence to each set of Shariah Boards as well as to their members todictate the best fatawa and matters for each IFI. These scholars in the GCC states are seento have the strength to influence the market. The benefits of this type of approach are that itallows quick progress in the development of products and growth in the industry, yet the riskis the lack of regulation.42 This risk was made evident by the February 2008 pronouncementof the AAOIFI with regard to the purchase undertaking or the put option prohibition wheresubstantial numbers of sukuk issuance – mainly from the Middle East – were drasticallyaffected. This incident caused a drastic drop in the issuance of sukuk in the Middle East, whichhas had a negative impact in the industry and also affected the credibility, from the perspectiveof market players, of the scholars who had earlier approved these structures.

Shariah scholars who work internationally adapt to the jurisdictions of the Islamic financialinstitutions’ Shariah Boards on which they work. One of the best contemporary sources forconsulting the geographical distribution of scholars, as well as their countries of origin andtraining, is the Shariah Report by Failaka Advisors from March 2008 (soon to be edited for2010).43 It indicates that in terms of nationality, a majority of Shariah scholars are Malaysian –24% out of the 253 surveyed in the report (Figure 15.1). Additionally, combining the percentageof scholars working on the boards of Islamic financial institutions from countries of the GulfCooperation Council, Saudi Arabia, Kuwait, Bahrain, and Qatar, indicates that 27% of scholarsare from the region. Considering the size of Malaysia, the influence of Shariah scholars comingfrom Malaysia in developing Islamic finance is significant.

Based on the function and role of Shariah Boards and their members, in the centralizedShariah framework of Malaysia or the decentralized framework of several of the GCC coun-tries, it can be noted that Shariah scholars have similar roles across the two regions of interestfor the study. Yet the method by which they endorse products for Shariah compliance isdependent on the relation between individual IFIs’ Shariah Boards and the central and regula-tory authorities. These frameworks themselves may contribute to regional variances. Moreover,Shariah scholars are naturally of diverse training and intellectual preferences, not to mentiontheir varying geographical and cultural backgrounds.

It is common for Shariah scholars to have varied interpretations of the Shariah-compliantinvestment principles and to have differing approaches on any particular fatwa.44 It is inter-esting to note that Gulf scholars and Al-Azhar trained scholars may generally have different

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Shari'a Scholars by Nationality (out of 253 active scholars in Islamic Finance)

Other 24%

Syrian 3%

Qatari 3%

Lebanese 3%

Indonesian 3%

Egyptian 3%

Bahraini 3%

Pakistani 6%

Bangladeshi 7%

Kuwaiti 9%

Saudi Arabian 12%

Malaysian 24%

Figure 15.1 Shariah Board members by nationality

Source: Failaka Shariah Report 2008, p. 14

views within the Middle East. Some working in the GCC may have been trained in Al-Azhar,but to work in the GCC they generally adopt more Hanbali views, as opposed to their ownShafii views and the Hanafi views that they would have learned formally, as they form theremnants of Ottoman laws still being used in countries like Jordan. This reflects the recordof the history of Islamic jurisprudence, when scholars were diverse and were of differentinterpretive views. Such differences are likely to persist and as the Shariah allows for thisin subsidiary matters other than faith, which adapt to local customs and other local factorssuch as the regulatory framework in which Islamic financial institutions operate. A locallyaccepted fatwa can be rejected by scholars, demonstrating that the view on the permissibilityof a product or a transaction is not recognized internationally, or at times – as in the case ofthe first few sukuk structures – a small amount of scholars may come up with a fatwa whichthen becomes accepted by the majority of Shariah Board members. Whereas independentresearch and ijtihad for innovative Shariah-compliant products is encouraged, there is also amove towards harmonization and standardization of interpretations, in particular in the areasthat involve cross-border deals.45 Islamic scholars of all schools of jurisprudence, regardingIslamic finance, respect and give equal recognition to all four surviving schools – the Hanafi,Maliki, Hanbali, and Shafii. As mentioned, there is a general view that the differences amongthe schools are merely details and do not relate to the fundamentals of the law as all schoolsacknowledge the authority of the Quran and the Sunna as sources of Islamic law.

15.6 CONVERGENCE BETWEEN THE GCC AND MALAYSIA

Universally accepted contracts in Islamic finance across the GCC and Malaysia, which areaccepted in practice by Shariah scholars of differing backgrounds and nationalities across thetwo regions, are the mudaraba contract to both project financing and deposits; the musharakacontract to project financing; the musharaka mutanaqisa contract to asset financing; the ijara

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contract to asset financing; the murabaha contract to asset financing; and the istisna’ contractto manufacturing and construction financing. Looking at the composition of the countries oforigin of the Shariah Boards of banks for this chapter, the permissibility of these contractsis recognized by jurists across the two regions: Saudi Arabian, Kuwaiti, Qatari, Egyptian,Bahraini, and those operating in the Malaysian regulatory context (including a Sudanese anda Syrian). They are from a broad range of institutions, having being trained both in the MiddleEast and Malaysia and working on the boards of the institutions in Malaysia and the GCC.As such these contracts do not seem to pose any issue from a Shariah perspective as scholarsfrom a variety of backgrounds, working in a variety of regions, for institutions headquarteredacross the two regions of interest, are in agreement on its permissibility.

The contract of mudaraba is broadly accepted across the two regions and can be applied inthe context of project financing but is more commonly applied in the context of deposits orinvestment accounts in banking. It is especially applied to deposit accounts in Islamic banksheadquartered in the GCC. The mudaraba contract in deposit accounts has a correspondingfunction to the wadiah yad dhamana contract which is often used for deposit accounts in theMalaysian market. It is recognized as permissible in institutions which have Shariah Boardsmade up of scholars of differing backgrounds. The study also indicates that the musharakacontract as the basis of project financing is recognized and applied by IFIs across the GCCand Malaysia and so is musharaka mutanaqisa.

15.7 SLIGHT DIVERGENCE IN INTERPRETATIONS

Differences of opinion may be identified in contracts that are exclusively offered in someregions or by particular IFIs and an analysis of this was made based on the compositionof background of their Shariah Boards. These differences included those surrounding theapplication of the wadiah contract, the application of the mudaraba contract to the takafulmodel, the application of the contract of qard to deposit accounts, the use of the bai’ alina contract for cash financing and as the basis of the deferred payment scheme of the bai’bithaman ajil scheme, the use of the tawarruq financing contract, the use of the murabahacontract in asset financing underlying the bai’ bithaman ajil scheme, the application of thewakala contract in the takaful model, and the use of bai’ al dayn in the Malaysian secondarymarket.

The wadiah contract is a readily available Islamic finance contract in the Malaysian marketfor savings and current accounts. From a sample of Malaysian Islamic financial institutions:all are Malaysia-based Islamic banks, and the contract of wadiah, as applied to depositsand current accounts, is approved by Bank Negara Malaysia’s Shariah Advisory Council.Two Islamic banks headquartered in the GCC with regional subsidiaries in Malaysia wereobserved not to apply the contract of wadiah for deposits and current accounts, but they bothuse the mudaraba and qard contracts for such purposes. Wadiah is not used for bankingproducts in GCC-based Islamic banks. In Islamic insurance or takaful, the mudaraba contractis predominantly used in Malaysia. The GCC seemingly has a preference for the use of wakala(agency-based) takaful. There is however evidence that the preferred structure is movingtowards a hybrid of wakala and mudaraba. Although there seems currently to be a trendtowards the mudaraba-wakala takaful model, the single use of the contract of mudaraba asa base structure for the takaful model is popular mainly in Malaysia. From the informationavailable from the study, it is mainly GCC-based companies that offer wakala-based takafulproducts.

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The qard ul hassan contract, which is meant to be benevolent in nature, is generally not usedby Malaysian Islamic banks for savings accounts. The contract of qard is applied by banksoriginating from the GCC in Malaysia but not by Malaysian Islamic banks. There is a generalview in Malaysia that the use of the qard ul hassan contract, due to its benevolent nature,should not be for financing as the Islamic bank offers financing facilities with customers’deposits who expect returns. The use of the contract of qard or qard ul hassan for depositsis prevalent in the GCC-based Islamic banks. From the study, the make-up of Shariah Boardsapproving these is Saudi Arabian, Kuwaiti, Bahraini, Egyptian, Qatari, and Emarati.

The contract of bai’ al ina in its application for cash financing is widely utilized in theMalaysian Islamic banking context but not in the GCC. In Malaysia, it is also applied as thebasis to facilitate the transaction of the bai’ bithaman ajil product offering. Bai’ bithaman ajiltechnically refers to a form of deferred payment arrangement between the bank and its customerout of a prior underlying transaction that can be either bai’ al ‘ina or murabaha. Thus bai’bithaman ajil was noted to be neither a financing nor a trading contract. Yet in Malaysia it hasbecome a normal product term used by Islamic banks for specific asset-financing products.The murabaha-based bai’ bithaman ajil is applied only in Malaysia by a Saudi Arabianbank (Al Rajhi) in 2009 as an answer to the broadly used Malaysian bai’ al ‘ina-based bai’bithaman ajil.

With regard to tawarruq (commodity murabaha or reverse murabaha), it is a recognizedconcept in the two regions and is increasingly regarded as a viable alternative to the bai’bithman ajil based on the bai’ al ‘ina contract in Malaysia, but there still is a considerableamount of debate among Islamic finance scholars on its permissibility. The concept of bai’ aldayn as applied in the secondary market is only applied in Malaysia and is rejected by scholarsfrom the Middle East. There is no application of bai’ al dayn in the GCC Islamic financialsystem, and there is therefore no Islamic money market in the GCC. The Islamic financialinstitutions of the GCC have to function with the conventional money market to some extent.In Malaysian Islamic financial institutions bai’ al dayn refers to the sale of two types of debt:the sale of debt arising from the sale of a commodity and the sale of debt arising from credit.That the debt is sold to a third party at a discount is the main point of divergence betweenscholars of the GCC and Malaysia. With regard to the sukuk market, discussions at a February2008 meeting among Shariah scholars of the board of the AAOIFI in Bahrain resulted in muchconfusion in the sukuk market about the permissibility of certain sukuk structures. What cameout of the research was that the sukuk ak ijara structure was univerally recognized by ShariahBoard members as Shariah-compliant.

15.8 THE IMPACT OF THE REGULATORY DIMENSIONSOF THE JURISDICTIONS

The Malaysian Shariah Advisory Council is influenced from within, from within the opinionsof Malaysian Shariah Board members at the national or central level, as well as externally, asit has encompassed and embraced the Shariah interpretations of international standard-settingbodies in Islamic finance originating from the Middle East. It has additionally organized dia-logues with Shariah Board members from the Middle East and among Shariah Board membersof South East Asia. In this area of dialogue among Shariah Board members, there are addi-tionally two other influences, internationally, that strive to harmonize Shariah interpretations.One is the market force of the globalized market and institutions like the AAOIFI. Anotherincludes forums organized by the Islamic Fiqh Academy of the OIC and the other is the Dallah

P1: TIX



al Barakah forum and the muzakara (dialogue) of Shariah scholars experts in South East Asia(nusantara region: Malaysia, Indonesia, Thailand, Brunei, Singapore, and the Philippines)organized by the Central Bank of Malaysia (Bank Negara Malaysia), which is influential inMalaysia.46 In fact, Bank Negara Malaysia organized a dialogue on the issue of the permissi-bility of the controversial bai’ al ina contract and its Middle Eastern, yet contested alternative,the tawarruq.47

In Malaysia, the central financial authorities are the central bank, Bank Negara Malaysia,and the Securities Commission. There is a national Shariah Board referred to throughout thethesis, the Shariah Advisory Council, for both financial authorities. At the individual level ofthe Islamic financial institutions, there is the Shariah Board committee. The Shariah AdvisoryCouncil of Bank Negara Malaysia covers all contracts under Islamic banking and takafulwhereas the Shariah Advisory Council of the Securities Commission covers contracts appliedin the Islamic Capital Markets. The Shariah standards followed are those of the SAC of BankNegara Malaysia and of the Securities Commission, which themselves are influenced by boththe Shariah standards of the AAOIFI and the Islamic Fiqh Academy, in addition to somelocal Islamic financial products based on Shariah-compliant contracts approved in Malaysiaonly. The Shariah compliance review in Malaysia is done by the Islamic financial institution’sShariah committee. This reflects the centralized nature of the Shariah framework in Malaysia,where there is no room for individual Shariah Boards of Islamic financial institutions toinnovate without the direct permission of the Shariah Advisory Council through which alldecisions of Shariah compliance of Islamic financial products are made.

The GCC-based standard-setting bodies include in their Shariah Boards members of theShariah Boards of Malaysian institutions. However, the predominant opinions seem to beconstant with the stricter norms of the GCC, as Malaysian exceptions such as bai’ al inaand bai’ al dayn, for instance, are not recognized or integrated into the opinions of thoseinfluential and international standard-setting boards. The diversity of countries of origin of theAAOIFI Shariah Board members reflects the efforts at harmonization that the AAOIFI aimsfor.48 It is also interesting to note the purpose of the AAOIFI’s Shariah Board, which is toachieve “harmonization and convergence in the concepts and application among the ShariahSupervisory Boards of Islamic financial institutions to avoid contradiction or inconsistencybetween the fatawa and applications by these institutions, thereby providing a pro-active rolefor the Shari’a supervisory boards of Islamic financial institutions and central banks”.49

As illustrated in Table 15.1, in the states of interest of the GCC – Bahrain, the United ArabEmirates (specifically the emirates of Dubai and Abu Dhabi), Saudi Arabia, Kuwait and Qatar –the influence of the central authorities on the permissibility of contracts or products is non-existent. This is the case even if in some of these states there is a Shariah Board at the centralbank in these states of the GCC. Bahrain, which has what resembles the closest to Malaysia inthat it has a National Shariah Board at the level of the central financial authority – the CentralBank of Bahrain – has no control over the permissibility of products from the central financialauthorities. At the IFI level in Bahrain, there are individual Shariah supervisory committeeswhich make decisions on the permissibility of financial products. There is no approval requiredin Bahrain by the Shariah Board of the central financial authority of the state on each productissued by Islamic financial institutions. The board at the level of the Central Bank of Bahrainis simply to assess the Shariah compliance of Islamic products issued by the central bankrather than to set standards for Islamic financial institutions operating in the state. The Shariahcompliance review in Bahrain is done by the Islamic financial institutions’ individual Shariahsupervisory committees and the Shariah standards of the AAOIFI are adhered to in the local

P1: TIX


Tabl

e15

.1T

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alau

thor

ities

and

the

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prov

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com

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(BN

M)

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)

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OIF

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(b)

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mic

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ks

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tinu

ed)

321

P1: TIX


Tabl

e15

.1(C

onti

nued

)

Shar

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)

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FSA

)

No

Shar

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rd

No

AA

OIF

I(a

)D

IFC

Law

no.1

3of

2004

No

Inte

rnal

&ex

tern

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322

P1: TIX


5.K

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323

P1: TIX



Bahraini Islamic finance market. This reflects the influence of the AAOIFI on the BahrainiIslamic financial sector.

In the United Arab Emirates’ emirate of Dubai, Islamic financial institutions are under thecentral financial authorities of the Dubai Financial Services Authority (DFSA) and the DubaiInternational Financial Center (DIFC). There is no Shariah advisory council at the level ofthe central financial authorities. However, there are individual Shariah Supervisory Boards atthe level of individual Islamic financial institutions. As in Bahrain, no approval by the centralfinancial authorities of Dubai is required for products issued by Islamic financial institutionsand they generally do follow the Shariah standards of the AAOIFI. The Shariah compliancereview is carried out by the internal and external Shariah audit committee of each Islamicfinancial institution. In Abu Dhabi, there is a Higher Shariah Authority (HSA) under thecentral financial authorities, under the Central Bank of the United Arab Emirates and AbuDhabi Investment Authority (ADIA). Reference to the HSA is made only in case of concerns,and the HSA does not operate like the Shariah Advisory Council of the Central Bank ofMalaysia that guides all products in the Malaysian Islamic financial sector. In Abu Dhabi,Islamic financial institutions each have a Shariah supervisory authority and are also influencedby the Shariah standards of the AAOIFI through their membership of it.

In Saudi Arabia, the central financial authorities are the Saudi Arabian Monetary Agencyand the Capital Market Authority, and there is no national Shariah Board. There are ShariahSupervisory Boards at the level of Islamic financial institutions but no fatawa on financialproducts are issued at a national level. The individual Shariah Supervisory Boards generallyfollow the Shariah standards of the Islamic Fiqh Academy of the OIC in Jeddah. Thereforeno approval is required by the central financial authorities for each financial product and thereis no Shariah compliance review. In Kuwait, individual Islamic financial institutions’ ShariahBoards generally follow the Shariah standards of both the AAOIFI through membership andof the Islamic Fiqh Academy of the OIC in Jeddah. The central financial authority is theCentral Bank of Kuwait and there is a national Shariah Board, called the Fatwa Board of theMinistry of Awqaf and Islamic Affairs, yet no fatawa for Islamic financial products are issuedat a national level.

Similar to Bahrain, Dubai, Abu Dhabi and Saudi Arabia, in Kuwait, Islamic financialinstitutions each have a Shariah Supervisory Board. The Shariah compliance review in Kuwaitis carried out by the internal audit committee of each Islamic financial institution as there is nonational approval by the central financial authorities on products issued by Islamic financialinstitutions. In Qatar, the central financial authority is the Central Bank of Qatar and there isa national Shariah Board called the Supreme Council of the Ministry of Awqaf. This nationalboard has no influence on the permissibility, at a national level, of Islamic financial products.Individual Shariah Supervisory Boards in Qatar generally follow the Shariah standards ofthe AAOIFI through a membership and the Shariah compliance review is carried out by theinternal audit committee of Islamic financial institutions.

As such, the influence of standard-setting bodies like the AAOIFI and the Islamic FiqhAcademy of the OIC can be noted. The influence of the AAOIFI seems even stronger on mostIslamic financial institutions’ Shariah Boards in the GCC states. Note that Islamic financialinstitutions operating in Saudi Arabia rely only on the opinions of the Islamic Fiqh Academyand not on those of the AAOIFI, and that otherwise Kuwait is the only other GCC stateinfluenced by opinions of the boards of both the Islamic Fiqh Academy and the AAOIFI.Thus for the purpose of this chapter, the focus is on the recognized Islamic finance contractsby the AAOIFI and the SAC of Bank Negara Malaysia and the Securities Commission of

P1: TIX



Malaysia as the AAOIFI seems to be directly influential in more GCC states than the IslamicFiqh Academy. It is important to stress at this point that the Malaysian Shariah AdvisoryBoard of the Securities Commission and of Bank Negara Malaysia also encompasses theopinions adhered to by the AAOIFI and the Islamic Fiqh Academy, as its scholars parti-cipate in discussion forums with Shariah Board members who function in the jurisdictionof states where Islamic financial institutions are more likely to adhere to the opinions ofthe AAOIFI and the Islamic Fiqh Academy. The next section indicates the similarities anddifferences in recognized Islamic finance contracts by these bodies. It clearly demonstratesthat the universe of Islamic finance contracts applied in the Malaysian Islamic finance sectorembraces all opinions of the AAOIFI and offers additional Malaysia-specific Islamic financecontracts.

As noted in the previous section, the Malaysian national Shariah Board at the level of thecentral financial authorities – Bank Negara Malaysia and the Securities Commission – theShariah Advisory Council, which dictates the permissibility of contracts and Islamic productsfor the Malaysian market, is influenced externally by the AAOIFI Shariah standards and theIslamic Fiqh Academy in Jeddah, and internally by the opinions of Malaysian Shariah Boardmembers with certain opinions particular to Malaysia. In the GCC, Bahrain, the emiratesof Dubai and Abu Dhabi, Kuwait, and Qatar, there are no national Shariah Boards, butindividual boards at the level of the Islamic financial institutions are influenced by the Shariahinterpretations on the permissibility of Islamic financial products by the AAOIFI. Saudi Arabiaand Kuwait are also influenced by the Shariah standards of the Islamic Fiqh Academy whichare almost equivalent to the Shariah standards by the AAOIFI. As such, although there is nosuperseding authority for Shariah interpretations at a formal level in the GCC states, there isan informal yet nevertheless strong influence by the AAOIFI and the Islamic Fiqh Academy.There is also an informal influence by these two bodies on the national Shariah AdvisoryCouncil in Malaysia, which influences all Malaysian Islamic financial institutions and theShariah interpretations of their Shariah Boards.

In this sense and as illustrated in Figure 15.2, which illustrates the convergence anddivergence in contract approval by the Shariah Boards of key Malaysian authorities andthe international standard-setting body of the AAOIFI, the Shariah standards of the ShariahAdvisory Council of Malaysia incorporates all the Shariah interpretations of the AAOIFI.In addition to the Shariah standards of the AAOIFI, it also approves interpretations that areparticular to Malaysia, such as the contracts of bai’ al dayn, bai’ al ina, bai’ bithamnan ajilbased on the bai’ al ina contract, wadiah, and others. It incorporates the Shariah standards ofthe AAOIFI such as the contracts of hawala (transfer of debt from the transferor to the payer),murabaha, ijara, salam, istisna’, musharaka, mudaraba, juala (a reward given upon the suc-cessful completion of a job), qard, and tawarruq. The Islamic finance contracts not recognizedor mentioned in the Shariah standards of the AAOIFI as well as the Islamic finance contractsthat are specific to Malaysia (mentioned in the Shariah interpretations of the SC and BNM) inaddition to the ones approved in Malaysia mentioned earlier are wakala, rahnu (Islamic pawnbroking), ujr, kafala, bai’ al wafa (the sale of a commodity based on the condition that whenthe seller pays back the price of the good sold, it is returned), bai’ al muzayadah (an action bya person to sell his assets in the open market which is accompanied by bidding from potentialbuyers), arboon (depositing a fraction of the price of a good to be completed in the future),istijrar (sale of supply), tabarru, ibra, and iqta.50

The influence in Malaysia is of a top-down nature, where regulatory control of the Shariahframework dictates the nature of the contracts permitted in the local Islamic banking and finance

P1: TIX



Figure 15.2 Commonalities in contract approval by Shariah Boards of key Malaysian authorities andthe international standard-setting body of the AAOIFI

Source: Bank Negara Malaysia Shariah Resolutions 2007; Accounting and Auditing Organisation for Islamic FinancialInstitutions, AAOFI Shariah Standards 1425-6 H / 2004-5, Manama: AAOIFI; Securities Commission, Resolutionsof the Securities Commission Shariah Advisory Council, second edition, 2007, Kuala Lumpur: Perpustakaan NegaraMalaysia

market, for the banking sector, takaful sector, and the Islamic capital markets. Additionally, asillustrated in Figure 15.2, the Malaysian Shariah framework – the range of permitted contractsand products – encompasses all the opinions that are recognized in the GCC. In this sense,the variety of products offered in Malaysia is broader than the universe of products likely tobe offered in the GCC, if there is a simple comparison of contract permissibility advised bythe standard-setting bodies. As discussed, the national regulatory framework has an influenceover the issuance of fatawa in Malaysia but the influence in the GCC can be qualified asbottom-up and driven by market forces.51 In Bahrain, the emirates of Dubai and Abu Dhabi inthe United Arab Emirates, the Kingdom of Saudi Arabia, Kuwait, and Qatar, the permissibilityof contracts and Shariah-compliant financial products is decided at the level of the Islamicfinancial institution, by its Shariah Board. That is not to say that the GCC is a market in whichthe Shariah Boards of Islamic financial institutions decide whatever they please. There is aninformal, nevertheless tangible, influence among Shariah board members of the GCC. Not onlyare many of the regional Shariah Board members shared across Islamic financial institutionsof the region, where the work locations of certain influential Shariah Board members coverseveral of the GCC states, but there is generally respect for the standard setting bodies of theAAOIFI and the Islamic Fiqh Academy, in which Shariah Board members have a platform todiscuss opinions and varying interpretations.

P1: TIX



It is important to note that on the Shariah Boards of these standard-setting bodies, to whichadherence is voluntary, not obligatory, there are some Malaysian Shariah Board members.As such, it can be assumed that they would be well aware of the opinions of their MiddleEastern counterparts, and the Middle Eastern counterparts may be made aware of their opin-ions. As illustrated in Figure 15.2, the GCC excludes certain contracts recognized by theMalaysian Shariah Board members, namely as delineated in the previous section and amongother contracts, the use and application of the contracts of bai’ al dayn, wadiah, bai’ bithamanajil (based on bai’ al ina), kafala, bai’ al wafa, bai’ al muzayadah, arboon, istijrar, andtabarru.

15.9 THE ROLE OF THE CREATION OF INTERNATIONALHUBS IN HARMONIZING VIEWS

As there are certain dimensions to the international harmonization of fatawa, especially on thedifferences with the Malaysian and the GCC Islamic financial markets that are debated from aShariah perspective, it is likely that the markets stay localized at some level, in particular forthe local Islamic banking retail sector, as certain interpretations seem to fit local needs and tobe designed for such local needs. Such provision for divergence of opinion between Shariahscholars exists in Islamic commercial law and is part of the existing wealth of perspectives inIslamic finance. These particularly surround the use of bai’ al ina and bai’ al dayn in Islamicfinancial transactions in the jurisdiction of Malaysia, the rejection or acceptance of tawarruqby Islamic finance scholars from the GCC, the discomfort with the use of hiba on wadiah orqard deposit accounts etc. Shariah Board members may have particular perspectives on thesedifferences due to particular interpretations on the harmonization of differences due to the roleof ijtihad in regional variations and in divergence in interpretations of the permissibility ofcertain financial structures. The regulatory environment in Malaysia, especially the Shariahframework in which Islamic financial institutions operate in the Malaysian jurisdiction, seemsto have developed a way around these regional variations. First, as noted, all opinions are rec-ognized in the Malaysian Islamic financial market by the Shariah Advisory Council of BankNegara Malaysia and the Securities Commission. In fact the range of permissible Islamicfinance contracts is larger in Malaysia and more encompassing of international interpreta-tions than the level of permissibility of Islamic finance contracts in the GCC based on theopinions of the standard-setting body of the AAOIFI (Figure 15.2). Yet a framework towardsharmonization at the level of foreign direct investment seems to exist in the development ofinternational Islamic financial hubs. This section discusses and describes why the interna-tional harmonization of fatawa may not be applied to all areas of the Islamic financial sector –initially by indicating why Shariah Board members may disagree with this idea – but alsowhy it may be done in the context of international Islamic financial hubs, as in the case of theMalaysia International Islamic Financial Center (MIFC) targeting particularly foreign directinvestment from the GCC region.52

Shariah Board members seem to diverge in their opinion on the idea of a total harmonizationof the Shariah standards for Islamic finance. Dr Muhammad Syafii Antonio, a Shariah Boardmember of Indonesian origin, indicates several reasons for this being the case.53 First, there isthe idea that such harmonization may counter the principle of ijtihad. If rules become standard,there is no place for ijtihad any more as rules become locked, damaging the purpose of ijtihadand the adaptability of the Shariah to different political and socio-economic circumstancesand times. It is this adaptability that leads to a wealth of opinions. A second reason for the

P1: TIX



divergence of opinion on the idea of harmonization is that the different schools of thought inthe Shariah differ in opinions on matters not related to faith which are matters of a subsidiarynature. At the level of subsidiary matters, various opinions may exist that may sometimes beconflicting. These relate to the non-essential or non-core dimensions of Islam and as such thestrength in these lies in their variety. Standardizing all Shariah opinions would go against thisand would indicate that one school of jurisprudence is to dominate others and that is not anacceptable approach internationally and in the variety of regions where Islamic finance hasdeveloped. The opinions of all schools are to be respected or recognized although they may notbe adhered to. As such there is the conflicting need for harmonization and standardization ofopinions in the Islamic financial sector so that there is consistency of fatawa. This consistencymay be said to be already existent as the divergence of opinions only surrounds the applicationof a few Islamic financial contracts. The need for flexibility and divergence brought bythe process of ijtihad is also a need that would be blocked by the standardization of allopinions.54

As an answer to this need for harmonization, market regulators, together with Shariahscholars, at the level of the Shariah framework of the jurisdictions of interest, seem to bedeveloping an approach to this issue of harmonization of fatawa in practice where there appearsto be a harmonization or a standardization at some levels of the Islamic finance market –particularly at the levels affecting foreign direct investment – while retaining pockets of“locality” that suit the local market (retail) only. Generally Malaysia stands out from theIslamic finance sector in the particularity of some of the Islamic finance contracts that areallowed as the base for certain products in its jurisdiction as noted earlier. What the MalaysianIslamic financial sector seems to have developed, together and in competition with some of itsGCC counterparts, are channels of exchange in which harmonization or internationalizationof fatawa is not only possible, but is necessary. For instance, the Islamic financial sector inMalaysia has welcomed three international Islamic banks in the past few years. These includedthe Asian Finance Bank (a consortium of Qatar Islamic Bank, Rusd Investment bank fromSaudi Arabia, and Global Investment House from Kuwait); Kuwait Finance House and Al RajhiBank from Saudi Arabia. All opinions of these banks’ Shariah Boards – remembering thatthey have a Malaysian Shariah Board for the Malaysian market to suit Malaysian regulatoryrequirements – need to be approved by the Shariah Boards of the IFI’s headquarters basedin the GCC; this is true for Al Rajhi Bank Malaysia and Kuwait Finance House Malaysia.Additionally, there is the development of international Islamic financial hubs which caterto Shariah standards that are recognized globally and that are not specific to Malaysia orotherwise local.

Leading authorities in Islamic finance such as the Malaysian regulatory authorities, orinternational standard-setting bodies such as the AAOIFI, are currently working towards thedevelopment of the internationalization of the Islamic finance industry. This is seen in effortsto internationalize the respective markets of Islamic finance in Malaysia and in the GCC intocentral locations in the form of international Islamic financial hubs. International financialhubs are economic centres to enhance local and international demand for financing services,as well as, in this case, for Shariah-compliant financing services. They provide a platformthat offers incentives and benefits in tax; additionally they offer an attractive legal and reg-ulatory framework and most importantly – in light of the topic of regional variations in theimplementation of Islamic finance contracts – a Shariah standard that is recognized interna-tionally by members of the Shariah Boards of varied jurisdictions. International financial hubsserve an equivalent purpose to conventional financial centres which is to attract international

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involvement into the local market in order to boost local economies by attracting foreign directinvestment.

In August 2006, the Malaysia International Islamic Financial Centre (MIFC) initiative waslaunched to promote Malaysia as an international hub for Islamic finance.55 Despite beingcriticized by some in Islamic finance in the GCC for having to adapt some of the contentiousapplications of Shariah-based products, the Malaysian Islamic financial market has beenvery innovative. Malaysia has spearheaded the initiation of several significant Islamic financeproducts which subsequently became exemplary models for other markets to follow and toimprove upon, such as the first sukuk al ijara in 2002 which is a model subsequently adoptedinternationally. As a result of over 30 years of developing the Islamic financial market, the statehas produced the largest pool of Islamic finance experts and Shariah scholars, as reflected inthe number of influential Shariah Board members in the Malaysian Islamic financial market.

The establishment of an international centre for Islamic finance indicates that the MalaysianIslamic financial sector is taking steps to open its door in accepting international – largelyemanating from the GCC and the Middle East – Shariah standards, in particular the Shariahinterpretations prevalent in the GCC which reject the Malaysian use of bai’ al ina and bai’al dayn, among other Malaysia-specific applications of Islamic finance contracts. This istypically done concurrently with the practice or application of certain contentious Shariahinterpretations to serve local needs. The approach that is taken by the Malaysian Islamicfinancial sector may be considered as more universal than that of other international financialcentres in accommodating and adopting “Shariah best practices” – a common term used in theMalaysian Islamic financial market – as it makes room for both local Malaysian interpretationsas well as international Middle Eastern interpretations to suit its international investors whoare largely from the GCC.

Other than Malaysia and in the GCC, Bahrain is considered by the Islamic finance industry asanother well-established financial market and an excellent platform as an international Islamicfinancial hub. The reputation and establishment of sound regulatory structures in Bahrain isbased on its development over the past few decades and the state is currently viewed as one ofthe best locations for Islamic banking and takaful operations. Bahrain, in a way, has played asignificant role by functioning as an impetus in shaping and driving the industry on a globalbasis. Some important milestones signify this role such as the establishment of institutions likethe Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) whichpronounces fatawa well respected in the market, the International Islamic Financial Market(IIFM), the Liquidity Management Centre (LMC), the Islamic International Rating Agency(IIRA), and the General Council for Islamic Banks and Financial Institutions (GCIBAFI),which has established the state as a holistic international Islamic financial hub.56

The United Arab Emirates, on the other hand, has taken a different approach in establish-ing itself as an international Islamic financial hub by focusing on constructing a physicalinfrastructure. This has created a large demand for financial services needed as a result of localdevelopments. In the last 10 years, the world has witnessed perhaps the greatest transformationand development of physical infrastructure in the city of Dubai.57 A substantial number ofhigh-rise buildings and modern residential properties have turned the city into one of the mostmetropolitan, modern, and the best locations for property investments up to the financial crisisof 2008 when the real estate sector in Dubai has been affected.58 Yet until the financial crisis,that activity had transformed this barren land into a business haven, not only for internationalexpatriates working in the UAE, but also for those working in other parts of the GCC. Theserapid infrastructure developments created a demand for Islamic financial products and in order

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to cope with these demands, the local authority established the Dubai International FinancialCentre of DIFC to serve both Islamic and conventional financial needs in the MENA regionand internationally.59

Other parts of the world have also been seen to follow in the direction of Islamic financialmarket leaders such as Malaysia, Bahrain, and the UAE in establishing international Islamicfinancial hubs. Brunei, for instance, has established the Brunei International Financial Centreor BIFC.60 The BIFC has been established to boost Brunei’s position as an internationalfinancial hub, and to promote areas such as banking, Islamic banking and takaful, mutualfunds, and asset management. The BIFC follows a similar approach to the emirate of Dubaiand to Malaysia. Other countries in Asia such as Singapore and Hong Kong (SAR China),which have long been conventional financial centres, have announced their interest in creatingtheir own Islamic financial hubs.61 Whereas Hong Kong is still in the preliminary stage ofmoving with the initiative, Singapore has led the way by offering a few licences for theinternational Islamic financial institutions to operate in the state, such as the Islamic Bank ofAsia which is an initiative of the Development Bank of Singapore (DBS).62 The state has alsomodified its legal framework to enable the smooth flow of Islamic finance operations. TheMonetary Authority of Singapore, or MAS, has become a full member on the Islamic FinancialServices Board (IFSB) to oversee the supervisory review process of Islamic financial matters,and to participate in the IFSB Council.63

In the West, the United Kingdom has taken the first initiative to become the European leaderin providing Islamic financial services. The recent establishment of the Islamic Bank of Britain,or IBB, indicates a level of commitment by the government to develop Islamic finance in theUK. Other than the IBB, it can be observed in the market that Islamic financial institutionshave been established such as the European Islamic Investment Bank, and Shariah-compliantproducts offered by the conventional financial institutions such as the Bank of London, TheMiddle East Plc, and Barclays Bank. In addition to the internationalization of Islamic finance,there are a number of fund managers and law firms specializing in Islamic finance in the UK.The UK government has also made the necessary arrangements to regulate a tax system moreconducive to certain products of Islamic finance by removing the double taxation on Islamicmortgages as well as providing tax reliefs for Islamic mortgage users.64

From this perspective of the harmonization of fatawa and the development of the Islamicfinancial system, it can be said that the market is witnessing the emergence of the internation-alization of Islamic finance through the development of International Islamic financial hubsin different jurisdictions. Further, as these link internationally, the standardization of Shariahinterpretations for these is becoming a possibility. There is the need to accommodate thepreferences or opinions of international players in the market and as much of the financingin Islamic finance may come from the GCC states, other countries are more likely to followthe Shariah opinions that are predominant in this wealthy region. The question is whetherthe internationalization of Shariah standards or fatawa is equated to Shariah harmonization.In order to address this question, it is important to observe different approaches taken by thepredominant markets in Islamic finance such as the Malaysian Islamic finance market, and theIslamic finance market in the UAE and in Bahrain.

The Malaysian approach to addressing the needs for global acceptance has been to widen itsrealm of Shariah standards to adopt international Shariah standards, which includes those fromthe GCC, while maintaining the fatawa that are specific to its market and are not recognizedby the GCC scholars. This is clearly illustrated in Figure 15.2 which indicates this processof broadening and embracing international Shariah standards by Malaysia. While certain

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contentious fatawa are maintained and designed to serve local needs for specific Shariahproducts, the international or global players may choose to omit these fatawa in their productsand operations. And this is clearly exemplified in the operations of Kuwait Finance HouseMalaysia and Al Rajhi Bank from Saudi Arabia in Malaysia. These two GCC-based Islamicbanks do not offer deposit accounts based on the contract of wadiah but offer deposit accountsbased on the contracts of qard and mudaraba. The trend they follow is that of Islamic banksin the GCC, as exemplified by Islamic financial institutions in the GCC. This, in a way, givessome kind of reverence and leniency to the opinions from both the local and internationalscholars and the opinions preferred by international Shariah Board members, generally fromthe Middle East, are embraced and accepted in the Malaysian Islamic finance market. On thepart of the Malaysians, it is a dynamic, diplomatic, and international, as well a pragmaticapproach in establishing a platform conducive to serving the needs of both local customersand investors. Such a step taken by the Malaysians may be seen as a form of harmonization ofthe fatawa that are available in the Islamic financial market internationally. In this sense, theMalaysians aim for mutual recognition and acceptance rather than harmonization that disruptsthe local particularities of its market to suit the opinions of the GCC-based IFIs.65

The approach to addressing the needs for global acceptance taken by both the UAE andBahrain is somewhat different from the approach taken in Malaysia. In both markets, interna-tional scholars are invited to be the Shariah scholars in almost all Islamic financial institutions,and in addition to working on many of the Islamic financial institutions of the GCC, as wellas on standard-setting regulatory bodies such as the AAOIFI. Since the Shariah frameworkstructure in these two countries is market-driven rather than regulatory-driven, the influence ofthese international Shariah scholars is strong and shapes the preference in the market. As such,contentious fatawa applicable in Malaysia are rejected and will most likely remain rejectedin these markets. This step may be considered as a process of internationalization of fatawarather than of harmonization of fatawa for global acceptance like what can be observed to behappening in the Malaysian market.

This section addressed the regulatory structures relating to the Shariah framework in whichfatawa are pronounced on the permissibility of contracts in the GCC and Malaysian marketsand indicates that it is predominantly at the level of a jurisdiction’s Shariah framework that aform of harmonization or convergence of fatawa is most likely to occur in the internationalIslamic financial sector. This chapter highlighted in particular the context of Malaysia whichhas been observed to embrace Middle Eastern opinions as its Shariah framework encompassesthe opinions of the Middle East while also accepting as permissible Islamic finance contractsthat are interpreted as Shariah-compliant in the context of the Malaysian jurisdiction only. Thecreation of international Islamic financial hubs will be conducive to creating an environmentin which there is a harmonization or internationalization of Shariah standards. This will leadto a gradual reduction in regional variations in the international dimensions of Islamic finance.

15.10 CONCLUSION

This chapter discussed areas of convergence and divergence in the Islamic financial sector inthe GCC region and in Malaysia. Islamic finance is noticeably applied in regions as diverseas South East Asia and the Middle East. With such a variety in the contexts in which it ispractised and implemented, it is to be expected that there will be variations at the level ofthe use and development of Islamic finance contracts. It is expected too that there will bedisagreements and a divergence of perspectives on the permissibility of contracts based on

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the context and the time at which Shariah pronouncements or fatawa are made. The variety inregions reflects a variety in needs, a variety in socio-economic and political contexts as wellas differing economies and regulatory environments, to which Islamic finance was adapted ata particular point in time in the evolution of the sector.

Shariah Board members who are predominantly experts in fiqh al muamalat have playeda key role in this process of adaptation as the contemporary financing needs of Muslimsare as diverse as the regions they are based in. Additionally, the financing needs of Muslimshave required interpretations beyond the classical contracts pre-existing the implementation ofconventional finance in the Arabian Peninsula and the Indian subcontinent and this interpretiveprocess has required Shariah Board members to exercise interpretation. With interpretationscome variations and divergence of opinions and this divergence is respected in subsidiarymatters in Islam. These subsidiary commercial matters are not core to the faith such as thetenets of the faith and its rituals. Secondary or subsidiary matters, such as those covered byIslamic commercial law, allow for this wealth and divergence in perspectives.

This chapter identified key regional variations in the application of Islamic finance contracts.Some of these variations are reflective of differences in opinion among Shariah Board membersof differing regional backgrounds, yet other variations have proven to be simply of a structuralor transactional nature but are recognized or accepted as Shariah-compliant by members ofthe Shariah Boards of differing backgrounds. The variations that were identified to be linkedto a direct difference of opinion on the permissibility of products are the financial productsbased on the contracts of bai’ al dayn, bai’ al ina, bai’ bithaman ajil based on the bai’ alina contract, tawarruq, and wadiah. These core contracts are applied in different capacities inthe Islamic banking sector and in Islamic capital markets. Other differences seemingly of astructural nature are those surrounding the Malaysian Islamic financial institutions’ use of themudaraba-takaful model and the GCC Islamic financial institutions’ use of the wakala-takafulmodel although both regions are moving towards a hybrid of the wakala- and mudaraba-takaful models. Additional structural differences, practised predominantly by GCC-basedIslamic banks, are deposit and investment products based on the contracts of mudaraba andqard. An equivalent product is generally offered in Malaysia with the alternative contractof wadiah yad dhamana. At the level of the Islamic capital market, a preference acrossregions for the sukuk al ijara model has emerged as the result of a 2008 pronouncementby the Shariah Board of the Accounting and Auditing Organization for Islamic FinancialInstitutions.

The Shariah Boards of the institutions offering particular Islamic financial products showeda distinctive composition or pattern based on the nationalities and backgrounds of ShariahBoard members of the type of products likely to be permitted. An analysis of the regions oforigin and regions of training of Shariah Board members revealed that a significant portionof the Malaysian members of the Shariah Boards have studied in the Middle East, and assuch that they would be familiar with the opinions of members of the Shariah Boards inthe GCC. As such the regional differences could not be linked only to the states of originof the Shariah Board members. A reflection on the regulatory structures at the level of theformal and the informal Shariah framework indicated that the difference in the centralizedapproach to guiding Shariah interpretations in a jurisdiction, as in the case of Malaysia, andthe decentralized approach in the GCC states, contributed most significantly to the regionalvariations observed. The Malaysian Shariah framework is broader and more encompassingof the perspectives of the GCC Shariah Board members than the converse. Malaysia-specificapplications of contracts such as bai’ al ina and bai al dayn are likely to remain localized to

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Malaysia and more steps are taken for Middle Eastern interpretations to be integrated to thelocal market by welcoming GCC-based Islamic financial institutions into Malaysia.

Additionally, dialogues among Shariah experts have been conducted on a regular basis byboth the private sector in Islamic finance – for instance the forums organized by Dallah alBaraka – and also at the level of international standard-setting institutions such as the AAOIFIand the Islamic Fiqh Academy of the OIC and at the level of central financial authorities. Thesehave been organized in Malaysia by the Central Bank of Malaysia, Bank Negara Malaysia, inthe form of dialogues between Shariah scholars of Middle Eastern and Malaysian backgrounds.The emergence of international Islamic financial hubs as well as these forums or dialoguesindicates that, at some level, a harmonization and internationalization of Shariah standards istaking place. It is at the regulatory level of the Shariah framework that it is likely that either aform of harmonization of fatawa will be carried out or a form of internationalization of fatawafrom the GCC into other regions, such as Malaysia, will take place. And such a development canalready be observed for the international dimensions of the Islamic financial sector, reflectingthe internationalization of Middle Eastern perspectives into the Islamic financial sector ofMalaysia. The internationalization may be interpreted to be one form of harmonization and itis likely that certain pockets of the Islamic financial sector will remain as they are, localizedand Shariah-compliant based on the local Shariah framework, primarily in the retail sectorwhere there is less international interaction.

NOTES

* Anne-Sophie Gintzburger was awarded in March 2010 an MPhil in international relationsand political science on the topic of Islamic finance at the Australian National University’sCenter for Arab and Islamic Studies, Canberra. Starting out in this field, she is contributinga chapter to our book which is a snapshot of her research on regional differences in Islamicfinance in the Gulf Cooperation Council (GCC) states and Malaysia. A comprehensiveoverview of her study, based on extensive fieldwork in Malaysia and the UAE, will beavailable in a book (Edward Elgar Publishing, forthcoming 2011). Of both French andAustralian citizenship, she is currently in France with a view to developing her career inthis field. She is currently the Shariah Report 2010 Project Manager for Failaka Advisors(Dubai/Chicago) and a consultant at Altran CIS (Paris). The views expressed in this chapterare solely those of the author and do not necessarily reflect the views of Failaka Advisorsor Altran CIS, their shareholders, or their affiliates. Special thanks to Razi Pahlavi AbdulAziz for reading through versions of this work and providing sharp and valuable insights.

1. Yusuf DeLorenzo (2007) Shari’ah compliance risk, Chicago Journal of International Law7(2), Winter, 1–12.

2. Tarek, Zaher and M. Kabir Hassan (2001) A comparative literature survey of Islamicfinance and banking, Financial Markets, Institutions and Instruments, 10(4), November,155–99, at 194; Walid Hegazy (2007) Contemporary Islamic finance: from socioeco-nomic idealism to pure legalism, Chicago Journal of International Law, Winter, 7(2),581–603, at 581; Yusuf Talal DeLorenzo (2008) “Shariah Boards and Modern IslamicFinance: from the jurisprudence of revival and recovery to the jurisprudence of trans-formation and adaptation”, London: IFSB Conference Presentation, May 2004, p. 3,www.yasaar.org/publications.htm. Accessed 21 August 2008.

3. Governor Tan Sri Dr Zeti Akhtar Aziz (Governor of the Central Bank of Malaysia),Globalization of Islamic Finance Services – Opportunities and Challenges, Fifth Islamic

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Financial Services Board Summit: Session 1, Amman, 13 May 2008, www.bnm.gov.my.Accessed 14 September 2008; Prime Minister Abdullah bin Ahmad Badawi, Prime Min-ister’s Speech at the Islamic Financial Services Board Annual Meeting and Global IslamicFinance Forum (GIFF), Kuala Lumpur, 27 March 2007, www.bnm.gov.my. Accessed 15September 2008. In rhetoric, it seems the case, and increasingly so over the past 10 years.However another opinion also noted throughout the research was that of Rodney Wilson,in 1998, a decade earlier, where it was debated that conventional economics is what ledto the country’s economic development and that which influences Islam, rather than theother way around, alluding to Mahathir’s rhetoric that Islam is a force for modernizationand development. According to Wilson in 1998, “Islam is likely to be a continuing factorinfluencing politics, but as far as Malaysia’s development is concerned, the influence ofconventional economics on Islam may be greater than the impact of Islam on economicpolicy”. See Rodney Wilson (1998) Islam and Malaysia’s economic development, Journalof Islamic Studies 9(2), 259–76, at 265–76.

4. In its contemporary application, the prohibition against riba in Islamic finance is equatedto conventional financial interest, although some interpretations refer to it as usury and notthe type of financial interest applied in conventional finance. However, the overarchinginterpretation among Islamic finance practitioners is that financial interest as applied bythe conventional financial sector is prohibited. Refer to Mohd Daud Bakar (2008) “Ribaand Islamic Banking and Finance” in Mohd Daud Bakar and Dr Engku Rabiah AdawiahEngku Ali, Essential Readings in Islamic Finance, CERT Publications Sdn Bhd: KualaLumpur; Abdullah Saeed (1996) Islamic Banking and Interest: A Study of the Prohibitionof riba and its Contemporary Application, Studies in Islamic Law and Society, E.J. Brill:Leiden.

5. Terms such as “Islamic finance scholars”, “Muslim jurists”, “Shariah advisors”, “membersof the Shariah committee”, “members of the Shariah advisory board”, “Shariah scholars”,and “member(s) of the Shariah board(s)” are referred to interchangeably in the thesis torefer to those specialized in fiqh al-muamalat, or Islamic commercial laws, who work onthe Shariah Boards of Islamic financial institutions to approve products and transactionsfor their compliance with Islamic commercial laws. Although the term “Shariah scholars”may be somewhat misleading in meaning from its translation into English, it is commonlyused in English in the Islamic finance industry. Rather than referring to a scholar per se,the term “scholar(s)” is a translation from Arabic that refers to “alim” or those who arelearned, and in this context, those who are learned in fiqh al muamalat. It refers more to theirprofessional capacity rather than an academic skill when the term “scholar” is used in thiscontext. For further information, see IFSB (Islamic Financial Services Board), ExposureDraft: Guiding Principles on Shariah Governance System, Kuala Lumpur, December2008, 27 pp., www.ifsb.org. Accessed 7 May 2009, pp. 3–4.

6. Yusuf Talal DeLorenzo (2008) “The Arboon Sale: a Shariah compliant alternativeto selling short with borrowed securities”, Shariah Capital Inc., 24 July 2008, p. 5,www.shariahcap.com/pubs/shariah/the arboon sale english.pdf. Accessed 20 May 2009.The Shariah Board members approving the product are from Bahrain (Sheikh NizamYaquby), from Malaysia (Dr Mohd Daud Bakar), from the United Arab Emirates (DrMohammad Abdul Rahim Sultan al Olama), and from the United States (Sheikh YusufTalal DeLorenzo).

7. In this thesis, Islamic financial institution(s) or IFI(s) refer to Islamic banks, the Islamicwindows of conventional financial institutions, takaful operators, as in Bank Negara

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Malaysia (BNM), Guidelines on the Governance of Shariah Committee for the IslamicFinance Institutions, Islamic Banking and Takaful Department, 16 pp., www.bnm.gov.my.Accessed May 2009, p. 2.

8. Rodney Wilson (2007) Islamic Finance in Europe, RSCAS Policy Papers PP 2007/2,MUSMINE – Muslim Minorities in Europe, Robert Schuman Center for Advanced Stud-ies, 22 pp., p. 1; Warde, Islamic Finance in the Global Economy, p. 2.

9. Note that in Islamic finance, assets have a different definition to those in conventionalfinance. In Islamic finance, “assets” refer to both tangible and intangible goods (that isrights) but not inclusive of monetary assets. Money from an Islamic perspective is purelya medium of exchange and not a commodity. Thus money cannot be traded unless on spotbasis and money cannot earn money. Money must be utilized to generate an economicactivity in exchange for profit. This can be demonstrated in the structure of contracts inIslamic finance products based on either contracts of exchange (buying and selling of anasset) and contracts of participation (equity partnerships) as opposed to the conventionalfinance contracts which denote a debtor-creditor relationship between the bank and thecustomer and where the gain for the bank is through interest rates in the loan or financingarrangement.

10. In principle, there is profit-and-loss-sharing (PLS); however in practice, for most financingproducts, reliance is on sales-based transactions (mark-up) due to the risks entailed forthe financial institution by PLS. For further information of this, refer to Rajesh Aggarwaland Tarik Yousef (2000) Islamic banks and investment finance, Journal of Money, Creditand Banking 32(1), February, 93–120, at 119.

11. Mohd Daud Bakar (2008) “Riba and Islamic banking and finance” in Mohd Daud Bakarand Dr Engku Rabiah Adawiah Engku Ali, Essential Readings in Islamic Finance, CERTPublications Sdn Bhd: Kuala Lumpur, see pp. 22–3: “. . . Perhaps if Islamic banks wereto venture into mudarabah and musharaka financing with some modifications necessaryto minimise the risk on the part of the bank, it will create a new chapter in the history ofbanking.” Further supporting the view that the current financial sector is based on contractsof exchange rather than contracts of participation, see the reference that Islamic bankingoperations currently consist of transactions that are predominantly debt-creating ones,resulting in debt accumulation. Whereas the transactions that are contributions-based fol-lowing the spirit of participation are not standard in the industry in its current applications.See Lahem Al Nasser (2009) “The effect of debt on Islamic banking”, 16 April 2009,Ryadh: Asharq al-Awsat, http://aawsat.com/english/news.asp?section=6&id=16425.Accessed 18 April 2009.

12. Thomas Abdulkader et al. (2005) Structuring Islamic Finance Transactions, EuromoneyBooks: London, p. 69 and pp. 32–6; Mohammad Daud Bakar (2006) “Islamic bank-ing vs. conventional banking: syariah principles, syariah interpretation and syariah fea-tures”, Seminar on Islamic Banking and Finance: Moving forward, Kuala Lumpur IslamicFinance Forum 2006; Saiful Azhar Rosly (2005) Critical Issues on Islamic Banking andFinancial Markets: Islamic Economics, Banking and Finance, Investment, Takaful andFinancial Planning, Authorhouse: Bloomington, p. 23; Mabid Ali Al Jarhi (interviewby Robin Wigglesworth) (2005) “Islamic retail banking deconstructed” Islamic Busi-ness & Finance, CPI Financial: Dubai, November, pp. 40–2; Mahmoud El-Gamal (2006)Overview of Islamic Finance, Occasional Paper no. 4, Department of the Treasury, Office ofInternational Affairs, August, p. 9; Alexia Garamfalvi (2007) “Islamic Scholars Play Rolein High Finance” Legal Times, 4 May, www.law.com. Accessed May 2007; Abdulkader

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Thomas (2007) “Islamic Finance Goes Global”, Far Eastern Economic Review, May,www.feer.com/articles1/2007/0703/free/islamicf.html. Accessed 4 May 2007; NathalieBrafman (2005) “A la conquete de l’ argent islamique” (2005) Le Monde (strategiefinanciere), 8 January 2005, p. 3; The Edge Daily (2007) “Securities Commission,Citigroup hold Shariah Dialogue to Strengthen Market” (2007) Kuala Lumpur: The EdgeDaily, 6 March 2007, www.theedgedaily.com. Accessed April 2007; Halim Wahab (2004)“The Debate Continues”, Malaysian Business, Kuala Lumpur, 16 March 2004, p. 38;Morgan Stanley (2008) Islamic Banking: Big Interest in Interest-Free Banking, MorganStanley, 5 September 2008, p. 15.

13. See the mention of the need for “Shariah convergence” by Paul McNamara (2006) “IslamicFinance on the Global Stage” Islamic Business & Finance, Dubai: CPI Financial: Dubai,8 February 2006.

14. Global Islamic banking assets and assets under management have reached US$750 billionand are expected to reach US$1 trillion by 2010. For further information, see Mckinsey,“Capturing the Trillion Dollar Opportunity” The World Islamic Banking CompetitivenessReport 2007–08.

15. Zeti Akhtar Aziz, in Shamshad Akhtar et al. (2008) “Understanding Islamic Finance:Local Innovation and Global Integration” Asia Policy, 6, July 2008, pp. 2–14.

16. Anne-Sophie Gintzburger (2009) The Sources in Variation in the Application of ShariahCompliant Finance Contracts: A Comparative Analysis of Shariah Scholars, ShariahBoard Roles, and Regulatory Variations in Malaysia and the Gulf Cooperation Council(GCC) States, MPhil thesis, The Australian National University, Canberra.

17. Mohd Daud Bakar (2008) “Developing modern Islamic financial system via Ijtihad:an overview”, in Mohd Daud Bakar and Dr Engku Rabiah Adawiah Engku Ali,Essential Readings in Islamic Finance, CERT Publications: Kuala Lumpua, pp. 27–43,at p. 28.

18. Such as for instance the shift in perception of Shariah compliance of certain sukuk struc-tures; see Appendix B and further details in Chapter 4. See also for reference to the timeand place of a fatawa: Babu Sahib, Hikmatullah, “The Nature of Fatwa and the Role ofthe Mufti”, Shariah Law Reports 2005, pp. 48–60.

19. Islamic windows of conventional banks offer Shariah-compliant products. It is usually inthe context of an “Islamic division” which has operations separated from the conventionalbanking products of the conventional bank – for instance, no co-mingling of funds betweenthe conventional side of the operation and the Islamic side of the operation (especially inMalaysia).

20. Michel Galloux (1997) Finance islamique et pouvoir politique: le case de l’Egypte mod-erne, Presses Universitaires de France: Paris, p. 51.

21. This view of Shariah experts enhancing the legitimacy of Islamic financial institutions intheir early days in the 1970s is also supported by Mohammad Nejatullah Siddiqi (2006)Select Ethical and Methodological Issues in Shariah Compliant Finance, concept paperpresented to stimulate discussion at the pre-forum workshop of the Seventh Harvard Forumon Islamic Finance, Cambridge, Massachussetts, USA, 21 April 2006.

22. Siddiqi, Select Ethical and Methodological Issues in Shariah Compliant Finance.23. Clement M. Henry (2001) “Islamic financial movements: Midwives of political change in

the Middle East?” Annual Meetings of the American Political Science Association, HiltonSan Francisco & Towers, 30 August to 2 September 2001.

24. Siddiqi, Select Ethical and Methodological Issues in Shariah Compliant Finance.

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25. Mohammad Daud Bakar (2008) The Shariah Report 2008: Profiles of the World’s LeadingScholars, Chicago/Dubai 2008.

26. Islamic Financial Services Board, Exposure Draft: Guiding Principles on Shariah Gover-nance System, December 2008, www.ifsb.org (accessed 4 May, 2009).

27. http://www.amanie.com.my/amanie/shariah board.htm. Accessed 26 May 2009.28. Mohammed Akacem and Lynde Gilliam (2002) “Principles of Islamic banking: Debt

versus equity financing” Middle East Policy, 9(1), March, pp. 124–38.29. Ibrahim Warde (2000) Islamic Finance in the Global Economy, Edinburgh University

Press: Edinburgh, p. 2.30. The permissibility of ijtihad is contested. For some scholars but generally not in Islamic

finance, there is no scope to engage in ijtihad. The use of ijtihad in the Islamic financesector is strongly supported in Islamic finance. For further discussions on this, refer toAbdur-Razzaq Abdul Majeed Alaro (2008) “Shari’ah boards in Islamic banks: a frontageof contemporary ijtihad”, pp. 216–33 at the International conference on Ijtihad and Ifta’in the 21st century: Challenges and Prospects, 12–14 August, Kuala Lumpur.

31. Mohd Daud Bakar (2008) “Developing modern Islamic financial system via Ijtihad: anoverview”, in Mohd Daud Bakar and Dr Engku Rabiah Adawiah Engku Ali, EssentialReadings in Islamic Finance, CERT Publications: Kuala Lumpur, pp. 27–43.

32. Bernard Weiss (1977–78) Interpretation in Islamic Law: The Theory of Ijtihad, TheAmerican Journal of Comparative Law, 26, 199.

33. Ibid., pp. 199–212.34. Interview with a Shariah scholar from Pakistan at the International Islamic Univeristy of

Malaysia, Gombak, 10 December 2007.35. Imran Ahsan Khan Nyazee (2003) Islamic Jurisprudence, The Other Press: Petaling Jaya,

p. 287.36. Yusuf DeLorenzo (2004) Shariah Boards and Modern Islamic Finance: From the Jurispru-

dence of Revival and Recovery to the Jurisprudence of Transformation and Adaptation,IFSB Conference Presentation: London, May 2004.

37. Abdulkader Thomas, Stella Cox, and Bryan Kraty (2005) Structuring Islamic FinanceTransactions, Euromoney Books: London, p. 33.

38. Bank Negara Malaysia (2007) Shariah Resolutions in Islamic Finance, Kuala Lumpur;Surunhanjaya Sekuriti (2007) Resolutions of the Securities Commission Shariah AdvisoryCouncil, 2nd edn, first reprint.

39. Thomas, Structuring Islamic Finance Transactions, p. 205.40. Hamid Ibrahim (ed.) (2007) “Islamic Banking Act 1983 (Act 276)” Islamic Banking and

Finance, Gavel Publications: Petaling Jaya, p. 253.41. Personal communication (email), Razi Pahlavi Abdul Aziz, consultant in Shariah compli-

ant finance, Kuala Lumpur, 24 May 2009.42. Ibid.43. Failaka Advisors (2008) The Shariah Report 2008: Profiles of the World’s Leading Schol-

ars, Chicago/Dubai.44. Mohd Daud Bakar (2008) Failaka Advisors. The Shariah Report 2008: Profiles of the

World’s Leading Scholars, Failaka Advisors: London.45. Muhammed Syafii Antonio (2008) “What is the Future Outlook of Shari’ah Harmoniza-

tion?” ISRA Islamic Finance Seminar (IIFS), 11 November; interview with a Shariahscholar, Kuala Lumpur, 30 November 2007, indicating that the differences of opinionbetween scholars have created the advantage of added creativity, innovation, and growth.

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46. Mohammad Syafii Antonio (2008) “What is the Future Outlook of Shari’ah Harmoniza-tion?” ISRA Islamic Finance Seminar (IIFS), Kuala Lumpur, 11 November, p. 5.

47. BNM, Muzakarah Cendekiawan Syariah Nusantara 2006: Bai’ al-’inah dan tawarruq:isu-isu dan penyelesaiannya dalam konteks kewangan Islam.

48. As a reminder, the Shariah Board of the AAOIFI consists of the following Shariah Boardmembers who represent some of the most influential Shariah scholars from their countriesof origin: Sheikh Muhammad Taqi Usmani from Pakistan; Sheikh Abdulla Bin SulaimanAl Manea from Saudi Arabia; Sheikh Al Siddiq Mohamed Al Darir from Sudan; SheikhAjeel Jasim Al-Nashmi from Kuwait; Sheikh Mohamad Ali Al Taskhiri from Iran; SheikhDato’ Ghazali bin Abdul Rahman from Malaysia; Sheikh Abdel Sattar Abdel Karim Abu-Ghuddah from Syria; Sheikh Nizam Yaquby from Bahrain; Sheikh Ahmad Ali Abdullafrom Sudan; Sheikh Dr Mohd Daud Bakar from Malaysia; Sheikh Dr Hussein HamidHassan from Egypt (based in Dubai); Sheikh Dr Ali Mohi Eldinne Alqoradaghi fromQatar; Sheikh Dr Mohamed Ali Al Qari from Saudi Arabia; Sheikh Yusuf Talal DeLorenzo from the United States; Sheikh Esam ‘Anezi from Kuwait; Dr Saleh AbdullahSaleh Al-Haidan from Saudi Arabia.

49. AAOIFI Shariah Board, http://www.aaoifi.com/sharia-board.html. Accessed 17 June2009.

50. Additional definitions in parentheses were obtained from the AAOIFI Shariah Stan-dards and the Securities Commission of Malaysia’s Shariah resolutions as referred to inChapter 3.

51. Interview with the head of the Islamic division of a conventional bank in Malaysia, whichhas operations globally in Islamic banking, Kuala Lumpur, 22 November 2007.

52. Interview with a senior Malaysian executive from the Islamic banking department ofregulatory authorities, Kuala Lumpur, 17 December 2007; Interview with a MalaysianShariah scholar from the Islamic banking department of the regulatory authorities, KualaLumpur, 17 December 2007; Interview with a Malaysian manager from the Islamic bank-ing department of regulatory authorities, Kuala Lumpur, 17 December 2007; Interviewwith the head of the Islamic capital markets section of a regulatory body, Kuala Lumpur,30 November 2007; Interview with a Malaysian senior executive at the Islamic bankingsection of a regulatory authority, Kuala Lumpur, 28 November 2007.

53. Mohammad Syafii Antonio (2008) “What is the Future Outlook of Shari’ahHarmonization?” ISRA Islamic Finance Seminar (IIFS), Kuala Lumpur, 11 November2008.

54. Jamal Abbas Zaidi (2008) “Shari’a harmonization, regulation and supervision” IslamicInternational Rating Agency, presented at AAOIFI-World Bank Islamic banking andfinance conference, Manama, 10–11 November 2008.

55. Malaysia International Islamic Finance Center (MIFC), “Primer to Islamic Finance”(no date, brochure) p. 23.

56. Abdulkader Thomas, Stella Cox, and Bryan Kraty (2005) Structuring Islamic FinanceTransactions, London: Euromoney Books: London, pp. 206–9.

57. Zawya, “Tech Data VP applauds Infrastructure Development” Zawya, 23 January,www.zawya.com. Accessed 3 July 2009.

58. Peter Cooper (2008) “What does the global financial crisis mean for Dubai real estate?”Ameinfo, Dubai, 16 October 2008, www.ameinfo.com. Accessed 3 July 2009.

59. Zawya, “DIFC is aiming to create a world class financial center” Zawya, 29 June,www.zawya.com. Accessed 3 July 2009.

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60. Brunei International Financial Center, http://www.finance.gov.bn/bifc/. Accessed 17 June2009.

61. Laurent Laurent (2008) “Global cities race to become Islamic finance hubs” Ameinfo,29 June 2008, http://www.ameinfo.com/161924.html. Accessed 23 November 2008; ZetiAkhtar Aziz (2005) “Metamorphosis into an international Islamic banking and financialhub”, special address by Dr Zeti Akhtar Aziz, Asian Strategy and Leadership Institute(ASLI) World Islamic Economic Forum, Kuala Lumpur, 1 October 2005; “DIFC aims tobecome global Islamic finance hub” Bernama, 25 January 2008, http://www. bernama.com/bernama/v5/newsindex.php?id=310234. Accessed 24 February 2009.

62. Interview with a Malaysian Islamic banker, working in corporate banking for a Singa-porean bank in Islamic investments, Singapore, 3 January 2008; Interview with an Iranianbanker, working in product development for a Singaporean bank in Islamic investments,Singapore, 3 January 2008.

63. Keat, Heng-Swee (2009) “6th IFSB Summit: The Future of Islamic Financial Services”,Monetary Authority of Singapore, 7 May, www.mas.gov.sg, accessed 10 June 2009.

64. Mohammed Amin (2008) The UK tax rules for conventional and Shariah compli-ant mortgages, PWC, 11 November 2008, http://pwc.blogs.com/files/islamic mortages111108.pdf. Accessed 3 July 2009.

65. Interview with a Malaysian Islamic finance strategist at the level of a major Malaysianfinancial authority, Kuala Lumpur, 28 November 2007.

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16

Developments in Islamic FinancePractice: The Experience of Australia

Abu Umar Faruq Ahmad and M. Kabir Hassan

16.1 INTRODUCTION

The Muslims are considered as the largest religious minority in the highly diversified mul-ticultural Australia (ABS, 2006). Naturally, the Muslims in Australia like Muslims in anyother countries wish to conduct their financial activities in accordance with the tenets of theirIslamic belief. Given this, there is a necessity for the establishment of Islamic financial institu-tions (IFIs) that would cater for the needs of Australian Muslims. The establishment of theseinstitutions would enhance competition in the financial market by offering an alternative tothe traditional interest-based banking, which ultimately would benefit the consumers. Conse-quently, this would contribute to the development of the Australian economy through creatingan opportunity to bring in significant foreign direct investments into Australia and also helpexpand its existing trade and economic ties with other Muslim countries.

Despite the remarkable growth and development of Islamic banks (IBs) and financialinstitutions over the last few decades in other comparable developed countries with minorityMuslim populations, their expansion in Australia is very slow though steady (Al-Salem, 2008).Currently there are two IFIs, the Muslim Community Cooperative Australia Limited (MCCA)and Islamic Cooperative Finance Australia Ltd (ICFA), which operate on the principles of thecooperative. The Iskan Finance Pty Ltd has also been providing Islamic financial services inthe country. Although another financial institute, namely Kuwait Finance House (Australia)Pty Ltd, has recently been licensed to provide financial services in the country it has not yetcommenced operation. Neither of the above mentioned IFIs has a banking licence to operateas a bank.

There is a plethora of reasons why these institutions did not succeed in growing substantiallyin Australia. Examination of all these reasons is not really possible within the permittedlength of this chapter. However, the chapter attempts to focus on the potential problems andhuge prospects of Islamic finance in Australia. Given the findings of the study, it is to berecommended that the necessary legislative changes are made to facilitate the growth of IFIsin Australia, as demonstrated by the experience of other comparable developed countriesaround the globe.

Among other key barriers the lack of regulatory support within a specific legal and policyframework continues to hamper the rapid expansion and acceptance of Islamic finance inAustralia (Ahmad, 2010). Given these perspectives, this chapter seeks to discuss some of the


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impediments restricting IFIs in offering Shariah-compliant financial products to Australianobservant Muslims. The Australian prudential regulations are administered by APRA, whichfollow the current Basel standards and are in the process of changing over to the Basel IIstandards. Neither of these makes provision for Shariah compliance. Both the Accords treatthese types of financial arrangements as equity, rather than credit – thus giving them a heavycapital treatment (Andrew, 2006).

Research conducted indicates that due to the unfamiliarity of the relatively new Islamicfinance system, IFIs in Australia have not been able to play the expected role in the developmentof Australian economy through mobilizing funds and attracting more customers (Ahmad,2008). Another major flaw in the Australian regulatory system is its federal structure. Allinstitutions, be they financial or otherwise, are required to follow both State and Federalregulations. These regulations may vary from State to State. The States and Territories mayhave different regulations. This lack of uniform regulation across all the six States and twoTerritories is also not conducive to the growth of Islamic finance in Australia (Ahmad andHassan, 2006).

This study is divided into a number of sections, which are organized as follows: followingan introduction, Section 16.2 gives a short outline of Australia’s current status in the globaleconomy. Section 16.3 then discusses the potential problems faced by the Islamic financeindustry in the Australian market. Section 16.4 delineates the prospects for the Islamic financeand banking market in Australia. Section 16.5 concludes with the summary and analyticalfindings of the study, and offers some suggestions and recommendations in the relevant field.

16.2 STATE OF THE AUSTRALIAN ECONOMY IN THE WORLD

16.2.1 The Australian Economy

In looking at the recent developments and future prospects of Islamic finance it is first nec-essary to discuss the position of Australia in the world economy and how the Governmentis positioning Australia to be a regional financial centre. While the Australian economyslowed significantly during the global downturn, it weathered the crisis better than most otheradvanced economies. In 2009, the Australian economy grew by 1.3% which is 4.5% above theaverage for all advanced economies. During this period public investment grew by a strong12.5% in the quarter. Stimulus programmes, including the Building the Education Revolution,are estimated to have contributed around 0.4 of a percentage point to GDP growth for thequarter. This outcome provides tentative signs that a self-sustaining private sector recovery isin prospect, although growth still relies on public infrastructure investment. The Government,by sticking to its very strict fiscal rules, is bringing the Budget back into surplus in 2012–13 –three years ahead of schedule. This will make Australia the first advanced economy in theworld to return to surplus. Furthermore, the Australian economy is forecast to grow by 3.25%in 2010–11, rising to 4% in 2011–12. The increasing pace of this growth means the economyis expected to approach full capacity in 2011–12. The Australian unemployment rate, alreadythe second lowest among the major advanced economies, is set to fall further, to 4.75% bymid-2012. Forecast deficits are now lower across the forward estimates. An underlying cashdeficit of $40.8 billion, or 2.9% of GDP, is forecast in 2010–11. This is $16.3 billion less thanexpected one year ago. Net debt is projected to peak at just 6.1% of GDP in 2011–12. This ishalf of the level projected a year ago and less than one tenth of the average across the majoradvanced economies – their average debt will peak at 93% (Sherry, 2010).

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Developments in Islamic Finance Practice: The Experience of Australia 343

The Government’s stimulus strategy has been one of the main reasons for Australia beingone of only three advanced economies to avoid recession. Another major reason has beenAustralia’s close economic links with the Asian region, particularly China. These countriesoutperformed the North American and European zones during the global recession and areleading the global recovery. This global recovery is pushing up prices for Australia’s keycommodity exports and this is expected to cause a substantial rise in the terms of trade in2010. In turn, this will support a recovery in incomes across the economy. The terms of tradeare expected to rebound by 23% – 14.25% in year average terms in 2010–11 – injecting$30 billion into the economy. This boost in incomes will help to reinvigorate the mining sectorand general economic activity. Australia’s solid performance through the global financial crisishas meant that it has avoided the erosion of the skills base and loss of business capital seen inother countries and in previous downturns. This leaves Australian firms and workers in goodshape to meet a recovery in demand (Sherry, 2010).

Apart from Australia’s better position in the world economy its financial services industry isone of the world’s most sophisticated, competitive, and innovative. It is also one of the safest.The finance and insurance sector is now the largest contributor to the Australian economy. In2008–09, the sector generated about 10.8% of GDP. Over the past decade, the sector has grownby an average of 4.3% a year which is significantly above the average for all sectors. Australiais highly regarded internationally as a place to conduct business. The World Economic Forumrecently ranked Australia second among the world’s financial centres, behind only the UnitedKingdom, primarily due to the stability of its financial institutions over the past 12 months(Sherry, 2010).

Australia has other competitive advantages in the Asia-Pacific region. These include havingthe largest funds management industry; the largest hedge funds industry, deploying the widestrange of investment strategies; the largest Real Estate Investment Trusts market; and the largestpension fund industry after Japan. Taking into consideration the generating of significant jobsand wealth by Australia’s finance and insurance sector it now has a great untapped potential.That is why the Australian Government is apparently working to position Australia as a leadingfinancial services centre. In September 2008, the Government commissioned a report into howit can work towards that goal. On 15 January 2010, the Government released the report,Australia as a Financial Centre – Building on our Strengths, known as the Johnson Report.The report concluded that Australia has arguably the most efficient and competitive financialsector in the Asia-Pacific region, but there are further opportunities to expand its exports andimports of financial services. The Australian Government is reported to have made progresson the recommendations in the report, in addition to introducing other initiatives to improveits international competitiveness (Sherry, 2010).

16.3 POTENTIAL PROBLEMS IN THE DEVELOPMENT OFISLAMIC FINANCE IN AUSTRALIAN MARKET

Given that all Australian banks and financial institutions as well as its regulatory system dealin interest, it has proven to be a significant challenge to develop and deliver non-interest-based Islamic financial products and services that will cater to observant Muslims’ uniqueneeds. Moreover, since Islamic finance is still in a state of infancy in Australia, it has beenfacing a number of problems and challenges, which can be identified as operational problems.This chapter highlights some of the issues and challenges that come with introducing Islamic

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finance into the Australian financial market. They include but are not restricted to the followingareas.

16.3.1 The Acceptance of Interest

The deep-rooted acceptance of interest as a function of how the financial sector operates maybe an obstacle to wider acceptance of Islamic finance. Australia is blessed with a profitable,strong, and stable financial sector in which the payment of interest plays a crucial part. Interestrates and bank charges are now important factors for customers in choosing where to invest,save, and borrow from.

The attention paid by media outlets from non-Muslim countries to the Islamic finance sectorin the Middle East and Malaysia stems in part from the uniqueness of a system in which interestis not used. An early report about Islamic finance on the Australian Broadcasting Corporationdescribed banking without interest as seemingly like “playing cricket without a bat” – such isthe accepted view on the link between interest and banking (Hassan, 1999).

Given this, despite the huge growth in Islamic finance over the past three decades, the widerbanking and finance sector may be reluctant to enter the sector, viewing a system that eschewsinterest as a niche market and even a gamble given that it operates outside the historicallyaccepted conventions of the sector.

16.3.2 A Wait-and-See Approach

While the major global players in the banking sector such as Citibank, HSBC, and StandardChartered in Malaysia; Deutsche Bank in Germany; and HSBC and Lloyds TSB in the UK haveembraced Islamic finance, Australian banks appear to have taken a wait-and-see approach.The non-existence of an Australian bank offering Islamic finance products could also changeonce Islamic non-banking financial institutions like the MCCA negotiate the often complexregulatory frameworks that govern both State and Federal financial operations.

16.3.3 The Size of the Muslim Community

According to Nasya Bahfen,

The size and infancy of the Muslim community may be a factor in the growth of Islamic finance.With more than three hundred thousand members, the Muslim community in Australia makes upless than two per cent of the population. As the primary market for Islamic finance the Muslimcommunity’s asset base is not strong. The demand for Islamic finance products among AustralianMuslims is greater than the available supply. This contrasts strongly with the United Kingdom,where a Muslim population of 2.4 million is serviced by at least two conventional banks withIslamic windows, and several stand-alone Islamic banks. (Bahfen, 2008)

16.3.4 Doubt Concerning Shariah-Compliant Finance and Investment Products

Scepticism about Shariah-compliant financing and investment products may be a furtherbarrier to the growth of Islamic finance. While Islamic financial services in Australia havebeen used by members of the Muslim community, and demand for such services exceedssupply, not everyone welcomes the growth of Islamic finance. Within Australia’s Muslimcommunity there are those who are sceptical about (and in some cases downright hostile to)

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the first Islamic finance products available to Australian Muslims, questioning the validity ofthe Shariah-compliant label.

The Australian Bond University Professor Dr Ariff comments in this regard:

Many would say that the Islamic banks are not really different from conventional banks and thatthey are playing with words and semantics and so on and so forth – coming up with Arabicterms that sound very Islamic but if you scratch it, you will find that it’s not that different fromconventional financial products. So such concerns do exist. (Bahfen, 2008)

16.3.5 Lack of Understanding on Islamic Finance

The first challenge is that many people – Muslims and non-Muslims alike – do not understandwhat Islamic finance exactly is. The underlying principle, that Islamic law does not allowmaking money out of money and thus capital should accumulate from buying and sellingand possession of real assets, is clear to many. However, there does not appear to be a unifieddefinition of an Islamic financial product (Ahmad, 2004). The key concern is that the respectiveShariah Supervisory Board (herein after SSB) of the IB or IFI in fact defines what is and isnot an Islamic financial product and it interprets transactions differently. This leads to anambiguity about what is, and what is not, an Islamic product and a good enough productto conduct business with, which in turn can complicate risk appraisal for both the bank andits customers. This ambiguity has so far prevented standardization and makes it difficult forregulators. Justifiably they would like to know precisely what it is they are authorizing (Ainley,1997).

16.3.6 Risk Analysis and Balance Sheet Management

The second problem for IFIs in the Australian financial market is the risk analysis and balancesheet management. Like in any other country, the challenge in formulating the risk manage-ment infrastructure in IFIs lies in having an accurate assessment of the various risk variantsunderlying the alternative modes of finance to provide for their effective quantification andmanagement (Ahmad, 2003). On the asset side, the IFIs enter into different financing modesthat have varying risk characteristics, ranging from the low risk sales and lease-based modesto the higher risk equity-based modes of finance. Each of these modes of finance has a distinctintrinsic characteristic dictated by its underlying Shariah principle, and they thus entail differ-ent risk profiles. An equity-based finance may for example involve higher risks and thereforeattract a higher capital requirement. Likewise, the liability structure of IBs is characterizedby two distinct categories of deposits: (1) demand deposits which are not subject to risksassociated with banking business and for which the principal is guaranteed, and (2) investmentdeposits which involve risks and hence are eligible to share the profits earned from the bankingbusiness (Aziz, 2004).

16.3.7 Absence of a Standard Rate of Return

A further regulatory challenge arising from the liability structure of IFIs is the determinationof a standard rate of return for account holders. Unlike conventional finance practice wherereturns are predetermined, profit sharing depositors of IFIs know their returns at the maturityof the deposits. These returns are subject to the earnings of the assets that are shared between

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the IFIs and the profit sharing depositors. In the event of loss, the depositor as the capitalprovider will bear the losses. As the deposits in Islamic finance practice for the most partare in the form of profit sharing deposits, it places a higher degree of fiduciary risk on themanagement to ensure the funds are utilized in the most efficient manner (Aziz, 2004).

16.3.8 Difficulty in Classifying Risk Sharing Funds

Another complexity is how to classify risk sharing funds placed with Islamic finance as theclassification of these funds has implications for IBs’ capital requirements. If these funds arecapital certain they would be defined as bank deposits under Australian banking regulation. Onthe other hand, if they are defined as investments in a collective investment scheme they are notbank deposits (Zaher and Hassan, 2000). On levels of adequate capital the Basel Committeeon Banking Supervision (BCBS) envisages that all internationally active banks should besubject to the minimum capital requirements, and the Basel Standards have gained generalrecognition throughout the world, including Australia. However, a number of key regulatoryissues pertaining to liquidity requirements remain unresolved, especially whether they shouldapply to all on-balance sheet funds; and how liquidity should be managed for funds whichare held off-balance sheet. Yet, the basic issue for any bank whether Islamic or conventionalis how easily and quickly, and at what discount, assets can be turned into cash (Ahmad andAhmad, 2007).

16.3.9 Problem of Accounting Standards

A subtle problem that conventional interest-based financial institutions have with Islamicfinance is the question of how to account for them. In most of the world, InternationalAccounting Standard, IAS 39, generally applies. In Australia the equivalent standard is knownas AASB 139 (the Australian Accounting Standards Board). The problem with Islamic financeis that it does not operate in the same way that the arrangements will actually work if thesestandards are used, as most of the world’s banks do. The risk sharing nature of many of thearrangements (musharaka for example) means that they are possibly of the nature of a jointventure, but the precise balance of the risks and control transferred really matters (Andrew,2007). The definition of a joint venture in the standard makes it plain that there must be anelement, not only of joint ownership, but also joint control. If there is no real control over theuse of the asset by the bank, then is it a financial instrument, merely entitling them to a flow ofrevenue (say the rental income) or is it an equity ownership of the asset, as they are entitled toa proportion of the unpaid, residual value? During the life of a musharaka arrangement whendo ownership and equity control really pass (Troshina, 2004)?

16.3.10 International Perspective

Another related problem is disregard for the potential for the sale of Australian-sourcedfinancial products overseas. Australia offers very stable political, regulatory, and judicialsystems. Returns on investments in Australia have, over the long terms favoured by Islamicinvestors, been very high and much of the investment in Australia is in Shariah-compliantproducts such as land, mining, and agriculture. The first company to issue products to investorsglobally is likely to encounter some regulatory hurdles, but they are also likely to tap into adeep and growing well of capital (Andrew, 2007).

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16.4 PROSPECTS OF ISLAMIC FINANCE IN AUSTRALIA

With one of the world’s largest contestable pools of investment fund assets, Australia hadA$1.3 trillion worth of assets under fund management by the end of 2009. This figure isapproximately equivalent to domestic equity market capitalization and represents almost 110%of the country’s nominal GDP. Australia’s investors are sophisticated, well informed, andoutward looking, with significant exposures to global markets and alternative asset classes(Parker, 2010).

There has been a surge in interest in Islamic finance in Asia-Pacific countries such as Korea,China, Hong Kong, Japan, Singapore, and Thailand. The recovery of global Islamic financehas been spearheaded by Muslim countries in the region, notably Malaysia, Indonesia, andBrunei. This has been achieved through sukuk issuances and consumer finance among otherproducts. Unlike its neighbours and in spite of its stellar performance in fund management,Australia is still at the nascent stage in the adoption of Islamic finance. Australian financialinstitutions have limited involvement in Islamic finance in their operations (Parker, 2010).

In a clear show of firmness of purpose and solidity of commitment, the Australian Govern-ment has launched a chain of initiatives which when completed and hopefully adopted willmake Australia one of the most proactive Islamic finance markets in the Asia-Pacific region.The Government is committed to an open and competitive financial system and a sociallyinclusive environment for all Australians. Sen. Nick Sherry, Assistant Treasurer of Australia,recently launched a new book, entitled Demystifying Islamic Finance – Correcting Misconcep-tions, Advancing Value Propositions, in Sydney. He confirmed he has requested the AustralianBoard of Taxation to undertake wide-ranging reviews of Commonwealth (Federal) Tax Laws,and State and Territory Tax Laws. The board will examine progress in this respect in otherjurisdictions such as the UK, Luxembourg, France, Malaysia, and Indonesia. The primary aimof the review is “to ensure that, wherever possible, the laws are not impediments to growthand expansion of Islamic finance, banking and insurance products” (Parker, 2010).

“The guiding principle for the board is that the tax treatment of Islamic financial productsshould be based, wherever possible, on their economic substance rather than their form. Iwould emphasize that this review is not about creating special treatment – which no one in thisarea has ever asked me for. Rather, it is about creating a level playing field for the provisionof Islamic financial products into the Australian market”, he said. Indeed the mandate ofthe Board of Taxation is to provide the Government with a final report by June 2011. Thisreview complements a cross-government review of the regulatory environment launched byAustralian Minister for Financial Services, Chris Bowen, which had the focal goal of removingany hurdles and roadblocks to the smooth operation of Islamic finance in Australia (Parker,2010).

The Australian Government is keen to emphasize the benefits of Islamic finance withrespect to the potential for job creation, wealth allocation, and contribution to financial andsocial stability. In the words of Assistant Treasurer:

This potential has been recognized in other jurisdictions that have, like Australia, traditionally beenfocused on more conventional finance products. Notably the United Kingdom has actively pursuedthe development of Islamic finance, with the result that the UK now has five licensed Islamicbanks – the only such institutions in the European Union. France is another jurisdiction takingmeasures to facilitate Islamic finance. The first French Islamic bank is expected to be licensed in thenear future. In our region, a few countries are taking measures dedicated to securing significantshares of the Islamic finance market; this presents us with strong opportunities. Malaysia has

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recently made moves to establish itself in this space with its international Islamic FinancialCentre, and is actively encouraging foreign firms. The Government continues to work towardenhancing access to foreign markets for all Australian businesses, and businesses offering Islamicfinance products should benefit from any successes we achieve in that sphere. (Sherry, 2009)

Senator Sherry also remarks:

While Australia may not have a large Islamic population, our geographical position presents uswith an important window into the Islamic finance sector. Our closest neighbor, Indonesia, is themost populous Muslim majority nation with over 207 million Muslims, with a further 40 million inthe broader south East Asia region. Last year, the Government established the Australian FinancialCentre Forum as the vehicle to promote the Australian financial services sector internationally.Islamic finance has been raised in the Forum as being an area of potential opportunity for thefinancial services sector. Australian bankers of late have stressed the growing awareness amongcommunity and policy makers, of the potential for Islamic finance in Australia. We are taking akeen interest in ensuring there are no impediments to the development of Islamic finance in thiscountry, to allow market forces to operate freely. This is in line with our commitment to foster anopen and competitive financial system, and a socially inclusive environment for all Australians.(Sherry, 2009)

The bulwark of the Australian asset management industry is portfolio construction, riskmanagement, wealth advisory, distribution capabilities, funds administration, and custodyservices. The country is set to export these financial management skills and this expertise toSouth East Asia and the Middle East region. There is potential for blanket application of thedepth and breadth of those skills, complemented by legal acumen, to the Islamic finance sector(Parker, 2010).

“We also have global leading skills in real estate and infrastructure financing – two areas withgreat potential in relation to wholesale Islamic finance activity as they both involve very realunderlying assets, something we all know is needed in Shariah-compliant projects”, stressedone Australian banker. There has been a concerted effort by independent reports and agenciesto identify the potential benefits of Islamic finance in Australia. A classic example is the reportpublished by Australian Financial Center Forum that identified Islamic finance as a feasiblemeans of accessing offshore pools of savings from the Middle East. Such pools of savingswould not only provide more diversified and competitive funding avenues for Australia’sinvestment needs. The report recommends equal treatment of Islamic finance products andconventional products under tax law (Parker, 2010).

Senator Sherry remarks:

While the growing interest in Islamic finance is evidence in Australia and globally, the marketfor Islamic finance products have grown phenomenally over the last ten years, being estimated tohave been worth in excess of US$700 billion in 2007 and US$822 billion by the end of 2009. Thisis projected to reach $1.6 trillion by 2012. Moody’s Investor Services estimates a global Islamicfinance market potential of at least $5 trillion at maturity. The Sukuk market in Australia will beencouraged by the Indonesian Government’s recent successful Sukuk issue of US$650 million,which was oversubscribed. The market for Sukuk appears to provide a promising wholesaleopportunity for innovative Australian financial sector companies. There are also opportunities tobe considered at the retail level. With over 340,000 Muslims in Australia, as well as presenting anew commercial opportunity, the offering of retail Islamic finance products contributes to fosteringsocial inclusion, by enabling Australian Muslims to access products that may be more consistentwith their principles and beliefs as well as widening the choice of products for non-Muslims.(Sherry, 2009)

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16.4.1 Opportunities for Introducing Islamic Banking

There is no fully fledged Islamic bank that exists in Australia. Also, there is not a singleconventional bank in Australia which has a separate Islamic banking branch or window orsubsidiary, like in some Muslim and indeed non-Muslim countries that carry out Islamicbanking operations. This is due to the existing legal, regulatory, and supervisory system ofAustralia that is exclusively made to control and supervise its conventional banking system, inaddition to which the Islamic banks are governed by the supervisory boards of Muslim clericsto ensure compliance with Shariah law (Ahmad and Hassan, 2009).

Nevertheless, in response to the local Muslims’ growing demand and as an alternativeto the global credit crunch in the financial market the opportunities of establishing Islamicbanks in Australia using the models of some Western countries like the UK have now becomemore urgent. According to Australian Assistant Treasurer Nick Sherry (Bell, 2009), “theFederal Government is committed to making the regulatory framework governing banksflexible enough to accommodate Islamic banking products and services while still protectingconsumers”. John Hewson, former Liberal Party leader and Global DC chairman predicts:“Australia is likely to have at least one Islamic bank within five years, if regulatory hurdlescould be overcome. . . . I believe strongly that not only will we see one or more Islamic banksin Australia, but I think we could emerge as the dominant Islamic financial centre in the AsiaPacific region. . . . the time is right to attract a foreign Islamic bank to Australia or to turn localIslamic banking co-operative, the Muslim Community Co-operative (Australia), into a bank.”

Based on the above comments made by the Government and opposition and given theluminous opportunities of Islamic banking in this vast continent, the MCCA became veryconfident of securing a banking licence within three years to become Australia’s first Islamicbank. The then Managing Director Chaaban Omran says: “The co-operative will work withthe Australian Prudential Regulation Authority to change its registrable superannuation entitylicense into a banking license.” The MCCA is currently regulated by ASIC (the AustralianSecurities & Investments Commission) and is the holder of an RSE licence (Bell, 2009).

16.4.2 Prospects of Islamic Banking and Finance in the Academic Sphere

The brilliant prospects of Islamic finance in Australia continue to be seen as preparationsare made by some Australian universities to offer courses in the field of Islamic bankingand finance. The La Trobe University has announced the introduction of the first course inAustralia dedicated to Islamic banking and finance, joining a handful of universities in the Westembracing this fast-growing segment of global finance. The university has recently introducedthe Master of Islamic Banking and Finance course which is believed to be capable of providingstudents with postgraduate training in the technical skills demanded by global Islamic capitalmarkets and institutions. This programme is also expected to appeal to international studentsfrom Asia wanting Islamic financial training in English and to local graduates keen to enterthe growing sector in Australia.

The following is an excerpt from the university’s newly introduced Islamic Banking andFinance (Master) course description (La Trobe, 2009):

This innovative program seeks to meet the growing demand for graduates with sound academic andindustry knowledge in Islamic finance in the Middle East and South East Asia, and in particular, theGulf Cooperation Countries (GCC), Indonesia and Malaysia. Graduates will also be prepared toenter the growing Islamic finance sector in Australia. The program provides postgraduate studentswith training in the technical skills in demand by global Islamic capital markets and institutions.Students develop expertise in Islamic banking, Islamic insurance and Islamic capital markets.

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The International Centre of Education in Islamic Finance (INCEIF), a training subsidiary ofBank Negara Malaysia (The Malaysian Central Bank), the equivalent to Australia’s ReserveBank, has agreed to provide industry-based certification for graduates of the La Trobe course,opening up employment opportunities throughout the international banking and finance sector.

Besides, the Australian Monash University offers Australian Postgraduate Award Industry(APAI) Scholarships funded by an Australian Research Council (ARC) Linkage Projects grantand worth $25 118 per annum to conduct postgraduate research over three years’ full-timestudy for PhD research projects in the general area of Islamic finance. The projects, which mustentail empirical work relating the application of finance theory to some aspect of Islamic banks,insurance companies, fund managers, markets, or instruments, are considered to be a significantdevelopment in Australia’s Islamic finance industry at academic and professional levels.

The University of Melbourne has also been offering different courses on Islamic bankingand finance at undergraduate and postgraduate level. For example, the University’s IslamicBanking and Finance Postgraduate programme (course 730737) mentions its objectives(UniMelb, 2009):

A candidate who has successfully completed the subject should:

Demonstrate a firm grasp of the history and development of Islamic bankingBe familiar with the basic principles and rules of Islamic bankingUnderstand the differences between Islamic banking and conventional interest-based banking

systemsUnderstand the basic structure and operation of the key financial instruments used in Islamic

bankingBe able to apply the knowledge gained to selected case studiesBe able to identify some of the key controversies in Islamic banking.

It has also Masters and Doctoral research programmes within this broad area which offerscholarships.

The Griffith University has introduced Islamic Banking and Finance course (Course 2608HUM) from Semester 2, 2009 at undergraduate level. The course aims, as is delineated in itscourse outline (Griffith, 2009), are:

To familiarise students with developments in global financial and capital markets in relation tofaith-based banking and finance;

Provide students with an overview of Islamic finance law, regulations and aspects of the Islamicbanking system;

Provide students with an understanding of Islamic banking products and concepts;Challenges faced by Islamic banks, andAdd a new facet to the study of finance.

In addition, a report published in The Australian on 20 October 2006 disclosed that NationalAustralia Bank (NAB) will look at introducing Islamic financing into its product range tocapture an “untapped” market that could be worth millions of dollars. It also declared thatit would offer A$25 000 post-graduate scholarships to a member of the Muslim communitystarting from 2007 to further NAB understanding of Islamic banking. Furthermore, NAB wasreported to be planning an A$35m investment in a Shariah-compliant listed industrial propertytrust (Kerbaj, 2006).

Table 16.1 summarizes the history of IF activities in Australia. It also shows how IF isemerging as a discipline in financial markets as well as in academic and government circles.

P1: TIX


Tabl

e16

.1E

volu

tion

ofIs

lam

icfin

ance

and

itsac

tiviti

esin

Aus

tral

ia

Gov

ernm

enti

nitia

tives

Yea

rT

reas

ury

Aus

tral

ian

Taxa

tion

Offi

ce(A

TO

)O

vers

eas

dele

gatio

ns

Con

fere

nces

/sy

mpo

sium

/m

eetin

gsT

heIF

SPs’

key

activ

ities

Act

iviti

esat

acad

emic

leve

ls

1989

Est

ablis

hmen

tof

Mus

limC

omm

unity

Coo

pera

tive

Aus

tral

ia(M

CC

A).

1997

Est

ablis

hmen

tof

Isla

mic

Coo

pera

tive

Fina

nce

Aus

tral

iaL

td(I

CFA

L).

2004

1.Su

bmis

sion

mad

eto

the

Join

tSt

andi

ngC

omm

ittee

onFo

reig

nA

ffai

rs,D

efen

cean

dT

rade

:Pa

rlia

men

tof

Aus

tral

iafo

rin

trod

ucin

gIF

;2.

The

Vic

tori

anL

egis

lativ

eA

ssem

bly

and

Leg

isla

tive

Cou

ncil

appr

oved

Stat

eTa

xatio

nA

ct(A

men

dmen

t)20

04ab

olis

hing

doub

lest

amp

duty

char

ges

onIs

lam

icho

me

finan

ce;

3.T

heV

icto

rian

Gov

ernm

enta

lso

reor

gani

zed

the

prin

cipl

esof

profi

tsh

arin

gan

dal

low

ing

Isla

mic

cont

ract

sto

avoi

d“i

nter

est”

.

(Con

tinu

ed)

351

P1: TIX


Tabl

e16

.1(C

onti

nued

)

Gov

ernm

enti

nitia

tives

Yea

rT

reas

ury

Aus

tral

ian

Taxa

tion

Offi

ce(A

TO

)O

vers

eas

dele

gatio

ns

Con

fere

nces

/sy

mpo

sium

/m

eetin

gsT

heIF

SPs’

key

activ

ities

Act

iviti

esat

acad

emic

leve

ls

2005

The

stoc

k-ta

keof

Isla

mic

stud

y(a

ssu

ppor

tive

ofIF

stud

y)at

Aus

tral

ian

univ

ersi

ties

com

men

ced

with

Gov

tin

itiat

ives

.20

07E

stab

lishm

ento

fT

heN

atio

nalC

entr

efo

rIs

lam

icSt

udie

s(N

CIS

)w

ithfu

ndin

gfr

omth

eA

ustr

alia

nG

over

nmen

t.

Aus

tral

ian

Fina

ncia

lO

pera

tions

Ass

ocia

tion

Lim

ited

(AFO

A)

docu

men

ton

the

dem

and

ofgl

obal

IF.

The

Fina

ncia

lSe

rvic

esIn

stitu

teof

Aus

tral

asia

(FIN

SIA

)sp

ecia

lses

sion

onIF

.

The

Nat

iona

lAus

tral

iaB

ank

laun

ched

the

A$2

0,00

0N

AB

Shei

khFe

hmi

El-

Imam

Scho

lars

hip

for

PhD

inIs

lam

icFi

nanc

e.20

08T

heA

ustr

alia

nT

rade

Com

mis

sion

(AU

STR

AD

E)

docu

men

tof

IF.

The

Uni

vers

ityof

Mel

bour

nehe

ldIB

Col

loqu

ium

.

Kuw

aitF

inan

ceH

ouse

,le

adin

gIs

lam

icba

nkin

ggr

oup

inK

uwai

tapp

lied

for

alic

ence

toop

erat

eIs

lam

icfin

ance

activ

ities

inA

ustr

alia

.

1.G

riffi

thU

nive

rsity

offe

red

teac

hing

ofIB

;2.

Mon

ash

Uni

vers

ityof

fere

dA

ustr

alia

nPo

stgr

adua

teA

war

dIn

dust

ry(A

PAI)

Scho

lars

hips

onIF

.

352

P1: TIX


2009

1.C

hris

Bow

en,t

heM

inis

ter

for

Fina

ncia

lSer

vice

s,Su

pera

nnua

tion

and

Cor

pora

teL

awco

mm

ente

don

grea

topp

ortu

nitie

sin

IFin

Aus

tral

ia;

2.A

ssis

tant

Tre

asur

erSe

n.N

ick

Sher

ryre

itera

ted

the

need

ofIF

inth

ePa

rlia

men

t;3.

Form

erL

iber

alPa

rty

lead

eran

dG

loba

lDC

chai

rman

Dr

John

Hew

son

pred

icte

dab

outt

hefu

ture

ofIB

and

IF;

4.M

inis

ter

ofT

rade

Sim

onC

rean

supp

orte

dop

enin

gup

MC

CA

’sm

arke

tsw

ithits

Sout

hE

astA

sian

Part

ners

;5.

The

Aus

tral

ian

Gov

ernm

ent

decl

ared

trea

tmen

tof

a)de

btin

stru

men

tsas

asse

ts;

b)in

tere

stas

inco

me

and

retu

rn;

c)IF

cust

omer

ssi

mila

rto

exis

ting

finan

cial

fram

ewor

k;an

dop

ened

upm

arke

tsfo

rsu

kuks

(by

intr

oduc

ing

secu

ritiz

edco

mm

erci

albi

lls.

6.T

heV

icto

rian

Gov

ernm

ent

anno

unce

din

its20

09–1

0bu

dget

the

Nat

ion

Bui

ldin

g–

Eco

nom

icSt

imul

usPl

anw

itha

cons

ider

able

pote

ntia

lfor

inve

stor

sto

wor

kw

ithSh

aria

h-co

mpl

iant

infr

astr

uctu

refin

ance

bids

.

1.T

he1s

tUA

EIF

Sm

issi

onac

com

pani

edby

seni

orin

dust

ryre

pres

enta

tives

from

Dub

aim

etth

eA

ustr

alia

nPr

uden

tial

Reg

ulat

ory

Aut

hori

ty(A

PRA

),A

ustr

alia

nFi

nanc

ialM

arke

tsA

ssoc

iatio

n(A

FMA

)an

dIn

vest

men

tand

Fina

ncia

lSer

vice

sA

ssoc

iatio

n(I

FSA

);2.

Ahi

gh-l

evel

Mal

aysi

anIF

dele

gatio

nm

etw

ithth

eT

reas

ury,

indu

stry

regu

lato

rsan

dot

her

Gov

ernm

enta

genc

ies

and

finan

cial

serv

ices

asso

ciat

ions

todi

scus

sis

sues

rela

ting

tofa

cilit

atio

nof

Isla

mic

finan

cial

prod

ucts

inth

eA

ustr

alia

nm

arke

t.

1.L

aT

robe

Uni

vers

itySy

mpo

sium

onIB

&IF

co-h

oste

dby

NA

B,M

CC

A&

Isla

mic

Dev

elop

men

tB

ank

(ID

B);

2.L

aT

robe

subm

itted

rec-

omm

enda

tions

toA

TO

,T

reas

ury

onSh

aria

hco

mpl

ianc

e

1.T

heN

AB

anno

unce

dpl

ans

toin

trod

uce

Shar

iah-

com

plia

ntlo

anpr

oduc

ts,a

ndto

cons

ider

deve

lopi

ngfu

rthe

rIs

lam

icfin

anci

alpr

oduc

tsin

the

futu

re;

2.M

CC

Asu

bmitt

edto

Chr

isB

owen

MP’

sof

fice

onre

ctif

ying

itsIF

cont

ract

s;3.

MC

CA

mad

ean

othe

rsu

bmis

sion

toA

ustr

alia

nFi

nanc

ialC

ente

rFo

rum

;4.

Gul

fFi

nanc

eH

ouse

and

Mac

quar

ieG

roup

Lim

ited

(MG

L)

sign

eda

MoU

toes

tabl

ish

ajo

intv

entu

reIF

Spl

atfo

rmin

the

Mid

dle

Eas

tand

Nor

thA

fric

a(M

EN

A)

regi

on;

5.T

heL

MIn

vest

men

tM

anag

emen

tLtd

.la

unch

edth

eL

MA

ustr

alia

nA

lifFu

nd–

Aus

tral

ia’s

first

Shar

iah-

com

plia

ntfu

nd.

1.L

aT

robe

Uni

vers

ityla

unch

eda

Mas

ters

ofIs

lam

icB

anki

ngan

dFi

nanc

ede

gree

;2.

The

Uni

vers

ityof

Mel

bour

neof

fere

da

subj

ecto

nIB

&IF

atun

-de

rgra

duat

ele

vel

(Con

tinu

ed)

353

P1: TIX


Tabl

e16

.1(C

onti

nued

)

Gov

ernm

enti

nitia

tives

Yea

rT

reas

ury

Aus

tral

ian

Taxa

tion

Offi

ce(A

TO

)O

vers

eas

dele

gatio

ns

Con

fere

nces

/sy

mpo

sium

/m

eetin

gsT

heIF

SPs’

key

activ

ities

Act

iviti

esat

acad

emic

leve

ls

2010

1.T

heA

ustr

alia

nFi

nanc

ialC

entr

eFo

rum

’sJo

hnso

nR

epor

tun

ders

core

dth

eim

port

ance

ofam

endm

ents

toex

istin

gA

ustr

alia

nta

xatio

npr

ovis

ions

inor

der

toen

sure

that

Isla

mic

finan

cepr

oduc

tsbe

trea

ted

onpa

rw

ithco

nven

tiona

lpr

oduc

ts;

2.T

rade

Min

iste

rSi

mon

Cre

anla

unch

edth

eA

ustr

alia

nG

over

nmen

t’sfir

st-e

ver

com

preh

ensi

vepu

blic

atio

non

Isla

mic

finan

ce;

3.Se

nato

rN

ick

Sher

ry’s

keyn

ote

addr

ess

atL

aT

robe

Uni

vers

ity’s

2010

Isla

mic

Fina

nce

Con

fere

nce,

Mel

bour

ne.

The

2nd

Isla

mic

Fina

ncia

lSer

vice

sT

rade

Mis

sion

(hos

ted

byD

ubai

Exp

ort

Dev

elop

men

tC

orpo

ratio

n)vi

site

dN

ewSo

uth

Wal

esan

dV

icto

ria

and

orga

nize

dm

eetin

gsin

part

ners

hip

with

AU

STR

AD

Eto

stre

ngth

enth

eex

port

sof

Isla

mic

finan

cial

prod

ucts

and

serv

ices

toA

ustr

alia

.

Wes

tpac

Ban

king

Cor

pora

tion

offe

red

ash

ort-

term

who

lesa

lein

vest

men

tst

ruct

ured

prod

uct

spec

ifica

llyde

velo

ped

for

Isla

mic

finan

cial

inst

itutio

ns.

Mac

quar

ieG

roup

has

also

anno

unce

dpl

ans

for

anIs

lam

icfin

ance

join

tven

ture

with

the

Bah

rain

-bas

edG

ulf

Fina

nce

Hou

seto

targ

etm

arke

tsin

the

Mid

dle

Eas

tand

Nor

thA

fric

a.

Sour

ces:

Web

site

sof

AFM

A;A

FOA

;AM

EIn

fo;A

PRA

;AT

O;A

UST

RA

DE

;Aus

tral

ian

Tre

asur

y;D

epar

tmen

tof

Edu

catio

n,Sc

ienc

ean

dT

rain

ing;

MC

CA

;IC

FAL

;FIN

SIA

;G

riffi

thU

nive

rsity

;ID

PE

duca

tion

Aus

tral

iaL

imite

d;IF

SA;I

nves

tVic

tori

a;L

MIn

vest

men

tMan

agem

entL

td.;

La

Tro

beU

nive

rsity

;Mel

bour

neC

entr

efo

rFi

nanc

ialS

ervi

ces;

NA

B;

The

Uni

vers

ityof

Mel

bour

ne.

354

P1: TIX



16.5 SUMMARY, FINDINGS, AND RECOMMENDATIONS

16.5.1 Summary and Findings of the Study

The objective of this research project was to suggest that the Australian regulatory regimedevelop appropriate regulations to make Islamic finance a truly viable alternative for bankingand finance based on religious and ethical considerations for Muslims living in Australia.Keeping this key objective in mind, the study suggests that steps be taken to introduce separatelegislation in the Australian Parliament for strengthening the country’s Islamic financialmarket system.

The following is a summary of the findings of the study examining the challenges andopportunities of Islamic finance in Australia:

1. Islamic finance in Australia was established in an environment where conventional financialservices providers are already in the market. The crucial challenge in this regard is thatIslamic finance customers must enjoy similar, although not necessarily the same, protectionas customers of conventional financial institutions. At the same time, it is expected thatregulatory authorities would ensure there is a level playing field, so that neither Islamicfinance nor conventional financial institutions are disadvantaged. In Australia whereMuslims are a minority and fully-fledged IBs are absent, regulators have nevertheless beenexpected to approve and monitor Islamic financial products, including those offered byIslamic managed funds.

2. The key philosophies that distinguish conventional from Islamic financial markets may sug-gest that the regulatory building blocks for regulating Islamic finance need to be differentfrom those used for conventional regulation, but in fact they are not different from a regula-tory perspective. The principles that strengthen conventional market regulation are mainlydesigned to ensure that financial firms are able to deliver upon their promises – promises tocover policy holders’ losses; or to repay investors or depositors upon particular terms agreedat the time of contract formation. Like other regulators, Australian regulatory authoritieswould like to be satisfied that Islamic financial markets have appropriate compliance andenforcement powers and practices; that the conventional and Islamic finance are both ingood standing with relevant international standard setters; and that they are committed toappropriate levels of information sharing and cooperation. If all of these hurdles can beovercome, obviously they can take comfort that differences of detail in regulatory approachwill not prejudice consumers of the Shariah-compliant products.

3. Islamic finance in Australia is still in its early stages. Because of the character of most ofAustralian immigrants, many incoming Muslims here have naturally been more worriedwith how to support their families than with developing financial institutions. However,quite a few small financial enterprises have started, with at least three in operation at present.Some of these IFIs, being cooperative in nature, are currently limited to providing facilitiesfor their shareholders and are not allowed to accept normal bank deposits as Australian lawnormally does not permit taking deposits without an appropriate licence, while others workwith a number of other providers and offer mortgage and leasing facilities.

16.5.2 Suggestions and Policy Recommendations for the Study

This study suggests that in order to overcome the underlying problems and challenges facedby Islamic finance in the Australian market the Islamic finance sector in Australia should workon the following two areas.

P1: TIX



1. The defining feature of Islamic finance is the prohibition on interest. Yet this is not the onlyfeature. Islamic finance is, theoretically at least, built on profit sharing, access to equity,and the idea of customers becoming partners with IFIs’ principles that seem alien to themodern-day concept of banks as corporate behemoths squeezing charges and fees out oftheir clients. The idea of shared risk and morally acceptable business practices that underpinIslamic banking can be further developed and used to market Islamic finance products. Suchideas can also be used to overcome the perception of Islamic finance from some quartersas simply regular finance with an Arabic nomenclature.

2. The future for Islamic finance in Australia might depend on whether the appeal of the prod-ucts offered by the sector can broaden to people outside the minority Muslim community.This has been the case in other parts of the world where Islamic finance has seen successes.The expansion of Islamic banking in the UK, for example, can be attributed in part to acorresponding rise in the size of the Muslim middle class whose members need accessto Shariah-compliant banking services. Australia has seen the growth of superannuationschemes that are based on ethical investments, suggesting that Islamic finance based on theShariah principles of risk and profit sharing, and fair dealings with customers, not merely onthe avoidance of interest, may find appeal among non-Muslim customers (Bahfen, 2008).

Furthermore, the study makes the following recommendations for consideration by regula-tory authorities for Islamic banking and finance in Australia.

1. The study recommends that a serious effort be made to educate people, given the highlevel of ignorance of the underlying philosophy and nature of Islamic finance among thegeneral populace and those associated with the industry. For example, it is not knownto many people that one of the great successes and growth of Islamic finance lies in “itsvalue-orientated ethos that enables it to draw finances from both Muslims and non-Muslimsalike”. Also, since the Shariah contracts that are now used and advertised by Islamic financein Australia appear to be traditional mortgage contracts where the borrower takes the riskand the lender gets a fixed rate of return it is suggested that Muslim customers should beprovided with fully disclosed information about the institutions with whom they enter intobusiness relationships.

2. The co-operative nature of Islamic Financial Services providers in Australia may mergewith each other for their future growth and development through attracting more capitaland providing investment facilities. This will help expand Islamic finance that Australia’svibrant Muslim community could use comfortably as it would meet their religious as wellas their financial and market requirements.

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Ahmad, A.U.F. (2004) Islamic Banking in Bangladesh: Legal and Regulatory Issues, conference paper,Harvard Law School, Harvard University, Sixth Harvard University Forum on Islamic Finance,Cambridge.

Ahmad, A.U.F. (2008) Law and Practice of Modern Islamic Finance in Australia, PhD Thesis, Universityof Western Sydney Law School, University of Western Sydney, Sydney.

Ahmad, A.U.F. (2010) Theory and Practice of Modern Islamic Finance: The Case Analysis from Aus-tralia, BrownWalker Press, Florida.

P1: TIX



Ahmad, A.U.F. and Ahmad, A.B.R. (2007) Islamic Micro and Medium Sized Enterprises (MMEs)Finance: The Case Study of Australia, conference paper, Centre for Islamic Banking Finance andManagement, Universiti Brunei Darussalam, First International Conference on Inclusive IslamicFinancial Sector Development, Brunei, Brunei Darussalam.

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Andrew (2007) Opportunities Down Under: Islamic Finance in Australia, Risk Management in Australia,available at: www.ozrisk.net. Accessed 20 November 2008.

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Hassan, T. (1999) Banking without interest becomes more popular, Australian Broadcasting Corporation– The World Today Archive, available at: http://www.abc.net.au/ worldtoday/stories/s66783.htm, 17November. Accessed 22 July 2009.

Kerbaj, R. (2006) NAB eyes “untapped” Islamic finance market, The Australian, 20 October.La Trobe University (2009) Course Finder – Islamic Banking and Finance (Master), avail-

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The University of Melbourne (2009) The Melbourne Law Masters, available at: http://www.masters.law.unimelb.edu.au/index.cfm?objectid=3A45C705-1422-207C-BA6886C167CEB45F&view=overview&sid=3472. Accessed 21 July 2009.

Troshina, L. (2004) Accounting Methods and International Accounting Standards, IMF Committee onBalance of Payments Statistics and the OECD Workshop on International Investment Statistics.

Zaher, T.S. and Hassan, M.K. (2000) A comparative literature survey of Islamic finance and banking,Financial Markets, Institutions & Instruments, 10(4).

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Part IV

Learning from Islamic Finance after theGlobal Financial Crisis

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17

The Current Financial Market Crisis:Lessons Learned, Risks and Strengths ofIslamic Capital Markets Compared to the

Conventional System

Rasem N. Kayed, Michael Mahlknecht, and M. Kabir Hassan

17.1 INTRODUCTION

The Islamic financial industry has come a long way in a short time since its revival in the early1970s as an honest financial theory that extends choices and offers alternatives. This emergingindustry is currently in the midst of a self-appraisal process that aims to affirm its status withinIslamic countries and find its role in the global economy. The current global financial crisisraised the profile of Islamic finance as not only being able to withstand financial crises ofthis nature and magnitude, but also as inherently well equipped to prevent such crises fromdeveloping. The primary objective of this chapter therefore is to examine these issues basedon a critical review of pertinent literature on the relevance of Islamic finance and its potentialcontributions towards a healthier and more stable global financial industry.

This chapter is organized in seven main sections, including this introduction. In Section17.2, we will briefly recapitulate the factors that are commonly being viewed as the roots andcauses of the recent global financial crisis. In Section 17.3, some implications of the crisis forthe global economy, as well as for Islamic finance, are highlighted. In Section 17.4, we seekto answer the question whether the current crisis would have occurred in an Islamic financialsystem, and look at the systemic trade-off between risks and returns related to prohibitions andrestrictions on the product and investment level, such as the precepts of Shariah. Section 17.5includes a theoretical examination of the “bad” risks, which are forbidden in Islamic finance.While the rules of Islamic finance are not equivalent to a purely regulatory regime, theprohibition of taking those undesired risks potentially has a direct impact on the entire riskof a financial system, and may significantly strengthen the efforts of regulators. Section 17.6enumerates some lessons learned from the financial crisis, which are relevant for both Islamicand conventional financial institutions. Finally, Section 17.7 concludes with an outlook on themain challenges for real-life Islamic finance, to achieve its higher objectives, and examinespossible paths of convergence between the conventional and the Islamic financial systems inthe future.


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17.2 CAUSES OF THE GLOBAL FINANCIAL CRISIS

While there are certainly different perspectives on what were the most important causes of theglobal financial crisis, there is a set of main influencing factors, which contributed to creating,deepening, and extending the financial crisis.

These driving forces were:◦ Macroeconomic roots and politics: The roots of the financial crisis go back to the preceding

long period of low interest rates, the booming global real estate markets and high growth, aswell as high leverage spurred by both the boom itself and by the creation of extensive shadowbanking and new financial products.

The long period of low interest rates was enabled by a highly expansive monetary policy,devised by the former Chairman of the Federal Reserve, Alan Greenspan, which was coupledwith a global trend towards deregulation of financial markets, and with pro-cyclical fiscalpolicies.

◦ Policy-fuelled market hypes: In the past decades, the emergence of China and India asnew global players has significantly spurred optimism, while at the regional level there was aremarkable building boom in Dubai and other oil-rich countries, which was driven by increasedoil prices and by the desire to diversify those national markets, particulary into banking andtourism. As a result, real estate prices skyrocketed and then dramatically dropped down duringthe crisis. Combined with excessive leverage, this further amplified the downward spirallingof markets and economies.

In the US, the housing boom was enabled by the Community Reinvestment Act (CRA) andits amendments, which were designed to encourage lending to borrowers in low- and moderate-income neighbourhoods, and which contributed to relaxed mortgage lending standards.

◦ Credit crisis: The beginning of the twenty-first century was characterized by a period ofleveraging, which lasted from 2000 to 2006. Mortgage lenders used very lax lending standards,based on the “originate-to-distribute” business model, which was supported by the creation ofever more complex securitized and resecuritized structured credit products. At the same time,credit rating agencies moved from their traditional business of rating corporate and sovereignbonds to the rating of much more complex instruments. In many cases, the investors did nothave sufficiently accurate and complete information about the quality of the securitized assets,and even the issuers (large internationally active banks) themselves often lacked adequatequantitative models and information regarding their own products.

◦ Transparency: As John Hull put it: “Transparency is an important feature of a financialproduct. If the cash flows from a product cannot be calculated in a relatively straightforwardway, the product should not be traded” (Hull, 2009). The lack of transparency erodes customerand investor trust, leads to undesirable uncertainty, and damages reputation, and in fact thelack of trust has been regarded as a central reason for the crisis, in particular when banks wereunwilling to lend to each other at the time when the financial crisis hit rock bottom. Withouttrust and certainty, financial markets become unstable and unpredictable.

◦ Regulatory failures: Transparency, however, was not only limited with regard to specificfinancial products. It also affected the analysis of entire banks by regulatory authorities allover the world, given the growing exposure to off-balance-sheet products, the extended use ofspecial purpose vehicles (SPV), the boom of ever more sophisticated structured products (notonly credit-type, but equally based on equity, interest rates, currencies, energy, and commodi-ties) and of over-the-counter (OTC) markets, as well as the talent of financial institutions tomake use of regulatory arbitrage.

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The Current Financial Market Crisis 363

Basel II may surely not be seen as a driving force for the crisis, given that it came intoeffect in the US and in the European Union only when the preconditions for the crisis hadbeen in place for a number of years. However, it is highly unlikely that regulators will foreseeand prevent systemic risks (which result from the interplay of market forces, in an oftenintransparent way), as long as they do not dispose of system-wide databases and informationsystems.

Moreover, it is not only about the rules, but also about how those rules are monitored andenforced in practice. While currently there is an intense discussion about more intense andsevere regulation, it should not be forgotten that market-leading financial institutions havemuch bigger staffs of experts, compared to supervisory authorities, so that banks are typicallythe winners of the regulatory “cat-and-mouse” game. Preventing such crises in the futuremay thus require a more profound structural change, rather than just relying on fine-tunedregulatory mechanisms again.

◦ Lack of risk management and good governance: Even large global financial institutionstypically often did not have adequate risk management systems in place. While some typesof risks (typically market risks) were quantified in a very sophisticated manner, other riskswere not looked at with the same interest and precision, and some risks were even ignored. Itshould not be surprising in this context, for instance, that various banks still do not have a clearunderstanding of the reputational risks that arise for them from complex and non-transparentactivities.

Likewise, the opinions of risk management departments very often were not sufficiently con-sidered in decision processes by the senior management, which often ignored good governance,and worst-case scenarios (like the bankruptcy of Lehman Brothers, or general macroeconomicscenarios) typically were not reflected and analysed in-depth at all.

Rather, financial institutions tended to base their worst-case “risk management” on thefact that there would always be a “saviour of last resort” – the government. Bearing in mindthat most financial institutions have in fact been saved (and “bailed out”) by the respectivegovernments during the global crisis, it is quite likely that this attitude will not change toomuch in many institutions.

◦ Expectations and greed: Myopic shareholders, an increasing risk appetite among marketparticipants (explicitly including retail investors and politicians), and an excessive greed bytraders and top managers in financial institutions are typically mentioned as being root causes ofthe financial crisis. However, it would be overly simplistic to say that greed, as an “exogenous”immoral force, was the central cause of the crisis. In fact, greed is an element that may alwaysbe present in human behaviour, not only in booming cycles. Rather, excessive optimism andrisk-taking of the kind that lead to overly “greedy” behaviour were fuelled by a long period ofgrowth and the related, overly optimistic adjustment of expectations.

To prevent overly greedy behaviour from damaging the entire system, the focus shouldtherefore be, first, on preventing the birth of an “expectation bubble” that relies on a shortmemory of market events and on a lack of transparency on risks. Secondly, the way in whichexcessively optimistic investors transform their expectations into “greedy” high-risk invest-ment behaviour may be restricted and regulated, e.g. through the prohibition of products andtransactions implying an excessive uncertainty, and by linking financial instruments directlyto real transactions and markets.

As Figure 17.1 indicates, there are several factors that have contributed directly or indirectlyto the occurrence and the spread of the current credit crisis triggered by the US sub-prime

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Global Financial Crisis

Interest-based financeMarket hype

Excessive risk Short selling

Lack of proper regulations standards

Speculations

Central bank policy

High demand for profit

Global Financial Crisis

Sub-primeMortgage

Crisis

Global F

inancial Crisis G

loba

l Fin

anci

al C

risi

s

Sale of debt

Credit Default Swaps (CDS)

Irrational borrowing

Lax on lending standards

SecuritizationCorruption

Figure 17.1 Causes of the US sub-prime mortgage crisis

mortgage calamities and the fallout of some US financial institutions. Derivatives and excessiveleveraging of US financial institutions have driven some renowned financial institutions intobankruptcy and brought others to the edge of collapse. Financial globalization has duly playeda key role in enabling hasty transfer of systemic risk within and across national boundaries.

Financial markets have been driven by excessive risk-taking and overly complex andintransparent credit and derivative products that have torn down the world’s financial sys-tem. According to many observers, speculation has reached intolerable levels. The intensecompetition and shareholders’ demands for higher returns have encouraged excessive risk-taking and lured banks to extend their credit to unworthy borrowers who normally do notqualify for loans under prime lending criteria. In many cases loans were approved withoutproper evaluation of loan applications or the credibility of the applicants. The nature andthe means of delivery of the interest and debt-based conventional banking have caused thefinancial system to be completely “split off from the real economy”. Deals and transactionshave been concluded and executed on paper, and what has been sold and bought has often beenof limited or even no real or economic value (Spiegel, 2008). Poor enforcement of inadequateregulatory systems and laxity on lending standards (easy credit) made it easy for lenders tosign off many loans and for borrowers to access loans that were considered beyond their reachwithout giving serious thought to the possibility of having to default on their loans.

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Good and poor quality mortgages were bundled together in securitized packages that weredeemed able to endure an economic downturn. These mortgage-backed securities were soldto secondary investors and traded in the intermediary market, generating massive earnings forlending institutions and key staff and directors in the form of fees and bonuses. By having morecash in hand, banks were able to extend new loans and thus make more money. The modelworked well while borrowers were making their payments. But when payments stopped, themodel, literally, caved in. The obvious scenario of simultaneous credit defaults and falling realestate prices was simply not taken into consideration realistically during the “bubble” period.

Alexander (2008) rightly concluded that the blame for the current financial crisis falls on thefollowing three distinct entities: (1) lenders and investment institutions for their impatience tosign off loans on “giveaway terms” and their (deliberate) failure to ensure the creditworthinessof loan applicants; (2) government for lack of adequate and effective regulation evidenced byits oversight and indifferent attitude when such deceptive loans were made; and (3) borrowerswho solicited the loans despite their awareness of the potential failure to meet such financialcommitments.

The common view held by a majority of Islamic financial scholars and practitioners is thatthe global financial crisis in reality is a crisis of failed morality (Siddiqi, 2008). Failed morality,arguably, is the product and the cause of greed, exploitation, and corruption. This ethical failureis coupled with a failure in the relationship between investment originators and investors(Loundy, 2008). It is evident that originators of sub-prime loans have deliberately failed tocommunicate potential risks involved in these transactions with the investors (borrowers).

According to Islamic economic experts, the most commonly known and acknowledged causeof almost all financial crises is excessive and imprudent lending by banks over a prolongedperiod of time. This unhealthy practice is not in the long-term interest of the bank. It alsoheralds destabilization of the global financial system. Chapra (2009) explains the motives ofbanks for embarking on excessive and imprudent lending by three factors: (a) lack of profit-and-loss-sharing (PLS) between lenders and borrowers leading to inadequate discipline inthe financial system; (b) astronomical expansion in the size of derivatives, particularly creditdefault swaps (CDS) and structured credit products (e.g. CDOs); (c) “too big to fail” attitudeof big banks which grant them assurance that the central bank will bail them out in crises toforestall their collapse.

17.3 SOME IMPLICATIONS OF THE GLOBAL FINANCIAL CRISIS

What began as a limited sub-prime mortgage impasse in the US real estate market grew to bethe world’s biggest financial crisis since the 1930s. The impact of the crisis was felt worldwide.Individuals, regardless of their whereabouts, have been directly or indirectly affected by thecrisis as it has hit almost every sector of the world’s economy. World economies at large areyet to devise prudent strategies on how to deal with the crisis, let alone to recuperate andovercome its harsh reality.

17.3.1 Implications for the Global Economy

Needless to say, conventional financial institutions, by and large, were the first to feel the fullimpact of the crisis that they had initiated. The year 2008 was packed with dramatic events,

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which have created mass uncertainty, such as:

• a sharp decline in global equity markets;• the failure or collapse of numerous global financial institutions;• governments of a number of industrialized countries allocated in excess of $7 trillion

bail-out and liquidity injections to revive their financial systems and economies;• commodity and oil prices reached record highs (that led to increased inflation, energy, and

food prices worldwide), followed by a slump;• central banks reduced interest rates in coordinated efforts to increase liquidity and avoid

recession and to restore some (confidence) in the financial markets.

The financial sector gloom is most evident in the many (forced) CEO resignations, masslosses, and many bankruptcies of what, up to recent times, were considered world-classfinancial institutions such as HSBC, Merrill Lynch, Citigroup, AIG, and Lehman Brothers.The setbacks of the Dow Jones, NASDAQ, P&P, TSE, FTSE, NIKKEI, and many otherEuropean and Asian markets are factual indicators of the severity of the crisis.

When Lehman Brothers Holdings Inc. (LEH) filed for bankruptcy in September 2008, itsproperty assets alone were valued at $43 billion, making it one of the largest bankruptciesin real estate history. The unprecedented $180 billion government bail-out of the insurancegiant American International Group (AIG) apparently was not good enough to rid the insuranceconglomerate of its troubles. Oil prices reached levels beyond the imaginations of oil-exportingas well as oil-importing countries alike before retreating to $35–$40. Yet nobody can reallyoffer any explanation as to why oil prices (and food prices) rose and fell except maybe fortheir being based on mostly speculative markets.

Economists, financial experts, and politicians as well do not foresee a near end to the crisisand warn of prolonged hard times to come as the world’s major economies are heading towardsrecessions. While comparisons are frequently made to the Great Depression, there are alsosimilarities to the “Long Depression” at the end of the nineteenth century, when economiestook many years to fully recover. The conjecture is that volatility and uncertainty in globalfinancial markets are likely to linger causing more unemployment and a downturn in growth.

17.3.2 Implications for Islamic Finance

The implications of the global financial crisis for Islamic banking are examined on two fronts:the immediate impact of the crisis on Islamic banking and the potential role that Islamicbanking is suited to assume in order to deliver noteworthy contributions to the internationalfinancial system. First, the direct impact of the crisis on the Islamic banking sector was limiteddue in part to the intrinsic principles that, to some extent, administer the operation of the Islamicbanking sector as will be discussed in a subsequent section. Emmanuel Volland, analyst withthe rating agency Standard & Poor’s, explains that “Islamic banks were not caught by toxicassets as Shariah law prohibits interest” (Khalaf, 2009). Furthermore, the lack of structuredproducts and the reluctance of Islamic banks to exploit sophisticated financial instrumentshas enabled these banks thus far to remain positive and to accommodate the stern impact ofthe current challenging global financial environment (Ambah, 2008). Praising the cautiousapproach adopted by Islamic banking, Amr al-Faisal, a board member of Dar al-Mal al-Islami,commented that “[w]e are more conservative and sober in our investments. That used to beconsidered a handicap. Now it’s considered the height of wisdom” (Ambah, 2008). In fact,successful banks have always been “conservative lenders”.

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Although Islamic finance has not felt “the full impact” of the global credit crisis, theimmediate fallout from the crisis is evidenced by the fall in equity valuations and the plungein the real estate market across the Gulf States with all that that entails for the Islamic bankingsector – bearing in mind the intense engagement of the Islamic banking sector in the real estateindustry (Richter, 2008; Khalaf, 2009). Lending under Islamic law is based on the conceptof asset backing, where real estate is the preferred instrument to protect these investments.According to Standard & Poor’s (S&P), the Islamic financial sector also has suffered a sharpdecrease in the value of sukuk issued in the year 2008 to $14.9 billion, down from $30.8 billionin 2007 (Khalaf, 2009; Malaysia leads in Islamic finance, 2009). Moreover, uncertainties inthe global financial markets are, by and large, adversely impacting on the Islamic financialindustry.

As to the long-term implications, Standard & Poor’s believe that while the immediate futurefor Islamic financial institutions was uncertain, they have strong long-term prospects. Theresilience of Islamic banking and its ability to navigate to safe shores depend largely on thecompetence of the human capital in charge of Islamic banking and its sincerity in reflecting andintegrating the ethos of Islamic teachings into all aspects of the financial industry. In his attemptto explain the shortcomings of the Islamic financial system that are most likely to prevent it fromassuming a leading role in the international financial market, Chapra (2009) argues that “[t]hesystem is still in its infancy” and “not fully prepared at present time to play a significant rolein ensuring the health and stability of the international financial system”1 Islamic banks needto diversify their funding sources beyond retail deposits and further develop and diversify newand existing products such as Islamic hedging, liquidity, and risk-management instruments.Chapra concludes on a more positive note that the Islamic financial system is on the right trackand is expected to sustain steady growth and progressively establish itself as an influential andconstructive key player in the international financial market.

Interestingly, and contrary to the above rationale presented by Chapra, Loundy (2008) hasa different reading into the issue of the “infancy” and “immaturity” of the Islamic financialindustry. He argues that the “[i]mmaturity [of the Islamic financial industry] has, in part, saved[the industry] from a subprime-like mess so far” and concludes by raising the question: “Whatwill save it when the industry grows up?” (Loundy, 2008).

17.4 CAN SUCH CRISES OCCUR UNDER AN ISLAMICFINANCIAL SYSTEM?

17.4.1 Islamic Theory of Finance and the Global Financial Crisis

The current global financial crisis has accentuated the urgent need to embark on a radicalreshape of the international financial system. The attitudes and the approaches articulated bythe advocates and the opponents of both dominant schools of thought (government interventionand free market economies) thus far have failed to deliver a viable long-term solution tothe crisis or to prescribe a practical mechanism on how to deal with its consequences andimplications. So has the time come to seek out alternatives?

The 1988 Nobel Prize winner, French economist Maurice Allais foresaw the inevitability ofthe current structural global economic crisis and warned against its stern consequences (Allais,1993). He categorically believes that the way out of such crises is best achieved throughstructural reforms that go far beyond addressing the symptoms of the crises to devising anefficient monetary system that is truly capable of preventing such crises from happening in the

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future. The two basic components at the heart of the proposed system are adjusting the rate ofinterest to 0% and revising the tax rate to about 2%. Incidentally, this is very close to the coreelements of Islamic economics; Islam prohibits interest (riba) and requires all Muslims whopossess minimum net worth above their basic needs (nisab) to pay zakah (2.5% of the assets thathave been owned over a year). Zakah is a major economic instrument premeditated to spreadsocio-economic justice amongst Muslims. Unsurprisingly, the US reserve has announced thecut in lending rate to be around 0% and the demand for meaningful tax cuts is building up.

The beauty of the Islamic system, embodied in Shariah rules and regulations, is that itaspires to close all avenues that might lead to harm rather than opting for various damagecontrol scenarios in order to minimize the damage after the damage has been done. This isbest achieved by devising preventive measures and procedures to protect the Muslim nation(ummah) and its institutions from the impending harms of risk. For example, while Islam frontsto safeguard Muslims against wrongdoing, the Holy Quran commands Muslims not only toabstain from the evil, but rather instructs them to avoid all means leading to it and to stay awayfrom the places that are likely to involve unlawful activities. Such laws came to root out theproblem rather than to deal with its derivatives and implications, and to protect individuals andsocieties from destructive behaviour before it takes place and becomes an entrenched crisis.

Likewise in finance, Islam establishes a unique system that protects individual investorsand financial institutions from potential risks. As with all other aspects of Muslims’ dailylives, Islamic finance is governed by Shariah rules and regulations, which forbid usury (riba),gambling (maisir), and ambiguity (gharar), and stipulate that income must be an outcome ofproductive economic activities based on trade and on the principles of profit-and-loss-sharingcontracts. Several Muslim scholars (Ayub, 2007; Ozturk, 2008; Rafique, 2008; Vandore, 2008;Aglionby, 2009; Chapra, 2009; Yudhoyono,2 2009) strongly argue that Islamic finance “hasthe potential to become an alternative model for global system”. Their arguments are basedon the following pillars of the Islamic theory of finance.

◦ Islamic finance is a model that “is based on themes of Community Banking, Ethicaland Socially Responsible Investments and Affinity Marketing” (Khan, n.d.). The most salientvalues of Islamic finance are fairness, socio-economic justice, and its uncompromising com-mitment towards the well-being of future generations through caring for the environment andpreserving earth’s valuable resources. The philosophical reasoning underlying the principles ofthe Islamic financial system is the implementation of a financial system (wealth accumulationand wealth distribution) that is fair, just, and unbiased towards the rich minority at the expenseof the poor majority. The ultimate aim is to spread socio-economic justice amongst all Muslimsregardless of their whereabouts. Shariah-compliant banking proposes uncompromising moralguidelines for dealing with money. Supply of money therefore must be proportionate with theprospects of real growth in the economy in order to provide for a sustainable development andmore equitable distribution of wealth.3

A host of intellectuals are forcefully arguing for the return to some form of commodity(i.e. gold) currency peg in order to reinstate value for money and streamline its supply. Theprinting of trillions of dollars and other currencies without proper backing in an attempt torestore a sense of economic equilibrium will undoubtedly lead to a much higher inflationrate, large deficits in fiscal and monetary policies and eventually drive interest rates to newheights, as central banks endeavour to restrain excessive spending (Lewis, 2007; Kent, 2005;Kindleberger, 2005; Lietaer; 2002; Vadillo, 2002).

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◦ All activities in Islamic finance are permitted (halal) except those which have beenspecifically forbidden (haram) by Shariah due to their harmful and destructive implications.The most fundamental pillar of this evolving, but extensive industry is the concept of Shariahcompliance, which dictates that the financial approach of Muslims should be governed bytwo major sets of rules. First, unlike in conventional finance, Muslims are strictly prohibitedfrom investing in or dealing with economic activities that involve interest, uncertainty, andspeculation, regardless of their form or shape or the pretexts that are often used to justify them.Secondly, Muslims are not only discouraged but also forbidden from investing in businessesthat are engaged in illicit (haram) activities such as the production and the distribution of goodsand/or services that stand against the tenets of the Islamic value system, such as alcoholicbeverages, pork-related products, drugs, gambling, conventional insurance, war profiteering,and indecent entertainment.

◦ Islam prohibits paying or receiving any predetermined fixed rate of return on bor-rowed/lent money. In the view of Islamic scholars, charging interest (riba) tends to drivethe poor into more poverty and create more wealth for the wealthy without doing work orsharing the risk involved in every business undertaking. Riba further creates wealth withoutactually being the outcome of productive economic activity or as the result of an increasein commodity supply. Islam therefore considers all interest-based financial arrangements tobe unfair, unjust, and morally unjustifiable and all money generated by such transactions tobe unearned money, and thus declares riba unlawful. “And because of their much hinderingfrom God’s way, and of their taking riba, though they were forbidden it; and of their devour-ing people’s wealth wrongfully. We have prepared for those among them who disbelieve agrievous punishment” (The Holy Quran [Al-Nisa] 4: 161). Interestingly, all major revealedreligions (Judaism, Christianity, and Islam), as well as other ethical systems and religions suchas Buddhism and Hinduism, were united in denouncing interest as an unethical and immoralpractice. Interest was also forbidden in Charlemagne’s laws, and it was limited by Roman law,the Magna Carta, and the Code of Hammurabi. Even many states of the US enforced interestlimits until 1981 (Mahlknecht, 2009).

◦ Money generated from “rent-seeking activity” such as charging interest creates new butartificial capital, which is by no means the life-blood of the markets. Ahmad (1996: 4) pointedout: “The essence of the market is entrepreneurship” and explained that “trade, not bankingis the primary function of markets”. Islam encourages business and productive economicactivities that generate fair and legitimate profit thus reinforcing the positive relationshipbetween financial flow and productivity. “This intrinsic property of Islamic finance contributestowards insulating it from the potential risks resulting from excess leverage and speculativefinancial activities” (Ozturk, 2008). The outcomes of several empirical studies have highlightedthe merit of interest-free banking over interest-based banking in relation to financial stabilityand economic efficiency (Darrat, 1988; Robertson, 1990; 1998; Vogel and Hayes, 1998; Millsand Presley, 1999).

The current financial crisis saw trillions of dollars evaporate and, literally, vanish from theworld economy. The extent of the financial meltdown has incited some Muslim scholars toconstrue such losses of virtual wealth as being God’s fulfilled promise that “Allah will depriveusury of all blessing and will nourish deeds of charity” (The Holy Quran [Al Baqarah] 2:276).

◦ In the absence of interest-based financial transactions under Islamic finance, financialrelationships between financiers and borrowers are best understood within the framework ofprofit-and-loss-sharing (PLS) contracts. The concept of PLS entails that when entering into a

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partnership (musharakah) contract, both parties share the risk (and returns) and have vestedinterest in seeing the partnership agreement come to a satisfactory ending.

◦ “Religious orientations aside, all those who care about the ethical content of their financialtransactions are likely to be inclined towards Islamic finance in that there is much more toIslamic finance than the mere elimination of riba” (Venardos, 2005; Iqbal, 1997). Socialresponsibility, sustainability, and morality in business are emerging issues that are increasinglyattracting the interest of scholars, politicians, economists, social activists, as well as investors.Interestingly, while these issues are now topics of debate in secular societies, they are embeddedwithin the ethical code of conduct of all major religions and are considered fundamental tenetsfor devout Muslims.

◦ The principles of Islamic finance advocate fairness in payoffs and reward structures andembrace socio-economic justice amongst all. The rules of Shariah unconditionally prohibitMuslims from taking part in any transaction that might involve fraud, dishonesty, exploitation,and ambiguity. “Woe to those that deal in fraud” (The Holy Quran, [Al-Mutaffifin] 83:1). TheProphet Mohammad (PBUH) emphasized the significance of honesty, specifically in businessdealings. Ibn Majah narrated that the Prophet (PBUH) said “if anyone sells a defective articlewithout drawing attention to it, he/she remain under Allah’s anger”. These noble values aretreasured and shared by many Muslims as well as non-Muslims who insist on investing insocial responsible portfolios, even when they think that such investment might have a lowerrate of return.4 Therefore, it would be fair and sensible to claim that each and every financialactivity that complies with the Shariah rules and guidelines is a socially responsible activity.

In addition to the conventional role of Islamic financial institutions, in providing interest-freefinancial services and investment opportunities, they are under religious and moral obligationsto assume a leading developmental role in promoting productivity and entrepreneurship.Sallah (1990) rightly argued: “Being an Islamic institution with [a] responsible mission, the[Islamic] bank must act with more developmental orientation.” While the prevailing objectiveof conventional banks in a capitalist market economy is maximizing profit by unjustly chargingthe optimal interest rate, Islamic financial institutions are expected to demonstrate their truespirit and prove their viability as partners in development rather than using instruments ofexploitation.

◦ The principle of “no pain no gain” embedded in the Islamic financial structure entailsthat no one has the right to rewards (profit) if they do not equally share the risk of incurringloss. Chapra (2009) believes that this concept “should help introduce greater discipline intothe financial system”. Realizing the affirmative linkage between sharing the profit and sharingthe risk involved in any business transaction would undoubtedly motivate financial institutionsto adopt a more cautious approach to lending. Being a partner, rather than merely a lender,compels the financier (lending institution) to assess risks more carefully and to effectivelymonitor the use of funds by the entrepreneur (borrower). The double assessment of risks byboth the financier and the entrepreneur “should help inject greater discipline into the system”and restrain excessive lending and borrowing as well (Chapra, 2009).

17.4.2 The Current Financial Crisis Would not have Occurred Under an IslamicFinancial System

Islamic finance remained relatively positive and resilient despite the gloom and volatilityof the prevailing global financial environment. It has been strongly argued that, had globalbanking practices adhered to the principles of Islamic finance, which are based on noble

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Global Financial Industry

Global Financing Industry

Proper risk Socio-economic justice Regulatory management control

Ethical investing Corporategovernance

No ambiguityor speculative

activities

Greater Contractual clearance reliance on equityand transparency

Ban on interest

One cannot sell or lease Sold or leased unless he/she possess assets must be real

IslamicFinancial Industry

Global F

inancial Industry Glo

bal F

inan

cial

Ind

ustr

y

Debtcannot

be traded

Figure 17.2 Key intrinsic principles of the Islamic financial system

ideas of entrepreneurship and transparency, then the global crisis would have been prevented.This argument is simply built on the fact that most, if not all, the factors that have caused orcontributed to the development and the spread of the current global financial crisis are notallowed under the rules and guidance of Shariah (Figure 17.2).

Theoretically, it would be impossible for a crisis such as the sub-prime mortgages to takeplace in the Islamic capital markets sector since:

◦ It is against Shariah principles to sell a debt against a debt. There is a very simple butfundamental rule in Islamic trade: one cannot sell or lease unless he/she possesses real assets.As Islamic finance prohibits the pure sale of debt and risky speculative financial businesstransactions, it demands that financial transactions be consistent with “fair play”, justice, andtransparency. All parties to a contract are required and entitled to a full disclosure of the prosand cons of the business transaction in order to have a better assessment of the risk involved.

◦ Islamic finance is based on equity rather than debt, and lending transactions are foundedon the concept of asset backing. Consequently mortgage loans under such a system would have

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been backed by a solid asset structure that safeguards the banking industry against possibleloan defaults. The enormity of loan defaults should they occur, within the Islamic financialsetting, will in no way threaten or compromise the health and proper functioning of the bankingsystem. In the present crisis, trillions of dollars have been trading without backing of assets.One can strongly argue that the current financial crisis would have been prevented if suchtransactions were conducted in conformity with the Islamic finance model, where “virtualmoney” has no place in its accounting books.

◦ Islam takes particular interest in fostering a close relationship and trust between origina-tors (financial institutions) of Islamic financial products and investors. This honest relationshipsuggests that a high level of transparency will be shared between the parties involved in a busi-ness transaction. Investors therefore will be compelled to open up to their financiers, who inturn will be inclined to authorize loans only to worthy borrowers based on genuine need andidentifiable business activity. The significance of nurturing positive relationships between thefinancier and the investor is gaining wide acceptance in Islamic as well as non-Islamic financiallandscapes. In an astounding move, the Vatican has recognized the implication of bringingbanks closer to their clients and accredited Islamic finance for offering ideas to resolve theWestern financial crisis. The Vatican urged conventional banks to consider the ethical rulesreflected in Islamic finance to restore confidence amongst their clients at a time of globaleconomic crisis (Napoleoni and Segre, 2009).

◦ Another major factor that contributed to the current financial crisis is the absence of anadequate and effective regulatory control system that monitors and consequently ensures theinterests of investors. The Islamic regulatory control system stipulates that potential investorsbe well versed in the prospects (opportunities and risks) that their investments are subject towhen entering into new contracts. Risk must be explicitly communicated to all stakeholders,and financial institutions are under the obligation to conform to comprehensive disclosure andtransparency standards.5

◦ An honest implementation of profit-and-loss-sharing (PLS) transactions (such asmudarabah and musharakah contracts) in accordance with the spirit of Shariah entails fulldisclosure and transparency. Full disclosure and transparency will definitely work towardsenhancing the perspective for market discipline by providing built-in mechanisms (checksand balances), which serve to control imprudent lending and to ensure the financial stabilityof the Islamic financial system (Ozturk, 2008). Mudarabah and musharakah are also seenas effective instruments for managing risk, where partners tend to take a balanced approachtowards business transactions by weighing the prospects of gain against the risk of loss thusavoid speculations and preventable uncertainty (gharar).

◦ Islam regards the relationship between the lender (financial institution) and the borrower(investor) as a partnership, wherein the lender has a continued stake in the transaction – ratherthan making a loan and shifting the risk by selling it off. It is unlikely in such a businessenvironment where both lenders and borrowers have mutual interest in the transaction that“sub-prime” deals will occur.

◦ The inclusiveness of the concept of risk-sharing as apposed to risk-taking is extended toinclude the prohibition of risk shifting as in CDS and CDOs. Siddiqi (2008) argues that “riskshifting is gambling” and explains that each and every loan made by a lending institution issubject to credit risk. Banks sought to protect themselves against risk of default by selling theserisks to a third party in a zero-sum game. Unlike PLS contracts where both parties are exposedto gain and loss, risk shifting assures only one party (seller of the risk or the buyer) to gain thelosses incurred by the other parties without the creation of additional wealth (Siddiqi, 2008).

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◦ In the wake of the many failures of large corporations to gain and/or retain the trust ofthe “typical investor” due to their unethical accounting and other business practices, Islamicfinance provides a moral and practical option for those keen to invest in socially responsibleand/or in ethical investment portfolios. Obviously, fraud, corruption, and greed are not limitedto non-Muslims. Muslims as well are engaged in such unethical and dire practices. But whatdifferentiates the ethical boundaries of Islamic finance is that ethics are entrenched in Islamicinstitutions and in the contractual structures and mechanisms they use, which yields a strongerlink between business rules and laws on the one side, and religious, ethical, and social valueson the other.

Table 17.1 links key principles of Islamic finance to observable market failures and suggeststhat the likelihood of certain types of market failure to occur will be significantly reduced,if not eliminated, when these principles are adhered to and put into practice in all financialtransactions. To provide a complete and consistent picture, it also describes potential economicdrawbacks of the described Islamic finance principles with regard to potential new risks arising,as well as to a possible loss of return, income, and development potential.

It is evident from the above that many assumptions have been made, most notably thatMuslims always practice Islam and abide by its teachings. They strictly adhere to the spirit ofShariah in their financial activities as well as in other aspects of their daily lives. However,the reality is not this simple. The merit of this assumption is largely questioned and at times iscontested. Muslims’ actions are not always in harmony with the ideals they preach. One needlook no further than to the authenticity when applying murabaha contracts in Islamic financein a way that sometimes appears to resemble riba. In some cases observed by practitioners,the banks involved did not even seem to be performing real transactions within their real-lifecommodity murabaha schemes.

17.4.3 A Systemic Trade-off Between Risks and Returns

As it was hinted in Table 17.1, a reduction of (individual and systemic) down-side risks obvi-ously may always come with a limitation of the available (up-side) potential, too. While it iseasy to criticize the current financial system in the light of the crisis today, it should be keptin mind that in the past 30 years, the influencing factors for the crisis have also contributedto establishing a uniquely long time period of growth, the admirable economic catch-up ofregions like South-East Asia, technological breakthroughs financed through (highly specu-lative) venture capital, and other types of progress all over the world. Likewise, while it istrue that financial derivatives have been increasingly used for purely speculative purposes(and, ultimately, triggered systemic effects by their nature as “weapons of mass destruc-tion”), derivatives also play a vital role for companies that need to hedge against dangerousfinancial risks.

The objective for financial regulators and policy makers should therefore be to find anoptimal, consistent, and stable systemic trade-off between risks and returns. In the Islamicfinancial industry, for instance, there is currently under way a global unification initiative,where the International Islamic Financial Market (IIFM) in cooperation with the InternationalSwaps and Derivatives Association (ISDA) tries to standardize Shariah-compliant hedging(“tahawwut”) products that fulfil exactly this purpose: to enable risk reduction while avoidingthe misuse of these hedging products for purely speculative motives. If credible and efficient

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Table 17.1 The economics of Islamic finance, market failures and potential drawbacks of Islamicfinance principles

Islamic financeprinciple Intuitive description

Linkage to “marketfailures”?

Drawbacks of respectiveprinciples

1. Prohibitionof Riba

“Earning money frommoney” is prohibited.Profit, which is createdwhen “money” istransformed into capitalvia effort, is allowed.However, some formsof debt are permittedwhere these are linkedto “real transactions”,and where this is notused for purelyspeculative purposes.

A real return for realeffort is emphasized(investments cannot be“too safe”), whilespeculation isdiscouraged(investments cannot be“too risky”). This mighthave productiveefficiency spilloverbenefits (“positiveexternalities”) for theeconomy throughlinking returns to realentrepreneurial effort.

In all developed economiesworldwide, interest-based lending is a vitalsource of financing forboth companies andindividuals. As long asefficient Riba-freefinancing modes are notavailable (which is, atleast in principle,feasible usingShariah-compliantcontracts), economicdevelopment may behindered and limited bypurely interest-freemodes of financing.a

Moreover, a purelyinvestment-based, nottemporarily restrictedfinancing model couldlead to undesirableconcentrations ofownership and power inthe hands of investors,and to associatedconflicts of interest.

2. Fair profit-sharing

Symmetric profit-sharing(e.g. Musharakah) isthe preferred contractform, providing effortincentives for themanager of the venture,while both the investorand management have afair share in theventure’s realized profit(or loss).

Aligning themanagement’sincentives with those ofthe investor may (incontrast to pure debtfinancing) once againhave productiveefficiency spilloverbenefits for theeconomy, throughlinking realizablereturns to realentrepreneurial effort.Profit-sharing and theprohibition of interestlead to a situationwhere financiers aretruly “interested” in thesuccess of their clients/companies.

Profit-sharing may implyadditional risks for bankaccount holders. Whilein the present system,retail customers can beindirectly affected by afinancial crisis (namely,through a collapse of thebank where they havetheir bank deposits), in apurely PLS-basedsystem they woulddirectly suffer from suchcrises. However, Islamicbanks typically offer amix of guaranteedaccounts, equity- andfixed-income-typeproducts, so that this riskin practice is not higherthan in conventionalfinance.

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Table 17.1 The economics of Islamic finance, market failures and potential drawbacks of Islamicfinance principles (Continued )

Islamic financeprinciple Intuitive description

Linkage to “marketfailures”?

Drawbacks of respectiveprinciples

3. No undueambiguity oruncertainty

This principle aims toeliminate activities orcontracts that aregharar, by eliminatingexposure of either partyto excessive risk. Thusall involved partiesmust be transparent inwriting the contract,must take steps tomitigate controllablerisk, and avoidspeculative activitieswith high levels ofuncontrollable risk.

This may limit the extentto which there areimperfect andasymmetricinformation problemsas part of aprofit-sharingarrangement.Informational problemsmight, for example,provide the conditionsfor opportunisticbehaviour by theventure (“moralhazard”), undermininginvestment in allsimilar ventures in thefirst instance.

High-uncertainty financialproducts havecontributed, in the past30 years, to very highreturns for investors andto high taxed revenuespaid by global financialinstitutions togovernments. Limiting(down-side/crisis) riskobviously comes alongwith a limitation ofreturns/up-side potential.Keeping in mind themagnitude of the recentfinancial crisis, such atrade-off, however,seems to be necessary.

4. Halal versusharamsectors

Investing in certain haramsectors is prohibited(eg, alcohol,armaments, pork,pornography, andtobacco) since they areconsidered to causeindividual and/orcollective harm.

Arguably, in certainsectors, there arenegative effects forsociety that the investoror venture might nototherwise take intoaccount (“negativeexternalities”).Prohibiting investmentin these sectors mightlimit these externalities.

There is no real drawbackof this principle.Empirical research hasproved extensively thathalal investmentperformance is clearlynot the poorer cousin oftraditional investing.However, to support thecreation of desirablesocial effects, it wouldbe helpful to integratepositive (environmental,development, and social)screens in Islamic/ethicalinvesting, too.

(Based on: Iqbal & Llewellyn, 2002 cited in Oxera, 2007, p. 2.)aThere are, however, also examples where Shariah compliance is an essential ingredient to support economicdevelopment in a credible and accepted way. For instance, microfinance is likely to be more easily accepted intraditionally Islamic countries, such as Afghanistan, while interest-based microlending may be rejected for religiousreasons (see Syminvest, 2008).

tahawwut products can be created and standardized, this type of product may also becomehighly interesting for the non-Islamic global financial community (Mahlknecht, 2009).

17.5 THE PROHIBITION OF “BAD” RISKS IN ISLAMIC FINANCE

17.5.1 Types of “Bad” Risks

When making a distinction between “good” and “bad” risks from the perspective of Shariah, afirst attempt could be to list, taxatively, all those types of transactions known from conventional

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finance that are prohibited in Islamic finance. Such conventional products and transactionsinclude:

• short-selling• financial derivatives• insurance products• interest-related activities• high leverage.

Such an approach has the advantage of simplicity, and it allows use to be made directly of alltechniques developed to analyse those conventional products and practices (both individuallyand on their systemic impact).

However, a simple 1:1 mapping of Shariah prohibitions on the existing conventional rangeof financial products and practices would clearly not be correct. For instance, the prohibi-tion of short-selling is based on the prohibition that one may not sell what one does notown. Recent product developments in the Islamic financial industry have shown that Islamicvariants of shorting are feasible, which do not rely on a broker “lending” the underlyingasset, but which fulfil the same economic objectives and requirements. Another example isthe above-mentioned, current global unification of Islamic hedging products undertaken bythe IIFM together with the ISDA, which make it possible to hedge in a way similar to con-ventional derivatives. Moreover, there are not only investment restrictions in certain types ofproducts/asset classes, but additional financial filter rules and requirements on the contractuallevel, which are not identically present in conventional financial products.

A finer method would therefore consist in accurately modelling the specifics of Islamicfinance, which are relevant for the analysis of risks. The nature of permitted (“good”) andprohibited (“bad”) risks may be derived directly from the precepts of Shariah, in particular, theprohibition of riba, gharar, maisir/qimar, as well as from the specifics of Islamic contract law.

Important insights in this context are:

1. Gharar is often interpreted as “excessive uncertainty”, given that a reduced amount ofrisk, which is allowed for, is sometimes called “minor gharar”. It is especially fruitful tolook at the term “gharar” from the perspective of game theory. In fact, gharar is equivalentto a zero-sum game with uncertain payout (al-Suwailem, 1999/2000). While positive-sum,Pareto-optimal games are acceptable in Islamic finance (e.g. the musharakah contract) andzero-sum games are not (e.g. bets, gambling, conventional derivatives), the question is how toevaluate mixed-sum games from the perspective of Shariah, which include both zero-sum andpositive outcomes as possibilities.

According to al-Suwailem, one can speak of “minor gharar” (and, thus, of allowed trans-actions) if the positive-sum outcome is dominant, and of “excessive” (unacceptable) ghararotherwise. The acceptability of mixed-sum games, therefore, depends on the likelihood ofthe positive-sum outcome (i.e. the mutual gain, cooperative aspect). Note that the zero-summeasure is based on actual, realized outcomes, and not on expectations. It is important to under-stand why gharar in general encompasses financial derivatives: in expected terms, derivativesmay imply a mutual benefit for both parties, viewed, for example, from the perspective of riskmitigation and hedging. In actual terms, however, ex post one party in a derivatives transactionexactly gains what the other counterparty loses.

This is true, for instance, for conventional futures contracts, where any price fluctuationspresent a gain for one party and a loss to the other. In contrast, in a salam contract, which

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may be viewed as the Shariah counterpart of forwards, the price is fully paid up-front. Thisallows the seller of the asset to utilize the paid amount in a way to compensate for moderateprice increases in the asset. The discount on the spot price, which is typically present in salamcontracts, provides the buyer with a cushion against future price changes (as well as with apartial protection against expected losses caused by counterparty defaults), making salam anacceptable form of transaction in Islamic finance (Mahlknecht, 2009). We can conclude fromthis discussion that it adds value and precision to our analysis if we do not simply rely on astrict list of “forbidden products”, but use game theory to look at each different situation andfinancial product individually. Moreover, in this way potential new products may be designed,which do not encompass “excessive uncertainty”, and a distinction between “good” and “bad”risks can effectively be made depending on their number of zero-sum game aspects.

This type of “bad” risk may be labelled excessive uncertainty risk. It may be decomposedinto risks like leverage risk, market interrelation risk, etc.

2. Islamic contract law requires certain elements of the subject matter. First, the seller mustown what he/she sells, with the exceptions of salam and istisna’a contracts, where all the detailsabout the commodity objects and the delivery have to be pre-agreed precisely. Secondly, theprice to be paid and the subject matter must be certain/precisely determined. Thirdly, the saleof debt or receivables is not allowed, since the seller of debt does not know whether and whenthe debt will be repaid. Only hawalah (assignment of debt), with full recourse, is allowed.Fourthly, mutually contingent contracts are not allowed. For instance, contingent sales are notaccepted, combining sale and lending is not allowed, a sale of an article for two prices is notapproved (e.g. depending on the time of payment), etc.

To isolate the different types of “bad” risks, we can use terms like shorting risk, unclearprice risk, unclear subject risk, debt trading risk, and contract complexity risk. The second,third, and fifth type of risk might be subsumed under intransparency risk.

3. A subtle interpretation of the prohibition of riba is that, “by prohibiting interest, Islam hasactually prohibited disinterest, in the sense that partnerships encourage active managementand oversight. That is the true benefit of the prohibition of interest. The lender-borrowingrelationship does not encourage the sort of transparency and accountability that come fromsharing risk and reward” (DeLorenzo, Foreword to Mahlknecht, 2009). We may term theassociated “bad” risk disinterest risk.

4. Moreover, at the core of Islam’s prohibition of interest is the principle that money is nomore than a measure of value, which has no intrinsic value of its own. As a consequence,the purpose of the prohibition of riba is to ensure that society operates an economy based onreal, rather than notional, value and one in which business, or the creation of real goods andservices, is used to create value, rather than trading money as a commodity. Given that “real”markets (of goods) are nowadays often opposed to “virtual” financial markets, the associatedtype of “bad” risk may be called virtuality risk.

17.5.2 Individual vs. Systemic Effects of “Bad” Risks

A clear differentiation has to be made between the impact of the various “bad” risks onindividuals and on the financial system as a whole. While the conventional regulatory practicetypically focuses on systemic resilience and stability, Islamic finance (as every major religiousand legal system) is also concerned with protecting individuals both from their own actions(e.g. from consuming nocuous substances) and from others’ (e.g. unfair) actions.

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This differentiation has to be preserved throughout the analysis. It is also essential in orderto understand in more detail the interrelations between (individually) allowed activities andsystemic risks, and to analyse how “bad” risks hitting individual parties translate into systemicrisks and instabilities. It appears, however, to be obvious that taking these types of “bad” risksis directly and significantly linked to the birth and development of financial crises, of the kindwe have just been experiencing since 2007.

For instance, high-risk speculation and investment behaviour brought about by excessiveoptimism is clearly limited by the prohibition of excessive uncertainty risk (gharar), leveragerisk,6 and intransparency risk. Therefore, while the overly optimistic adjustment of expec-tations in a boom cycle is certainly typical for human beings, a legal and moral prohibitionmay impede translating these expectations into real-life investment behaviour. The prohibitionof disinterest risk directly prevents lax lending standards from becoming a reality, and theprohibition of virtuality risk makes the detachment of purely speculative activities from realmarkets impossible.

17.6 LESSONS LEARNED

We want to briefly review some lessons learned from the global financial crisis. It should benoted that these lessons are not only relevant for conventional financial institutions, but also forIslamic ones, although the degree and type of risks in both systems are likely to be different.

17.6.1 Reputational Risk and the Recreation of Trust

In the light of the global financial crisis, banks all over the world and the industry as a wholehave suffered a dramatic loss of reputation. It became clear that not only systemic risk was anissue, but that financial institutions had to take a much closer look at so-called reputational risk.It was thus no surprise that the Basel Committee of Banking Supervisors (BCBS) includedthis issue in their 2009 “Enhancements to the Basel II framework” (BCBS, 2009a). Reputationrisk was there defined as “the risk arising from negative perception on the part of customers,counterparties, shareholders, investors, debt-holders, market analysts, other relevant partiesor regulators that can adversely affect a bank’s ability to maintain existing, or establish new,business relationships and continued access to sources of funding (e.g. through the interbankor securitisation markets). Reputational risk is multidimensional and reflects the perception ofother market participants” (BCBS 2009a).

The multidimensionality of reputational risk is best understood by looking at the varioustypes of reputational benchmarks that banks have to keep an eye on. These do not onlyinclude regulatory and legal criteria, which financial institutions must comply with, but alsothe expectations of people on what they regard as responsible conduct, as well as the valuesthat are generally embedded in a society.

Walter (2009) differentiates between:

• Enforcement infrastructure (“External compliance failure”)• Legislation (“Illegal conduct”)• People’s expectations (“Irresponsible conduct”)• Society’s generally accepted values (“Immoral conduct”).

In fact, laws and regulations that govern the market conduct of firms are not created in avacuum, but they are rooted in social expectations, which in turn are driven by basic values

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existing in a society. These values “are the ultimate benchmarks against which conduct ismeasured and can be the origins of key reputational losses” (Walter, 2009).

Elaborating further, it can be observed that the fundamental (religious, moral, and ethical)values of a society are not always reflected 1:1 in the public expectations as to how a companyis assessed. Expectations depend on the context of the evolution of a society, as well as on thenature of the market and its behavioural standards. Analogously, there may be similar slippagebetween the expectations of a society and the formation of a public policy.

As a consequence, by complying only with legal and regulatory criteria, financial institutionsmay fail to comply with much more general expectations regarding their conduct. It is nosurprise that a number of financial institutions (such as UBP in Switzerland and BancoSantander in Spain) decided to reimburse client losses from the sale of Lehman bonds, or frominvestments in Bernard Madoff’s scheme, even though they were not really legally forced to.

Looking at Islamic finance, at least two lessons can be learned in this context from thecrisis: first, it is not sufficient to comply with laws and regulations, in order to ensure a stableand sustainable reputation. More general values and ethical constants need to be considered,such as those present in all major religions, and as fulfilled within Islamic finance.

Secondly, it is very likely that people’s expectations are much higher with regard to financialinstitutions that claim to be “ethical”, “solidary”, or “Shariah-compliant”. This is probablywhy a significant number of Muslims are not yet satisfied with the current quality of manyIslamic financial institutions, which often give preference to legal form over social substance,rather than having a credible and clear social and ethical agenda. While the crisis of conven-tional finance now opens a window of opportunity for Islamic banks to increase their globalreputation, Islamic practitioners should be aware of this fact and avoid legal stratagems andcontroversial practices.

17.6.2 Real vs. Virtual Transactions: sukuk and the Escape from the Debt Trap

During the crisis, the criticism in Western media has significantly increased regarding the“virtuality” of financial markets and the detachment of financial products from the “real”economy. While an independence of the need to perform real transactions in some areasclearly yields cost-efficiency gains (e.g. in the settlement of futures contracts, where actualdelivery would be costly), it appears that a move towards a real economy-based financialsystem is enjoying broad acceptance.

In this context, Islamic finance may be able to offer interesting alternatives. In practice,lending-like financing is possible in Islamic banking in a very flexible way, but only in a mannerthat it is directly and inseparably linked to real transactions. This is true for murabahah-linkedtransactions, for ijarah (Islamic leasing), and for various other contract types.

Sukuk are a particularly interesting innovation in this area. They can be based on variousShariah-compliant contracts and are a directly asset-based means of financing for companies,sovereigns, or financial institutions. Looking at developing countries, for instance, sukuk cancontribute to avoiding the so-called “debt trap”, which has been causing sorrow and povertyto so many countries in the world. In fact, such countries typically have no issuer credit rating(or a weak one). The issuance of conventional bonds would therefore not be a realistic routefor them. Sukuk, however, can achieve a significantly higher credit rating, given their directlinkage to real assets and transactions.

At the macroeconomic level, another advantage of sukuk can be realized in connection withprivatization programmes. As the example of Bahrain shows, the asset-based/leasing approach

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to sukuk issuance can solve many of the economic reasons underlying the privatization pro-grammes in various countries (El-Gamal, 2006). From the perspective of investors, sukuk canbe structured as fully secured investments, which may also give higher certainty to investorsin times of economic crises and financial distress of bond issuers. The effectiveness of the col-lateral, of course, depends on the market value and the price stability of the underlying assets,which can be adversely impacted by financial crises (e.g. in case of real estate-based sukuk).

17.6.3 The Need for Clearing Houses

To a large extent, the global boom of derivatives and structured products markets within thelast decade was based on OTC transactions. Not only do OTC transactions typically involveweak protection against counterparty default risk, but they also cause a high intransparencyboth for individual financial institutions and for regulators, who try to foresee systemic risks.There is, thus, an increased call for clearing houses to control many types of complex financialproducts and transactions, and to restore transparency and reputation. While it is true thatthe global crisis arose from the conventional financial industry, this is certainly a lesson thatIslamic capital markets are also seriously recommended to learn.

17.7 CONCLUSIONS AND OUTLOOK

The premise that the current financial crisis presents Islamic finance with abundant opportuni-ties to confirm its presence and demonstrate its relevance as an effectual economic authority inthe international market is evidenced by its emergence as a more equitable and efficient alter-native to the existing system. While the global banking industry is facing profound difficultiescausing many closures and bankruptcies, Islamic banking defies the trend by embarking onnew global undertakings.7 A number of new Islamic banks had been formed in recent monthsincluding the United Arab Emirates’ first Islamic commercial bank and the Ajman Bank;more than 20 existing Islamic banks have extended their operations into new countries suchas Botswana, Iraq, Kenya, Syria, and South Africa.

While accepting that some issues pertaining to the globalization of Islamic banking are stillpending and in need of further research and consideration, Wilson (2007) upheld that Islamicbanking presents the West with an opportunity. He spoke of his confidence about the futureof Islamic banking in the West, and concluded that “Islamic banking is here [in the West] tostay” and that “the West should promote Islamic Banking”.

Germany, France, and Japan, amongst many other non-Islamic countries, have recognizedthe potential contribution of Islamic banking towards restoring credibility and stability to theinternational financial market. Leading German, British, and French financial institutions areseeking to secure funds from the promising Islamic investment market in order to alleviate thegrowing liquidity shortage in their financial markets (Bohmler, 2007; Hassan and Lewis, 2007).

France is taking an exceptional interest in Islamic finance as it has affirmed its intention“to make of Paris a great center for Islamic finance”.8 The French Senate has agreed totap into this multi-billion9 dollar market and is considering harmonizing the French law byimplementing revisions required at a financial level to adapt French laws to the Islamic financialregime.10 Following in the footsteps of London, where the first Islamic bank opened its doorsin September 2004, it is expected that three Islamic banks will open branches in Paris in 2010.In Germany, Kuveyt Turk Bank was the first to receive a (partial) German banking licence in2009, and in Liechtenstein the first Pan-European Islamic life insurance company (takaful) isbeing created.

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So, is Islamic finance already strong enough to meet the challenge posed by the currentcredit crunch? The positive feedback to Islamic finance from various corners of the worldin the time of the crisis could be interpreted as a vote of confidence in the Islamic financialindustry. Economists as well as politicians envisage that the current global financial crisis isset to create a “New International Economic Order” and to restructure the global economicinstitutions. Coupled with the emergence of the G20 as a major international economic powerthat outdistanced the G7, and the fact that three developing Muslim-led countries (Turkey,Indonesia, and Saudi Arabia) are among the top 20 economies should encourage Islamicfinance to exploit existing opportunities and demonstrate its worth by offering momentousalternatives to the international economic community.

17.7.1 Main Challenges for Real-life Islamic Finance

The opportunities for Islamic finance are enormous; so are the challenges. Iqbal andMirakhor (2007) concluded that Islamic finance is being simultaneously challenged on threedifferent fronts: theoretical, operational, and implementational, and that each of these chal-lenges has profound implications for the development and the future direction of the Islamicfinancial industry. First, theoretical challenges are concerned with explaining what makesIslamic finance unique: How does the Islamic financial system function? What are the featuresand the advantages of the Islamic financial system? On the operational front, the focus is onmaking available the means and procedures necessary for the true and honest implementationof Islamic finance. Among the many operational challenges facing the Islamic financial indus-try are: innovation, financial engineering, intermediation, risk management, and supportiveinfrastructure. However, the most serious challenge facing the Islamic financial industry re-mains at the implementational front: how to transform the Islamic financial model into workingpolicies and enabling institutions.

The industrialized countries have realized that achieving zero (or close-to-zero) interestrates is a crucial milestone in order to stimulate their economies and counter the effect of theglobal financial crisis. However, the fact remains that the conventional financial system, whichis based on the institutions of interest, is deeply rooted in every aspect of modern life, and thatinterest rates will certainly move above their current levels again. Khan (2008) prudently statesthat “interest cannot be eliminated without providing interest-free loan facility to loan seekersjust as illiteracy cannot be eliminated without providing schooling facility to every child”.He further explains that the PLS arrangements are not appropriate in all situations especiallywhere there is genuine need for a personal loan not intended for business purposes.

There is no assurance that Islamic finance, once it matures, will weather a similar financialcrisis in the future unless it commits itself to being Shariah-based (the substance) rather thanShariah-compliant (the form). Such commitment compels the young evolving Islamic financialindustry to embark on vigorous, first class, and steady research with the aim of developing itsown sophisticated intermediary markets or alternatives – while remaining faithful to the spiritand the essence of Islamic finance.

17.7.2 Convergence Between Conventional and Islamic Financial Industry

It is an interesting question to what degree the conventional and the Islamic financial industryare going to converge in the future. On the one hand, it is clear that the Islamic financialindustry is actively learning from conventional finance in many areas: the World Bank and

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the International Monetary Fund (IMF) have traditionally supported the setting up of Islamicbanking, insurance, and capital markets since the 1970s; the IIFM works together with theISDA and the ICMA to standardize Islamic hedging and, possibly, repo-type products; theIFSB based its capital adequacy standards and risk management guidelines on the “Western”Basel II framework; and last, but not least, Islamic financial institutions are cooperatingwith global conventional banks and replicating many financial products, including structuredproducts, in a (formally) Shariah-compliant way.

On the other hand, the principles of Islamic finance are increasingly gaining attention evenin non-Muslim countries, and as we have explored in this chapter, there is certainly an enor-mous potential for learning effects also in this direction. Unfortunately, this exchange of ideasis still limited and hindered by two major issues: first, the Islamic financial industry as a wholesuffers from a certain lack of credibility among both Muslims and non-Muslims. This is due tothe clear existence of legal ruses and of “copy-paste” efforts in product imitation, as well as toa lack of a social agenda (such as the one in microfinance). Secondly, there are significant mis-understandings in the West regarding Islam and Shariah, both due to a lack of knowledge andto issues like 9/11 and to some political interpretations of Shariah, which are in clear contrastto the human rights declaration. Representatives of Islamic finance need to understand theseconcerns in order to effectively promote Shariah-compliant finance in Western countries. Topromote discussion and learning from Islamic finance, it should therefore be emphasized thatethical norms like the prohibition of interest are traditionally shared by Muslims, Christians,and Jews alike, and perhaps by explaining and communicating that most Arab contract typesin fact already existed before Islam. Once the initial hurdles of misunderstanding have beenremoved, the principles of Shariah-based finance can undoubtedly play a major role in shapingthe financial system according to worldwide accepted and Islamic values.

NOTES

1. “This is partly due to a lack of proper understanding of the ultimate objectives of Islamicfinance, the non-availability of trained personnel, and the absence of a number of shared orsupport institutions that are needed to minimize the risks associated with anonymity, moralhazard, principal/agent conflict of interest, and late settlement of financial obligations”(Chapra, 2009).

2. Susilo Bambang Yudhoyono, the Indonesian president while addressing 1550 delegatesfrom 36 countries at the opening of the fifth World Islamic Economic Forum (WIEF)held in Jakarta, Indonesia on 2–3 March 2009. Delegates gathered in Jakarta to debate theglobal financial crisis.

3. Interestingly, this view on monetary policy is much closer to the theories of MiltonFriedman than to the “activistic” approach of Greenspan-type monetary politics, whichaimed at purposefully fuelling financial markets.

4. Empirical research has, however, proved extensively that the performance of Islamicinvestments is not inferior at all to the performance of conventional investments(Mahlknecht, 2009).

5. Islamic Financial Services Board (IFSB) is one of the many professional bodies thathave been working to meet the various needs of the growing Islamic financial industry.IFSB is in the process of bringing together a set of “Transparency and Market DisciplineStandards”.

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6. To reduce leverage risk at the bank level, the Basel Committee on Banking Supervi-sion (BCBS) is currently discussing the introduction of maximum leverage ratios, as asupplementary measure to the Basel II risk-based framework (BCBS, 2009b).

7. Joseph DiVanna, managing director of UK-based consulting and advisory firm MarisStrategies – addressing the fifth World Islamic Economic Forum (WIEF) held in Jakarta,Indonesia, on 2–3 March 2009.

8. Christine Lagarde, the French Finance Minister as she inaugurated the second Frenchforum on Islamic banking, November 2008.

9. Estimated by French authorities at $500 to $600 billion with projected growth of 11%a year.

10. The French Senate said its initiative was in line with recommendations from a report onIslamic finance prepared by the Financial Affairs Commission, May 2008.

REFERENCES

Aglionby, J. (2009) Islamic banks urged to show the way, Financial Times. www.ft.com/world/economy.Accessed 3 March 2009.

Alexander, S. (2008) The week capitalism failed, News-and-Society/Economics. http://www.ezinearticles.com/? Accessed 3 November 2008.

Allais, M. (1993) The Monetary Conditions of an Economy of Markets: From the Teachings of the Pastto the Reforms of Tomorrow, Eminent Scholars’ Lecture Series, IRTI/IDB.

Al-Suwailem, S. (1999/2000) Towards an objective measure of gharar in exchange, Islamic EconomicStudies, 7, 61–102.

Ambah, F. (2008) Islam is the solution for current financial crisis. The Washington Post, 31 October.http://www.washing. Financial tonpost.com/wp-dyn. Accessed 12 November 2008.

Ayub, M. (2007) Understanding Islamic Finance, USA: John Wiley & Sons Inc.Basel Committee on Banking Supervision (BCBS) (2009a) Enhancements to the Basel II framework,

July 2009. http://www.bis.org/publ/bcbs157.pdf?noframes=1. Accessed 10 February 2010.Basel Committee on Banking Supervision (BCBS) (2009b) Strengthening the resilience of the banking

sector. Consultative document, December 2009. http://www.bis.org/publ/bcbs164.pdf?noframes=1.Accessed 10 February 2010.

Bohmler, R. (2007) Islamic finance – the European challenge. Paper presented at the 2nd IslamicFinancial Services Forum: The European Challenge, Frankfurt. 5 December 2007.

Chapra, U. (2009) The Global Financial Crisis: Can Islamic Finance Help? Retrieved 5 January 2009from: www.newhorizon-islamicbanking.com

Darrat, A. (1988) The Islamic interest-free banking system – some empirical evidence, Applied Eco-nomics, 20 (3), 417–25.

El-Gamal, M.A. (2006) Islamic Finance: Law, Economics, and Practice, Cambridge University Press.Hassan, K. and Lewis, K. (2007) Handbook of Islamic Banking, Edward Elgar Publishing, UK.Hull, J. (2009) The credit crunch of 2007: What went wrong? Why? What lessons can be learned?

Journal of Credit Risk, forthcoming.Iqbal, M. and Llewellyn, D. (eds) (2002) Islamic Banking and Finance, Edward Elgar Publishing:

Cheltenham.Iqbal, Z. (1997) Islamic Financial Systems. www.worldbank.org/fandd/english/0697/articles/0140697.

Accessed 19 May 2007.Iqbal, Z. and Mirakhor, A. (2007) An Introduction to Islamic Finance: Theory and Practice, John Wiley &

Sons (Asia) Pre Ltd: Singapore.Kent, K. (2005) Healthy Money, Healthy Planet, Craig Potton Publishing, New Zealand.Khalaf, R. (2009) Islamic finance must resolve inner tensions. Financial Times, 5 April 2009. www.

sukuk.net/news/articles/1/Islamic finance must resolve inner tensions. Accessed 10 April 2009.Khan, A. (2008) Deliberations of the 7th International Conference on Islamic Economics. Electronic

posting at the Islamic Business and Finance Network (IBF-Net) – 14 May 2008. www.bfnet.com.Accessed 16 October 2008.

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Khan, I. (n.d.) Issues and Relevance of Islamic Finance, Institute of Islamic Banking and Insurance.www.islamic-banking.com/aom/ibanking/ia khan.php. Accessed 17 June 2007.

Kindleberger, C. (2005) Manias, Panics and Crashes – A Short History of Financial Crises (5th edn),USA: John Wiley & Sons Inc.

Lewis, N. (2007) Gold – The Past and Future Money, USA: John Wiley & Sons Inc.Lietaer, B., Ulanowicz, R. and Goerner, S. (2008) White paper on the options for managing systemic

bank crises. www.er.ethz.ch/inspire/systemic bank crises. Accessed 13 December 2008.Loundy, D. (2008) Islamic Finance and the U.S. Sub-prime Mortgage Mess: Lessons to be Learned.

http://www.usbahrainbusiness.org/view/images/uploaded/Loundy Lessons Learned.pdf. Accessed10 February 2010.

Malaysia leads in Islamic finance (2009) Malaysia leads in Islamic finance, The Malaysian Insider.13 April 2009. www.themalaysianinsider.com/index.php/features/21940-malaysia-leads-in-islamic-finance. Accessed 13 April 2009.

Mahlknecht, M. (2009) Islamic Capital Markets and Risk Management. Global Markets Trends andIssues. Incisive Media, RISK Books.

Mills, P.S. and Presley, J.R. (1999) Islamic Finance: Theory and Practice, Macmillan Press Ltd: Bas-ingstoke.

Napoleoni, L. and Segre, C. (2009) Dalla finanza islamica proposte e idee per l’Occidente in crisi.Osservatore Romano, Vatican, March 2009 (initially published in “Vita e Pensiero”, UniversitaCattolica del Sacro Cuore, Milan, 2009).

Oxera (2007) Faith in Finance: The Economics of Islamic Finance. Oxera Agenda – Advancing eco-nomics in business, April 2007.

Ozturk, I. (2008) Global Financial Crisis Highlights Benefits of Islamic Finance. www.todayszaman.com/tz-web/yazarDetay.do?haberno. Accessed 23 November 2008.

Rafique, M. (2008) Islamic finance can solve global crisis, says scholar. Arab News, 24 April 2008.Richter, F. (2008) Islamic Finance is no Longer Immune to Crisis. www.reuters.com/article/ousiv/

idUSTRE4B21UM20081203. Accessed 8 January 2008.Robertson, J. (1990) Future Wealth: A New Economics for the 21st Century, Cassell Publications:

London.Robertson, J. (1998) Transforming Economic Life: A Millennial Challenge, Green Books: Devon.Sallah, Ramadan (1990) “Jordan: The experience of the Jordanian Islamic bank” in R. Wilson (ed.),

Islamic Financial Markets, Routledge: New York, NY, pp. 100–28.Siddiqi, M.N. (2008) Current Financial Crisis and Islamic Economics. www.siddiqi.com/mns. Accessed

7 January 2009.Spiegel online (2008) Interview with Nobel Laureate Mohammad Yunus: Capitalism has degenerated

into a “casino”. www.opednews.com/populum/link.php?id=71990. Accessed 23 October 2008.Syminvest (2008) Afghanistan Favours Islamic Microfinance. http://www.syminvest.com/market/news/

microfinance/afghanistan-favours-islamic-microfinance/2008/3/19/926. Accessed 3 February 2010.Vadillo, U. (2002) The Return of the Islamic Gold Dinar, Madinah Press: Kuala Lumpur.Vandore, E. (2008) Crisis widens appeal of Islamic banking. AP Business Writer, 24 December 2008.Venardos, A.M. (2005) Islamic Banking and Finance in South-East Asia: Its Development and Future,

World Scientific: Singapore.Vogel, F. and Hayes, S. (1998) Islamic Law and Finance: Religion, Risk, and Return, Kluwer Law

International: The Hague.Walter, Ingo (2009) “Reputational risk and the financial crisis” in S. Thomsen, E. Rose, and O. Ris-

ager, Understanding the Financial Crisis: Investment, Risk and Governance, SimCorp StrategyLab:Copenhagen.

Wilson, R. (2007) The West Should Promote Islamic Banking, Islamica Magazine. www.islamicamagazine.com/online-analysis/the-west-should-promote-islamic-banking. Accessed 25 June 2007.

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18

An Islamic Perspective of FinancialEngineering

Sami Al-Suwailem1 and M. Kabir Hassan

18.1 INTRODUCTION

Financial engineering has been the buzzword in the financial markets dealing mostly inderivative products. The phrase has, however, a number of connotations, and might havedifferent meanings in different contexts (Marshall and Bansal, 1992). In the financial world, itrelates mostly to mathematical modelling of financial products with a particular aim of pricingfinancial derivatives and other financial structures.

The world of Islamic finance today is viewed as an important and thriving niche marketwithin the universe of traditional or conventional finance. Financial engineering is as relevantfor Islamic finance as for mainstream finance since both share a number of characteristics thatfocus on designing financing modes. It is therefore imperative to shed some light on the natureof Islamic finance in the very beginning. The Islamic financial system is a collective notionaccording to which financial institutions follow a set of comprehensive guidelines commonlyknown as Islamic Jurisprudence, or simply, Shariah, in designing details of their products.As this simple definition puts it, Islamic finance is merely organizing financial activities in amanner that complies with a broader set of juristic rules and injunctions governing the entiresphere of human life, of which finance is a part. Against this backdrop, it is then easy forone to understand that while engaging in either product development or financial engineering,financial institutions will need to conform to norms of Islamic jurisprudence. A very simpleoutcome of this could mean abandoning financial products that have profit potential butviolating one or more such juristic norms.

18.1.1 Financial Engineering and Financial Innovation

While product development is a broad term encompassing a wide range of techniques andissues when offering new products or modifying the existing ones, the term financial engineer-ing refers specifically to the product development activities involving financial instrumentsdirectly. In other words, financial engineering involves designing and pricing innovative finan-cial products that offer a better risk–return combination while enhancing profitability for theoffering institutions. Further, it involves the application of some analytical tools to financialproblems, especially the pricing and structuring of financial instruments, such as derivativeproducts.


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The phrases “financial innovation” and “financial engineering” are used interchangeablyhere although the use of the term financial innovation might be more appropriate. Financialengineering, as it is practised in conventional finance, resembles more a gambling and bettingmechanism than a productive financial improvement. The world has already witnessed yetanother recession between 2007 and 2009 inflicted on the economy by a handful of geniusbut failed financial engineers. These financial engineers developed sophisticated models in thederivatives markets and promised huge fortunes. As the promised fortune was never realized,the sponsor institutions suffered massive losses and reached the brink of challenging the “toobig to fail” theory.

Governments worldwide had to inject trillions of dollars in the aftermath of financial sectorcollapse following the acts of financial engineers. If Islamic financial institutions allow suchfinancial gambling to take place then they are likely to face disasters such as those as faced bythe conventional institutions.

18.2 FINANCIAL ENGINEERING: DEFINITION AND CONCEPT

According to Finnerty (1988, 1994), financial engineering involves the “design, developmentand implementation of innovative financial instruments and processes, and the formulationof creative solutions to problems in finance”. The objectives of financial engineering are tolower transaction costs and achieve better returns (Merton, 1992). Innovation is by natureunpredictable. If it were predictable, it would no longer be innovative. Thus, attention shouldbe directed towards tools and techniques that facilitate innovation and creativity. Financialengineering therefore can be better described as the principles and strategies for developinginnovative financial solutions.

The difference between tools for innovation and innovation itself is emphasized by de Bono(1970). He coined the term “lateral thinking” to describe thinking strategies and techniques thatpermit and encourage creativity. Creativity therefore is a consequence rather than the subjectof analysis. Similarly, financial engineering should be concerned with tools and techniquesfor developing creative instruments and innovative products (see also Mason et al., 1995:xiii). From an Islamic point of view, there are Shariah principles that should be observed fordeveloping financial products. Thus the definition emphasizing both principles and strategiesfor financial innovation can naturally be extended to financial engineering in Islamic finance.

In addition, the definition mentions financial solutions rather than instruments or contracts.This highlights the added value of innovation. A “solution” is something that satisfies agenuine need that was not possible before. This is general enough to include processes,instruments, or products that result in better efficiency and returns, as emphasized by Merton(1992). According to Mason et al. (1995), financial engineering shall not be measured by thecomplexity of mathematical models involved or of the legal documents required. Rather, it ismeasured by the expanded economic and managerial flexibility it offers (p. xiii).

18.2.1 Value of Innovation

Innovation often results in measured changes, and changes have the potential to create insta-bility. As instability obviously is not desirable, innovation cannot be considered a goal in itself.This is also true for the financial services industry. Innovation in finance is desirable only whenit creates value for either or both of the offering institutions and their customers, offsettingthe associated instability. Innovation therefore can be thought of as a tool and a means for

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An Islamic Perspective of Financial Engineering 387

generating value. It is in this regard that Mason et al. (1995) rightly note that the relevanceof financial innovation is better measured by its impact on the effectiveness of the financialsystem, not merely by its novelty. Leathers and Raines (2004) point out the negative effectsof derivative innovations, and that such innovations are inconsistent with the Schumpeterianview of creative destruction. Hence, an analysis of financial innovation within the Islamicfinancial framework has to take this aspect of financial innovation into account. The goal forinnovation in Islamic finance would then be to add net business value to the industry withoutdestabilizing it. Innovative products introduced to the market by financial institutions offeringIslamic financial products therefore need to conform to value creation criteria as well as othernormative standards that serve as the cornerstones of the stability of the industry.

18.2.2 Shariah and Creativity

A major building block of the Islamic financial system is its conformity to the normativestandards, frequently referred to as Shariah, that define the characteristics of the industry.Shariah provides a comprehensive set of rules governing and guiding all aspects of humanbehaviour including financial ones. Although these rules restrain human behaviour in manyrespects, they are not supposed to hinder creativity. In fact, the opposite is more likely to betrue, since creativity is stimulated by constraints. Elster (2000) shows how and why rationalagents in some cases might be better off when they have fewer options. In such cases, lessis more, which has been supported by many experimental studies (Gigerenzer et al., 1999).Elster also shows how artists, for instance, deliberately choose to restrain themselves in orderto be more creative. On the other hand, Silber (1983) provides evidence that constraints werea major force behind financial innovations that improved economic performance and welfare.

Although creativity is encouraged within the Islamic framework, it should not, however, beused as a means of circumventing the objectives of Shariah injunctions. Such rulings reflectthe ultimate wisdom of Allah (s.w.t.), and their observance therefore will only improve humanlife. If innovation or engineering results in a financial product that appears to get around anotherwise prohibited financial contract, it would not be considered desirable or even acceptable.

Islamic teachings, in general, provide the right environment for valuable creativity andinnovation. The Quran frequently emphasizes reflecting and pondering upon signs of truth,and condemns those who blindly follow the inherited culture that often contradicts the facts. Tosum up, financial engineering and innovation in Islamic finance will strike a balance betweencreativity and conformity with the normative standards of Shariah.

18.2.3 Regulatory Arbitrage

A well-known fact about the financial services industry is that it is highly regulated, primarilyto avoid systemic failure and ensure consumer rights. Merton Miller (1986) argues that amajor impulse for financial innovation is to avoid regulation. Given the increasingly globalizedfinancial markets, investors face different regulatory environments. This creates an opportunityto overcome local regulations using suitably designed instruments (mostly derivatives) issuedacross the borders. Free-market advocates particularly see regulations hindering economicefficiency, and thus consider circumventing regulations via financial innovation as a means torestore market efficiency (Partnoy, 1997).

Financial engineering for the purpose of avoiding regulations is rather relevant for outdatedor artificial regulations that distort the free market mechanism and serves little or no social

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function. However, regulation in principle serves a crucial role in stabilizing the market andminimizing systemic risks. Regulations regarding disclosure and capital requirements, forexample, are essential for self-discipline and risk control in financial institutions. Circumvent-ing such regulations – through financial innovation and accounting manipulation – would verylikely lead to undesirable consequences, with Enron and similar episodes as visible examples.Similarly, from an Islamic point of view, as mentioned earlier, circumventing Shariah princi-ples would negatively affect market performance and jeopardize objectives of Islamic financein the first place.

18.2.4 State of Financial Innovation

One of the major business strategies to move forward is to innovate on a regular basis.Innovation, however, has to be for producing real value through new goods and services, ratherthan for producing speculative structures used for betting and wagering. Lack of productiveinnovative ideas can potentially put a brake on the advancement of the industry. It is in thisregard that Professor Peter Drucker (1999) argued that the financial services industry (atthe time the article appeared) is declining. The reason, he writes, is simple: “The dominantfinancial-services institutions have not made a single major innovation in 30 years.” Instead ofinventing new services for customers, financial firms are mostly trading for their own accounts,thus being involved in a “zero-sum game” since the gain of one firm is the loss of the other. Theonly innovations during the past three decades, he continues to argue, have been “allegedly‘scientific’ derivatives”, which are no more scientific than systems used in Monte Carlo or LasVegas. “As a result, the industry’s products have become commodities and increasingly bothless profitable and more expensive to sell.”

Drucker (1999) outlines three possible roads the industry can take in the time to come.The easiest is to maintain the current practices and trends. The industry may survive, but willcontinue to decline. The second is for the industry “to be replaced by innovating outsidersand newcomers”. The third is for the industry players “to become innovators themselves andtheir own ‘creative destroyers’ ”. With the increasing change in the world economy, the firstroad is not really an option. Thus, the industry either changes itself, or outsiders will do so.Not surprisingly, he titles his article: “Innovate or die.” This points to the fact that the Islamicindustry has a good opportunity at this stage to provide genuine and value-adding financialservices that the industry is seriously lacking. Introduction of interest-free financial productsis already considered an innovation, and further product development within Islamic financewould contribute to going a long way towards winning a highly esteemed position in theuniverse of finance.

18.3 PRINCIPLES OF ISLAMIC FINANCIAL ENGINEERING

Financial engineering has received considerable attention in the finance literature as havinga crucial role in securing sustainable competitive advantage in today’s financial environment.Some writers have viewed financial innovation and engineering as a common tool with which afinancial organization could ensure comparative advantage in its revenue generating activitiesover others. For example, Devlin (1995) refers to the term innovation in the delivery systemof financial services as “an opportunity to gain competitive advantage” which would give,say, a retail banking service provider “the basis for differentiation”. Similarly, Prajogo and

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Sohal find that innovation has a “crucial role in securing sustainable competitive advantage intoday’s competition” (2001: 539).

In comparison to conventional finance, Islamic finance literature on innovation is laggingbehind. Although scholars as well as bankers increasingly talk about financial engineeringand further development within the industry in order to ensure future growth and profitability,a consolidated body of relevant literature documenting various aspects of Shariah-compliantfinancial innovation and its process of implementation is noticeably lacking.

We identify four principles for financial engineering from an Islamic perspective. Two ofthese concern the objectives of financial engineering, namely, the principle of balance andthe principle of integration, and the other two concern methodology, namely, the principle ofacceptability and the principle of consistency.

18.3.1 Principle of Balance

The first principle of financial engineering in Islamic finance relates to the comprehensiveapproach that Islam has recommended in all spheres of human activities. It stresses the balancebetween self-interest and regard for others, between for-profit and not-for-profit activities,between competitive and cooperative relations. Islamic rules draw clear boundaries betweenthe two domains, and successfully achieve internal balance and equilibrium between them.The obligation of zakat and prohibition of riba are two clear examples. Capitalism stresses thefor-profit and market-oriented approach for nearly all economic problems. Communism, onthe other hand, relies mainly on non-profit mechanisms to solve the same problems. Islamiceconomics, in contrast, takes a balanced approach. Both for-profit and non-profit mechanismsare essential for satisfying economic needs.

It is worth noting in this respect that no economy can thrive based on a mechanism thatrecognizes solely the for-profit transactions. In fact, the existence of society, through interactionbetween families and communities, is based largely on cooperation rather than competition.In today’s business world, corporate social responsibility has gained as much in importanceas any other profit-oriented activities.

In the Islamic economic environment, cooperation among economic agents is promoted inparallel with normal competition. Many financial and economic objectives can be achievedthrough cooperative, rather than for-profit, arrangements. The most obvious example is insur-ance. While commercial insurance is widely considered unacceptable from a Shariah point ofview, cooperative and mutual insurance is unanimously accepted. Cooperative arrangementsmay prove to be more efficient than commercial instruments in certain circumstances, and canserve the relevant needs of economic agents.

18.3.1.1 Interdependence

It is important to distinguish here between cooperative arrangements and charitable activities.Both mutual cooperation and charity imply a certain degree of others regards among the mem-bers of a society, but they have different nature of interaction. Stephen Covey (1990) classifieshuman relations into three stages depending on their degree of maturity: (a) dependence; (b)independence; and (c) interdependence.

The first stage is dependence, where one relies on others to satisfy one’s needs. This isespecially true in the early stages of life, where a child is largely dependent on his or herparents and family. Afterwards, one builds up his or her identity and tries to be independent

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from others. The third and most advanced stage is interdependence. It is a mutual relationshipamong independent persons that utilizes the benefits of cooperation to achieve results no singleperson can do individually.

These three stages have their counterparts in economic behaviour. Dependence correspondsto reliance on donations and charities. The receiver is dependent on the donor. At any point intime, there are always people who cannot satisfy their needs on their own, and must dependon others for that. Independence corresponds to self-interest, for-profit, transactions. Agentsget what they want through their own resources. The most advanced stage, interdependence,corresponds to mutual and cooperative behaviour. It relies on reciprocal relations (e.g. Gintiset al., 2005; Sobel, 2005). These are neither pure for-profit nor pure charity, but combineproperties of both to achieve higher objectives. While communism was concerned mainlywith solving the problem of dependent agents, capitalism is concerned mainly with achievingindependence through self-interest and market forces. Islamic economics acknowledges thesetwo types of relations, but adds to them the more mature relation: cooperation and interdepen-dence. Therefore, cooperative insurance is built on reciprocal, interdependent relations, ratherthan pure charity and donation.

18.3.2 Principle of Acceptability

Although the second principle of financial engineering, the principle of acceptability, relatesto methodology, logical sequencing requires presenting it at this point. The principle statesthat all economic dealings are generally acceptable unless otherwise stated by Shariah. Theprinciple is based on the assumption that economic interactions aim to satisfy normal humanneeds and preferences. Islam views man as being driven by nature to the good, and thus regularinteractions will normally lead to the good of the society. Obviously, evil exists, and this iswhy there are rules to ensure that humans do not fall prey to evil.

From an economic viewpoint, these rules are on the preventive side with respect to for-profitactivities, but are on the affirmative side with respect to non-profit activities. The reason lies inthe nature of human incentives. Whenever there are sufficient incentives to pursue legitimateobjectives, for example, seeking profits, the Quran will not overly insist on it in order to avoidextreme responses. On the other hand, when there are less than sufficient incentives to pursuesome other objectives, for instance, giving donations, the Quran will particularly emphasizeit to compensate for the inexistence of necessary incentives. This explains why most of theShariah regulations of for-profit transactions are on the preventive side. Nonetheless, the Quranin many verses commends commerce and trade (e.g. 73:20).

The principle of acceptability is a cornerstone for innovation. It allows for human imagina-tion and creativity, as long as it does not cause more harm than good. One need only ensurethat business and other transactions do not have elements that are prohibited. In accordancewith this principle, if two opposing views are presented regarding a certain financial product –one considers it acceptable while the other does not – then the burden of proof lies on thelatter. Those who accept the innovative product, in the absence of any clear prohibition, do nothave to prove its legitimacy, since this is the default position of Shariah.

18.3.2.1 Roots of Prohibited Dealings

Based on the principle of acceptability, we need to worry mainly about prohibited dealingswith respect to for-profit activities. Generally speaking, most regulations of for-profit activities

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serve to prevent the two most serious unjust dealings: riba and gharar. Although there is morethan a single interpretation of the term, riba or usury is essentially interest on lending. Islam isnot unique in prohibiting riba, since all divine religions had also prohibited it (Chapra, 2004).The simple reason behind its prohibition lies in the objective of finance, in general, which isto promote growth and fair distribution of real resources. The financial sector works to servethe real sector of an economy which determines the ultimate value of prosperity and welfare.Riba, or interest, separates finance from real transactions.

An interest-based loan involves exchanging two counter-values which are identical, plus anadditional amount (i.e. interest) paid by the debtor to the creditor. It then follows that interestbecomes purely the cost of time, or the cost of pure finance. Pure debt creation is, however,less constrained than real wealth creation as the former takes only the agreement between twoparties postponing a due debt for additional interest. Consequently, growth of debt tends toexceed that of the real economy. With compounded interest, debt services grow much fasterthan real income, and will take an increasingly dominant share of it. Thus the real sector willbe servicing the financial sector, instead of the other way around. The economy obviouslycannot normally continue to grow, since interest-based debt, if not checked, threatens to absorbeconomic wealth through its unlimited growing services.

The devastating consequences of interest-based debt make it necessary to regulate financingfrom the beginning to avoid uncontrollable results. Islamic principles therefore make financean inseparable part of real activities. That is why there is no “pure financing” instrument inShariah. Islamic instruments have debt finance as an integrated component of real transactions,as in deferred sale and salam. As long as debt is integrated with real activities, there is noissue in taking time value and cost of finance into account. Such costs are controlled by realtransactions, and thus, debt cannot grow on its own.

The preceding discussion points to the difference between interest on lending and mark-upin credit sale. Interest is a self-replicating mechanism that makes debt grow and multiplymanifold independent of the real economy. As mentioned above, this eventually drains realresources, obviously to the benefit of lenders. Mark-up, on the other hand, is time valueintegrated into the real transaction. This eliminates the possibility of self-replication of debt.Time value as such is not the issue; rather it is the growth of debt independent of real wealththat threatens social welfare. By integrating time value with real transactions, this replicatingmechanism is eliminated.

The difference between integrated and separated debt is very much like the differencebetween a normal and a cancerous cell. A cancerous cell grows and multiplies in a disorderlyand uncontrollable way. It escapes the control mechanism that keeps cells growing in theirnormal and orderly manner (Buckman, 1997: 9). When debt evades control mechanisms, itgrows on its own, just as cancerous cells do. The control mechanism is what keeps cellssynchronized and integrated to perform normal body functions. Islamic regulations of debtrepresent the necessary control mechanism that keeps debt synchronized with the real economy.Interest allows debt to evade control, and thus becomes a threat to the economy.

The other pillar of prohibited dealings is gharar. In Arabic, gharar is risk but with delusionor deception. Whenever a transaction is more likely to lead to loss rather than gain, it isconsidered as gharar. The reason one would accept a high risk transaction is the size of theprize in case he wins. Hence the element of delusion in gharar. A special case of high risktransactions is zero-sum games, in which one party gains if, and only if, the other loses. Sincethe party who gains does so only at the expense of the other, it is a form of “eating wealth fornothing”, strictly prohibited in the Quran.

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In essence, gharar is trading of risk, while riba is trading of time. Time and risk, however,are two sides of the same coin. It is not surprising, therefore, that Shariah prohibits both.

As pointed out earlier, as long as a transaction is devoid of these two pillars of prohibiteddealings, the default position is that it is acceptable from the Shariah point of view.

18.3.3 Principle of Integration

The third principle of financial engineering is that of integration which signifies adoption of acomprehensive approach while developing a new financial product or modifying an existingone. In particular, this principle emphasizes the need for integrating the two sides of theeconomy, namely, the financial and the real sectors. Both riba and gharar work to disconnectsubjective preferences from objective wealth, whereby one applies to time preference, whilethe other applies to risk preference, as mentioned earlier. Since financial activities are motivatedmainly by these two types of preferences, riba and gharar decouple the financial sector fromthe real sector.

This decoupling leads to divergence of the financial sector from the real economy. Theseparation however is inconsistent with the nature of economic relations, and thus is notsustainable. This makes it increasingly costly to keep the two sectors apart. The rising costsof separation defeat its original purpose, namely efficiency and reduced transaction costs.Eventually, the real sector will pay much higher costs for separation than it costs to keep thetwo sectors integrated. The wisdom of Shariah, therefore, requires the integration between twosectors to achieve balanced and sustained economic growth. This is an essential principle indeveloping Islamic financial products.

18.3.3.1 Integration and Specialization

Integration can be seen as a constraint on economic behaviour, but it is a productive constraint.As explained in Elster (2000), not all constraints are inefficient. North (1990) elaborates onhow institutional constraints help reduce transaction and informational costs. Specialization,which drives economic progress, as economists recognized long ago, is a sort of self-constraintto improve productivity and discipline activities. Integration builds upon specialization at theinput level to synchronize the output of various sectors. As Milgrom and Roberts (1992) pointout, “specialization requires coordination” (p. 25).

Advocates of financial derivatives argue that separation of risk from underlying assets makesit more efficient to manage risk, since it is a form of specialization and division of labour. Butrisk is a purely mental construct, and thus cannot exist outside the human mind. Separationof risk therefore is an abstraction from reality rather than specialization. While specializationnaturally imposes greater discipline on economic behaviour, abstraction by design lifts mostboundaries and constraints that arise from the complexity of reality. Since abstraction is notsustainable, the real sector eventually pays most of the costs of the undisciplined behaviourresulting from abstraction. It is therefore necessary to assure the integration of the real andfinancial sectors from the beginning to avoid serious problems of coordination failure.

18.3.3.2 Evaluation of Financial Products

A direct implication of the principle of integration is that financial instruments involvingmoney-for-money transactions are unacceptable, if performed for profit. An acceptable

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transaction therefore must incorporate a real component, e.g. goods, utilities, or services.Although the real component is necessary for integration, it is not sufficient. In some casesgoods are used only for artificial integration. Legitimate contracts involving real goods orservices may be used in a manner that defeats the purpose of integration, namely, to createreal value. It is quite possible to combine acceptable contracts such that the final outcome ofthe combination is unacceptable. This is called hila (artifice) or hiyal (artifices). In artificesto circumvent usury, for example, real components are used for the purpose of lending.Real goods therefore are used to obtain financing, instead of financing used to facilitate realobjectives.

The problem of artifices arises from the tension between substance and form of financialarrangements. The solution is determined by what has precedence over the other and when. Itis useful to note, however, that this problem is not confined to Islamic jurisprudence. The sameproblem arose in the late nineteenth century in the West with respect to futures and options(Al-Suwailem, 2006, ch. 3). It arises now with respect to over-the-counter derivatives, as wellas accounting rules pertaining to such derivatives. Manipulation in both domains is common,as reflected in Enron and similar scandals (e.g. Partnoy, 2003). The manipulation hinges on thetension between the letter and the spirit of the law, between form and substance of the financialproduct. What makes Islamic jurisprudence different, however, is its moral dimension. Theintention of evading the commands of Allah (s.w.t) is considered a major sin, regardless ofwhether or not it could be proven in court.

There are theoretically two extremes with respect to the relation between form and substance:to consider either form only or substance only, and ignore the other. Both are Islamically notacceptable. Hiyal were unanimously condemned by the companions of the Prophet, peace beupon him. It is reported that no prominent Muslim scholar endorses all kinds of artifices. Thisimplies that form or means cannot have an absolute precedence over substance or ends. Onthe other hand, all scholars agree that good intentions are not enough for a certain transactionto get approved. It means that ends do not justify means. Accordingly, neither of the twoextremes is acceptable, nor in fact practical. Muslim scholars generally agree that theremust be a balance or consistency between form and substance. Thus, differences amongscholars in this regard can be attributed to differences in determining the degree of consistency,not regarding consistency in principle. This leads to the next principle of Islamic financialengineering.

18.3.4 Principle of Consistency

The last and fourth principle for developing innovative products for the Islamic financialindustry states that the form and the substance of Islamic products must be consistent with eachother; i.e. form should serve substance, and means should conform to ends. This principle relieson generally acceptable fiqh maxims, like “actions are based on objectives”, and “meaningssupersede letters”.

It is important to note that we start with substance, and then move to form. Both, substanceand form, are necessary for final approval of the product. Neither one, however, is sufficientalone for full approval, but substance has the priority. If substance is acceptable, then we haveto check if the form is also acceptable. If both are acceptable, the product is fully Shariah-compliant. However, if substance is not acceptable, then it does not help if the form is. The

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form is simply a means, and if that means is used to reach an illegitimate end, it is not legitimateany more.

If, on the other hand, the substance is acceptable, then it is very likely that there is a Shariah-compliant way to implement it. Shariah never prevents reaching a legitimate and beneficialobjective.

A good example to further clarify the relationship between form and substance is to comparepork with lamb or beef. Pork is categorically prohibited by the Quran, no matter how the pigwas killed, whether slaughtered properly or not. The means is not relevant if the end itselfis prohibited. Lamb, in contrast, is good in itself, so it has to be slaughtered properly to becompletely acceptable.

Obviously, not all animals are sheep, neither are all pigs. It is certainly possible that peoplewould differ according to whether a certain animal is a pig or a sheep. This difference wouldbe normally tolerated, as it is only humane to differ. Thus, in many instances we can viewdifferences amongst scholars regarding some artifices as differences regarding the type of“animal” rather than how it was processed.

A direct application of the above approach to financial transactions relates to two contem-porary financial products: murabaha on one hand, and einah, including organized tawarruq,on the other. Both are used for the purpose of financing, but murabaha requires the financier(bank) to purchase the good the customer requests, then sell it to the customer for a profit on adeferred payment basis. In einah and tawarruq, in contrast, the financier sells to the customer agood for a deferred price, then either buys it back in case of einah, or sells it on the customer’sbehalf in case of tawarruq. In both cases the last transaction is done for a cash price that issubsequently deposited in the customer’s account.

Now, in terms of substance, the objective of murabaha is to provide the good the customerneeds for a deferred price. The final result therefore is a standard sale. The objective ofeinah and (organized) tawarruq, on the other hand, is to provide liquidity. The customereventually gets cash in exchange for a debt of a larger magnitude. It therefore ends in puredebt financing. Obviously, in terms of substance, murabaha serves a legitimate objective,but einah and tawarruq simply serve the same objective of riba. Not surprisingly, therefore,murabaha is widely accepted, while organized tawarruq is highly controversial (the two mostprominent Fiqh academies in the Muslim world, that of the Muslim World League and of theOrganization of Islamic Conference, ruled out that organized and reverse tawarruq are notShariah-compliant).

Given that the objective of murabaha is legitimate, we have to be sure it is implementedproperly. The process must observe the detailed Shariah rules, for example, avoiding sellingwhat you do not possess or making profit without being liable for the underlying good. Oncethese rules are observed, the instrument is acceptable since it passes through both stages ofevaluation. For tawarruq or einah, it would not be acceptable, even if all detailed rules wereobserved, since the final result is not legitimate.

18.4 STRATEGIES FOR PRODUCT DEVELOPMENT

Product development is an integral part of every business organization today. Product de-velopment often forms the basis for moving forward in the markets with many competitiveplayers. Business organizations facing severe competitions, both financial and non-financialmarkets, continually engage themselves in the tedious job of product development in order toavoid becoming obsolete. Back in the 1980s, Tushman and Nadler said: “In today’s business

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environment, there is no executive task more vital and demanding than the sustained manage-ment of innovation and change [. . .] they must adopt innovation as a way of corporate life”(1986: 74). Kelly and Storey (2000) note that financial institutions like any other firms will alsoneed to be continually innovative and create new ideas and new products. And the businessworld now points to the fact that development of “successful new products are probably thesingle most important issue facing managers today” (Poolton and Ismail, 2000).

The literature on product development strategies in Islamic financial institutions is ratherscarce. Gainor (2000) makes an effort in this regard by offering some recommendations. Inparticular, he regards the customer value, expectation, and needs of the customer as importantissues to consider while ensuring profitability of new products. He suggests that new productsbe kept as simple as possible and emphasizes adding value rather than making a product lookcomplex to the customers.

The next step in our analysis on Islamic financial engineering is to examine differentstrategies and techniques for developing financial products. There are generally three strategies,depending on the starting point of the development process: (a) to start from conventionalproducts; (b) to start from Islamic products; (c) to start from the real needs of customers.

18.4.1 Imitation

The first strategy to engage in financial engineering within the Islamic financial frameworkis to have an existing conventional product (but, Islamically questionable) as a reference, andthen use available Islamic contracts to construct an equivalent product with almost identicalproperties. The strategy is also called “reverse engineering” (Iqbal, 1999). Examples include:

1. Replicating a conventional loan with interest through organized tawarruq or einah.2. Time deposits are replicated through reverse tawarruq.3. A financial call option is replicated through urbun.4. An interest rate swap is replicated through reciprocal tawarruq and reversed tawarruq, with

different mark-up structures, and so forth.

This strategy, or imitation, is probably the easiest for the purpose of developing products,since the target is already determined. Imitation might help particularly in the early stagesof development of the industry, but it has certain drawbacks that could affect the long-termgrowth of the industry. The main drawbacks are as follows. First, the strategy gives persistentprecedence of form over substance, and means over ends. Application of Islamic rules becomesa matter of passive and visionless observance of Shariah with little confidence in its economicvalue. Secondly, it renders the Islamic industry a follower by design of the conventionalindustry. Since it is based on replication and imitation, conventional industry will always bethe leader. This contradicts the essence of creativity and innovation, and thus the strategycannot belong to financial engineering in its true sense.

Thirdly, since imitation implies the same objectives for Islamic financial instruments asfor conventional ones, but with only the additional constraints of Shariah rulings, it followsthat Islamic instruments will always be inferior to their conventional counterparts. This is awell-known result in optimization theory where a binding constraint cannot improve the valueof the objective function. In particular, this inferiority arises because of taking the conventionalproduct as the objective function. The more natural approach is to take Shariah rules as givenconstraints, then derive an objective function for which the solution is optimal. That is, we

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should start from Shariah rules then arrive at the objective function, rather than going in theopposite direction.

Fourthly, conventional financial instruments are developed to solve the problems of theconventional finance industry. Replicating these products will make Islamic institutions sus-ceptible to the same problems which these products were developed to solve. In other words,the strategy will bring in new and alien problems to the industry. As these problems gettransmitted, the need for conventional products becomes stronger. This in turn necessitatesreplicating more products, which adds more problems, and so on. The cycle becomes self-feeding and the industry risks losing its identity in the process. Finally, in a healthy competitivemarket, imitation will lose its edge and its returns will diminish rapidly. The strategy thereforeis not sustainable.

18.4.2 Mutation

As opposed to the strategy of the imitation, the second strategy involves starting from someacceptable Islamic products and attempting different variations and modifications on them.Using the jargon of genetic algorithms (GA), existing products will be subjected to mutationsand cross-over, then using a selection criterion based on the degree of integration, for example,superior products are retained and poor ones are dropped. The process is repeated until furtherimprovements become minimal. Genetic algorithms are used for a wide range of applications,and can be effective in evolving desirable solutions for which traditional techniques fail (seefor example Mitchell, 1998; Holland, 1995; and Goldberg, 1989).

The strategy could generate an effectively infinite number of products. Given that theproducts in the beginning of the process are all Shariah-compliant, a substantial part of newlyevolved products would also be acceptable. It shows that the space of Islamic products is veryrich and open.

One example of mutation is istisna. Istisna is equivalent to a production or constructionagreement, in which the contractor is responsible for both material and labour in order todeliver the specified product. It is a kind of hybrid between a salam contract, in which thecounterparty is responsible for the material but not for labour, and an ijarah contract, in whichhe is responsible for labour but not material. However, the resulting contract has propertiesthat are different from those of either salam or ijarah.

Another example is value-based salam. In a classical salam contract a creditor pays theprice in advance for a specified quantity of a certain commodity to be delivered in the future.In value-based salam, in contrast, the future commodity is determined by value rather thanquantity. For example, an investor would pay $10 000 up-front for an amount of oil the valueof which at maturity is, say, $10 500. At maturity, the price of a barrel of oil is known fromthe market, and accordingly, the required number of oil barrels to be delivered is determinedby dividing the value by the price of a barrel. For example, if the price of a barrel at maturityis $80, then the required quantity is 10 000/80 = 125 barrels.

The product is a “mutation” of the salam contract in response to the price risk in classicalsalam. At maturity, the price might go up to $100, whereby the debtor of a classical salam willbe severely affected. Or it might drop to $40, whereby the creditor now takes the hit. Limitedprice fluctuations might be absorbed by the gains the two parties obtain. The creditor enjoysa price discount that might make up for a minor drop in price. The up-front liquidity wouldcompensate the debtor for a limited rise in price. But with large swings, the impact cannotnormally be absorbed, as was the case in Sudan.

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During the nineties salam was applied in Sudan for financing agricultural production. Butdue to highly uncertain price fluctuations, the authorities had to respond by developing “Ihsanformula”. This formula states that the debtor has to deliver the specified quantity as long asthe price at maturity is not greater than 33% of the expected price based on which the contractwas initiated. Beyond +33% the debtor has to deliver a quantity determined by value ratherthan the amount specified in the contract. For example, if the expected price at contract timewas $80, and the specified quantity was, say, 100 barrels of oil, then the debtor has to deliver100 barrels as long as the price of a barrel at maturity is less than 80 × 1.33 = $106.4. If itbecomes greater than or equal to $106.4, then the debtor has to deliver an amount equal to thevalue of 106.4 × 100 = $10 640, regardless of the prevailing price. So if the price at maturityis 150, then the debtor has to deliver 10 640/150 = 70.93 barrels. Further discussions andother economic applications of value-based salam can be found in Al-Suwailem (2006).

18.4.3 Satisfaction

The third strategy begins with the identification of the actual wants of customers, as opposedto the previous two strategies that start with pre-existing conventional or Islamic products.Identification of what the consumer wants requires a great deal of research that takes thefinancial institutions beyond their narrow objective of profit maximization. The results ofsuch research would bring about enormous opportunities for innovation and engineeringin the financial services industry by pushing out the horizon of its business. Identificationof consumer wants as an active impetus for developing products is the natural processof market evolution. Customers to a large extent determine the direction of the industry.Economic progress in fact can be measured by the ability of agents to satisfy their needs.Products, whether financial or physical, are means to satisfy such wants and needs. This ap-proach is also in line with the notion of the ends determining the means, and not the otherway around.

The strategy can be illustrated with the help of an example of a representative consumerwho needs to buy household furniture or appliances and approaches a bank to obtain a loan.Though the consumer asks for a loan, or more precisely, cash, this is not what she actuallywants. Money is only a means for performing economic transactions; thus the actual need ofthe consumer is the goods that he or she is seeking to obtain. In a conventional framework,the relationship between this consumer and the bank is focused on providing the cash,rather than the goods. As a result, conventional banks will engineer financial products thatcater for this purpose.

For Islamic finance, in contrast, the objective is to finance the actual need, which is the goodsor services the customer is looking for. This can be done through murabaha or leasing. With theadvancement of technology, the Islamic bank is able to purchase the goods electronically andhire the merchant to sell it on his behalf to the customer on a deferred price basis. Obviously,the bank would have arranged for these steps in advance so that it takes only a few momentsfor the whole process to be concluded.

In contrast to a loan, this “e-murabaha” product provides credit-on-demand: only whenthe actual need arises, does the customer obtain credit to facilitate his or her purchase. Giventhe objective of financing, Islamic finance is more efficient than interest-based lending, sincefinance is provided exactly for its purpose. Instead of first taking cash and then using it for thereal transaction, the real transaction is directly financed. This shows that Islamic finance canbe more efficient than conventional finance (see al-Jarhi, 2002).

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While the above structure is similar in many aspects to credit-card financing, there arecrucial differences. Given that Islamic finance strictly prohibits rescheduling and financecharges on past-due, Islamic finance in fact helps customers pay off their debt rather thanbeing submerged in ever deeper layers of debt. Hence, Islamic finance provides more efficientmeans of financing real needs, without the dangers of self-replicating debt that depletes theconsumers’ net worth.

If the customer needs the money to pay an existing debt, the same technique could beapplied to the creditor. The creditor, again, must use the money for real purposes. The bankwould be ready to finance the creditor’s needs using the customer’s money. Effectively, thebank would offer the creditor an e-murabaha card that will be paid off by the debtor. The cardwill be used only for financing goods and services, not for obtaining cash. Similarly, if thecustomer needs to finance a dowry for his bride, the bride can be offered an e-murabaha cardto finance her purchases.

Money is a veil, as classical economists argued long ago. This means that real transactionsare the actual objective of economic transactions. With the advancement of technology andelectronic money (see Shiller, 2003: 73–5 for more on this), we are approaching the “cashlesssociety” where money becomes a transparent layer revealing real transactions behind. Thiswill not only improve the integration of financial and real sectors, it will also make financingmore efficient with fewer transaction costs, while taking us closer to Shariah principles.

18.5 CHALLENGES IN FINANCIAL ENGINEERINGIN ISLAMIC FINANCE

18.5.1 Fragmented Approach to Shariah

Differences in opinion and interpretation of Islamic injunctions relating to economic andfinancial transactions might hinder the orderly progress of the Islamic financial industry. Butif these differences are treated within the generally agreed upon principles, it provides afertile environment for innovation and creativity. These differences can be properly viewed asdiversity in application of Shariah goals and major principles, rather than inconsistencies andcontradictions. Unfortunately, the absence of this dimension, and the objectives and maquasedal-Shariah, raises the risk of fragmentation of Shariah injunctions, leading to improper andfragile development of the industry.

It is very likely that Shariah Boards in different regions of the Islamic world would differon the permissibility of the same product. This need not be a problem as such unless thesedifferences become commercialized, and shareholders start pressing their Boards to followthe least restrictive fatwa. In this environment, Gresham’s Law applies: less restrictive fatwasdrive out more restrictive ones.

Without taking the objectives of Shariah into consideration in issuing fatwas, these differ-ences intensify the effect of Gresham’s Law, and thus might lead to degeneration of the Islamicindustry into a shallow cover of conventional banking.

This makes the responsibility of a financial engineer more critical and challenging: theengineer must be able to differentiate between those products that are in direct oppositionto objectives of Shariah and those that are not. This requires a sound knowledge of Shariahrulings and principles. Developing products that do not violate objectives of Shariah mightappear more restrictive, but it is more creative and fruitful.

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18.5.2 Product Development Process in Islamic Financial Institutions

A second important challenge is the absence of a systematic and well-defined process inIslamic financial institutions for developing new products. More frequently than not, newproducts are introduced by imitation of either other Islamic banks or, worse, conventionalbanks. Unfortunately, in many cases major conventional banks take the lead in developingIslamic products. Since the environment in such institutions is not Islamic by design, theseproducts very likely become superficial accommodations of conventional products ratherthan genuine value-adding products. Since these big banks are major players in internationalmarkets, they effectively become the leaders of the Islamic financial industry.

While the involvement of international banks is very welcome in the Islamic financialarena, Islamic products must be designed following the rules and logic of Islamic finance, notconventional finance. Playing Islamic finance using conventional rules of the game is a losingstrategy for both conventional and Islamic banks.

18.5.3 Specialized Institutions and Advanced Markets

While we emphasize the need for new products in the Islamic financial industry, it is importantto realize that products do not operate in vacuum; they are implemented by institutions. Thestructure of the institution to a large extent decides the set of products relevant to its activitiesand objectives. For example, pure equity investment is more suitable to venture capital andinvestment banks than to commercial banks. The existence and development of specializedinstitutions, such as venture capital, mutual funds, leasing companies, etc., not only make theindustry more diversified, but also allow for more creative and innovative products. This inturn makes the industry more resilient and productive, and speeds up the rate of growth by anorder of magnitude.

18.6 CONCLUDING REMARKS

Academics as well as practitioners recognize the need for product development within Islamicfinance. The necessity for new product development can hardly be overemphasized. This is alsotrue for the Islamic financial services industry. This section outlined the basic idea of financialinnovation and engineering with its particular implication for institutions that offer Islamicfinancial services. The main reasoning of this analysis is that financial engineering in Islamicfinance has to be in accordance with the tenets of Shariah. In this chapter, some principles forfinancial engineering have been defined and relevant strategies have been developed.

The Islamic finance industry however needs to review the currently available applied strate-gies for product development to take full advantage of the potential efficiency of the Islamicfinancial system that aims at the integration of the financial and the sector of an economy.

NOTE

1. This chapter draws heavily from Al-Suwailem’s (2006) paper on Hedging in IslamicFinance.

REFERENCES

al-Jarhi, M. (2002) Transactions in conventional and Islamic economies in H. Ahmed (ed.), TheoreticalFoundations of Islamic Economics, Islamic Research and Training Institute: Jeddah, Saudi Arabia.

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al-Suwailem, S. (2006) Hedging in Islamic Finance, Islamic Development Bank: Jeddah.Buckman, R. (1997) What You Really Need to Know about Cancer, Johns Hopkins University Press.Chapra, M.U. (2004) The Case Against Interest presented at the International Conference on Islamic

Banking and Finance, Brunei, 5–7 January.Covey, S. (1990) The Seven Habits of Highly Effective People, Simon and Schuster.de Bono, E. (1970) Lateral Thinking: Creativity Step by Step, Harper & Row, Publishers.Devlin, J.F. (1995) Technology and innovation in retail banking distribution. International Journal of

Bank Marketing, 13(4), 19–25.Drucker, P. (1999) Innovate or die, The Economist, 23 September.Elster, J. (2000) Ulysses Unbound: Studies in Rationality, Precommitment, and Constraints, Cambridge

University Press.Finnerty, J. (1988) Financial engineering in corporate finance: an overview, Financial Management, 17,

14–33.Finnerty, J. (1994) Financial engineering in P. Newman, M. Milgate, and J. Eatwell (eds), New Palgrave

Dictionary of Money and Finance, McMillan Press, vol. 2, pp. 56–63.Gainor, T. (2000) A Practical Approach to Product Development, Paper, Fourth Harvard University

Forum on Islamic Finance, 30 September–1 October 2000.Gigerenzer, G., Tedd, P. and the ABC Research Group (1999) Simple Heuristics that Make Us Smart,

Oxford University Press.Gintis, H., Bowles, S., Boyd, R. and Fehr, E. (eds) (2005) Moral Sentiments and Material Incentives:

The Foundations of Cooperation in Economic Life, MIT Press.Goldberg, D. (1989) Genetic Algorithms in Search, Optimization, and Machine Learning, Addison-

Wesley.Holland, J. (1995) Hidden Order: How Adaptation Builds Complexity, Basic Books.Iqbal, Z. (1999) Financial engineering in Islamic finance, Thunderbird International Business Review,

41, pp. 541–59.Kelly, D. and Storey, C. (2000) New Service Development: Initiation Strategies. International Journal

of Service Industry Management, 11(1) 45–62.Leathers, C. and Raines, J.P. (2004) The Schumpeterian role of financial innovations in the new economy’s

business cycle, Cambridge Journal of Economics, 28, 667–81.Marshall, J. and Bansal, V. (1992) Financial Engineering, New York Institute of Finance.Mason, S., Merton, R., Perold, A. and Tufano, P. (1995) Cases in Financial Engineering, Prentice Hall.Merton, R. (1992) Financial innovation and economic performance, Journal of Applied Corporate

Finance, 4, 12–22.Milgrom, P. and Roberts, J. (1992) Economics, Organization & Management, Prentice Hall.Miller, M. (1986) Financial innovations: the last twenty years and the next, Journal of Financial and

Quantitative Analysis, 21, 459–71.Mitchell, M. (1998) An Introduction to Genetic Algorithms, MIT Press.North, D. (1990) Institutions, Institutional Change, and Economic Performance, Cambridge University

Press.Partnoy, F. (1997) Financial Derivatives and the Costs of Regulatory Arbitrage, Journal of Corporation

Law, 22, 211–27.Partnoy, F. (2003) Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, Henry Holt

and Company.Poolton, J., and Ismail, H. (2000) New developments in innovation, Journal of Managerial Psychology,

15(8), 795–811Prajogo, D.I., and Sohal, A.S. (2001) TQM and Innovation: a Literature Review and Research Framework,

Technovation 21, pp. 539–558Shiller, R. (2003) The New Financial Order: Risk in the 21st Century, Princeton University Press.Silber, W. (1983) The process of financial innovation, American Economic Review, 73, 89–95.Sobel, J. (2005) Interdependent preferences and reciprocity, Journal of Economic Literature, 43, 392–436.Tushman, M. and Nadler, D. (1986) Organizing for Innovation, California Management Review,

28(3 Spring), 74–92.

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19

Shariah-compliant PortfolioManagement: Processes, Methodologies,

and Performances

Shehab Marzban1

19.1 INTRODUCTION

Islamic finance is currently witnessing a huge momentum in the global financial marketstriggered by the growing Muslim population and their demand to invest their capital in financialproducts that do not conflict with the Shariah. The Islamic fund and wealth managementindustry specifically is growing rapidly in terms of number of funds launched or portfoliosmanaged as well as the value of assets under management. According to Ernst & Young,global Islamic funds reached about 700 funds with assets under management exceeding aboutUS$44 billion. Similar numbers were reported by Booz & Co. who state that the numberof Islamic funds is growing annually by about 30% – which of course slowed down duringthe recent financial crisis. This growth is not only witnessed in Muslim dominated countriessuch as the GCC countries or Malaysia but even extended to offerings in Western countriessuch as the US, UK, and Germany. Asset management firms in the West either offer theseservices to the Muslim communities residing in these countries, or as is most common, toattract and manage GCC wealth.

Asset managers are keen to do one thing for their investors – generate alpha. The Islamicinvestor on the other hand is keen to receive alpha constrained by his religious beliefs – theShariah. Generally asset managers would be Shariah illiterate and thus Shariah requirementsjust represent an additional set of limiting rules they have to follow while selecting theirinvestments, similar to the legal guidelines or internal investment guidelines followed.

Due to the multi-disciplinary and multi-stakeholder nature of Islamic finance and the fact thatthe industry is still young and characterized by a dynamic change of processes and guidelines,appropriate procedures and systems have to be defined to support the financial needs of assetmanagers as well as the Shariah requirements of the governing Shariah scholars.

This book attempts to connect the asset management world with the Shariah world throughintroducing clear and standardized processes and methodologies as well as surveying currentpractices to ensure that investments really adhere to Shariah requirements as intended ratherthan just being labelled as being Shariah-compliant.


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19.2 SHARIAH-COMPLIANT PORTFOLIOMANAGEMENT PROCESS

Fund management is generally about generating alpha. So, ideally there is no differencebetween a Shariah-compliant fund and a conventional fund except that a smaller asset universeis available to the fund managers.

But the task of ensuring that a fund is managed in a Shariah-compliant manner goes beyondstatic compliant lists and spreadsheets used to automatically screen potential investments usingdata retrieved from conventional data providers. Unfortunately a large number of Islamic fundsare managed in this manner while valid Shariah compliance goes far beyond these simple pro-cedures. Shariah compliance is about providing fund managers with credible Shariah advisory,data, and screening services, purification, and ongoing compliance monitoring capabilities.

Investment trusts which are willing to offer Shariah-compliant investment products haveto extend their conventional portfolio management processes by a set of Shariah-relatedconcepts so that the entire investment process operates in a Shariah-compliant manner. Figure19.1 summarizes how the different stages in the portfolio management process are extendedby Shariah-specific or Islamic issues.

19.2.1 Shariah Issues in Investment Policy Analysis

Within investment policy analysis a crucial aspect is to determine the Shariah requirementsor perceptions of the investors. The investment policy analysis includes identifying investors’

Investment Policy Analysis

Portfolio ConstructionPerformance AnalysisAnd Portfolio Revision

Conventional

Conventional

Conventional

Requirement analysis

Portfolio implementation

Portfolio optimization/strategy

Performance measurement

Purification reportingCompliance reportingViolation reporting

Feasibility compliance

Return/riskConstraints

Investment strategy selectionBenchmark selection

ConventionalAsset universe definitionQuantitative measures for riskand return

Islamic Considerations

Islamic ConsiderationsIslamic Considerations

Financial Analysis

Planning Implementation Controlling

Defining Shariah ruling source

Shariah-compliance checkingConsidering purification losses

Defining screening providerDefining Islamic benchmark

Islamic ConsiderationsShariah-compliance proceduresQuantification of purificationCompliance sustainability

Figure 19.1 Shariah-compliant portfolio management process

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Shariah-compliant Portfolio Management: Processes, Methodologies, and Performances 403

preferences and requirements, which also requires analysing the investors’ perceptions aboutShariah issues and which Islamic school of thought to follow.

It is worth mentioning here that in the case of managed accounts it might occur that the clienthas his own Shariah Board, as it is frequently the case with GCC clients, and thus would providethe asset manager with the Shariah guidelines to follow or would for instance suggest the usageof a commonly used Shariah mandate defined by an accredited Islamic governing institutionsuch as AAOIFI.2 Market insight reveals that several asset management firms manage theportfolios for different institutions or high net worth individuals using client-specific Shariahmandates or guidelines.

In the case of launching a public fund a Shariah Board has to be appointed which defines theShariah guidelines to follow and periodically checks that investment practices and portfolioholdings adhere to the guidelines they have defined (DeLorenzo, 2000). The selection of theShariah Board members is one of the most important decisions to take while planning thelaunch of the fund. The reason is that different schools of thought exist across the Muslimworld which can also be noted through the diversity of Shariah guidelines defined. Shariahguidelines defined by Malaysian scholars might be considered too liberal for GCC investorswhereas Pakistani or Indian Shariah scholars define different Shariah guidelines to thosedefined by GCC Shariah scholars for instance. Therefore the target investment group shoulddictate the appropriate Shariah Board. A German fund for instance should appoint a ShariahBoard which contains, but must not be limited to, scholars from Germany and Turkey to ensurethat German Muslims who predominantly originate from Turkey can identify themselves withthe offered product. The same applies to a Western fund targeting GCC or especially SaudiArabian investors. In that case it would be wise to appoint a Shariah Board well known inSaudi for its credibility and opinions.

Then, after the Shariah ruling source has been identified the trust should provide theseinvestors with the appropriate mechanism to ensure that investments are conducted in accord-ance with the prescribed Shariah guidelines. This can be done through selecting an appropriateShariah screening provider that would provide tools or means to identify the subset of invest-ments which would be considered Shariah-compliant. Shariah screening can be done eitherthrough the use of Islamic indices or relying on a customizable Shariah screening system.Using a screening system encompassing the diverse Shariah guidelines defined by differentShariah scholars has a number of advantages.

◦ Tailored funds. The investment trust is capable of providing different products fordifferent Islamic investor groups. The perception of Islamic investors from Arab countriesdiffers from that of Muslims from Pakistan and India or from South East Asia for instance.Thus, the use of a screening system facilitates the management of multiple managed accountswith different Shariah perceptions.

◦ Independence from index provider. The use of Islamic indices is advantageous inthat it provides you both with an asset universe and a performance benchmark. The majorproblem with Islamic indices is that the index is constructed using a specific Shariah mandatewhich might differ from the one your client or Shariah Board has imposed on your funds.Another disadvantage is that indices might not cover your entire requirements – for examplethe limited asset universe means that there might be equities of interest which are not part ofthe index. Another issue with indices is that they change their constituents over time based oncriteria independent from Shariah issues such as minimum market capitalization or liquidity

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requirements. Compliant equities might be removed from an index and thus the asset managerloses track as to whether his holdings are still compliant or not. Using a flexible screeningsystem enables trust funds to check the compliance of an asset they want to include in theirasset universe and to remain unaffected by non-Shariah related index revisions.

Finally, an adequate benchmark needs to be determined in order to evaluate the asset managerperformance. Benchmarks used could be a conventional index, an Islamic index provided byindex providers, or a customized Islamic index where the index is constructed using the sameShariah requirements as the ones used to evaluate compliance for the managed portfolio. Usinga conventional index might be misleading due to the fact that the conventional index includesfor instance equities from the financial sector which are not eligible for investment for theShariah-compliant managed portfolio. Therefore the best choice would be to benchmark thefund to a customized index which is determined using the same Shariah guidelines used toscreen the fund positions.

19.2.2 Shariah Issues in Financial Analysis

The investment policy statement defined in the policy analysis is used as input to further analyseand identify the appropriate investment strategy and to explore potential asset classes and assetsto be considered for investment. The financial analysis phase has to be extended to analysethe effect of the Shariah guidelines on the asset universe, expected risk and performance,as well as the compliance sustainability of the investments. Based on recent research usingdifferent Shariah mandates, about 30% to 35% of the global asset universe would be consideredShariah-compliant. Asset managers have to analyse their portfolio strategies and their expectedreturns and risks based on this limited asset universe. Since the Shariah guidelines are basedon financial figures which change over time, an equity which is Shariah-compliant todaymight turn non-compliant in the near future and therefore asset managers should be able toassess the probability or risk of an equity to turn non-compliant so that they are not facedwith a forced liquidation due to a sudden compliance change. Finally, purification which is aprocess of cleansing your investments from any non-compliant portions should be analysed andaccounted for by the managers to calculate net expected returns after purification. Purificationwill be discussed in more depth in the Shariah screening section.

19.2.3 Shariah Issues in Portfolio Construction

Based on the definition and analysis reached in the planning phase both the conventionalportfolio requirements (objectives, legal and internal guidelines for instance) and the Shariahrequirements are to be considered within the portfolio construction process. Once the portfoliosare implemented an ongoing Shariah compliance check needs to be run to ensure that holdingshave not not changed compliance. In the case where holdings do change compliance theasset manager is granted a predefined time window within which he has to liquidate theseshares. Based on the Shariah mandate followed, this time window might range from immediateliquidation up to a period of 90 days.

Since Shariah investments have to adhere to local laws, legal requirements might enforcestructuring investment processes differently from one country to another. A good example ofthis is the purification of investments. In the GCC for instance dividends can be accountedto the fund and on a periodic basis (for instance quarterly) can be purified from the impureportion and be donated. In the West this might be a problem due to taxation issues whereas if

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the total dividends are pooled into the fund, it will be complicated to purify these dividendswithout taxing the impure amount and to deduct these amounts from the fund wealth. Toovercome this problem, a Luxemburg-based fund for instance calculates purification amountsonce dividends are received and before pooling these dividends into the fund and thus is ableto deduct these non-compliant portions immediately. Another approach followed in Westerncountries is not to purify dividends directly and instead to report to the investors the amountsthey have to purify in order to consider their investments purely Shariah-compliant.

19.2.4 Shariah Issues in Performance Analysis and Portfolio Revision

Shariah compliance is dynamic in nature and therefore with the availability of newly publishedfinancial information, an investment may turn from compliant to non-compliant. Thereforeexactly as is the case with conventional guidelines, the Shariah feasibility of the portfolio is nota constant and has to be frequently checked and the portfolio has to be rebalanced if compliancedoes not hold any more. A compliance report should be generated that reflects the compliancestatus of the portfolio as well as the reason of non-compliance if non-compliant equities areheld. It is also important from a Shariah perspective to generate violation reports through whichthe Shariah governing authority can investigate whether non-compliant holdings exceeded theallowed liquidation time window. Another relevant Shariah issue is the periodic reportingof purification amounts to investors as described above, to finalize the Shariah compliancerequirements of the proposed Shariah-compliant portfolio management process.

19.3 SHARIAH GUIDELINES

An investment trust that offers Shariah-compliant products contractually ensures that theentire investment process and the assets of the underlying companies in which the trustinvests comply with Shariah. The Shariah is the legal framework governing the practicesand activities of Muslims. Such practices can be classified into ibadat and muamalat. Ibadatrefers to the relationship between mankind and God whereas muamalat encompasses activitiesbetween people in terms of social, economic, and political activities. Such economic activitiesinclude of course banking and financial activities in which Muslims are involved. Therefore aninvestment can only be considered Shariah-compliant and accessible to Islamic investors if itdoes not conflict with the muamalat principles defined by the Shariah. The main requirementsof Shariah-compliant investments are to be free from riba, gharar, and quimar and maysir.

19.3.1 Shariah Compliance of Asset Classes

The Arabic word riba means usury or excess return and is considered by most scholars to beequivalent to interest rates. Since in Islam excess return such as interest without bearing riskis not halal, Islamic investors are generally not allowed to earn or pay interest.

Therefore interest-based assets such as conventional interest-based bonds are definitely notcompliant under Shariah. Here it is important to note that the riba ban also impacts a subset oftraded shares which are preferred shares giving a promised or minimum fixed dividend for theirshareholders. So, preferred shares that give a preference in the form of an insured fixed incomewould have to be considered non-compliant whereas it is worth mentioning here that a largenumber of Shariah mandates do not address this issue. The AAOFI Standards even go beyondthat and ban investment in any preferred shares since preferred shareholders should not be

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given liquidation priority over common shareholders for instance. Another consideration assetmanagers have to take care of is not to have excess cash amounts placed in interest-bearingaccounts.

Another main concept impacting the compliance of asset classes is gharar which refers tohigh or excessive uncertainty which is attributable to speculative activities. Since conventionalderivative instruments are highly speculative in nature they are also considered by most Shariahscholars as being non-compliant. Since every business transaction involves an element ofrisk and uncertainty, Islam differentiates between uninformed speculation (gharar) whichis comparable to quimar and maysir (Arabic words for gambling and games of chance)and business transactions where the uncertainty is minimized through in-depth analysis ofthe risks faced. Since the gharar, quimar, and maysir characteristics can be attributed toconventional derivative instruments (such as options and future contracts) which are highlyspeculative in nature they are also to be considered non-compliant under Shariah laws per se(Ketell, 2008).

The possibility to invest in different asset classes provides investment trusts with diversi-fication and hedging opportunities affecting the overall risk exposure of the portfolio. Equityinvestments are considered generally by Shariah scholars to be a Shariah-compliant assetclass since they present a partnership in a company where the investor shares both profits andlosses whereas other asset classes such as bonds and derivatives are considered non-compliantdue to the existence of elements of riba, gharar, quimar, and maysir. To overcome thisproblem, Shariah scholars worked together with financial institutions to analyse how to over-come the riba, gharar, quimar, and maysir characteristics found in conventional interest andspeculation-based financial instruments such as bonds, options, futures, forwards, and swaps.Using specific Shariah jurisdictions and compliant contract types some of these conventionalproducts were restructured to adhere to the Shariah using specific jurisdictions and compliantcontract types. An example for a conventional financial instrument that has been restructuredto adhere to Shariah is an Islamic bond or sukuk. Sukuks are asset-backed securities wherethe sukuk holders lease the asset to receive a halal return instead of yielding haram interest aswith conventional bonds.

Irrespective of the compliance of the asset classes (such as equities, bonds, or derivatives)another condition which has to be fulfilled is that the business activities and financial operationsof the company issuing the assets do not contradict with Shariah. Thus, the issuing companyitself has to be operating in a Shariah-compliant manner, i.e. the company has to be free of,or have limited involvement in, practices related to riba and gharar for instance. The readermight question why the wording “limited” and not just “free” of non-compliant practices isused. The wording “limited” represents a relaxation of the puristic application of the riba ban(as stated in the Holy Quran) and a tribute paid to today’s complex financial world in which itis almost impossible to find any company that is not involved in any interest payments due tothe existence of cash deposits, loans, or credits with the consequence that if Islamic scholarsare extremely dogmatic and intolerant, Muslim investors would not be allowed to participatein the capital market at all (Wilson, 2004). Instead, Shariah scholars use the different sourcesof Shariah to further interpret such situations resulting in the definition of thresholds whichlimit the amount of riba acceptable from an Islamic perspective as well as instructions onhow to purify these non-compliant earnings portions. The rationale for using thresholds isderived from the fact that in general Islamic investors are only minority shareholders in thesecompanies without voting power to force the company to operate in a completely Shariah-compliant manner.

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Another essential requirement is that companies considered for investment are not involvedin business activities contradicting the ibadat principles of the Islamic investor. Since Muslimsare for instance not allowed to consume or sell alcohol, gamble, or provide gambling facilitiesthe companies considered for investment should not be involved in such practices.

Since the Shariah-compliance status of asset classes is mainly agreed upon and resolvedthrough categorizing asset classes either as being compliant (such as equities or restructuredconventional bonds or sukuks) or non-compliant (such as conventional bonds), in the followingwe will focus on identifying and validating the Shariah compliance status of the underlyingcompanies within one compliant asset class, i.e. equities. To decide upon the compliance of aspecific company experienced Shariah scholars define rules or screening guidelines with whichthe involvement in non-compliant financial practices and business activities can be quantified.

19.3.2 Shariah Screening

Shariah screening is about identifying whether companies are involved in Shariah non-compliant activities – such as the sale of pork or alcohol – and financial activities. Thisenables the exclusion of business whose primary business activity does not comply with theShariah, such as conventional banks, bars, and casinos. Financial screens, on the other hand,measure businesses’ involvement in Shariah non-compliant activities, such as interest earningsand debt financing. Unfortunately, non-compliant activities screening is frequently carried outacross the industry using industry classification codes which only indicate the major busi-ness activity of the company. Accurate screening is about translating the verbal requirementsdefined by the respective Shariah governing body into practice as intended. This can only beachieved by following a research-based screening approach rather than simplifying processesusing automated screening or spreadsheets based on conventional data which would resultin less credibility because compliant companies might be classified as being non-compliantand vice versa. Highly leveraged companies are normally non-complaint. But this cannot bea generalized rule because a lot of debt raised in Islamic countries is Shariah-compliant innature (such as sukuks) and should be considered compliant. But, due to the fact that conven-tional data providers do not distinguish between interest-bearing and Shariah-compliant debt,this company would be deemed non-compliant if not researched in depth. On the contrary,clothing and accessories companies are generally considered by automated screening servicesas compliant from a business perspective. But if companies like Christian Dior are researchedin depth these companies would have to be considered non-compliant due to the large revenuethey generate from the sale of luxurious alcoholic spirits. By using a research-based approachcompared to automated screening on the GCC asset universe, a larger asset universe andincreased compliance credibility is achieved. The asset universe is almost doubled and this ismainly attributable to the fact of identifying companies that operate according to Shariah andwhose debt structure as well as investments comply with the Shariah and are not generallyconsidered non-compliant.

Generally, different rulebooks can be found across the industry which may result in differentasset universe sizes and constituents. The main distinction between the different rulebooks isthe use of either total assets or market capitalization as a base to value a company and to use asthe denominator for the different financial ratios (see Table 19.1). It is worth mentioning herethat the stated rulebooks are only applicable using a research-based screening approach sincefinancials are screened based on interest-bearing debt instead of total debt and companies arescreened based on their detailed sources of revenue instead of using broad sector categorization.

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Table 19.1 Common Shariah mandates

Asset-based rulebook3 Market cap-based rulebook4

Non-permissible income/total income < 5% Non-permissible income/total income < 5%Interest-bearing cash and investments/

Assets < 33%Interest-bearing cash and investments/12-month

average market capitalization < 33%Receivables/assets < 33% Receivables/12-month average market

capitalization < 33%Interest-bearing debt/assets < 33% Interest-bearing debt/12-month average market

capitalization < 33%

Other varieties of the above-mentioned rulebooks can be found across the industry suchas using a combined cash and receivables ratio or including non-operating interest as part ofnon-permissible income.5

Some additional screening alternatives have emerged such as:

◦ Using 24-month or 36-month average market capitalization as divisor:6 Due to thecurrent crisis and the fact that price fluctuations are much more a result of general marketconditions and risks rather than being attributable to the real value of listed companies, somescholars as well as index providers approved smoothing out the crisis effect by using 24-monthor 36-month average market capitalization instead of the commonly used 12-month averagemarket capitalization.

◦ The use of maximum of total assets and average market capitalization:7 Anotherapproach is based on using the maximum of total assets and average market capitalizationto value a company, in order to be able to reflect the real or intrinsic value of the respectivecompany. Taking the information technology sector as an example, market capitalization isgenerally a better estimate than total assets as divisor since total assets do not capture the valueof intellectual property, brand value, employees, management, or projects in the pipeline.However, since these are the factors considered by investors in valuing such companies, theirreal value is reflected in their market price and thus market capitalization. By contrast, largeindustrial companies such as in the petrochemical sector might during a financial crisis have alow market capitalization whereas their total asset value stays stable and reflects the companyvalue more appropriately.

A good example is a company like AT&T (see Figure 19.2) which is consistently compliantusing total assets whereas it had been compliant using 12-month average market capitalizationuntil July 2008 and afterwards exceeded the 33% debt to market capitalization threshold.

So using market capitalization AT&T would be non-compliant whereas if total assets ormaximum is used the AT&T would be part of a compliant asset universe.

This shows that depending on each company market capitalization or total assets would bea better measure to value a company.

Finally, Derigs and Marzban (2009) proposed another approach: to use sector-specificdivisors so that, based on the sector in which the company operates, total assets or marketcapitalization is used.

Using a professional Shariah screening service8 an asset universe containing the top 5000global market capitalization companies is screened based on the AAOIFI Shariah mandatewith varying divisors and analysed as shown in Table 19.2.

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Debt Ration of AT&T in 2008–200960%

50%

40%12-month

Threshold

36-month

Total AssetsDeb

t Rat

io

30%

20%

10%

0%

2008

-Jan

2008

-May

2009

-May

2009

-Jan

2009

-Mar

2008

-Nov

2009

-Nov

2008

-Sep

2009

-Sep

2008

-Jul

2009

-Jul

2008

-Mar

Figure 19.2 Debt ratio movements of AT&T in 2008 to 20099

As can be noted, the compliant asset universe using the maximum of assets and 12-monthaverage market capitalization as divisor results in the largest compliant universe compared tousing the total assets or market capitalization figures separately. Using total assets as divisorresults in having the second largest compliant universe. This is attributable to the fact thatduring the financial crisis market capitalizations were highly affected and went down comparedto more robust total asset figures. About 200 companies from the industrial, oil and gas, andutilities sectors would pass using total assets and fail using market capitalization-based divisorsdue to their heavy asset base on their balance sheet. By contrast, about 100 technology andhealth care companies would pass using the market capitalization-based divisors and fail usingtotal assets due to the off-balance sheet elements such as intellectual property or pharmaceuticalprojects in the pipeline which are valued by the market participants.

The analysis in Table 19.3 reflects that it is not only about an increase or decrease in theasset universe size but also the constituents differ. So comparing the asset universe deducedusing total assets compared to 12-month average market capitalization it can be noted that28.44% of the total universe would be compliant and 51.14% would be non-compliant using

Table 19.2 Compliant asset universe by sector

Equities passing using following divisor

Sector Universe Maximum Assets 36-month 12-month

Basic Materials 540 379 315 300 300Consumer Goods 570 347 294 250 243Consumer Services 557 193 164 145 142Financials 1091 106 94 75 73Health Care 277 224 169 202 206Industrials 897 551 493 396 376Oil & Gas 325 217 201 161 161Technology 319 227 152 194 184Telecommunications 148 78 70 63 55Utilities 276 123 112 67 61

Totals 5000 2445 2064 1853 1801

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Table 19.3 Compliance inconsistencies

Asset universe Total assets

12-month market cap Complaint Non-compliant Total

Compliant 28.44% 12.84% 41.28%Non-compliant 7.58% 51.14% 58.72%Total 36.02% 63.98% 100.00%

either one of the two divisors. But there is a total of about 20% of the asset universe whichwould be compliant using one of the divisors and non-compliant using the other one andvice versa. This number is really significant and experienced asset managers would analysethe quality of equities to be added to the compliant universe using each of the respectivedivisors.

A very good example to mention here is SABIC (Saudi Basic Materials) a petrochemicaltitan in the Saudi Arabian market. Using total assets the company’s debt ratio is at 28% aclear pass based on the 33% debt ratio threshold. Whereas the same company, if 12-monthaverage market capitalization is used, would have a debt ratio of 34% which slightly exceedsthe threshold and fails.

19.3.3 Purification

The use of financial screens as previously mentioned is a clear relaxation of the absolute banon generating earnings from interest or any other Shariah non-compliant activities. Since thisrelaxation is established to enable Islamic investors to participate in capital markets and isgenerally not compliant with Shariah, the fraction of earnings generated from non-permissibleactivities needs to be cleansed and deducted from investors’ returns so that this relaxationis only of a temporary nature and corrected through purification. Only after investments arepurified from non-compliant earnings are they referred to as being Shariah-compliant. Shariahforbids Islamic investors to take any advantage from the non-permissible income that is to bepurified. Therefore Islamic investors are not allowed to use the purified amounts for any taxbenefits or to account it as Zakat, which is the Islamic obligation to donate a certain fractionof their wealth annually to the poor as stated in the Holy Quran.

A major problem with purification is the exact quantification of non-compliant income.Interest earnings on the one hand are in most cases identifiable through the detailed financialstatements published by the companies. But, on the other hand the identification of the portionof earnings generated by non-compliant activities such as the sale of alcohol or pork productsis a highly complex task requiring in-depth manual research and not just screening companieson a sector level.

The lack of standardization found in Shariah screening can also be recognized in purificationpractices recommended by different Shariah scholars. Purification in itself, a practice thatcorrects temporary Shariah relaxations, is not debated by the scholars. The main reasonbehind discrepancies between Shariah scholars with respect to purification is attributable tothe argumentation used in defining from which investment return the non-permissible incomeis to be deducted.

The main purification practices found are dividend purification and investment purification.

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19.3.3.1 Dividend Purification

In the case of dividend purification the calculation is done as follows:

1. Identify the amounts of dividends paid out.2. Define the percentage of non-compliant income as a portion of total income.3. Multiply these dividends per share by the non-compliant income percentage and by the

number of shares you are holding.4. Repeat this process for all your portfolio holdings and sum them up to get the total portfolio

purification value.

It actually sounds straightforward but in reality it is not. Asset managers and Shariah officersknow that purification is really complex to achieve due to multiple factors such as identifyingthe non-compliant portions and handling special cases such as how to handle dividends paidout during a non-compliance status. As mentioned before asset management firms shouldfocus on one thing and that is generating alpha. Therefore the identification of non-compliantportions as well as supporting the complex processes should be effected through professionalShariah screening services.

Most Shariah mandates would follow a dividend purification approach as defined by theirrespective Shariah Boards. Marzban (2009) considered the dividend purification approach tobe only suitable to use for companies that pay out all their net income as dividends whichactually is not commonly the case especially with growth companies. The problem with growthcompanies is that they retain their income and reinvest it to grow which indirectly over timemight increase the market value of the company and thus benefit the investor. So if a companyhas a non-compliant income representing 4% of its total income and the company did not payout any dividends, then 4% of its reinvested income is coming from a non-compliant sourcewhich would not be purified by the investor based on the dividend purification approach.

19.3.3.2 Investment Purification

In the case of investment purification, non-compliant income is purified irrespective of whetherthe company makes profits or not and pays dividends or not (Elgari, 2000).

In the case of investment purification the calculation is done as follows:

1. Identify the total common shares of the company.2. Define the non-compliant income per share through dividing the non-compliant income by

the total common shares outstanding.3. Multiply the non-compliant income per share by the number of shares you are holding.4. Repeat this process for all your portfolio holdings and sum them up to get the total portfolio

purification value.

Investment purification is a conservative purification practice followed by some majorfinancial institutions in the GCC as well as being defined as the purification practice to followby AAOIFI.

19.3.3.3 An Illustrative Example

Consider the following hypothetical example in Table 19.4:

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Table 19.4 Purification: example

Stock A Stock B

Portfolio DataNumber of shares 10 000 40 000Market price $28 $1.36

Company DataDividends per share $0.2 $0.18Total common shares 3 000 000 000 5 000 000 000Non-permissible income $200 000 000 $30 000 000Total income $8 000 000 000 $1 300 000 000

Applying the two purification approaches using the hypothetical example the result wouldbe as follows in Table 19.5:

Table 19.5 Application of dividend and investment purification

Dividend purification Investment purification

Stock A Stock ANon-compliant percentage = $200M/$8B = 2.5%Non-compliant dividends per share = $0.2 *

2.5% = 0.005 $/sharePurification amount for equity A = 10 000 share

* 0.005 $/share = $50

Stock BNon-compliant percentage = $30M/$1.3B =

2.3%Non-compliant dividends per share = $0.18 *

2.3% = 0.00414 $/sharePurification amount for equity B = 40 000 share *

0.00414 $/share = $165.6Portfolio purification = $215.6

Non-compliant amount per share = $200M/3Bshares = 0.067 $/share

Purification amount for equity A = 10 000 share* 0.067 $/share = $666.67

Stock BNon-permissible percentage = $30M/5.3B

shares = 0.00566 $/sharePurification amount for equity B = 40 000 share

* 0.00566 $/share = $226.42Portfolio purification = $893.09

As this example illustrates, using investment purification a four times larger value needsto be purified compared to using dividend purification. Additionally, in the case where nodividends are paid out using dividend purification nothing would have to be purified whereasusing investment purification, the total amount has to be purified.

Therefore it is crucial for asset managers to understand and know what their net returnsafter purification deduction would be like so that they can account for these losses in advance.So expected returns should be estimated considering purification losses so that appropriateinvestment decisions are taken.

19.4 FUND PERFORMANCE

Shariah-compliant investments are perceived to be more vulnerable than conventional invest-ments due to the limited asset universe. This is actually wrong since a smaller asset universe

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Conventional

11.05% 10.68% 11.03%

15.05%

21.45%

12.49%

Low Risk Medium Risk High Risk

Shariah

Figure 19.3 Actual performance of efficient portfolios in 2009

does not imply automatically that there exists a higher risk exposure or lower expected return.On the contrary, it is the quality of the equities included in the asset universe that make thedifference.

Recent research done by Donia and Marzban (2010) and Asutay and Marzban (2009) revealsthat Shariah-compliant investments actually outperformed their conventional counterparts.Donia and Marzban (2010) proved through testing the results of a mean-variance optimizationmodel applied on US large capitalization companies that if the optimal weights are usedto construct portfolios using actual price movements for different risk levels the Shariah-compliant alternatives outperform the conventional one (see Figure 19.3).

Based on their analysis the performance difference is not related to the underperformingfinancial sector during the crisis. Actually, the Shariah-compliant portfolios performed bettersince the portfolios did not contain highly leveraged companies that performed weakly during2009. Leverage is measured from a Shariah perspective through debt to market capitalizationor assets and thus the Shariah guideline limits the exposure to highly leveraged companies andthereby also limits the risk exposure.

Asutay and Marzban (2009) reached the same conclusion using a simplified portfolio strat-egy through which portfolio weights are determined based on the relative market capitalizationof the universe constituents. Analysing portfolio performances for the GCC and Islamic coun-tries market based on different holdings periods the Shariah-compliant alternatives almostalways outperformed their conventional counterparts.

So, the common perception that Shariah-compliant investments have to come with a costor that there has to be a cost of being a good Muslim might not be valid here: on the contrary,being a good Muslim might positively impact your portfolio performance and risk.

NOTES

1. Head of Research at IdealRatings Inc. and Visiting Fellow at Durham University, UK.2. Accounting and Auditing Organization for Islamic Financial Institutions.3. Total Assets as divisor is used to screen the Islamic indices of MSCI and FTSE for instance.4. Different varieties of average market capitalization are used as divisor for the Russell

Indexes, Dow Jones Indexes, S&P Indexes, as well as AAOIFI.

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5. A detailed survey of Shariah screens can be found in U. Derigs and S. Marzban (2008)“Review and analysis of current Shariah-compliant equity screening practices”, Interna-tional Journal of Islamic and Middle Eastern Finance and Management, 1(4).

6. This approach was approved by some Shariah scholars in Saudi Arabia and the 36-monthaverage is adapted for screening by S&P Shariah indices and the 24-month average by DowJones.

7. This approach is used for instance by Al-Rajhi Bank in Saudi Arabia.8. The analysis is conducted using the IdealRatings research-based Shariah Screening Service

through which more than 44 000 equities can be screened using customized Shariah man-dates. The analysis is conducted on listed equities with a minimum market capitalizationof US$1 billion.

9. Presented by M. Donia and S. Marzban in “Shariah-Compliant Equity Investments –Frameworks, Trends and Crisis” at the Harvard Islamic Finance Forum in 2010.

REFERENCES

Asutay, M. and Marzban, S. (2009) Questioning the perceived vulnerability of Shariah-compliantinvestments in Moral Values and Financial Markets: Resilience of Islamic Finance Against FinancialCrisis, Milan, Italy.

DeLorenzo, Y. (2000) Shariah Supervision of Islamic Mutual Funds, Proceedings of the Fourth HarvardUniversity Forum on Islamic Finance, Harvard University, Cambridge, Massachusetts.

Derigs, U. and Marzban, S. (2008) Review and analysis of current Shariah-compliant equity screeningpractices, International Journal of Islamic and Middle Eastern Finance and Management, 1(4),285–303.

Derigs, U. and Marzban, S. (2009) A new paradigm and new strategies for Shariah-compliant portfoliooptimization – Management and system-oriented approach, Journal of Banking & Finance, 33(6)June, 1166–76.

Donia, M. and Marzban, S. (2010) Shariah-Compliant Equity Investments: Framework, Trends andCrisis, Harvard University Forum on Islamic Finance, Harvard University, Cambridge, MA.

Elgari, M.A. (2000) Purification of Islamic Equity Funds: Methodology and Shari’ah Foundation, Pro-ceedings of the Fourth Harvard University Forum on Islamic Finance, Harvard University, Cam-bridge, MA.

Ketell, B. (2008) Why are derivatives haram under Shariah law? Islamic Banking & Finance, 6, 23–5.Marzban, S. (2009) Strategies, Paradigms and Systems for Shariah-compliant Portfolio Management.

Shaker Verlag: Aachen, Germany.Wilson, R. (2004) Screening criteria for Islamic equity funds, in Jaffer, S. (ed.), Islamic Asset Man-

agement: Forming the Future for Shari’a-Compliant Investment Strategies, Euromoney InstitutionalInvestor PLC: London, UK.

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20

Islamic Microfinance: The Way Forward

Mohammed Obaidullah

Poverty alleviation remains the most important challenge before policy makers in the Islamicworld that is characterized by high and rising poverty levels. The poverty levels are alsoassociated with high inequality alongside low productivity. In Indonesia alone with the world’slargest Muslim population, over half of the population of about 129 million are poor or vul-nerable to poverty with incomes of less that US$2 a day. Bangladesh and Pakistan accountfor 122 million each. A recent IRTI study1 reveals that only five of the OIC member coun-tries – Indonesia, Bangladesh, Pakistan, Nigeria, and Egypt – account for over half a billion(528 million) of the world’s poor with incomes below US$2 a day or the national poverty line.

Microfinance (MF) is a powerful poverty alleviation tool. It involves provision of financialservices to poor and low-income people whose low economic standing excludes them fromformal financial systems. Access to services such as credit, venture capital, savings, insurance,and remittance is provided on a micro-scale enabling participation of those with severelylimited financial means. The provision of financial services to the poor helps to increasehousehold income and economic security, build assets, and reduce their vulnerability. However,in a typical developing economy the formal financial system serves no more than 20–30% ofthe population. Financial exclusion binds the poor into a vicious circle of poverty. A majorcontributing factor to financial exclusion in Islamic countries is the insensitivity of conventionalmicrofinance to cultural and religious beliefs of the poor in these societies.

20.1 MODES OF ISLAMIC MICROFINANCE

Microfinance institutions provide to the entrepreneurial poor financial services that are tailoredto their needs and conditions. Good microfinance programmes are characterized by small,usually short-term loans; streamlined, simplified borrower and investment appraisal; quickdisbursement of repeat loans after timely repayment; and convenient location and timing ofservices. Microfinance institutions thus have distinct characteristics that make them specializedcomponents of the formal financial system. The main point of departure of microfinance frommainstream finance systems is its alternative approach to collateral that comes from theconcept of peer pressure and/or joint liability. Funds are disbursed to individuals within agroup after they are approved by other members in the group. Repayment of the financing is ashared responsibility of all of the group’s members. In other words they share the risk. If onedefaults, the entire group’s members face a setback. In most cases, microfinance programmesare structured to give credit in small amounts and require repayment at weekly intervals andwithin a short time period – usually a month or a few months. The beneficiary looks forward


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to repetitive financing in a graduated manner and this also helps mitigate risk of default anddelinquency.

Two types of models of Islamic microfinance have come into existence in Islamic societies.The first type is the replication of conventional models in which successful models likeGrameen are replicated with necessary modifications in product characteristics to make themShariah-compliant. The second type is indigenous model, which developed in response tolocal needs and is largely an outcome of local creative initiatives.

20.1.1 Replication of Conventional Models

The model that has now almost become the textbook model of microfinance is the Grameenmodel. This has been replicated in many countries in a wide variety of settings. The modelrequires careful targeting of the poor through means tests comprising mostly of women’sgroups. The model requires intensive fieldwork by staff to motivate and supervise the borrowergroups. Groups normally consist of five members, who guarantee each other’s loans. A numberof variants of the model exist; but the key feature of the model is group-based and graduatedfinancing that substitutes collateral as a tool to mitigate default and delinquency risk. An earlyGrameen replication that sought to offer Shariah-compliant microfinance is Amana IkhtiarMalaysia (AIM). Closer to home, the Islami Bank Bangladesh operates a Rural DevelopmentScheme that offers Shariah-compliant microfinance using a modified Grameen methodology.

A second model that has been widely replicated mainly in Latin America and Africa, butwith substantially less total outreach than the many Grameen Bank replications, is the VillageBank model. The model involves an implementing agency that establishes individual villagebanks with about thirty to fifty members and provides “external” capital for onward financingto individual members. Individual loans are repaid at weekly intervals over four months, atwhich time the village bank returns the principal with interest/profits to the implementingagency. A bank repaying in full is eligible for subsequent loans, with loan sizes linked tothe performance of village bank members in accumulating savings. Peer pressure operatesto maintain full repayment, thus assuring further injections of capital, and also encouragessavings. Savings accumulated in a village bank may also be used for financing. As a villagebank accumulates sufficient capital internally, it graduates to become an autonomous andself-sustaining institution (typically over a three-year time period). This model has been verysuccessfully implemented in a Shariah-compliant manner in Jabal al-Hoss, Syria. A newexperiment by FINCA in Afghanistan also seeks to implement this model.

20.1.2 Indigenous Models

Among the indigenous models of Islamic microfinance that have received wide acclaim arethe Islamic financial cooperatives of Indonesia. Popularly known as Baitul Maal wat Tamweel(BMT), there are currently over three thousand such home-grown institutions dotted acrossIndonesia. BMTs, unlike pure mutuals and cooperative organizations, do not restrict theirservices to members alone. They operate more as banks with many customers and depositors.They also follow a more indirect and informal governance structure unlike member-basedcooperatives that strictly follow a one-member-one-vote rule in decision-making. Anotherdistinct feature of a BMT is the duality in its functions: (i) collection and distribution ofcharity funds, and (ii) for-profit savings and financing.

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Islamic Microfinance: The Way Forward 417

Qard Hasan Funds are another instance of indigenous models, which are operational inlarge numbers in Iran and the Indian subcontinent. These Funds operate like small stand-alonebanks that accept deposits as well as provide loans in the qard hasan mode. Neither thedepositors nor the institution expects any returns while parting with their funds. Needless tosay, the observed popularity of these institutions runs contrary to modern finance sense.

20.2 INSTRUMENTS OF ISLAMIC MICROFINANCE

Islamic finance in general and Islamic microfinance in particular is governed by several normsthat essentially prohibit riba, gharar, and other norms. A detailed discussion of these norms isbeyond the scope of this chapter.2 It may be noted, however, that these constraining norms donot constitute an obstacle in building sound microfinance products. On the contrary, the needfor Shariah compliance has led to considerable research into product development. Whilethe conventional system provides for simple interest-based deposits, donations, and loans,the Islamic financial system comprises an array of instruments for mobilization of funds,financing, and for risk management.

20.2.1 Instruments for Mobilization of Funds

Instruments for mobilization of funds may be broadly divided into (1) charity that includeszakah, sadaqa, awqaf ; gifts that include hiba and tabarru; (2) deposits that may take the formof wadiyya, qard-hasan, and mudaraba and (3) equity that may take the form of classicalmusharaka or the modern stocks.

While sadaqa, hiba, and tabarru have parallels in conventional microfinance, such asdonations or contributions, zakah and awqaf have a special place in the Islamic system andare governed by elaborate fiqhi rules. Zakah is one of the five pillars of Islam and is meantto finance the poorest of the poor. These sections of the society are unlikely to have positive-NPV projects in need of financing and hence are “unbankable”. Awqaf creates and preserveslong-term assets that generate income flows or indirectly helps the process of production andcreation of wealth. By targeting its benefits towards the poor, awqaf can play an importantrole in poverty alleviation. Though there has been significant improvement in management ofzakah and awqaf in recent years, their role as vehicles of microfinance and poverty alleviationis grossly underestimated. Their growing popularity evidenced through establishment of manya zakah fund and awqaf fund is an indication of their vast potential in Muslim societies.

Deposits in the form of wadiyya, qard hasan, and mudaraba have their parallel in savings,current and time deposits respectively, and are a regular source of funds for Islamic micro-finance institutions, especially those in South-East Asia. Wadiyya deposits attract gifts tocompare favourably with returns available on interest-bearing deposits. Qard-based depositsdo not provide any return and in some cases involve a charge. Mudaraba deposits are based onprofit-and-loss sharing with the depositor as rabb-al-mal and the microfinance institution asthe mudarib. Available empirical evidence from Indonesia asserts that Islamic microfinanceinstitutions have lagged far behind their conventional counterparts in raising funds throughdeposits. Clearly there is a need to redesign many of the deposit products by taking intoaccount customer needs and preferences. Microfinance institutions also have the option ofraising funds through participatory modes, such as musharaka or modern equity.

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20.2.2 Instruments of Financing

Instruments of financing may be broadly divided into (1) participatory profit-and-loss-sharing(PLS) modes, such as mudaraba and musharaka; (2) sale-based modes, such as murabaha;(3) lease-based modes or ijara; and (4) benevolent loans or qard with service charge.

Real-life experience shows that murabaha is preferred over mudaraba primarily because iteliminates the need for written records, often unavailable at the micro enterprise level or ifavailable, the client may be unwilling to share them. Further, in case of murabaha a well-definedcontract exists, with pre-defined amounts; a fixed contract creates a less complicated processand a lower implementation cost to the institution. A profit-sharing mudaraba arrangement,however, generates high returns for the institution.

Unlike mainstream Islamic finance that does not treat qard-hasan as a financing mechanism,Islamic microfinance has found this mechanism to be a “pure and effective” way of financingthe poor. Many Islamic microfinance programmes are modelled solely using qard-hasan –both as an effective fund-raising and a financing mechanism. Qard-hasan has a much strongerreligious undertone than other “halal” mechanisms, being directly ordained by the Holy Quran.Such programmes popularly known as Bait-ul-Maals are administered often through mosquesand Islamic centres resulting in low overheads, leading to low service charges. A combinationof financing with Islamic teachings and oaths administered in mosques helps reduce defaultsand delinquencies to the minimum.

20.2.3 Instruments of Risk Management

Instruments of risk management and insurance in Islamic microfinance are based on theconcept of guarantee (kafala) and collateral (damanah). In case of financing individuals,guarantee is used as an alternative to collateral (e.g. kafala or guarantee by two persons isconsidered adequate by Pakistan-based Akhuwat) and as a tool to manage the risk of defaultand delinquency. As stated earlier, in case of financing groups, mutual guarantee is used byalmost all microfinance institutions – both conventional and Islamic.

A relatively smaller number of Islamic microfinance institutions require collateral in theform of physical assets (e.g. the Lebanon-based Hasan Fund and the Indonesian BMTs).

The risks confronting individual and group borrowers translate into risk of default anddelinquency for the MFI. One way to mitigate this on the part of the MFI is to insist thatborrowers participate in a micro-takaful programme. However, micro-takaful products are yetto appear in the market place. In the absence of micro-takaful products, real life projects seekto protect their members in a variety of ways that are informal and perhaps inefficient.

20.3 ISLAMIC MICROFINANCE PROJECTS ACROSS THE GLOBE

Cases of successful Islamic microfinance experiments in Muslim societies are small in number.Further, these institutions are not well integrated into the formal financial systems, withthe notable exception of Indonesia. In most cases these are in the nature of experimentalprojects initiated by international donor agencies, religious, or political groups. Cases ofIslamic banks practising microfinance are even fewer. Islamic microfinance institutions displaywide variations in the models, instruments, and operational mechanisms. While, in terms ofreach, penetration, and financial prowess Islamic microfinance institutions lag far behind theirconventional counterparts they certainly score better in terms of richness and variety.

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20.3.1 Middle East North Africa (Mena)

It was a microfinance initiative in Egypt – the Mit Ghamr project – that laid the foundationof modern Islamic banking, notwithstanding the short lifespan of the project. In the MiddleEast North Africa (MENA) region several successful experiments have been undertaken in therecent past: (i) the Sanadiq project at Jabal al-Hoss in Syria; (ii) the Mu’assasat Bayt Al-Malin Lebanon; and the (iii) Hodeidah Microfinance Program in Yemen.

The Jabal Al Hoss “Sanadiq” (village-banks) in Syria is an excellent model worth repli-cation. Some of the unique features of this model are: (i) musharaka-type structure ownedand managed by the poor; (ii) financing based on the concept of murabaha – high profitrates with net profits shared among members; (iii) good governance through committees withsound election and voting procedures; (iv) project management team responsible for creatingawareness of microfinance practices, and training of committee members; (v) financial man-agement of the funds based on standardized by-laws and statutes for each of the village fundsresulting in “fair” credit decisions and low transaction costs; (vi) financially viable operationswith repayment rates close to 100%; (vii) equal access to both men and women as owners andusers; (viii) Sanadiq apex fund for liquidity exchange and refinancing; and (ix) support fromUNDP in the form of matching grant equal to minimum share capital of village fund.

The Mu’assasat Bayt Al-Mal in Lebanon is an affiliate of a political party – the Hezbollah –and comprises the Hasan Loan Institution (Al-Qard Al-Hasan) and its sister organizationcalled Al-Yusor for Finance and Investment (Yusor lil-Istismar wal Tamweel). The formerprovides qard-hasan financing while the latter provides financing on a profit-and-loss-sharingmode. The uniqueness of the Mu’assasat Bayt Al-Mal is its emphasis on voluntarism. Ithas maintained a very close relationship with the people and is seen as a very creditableorganization with volunteers entirely taking care of collection and disbursal of funds. It has anetwork of donors with complete confidence in the activities of the institution and also enjoysa high repayment rate. Financing is backed by collateral in the form of capital assets, land,gold, guarantor, and bank guarantee.

The Hodeidah Microfinance Program in Yemen predominantly uses group and graduatedfinancing methodology that was successfully pioneered by Grameen. Unlike Grameen, how-ever, it uses a murabaha mode for financing.

20.3.2 South Asia

Among South Asian countries Bangladesh leads the group with organizations like IslamiBank Bangladesh, Social and Investment Bank Bangladesh, Al-Falah, and Rescue. Akhuwatin Pakistan is notable for its unique mosque-based model. India, with the second largestMuslim population in the world, has witnessed some experiments largely outside its formalfinancial system, such as AICMEU and Bait-un-Nasr.

The Islamic microfinance institutions in Bangladesh have been primarily using the deferredpayment sales (bai mu’ajjal) mode of financing. They have been facing tough competition fromconventional giants like Grameen Bank and BRAC. Though according to some studies, Islamicmicrofinance institutions have displayed a better financial performance than their conventionalcounterparts, the latter have a far greater outreach. Indeed, institutions like Grameen and BRAChave pioneered models of microfinance that are replicated across the globe.

In Pakistan a model of microfinancing that has generated considerable interest amongobservers is Akhuwat. The financing is in the nature of small interest-free loans (qard hasan)

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in a spirit of Islamic brotherhood where most activities are performed by volunteers. There isno funding from international donors or financial institutions. All activities revolve around themosques and involve close interaction with the community. There are no independent offices;loans are disbursed and recovered in a mosque and therefore involve low overheads. It usescollateral-free group and individual financing based on mutual guarantees. Loans are disbursedin a mosque, which also attaches a religious sanctity to the oath of returning it on time.

20.3.3 South East Asia

In South East Asia Malaysia made an early beginning with Tabung Haji aimed at financingthe Hajj-related expenditure of poor Malaysian farmers who used to sell their only sourceof livelihood – agricultural land – for the purpose. Tabung Haji was primarily a savings andinvestments institution and has since grown into a large specialized finance house. Indonesiahas largely followed Malaysia in the development of the Islamic financial sector including themicrofinance sector. Cases of Islamic microfinance projects have also been documented forThailand, Brunei, and the Philippines.

With its rather well-developed Islamic banking system and capital markets, Malaysia hasestablished several organizations under the aegis of government agencies to finance small andmedium scale enterprises using a wide range of Islamic financial instruments.

20.3.4 Rest of the World

There are also examples of Islamic microfinance being practised among smaller Muslimcommunities in the rest of the world. Islamic Relief Worldwide and Muslim Aid have beenpioneers in this regard in bringing Islamic microfinance to Europe. From its primary respon-sibilities of distributing relief among war-ravaged communities in Bosnia and Herzgovinaand Kosovo, Islamic Relief has made some bold departures in experimenting with variousfor-profit microfinance initiatives.3

20.4 PRODUCT DEVELOPMENT IN ISLAMICMICROFINANCE SECTOR

The Islamic microfinance sector faces some major challenges in the matter of product devel-opment. The sector in spite of the richness of fiqh literature remains highly murabaha-centric.Even ijara has not witnessed many takers unlike mainstream Islamic finance. Profit-and-loss-sharing, though highly acclaimed as “ideal” is hardly used. The “actual” number of institutionsbased on zakah, awqaf , and qard-hasan is nowhere near the vast potential these institutionsand instruments offer. Voluntary savings, deposits services, insurance, remittance, and otherfee-based services are generally not offered. Some of the contributing factors to this state ofaffairs are highlighted below.

20.4.1 Shariah Compliance

Shariah compliance is indeed the differentiating factor between a conventional and an Islamicmicrofinance institution. Islamic microfinance institutions must not only conform to Shariah

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in all their products, processes, and activities, they should be perceived to do so by theirclientele.

Mainstream Islamic financial institutions provide comfort to their stakeholders that theyconform to Islamic finance principles by setting up Shariah Supervisory Boards (SSBs). Themembers of SSBs are usually distinguished scholars and experts of fiqh who confirm thecompliance of financial products and consistency of operations with Shariah. A review ofIslamic microfinance institutions reveals that none of them have instituted SSBs. A simplereason may be that this approach is costly. As an alternative, Islamic microfinance institutionsmay consider pooling together their resources and forming associations of organizations whichcould then set up a joint SSB.

Divergence of views among Shariah scholars on many issues needs no elaboration andcontinues to be a major challenge to the development of Islamic finance. The problem becomesparticularly acute in the context of Islamic microfinance. The local nature of the practices inmicrofinance allows for many variations from the standardized set of contracts discussed infiqh literature and can open up room for debate.

Unlike mainstream Islamic bankers, many Islamic microfinance providers with multiplebottom-lines are not comfortable with techniques like murabaha and ijara (lease-purchaseand financial lease variety) and view them as interest-based loan substitutes. The Islamicalternative to them is qard-hasan – what attracts them is its benevolent nature. Use of qard-hasan, where only the “actual” service charge is recovered from the beneficiary, does not allowthe portfolio of financings to grow while inflation is likely to erode their real value, seriouslythreatening their long-term survival. Suggestions such as linking the loan amount to a physicalcommodity have been made, but without much of a consensus.

On another level, many interest-based loans would like to highlight their closeness to thespirit of Shariah because of their “benevolent” nature. For instance, successive governmentsin India have routinely provided through a network of microfinance outfits loans at interestrates grossly below the prime lending rate in the economy and would, at periodic intervals,waive the entire loan amount in the face of hardships (such as crop failure, or even smallenterprises becoming sick), consequently claiming to be more equitable than profit-and-loss-sharing. Another instance is the Grameen system that cites the following features of its loansto be labelled differently from interest-bearing conventional loans: (i) cap on the total interestdue; (ii) no recovery in case of project failure; (iii) no formal contract for interest payments;(iv) no shareholder-owner(s) as counterparty to receive interest etc. Such variations naturallyrequire renewed discussions on the existence or otherwise of riba in such financing modes.

Issues such as dealing with delays and delinquencies through penalties invariably lead todivergent views. Unlike mainstream Islamic finance, a case-by-case approach in the matter ofgranting waivers in case of genuine delays and delinquencies seems to be feasible due to thelocal nature of financing and easier access to information. Thus Islamic microfinance may callfor a solution to delinquency management that is different from mainstream Islamic finance.

Many other unresolved issues in mainstream Islamic finance are also a challenge to Islamicmicrofinance. This issue may be addressed by initiating a dialogue on a common forum onthe subject. In the past many a divergence of views has been resolved through the processof dialogue. The Annual Fiqh Seminars organized by Dallah Al Baraka or those organizedunder the aegis of Islamic Fiqh Academies have successfully resolved many intricate andcomplex issues in the past. These and other institutions should be routinely approached bymicrofinance providers jointly through their associations to resolve specific matters pertainingto microfinance.

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20.4.2 Divergent Perceptions

Client perceptions towards mudaraba, murabaha, qard hasan, which are predominant formsof Islamic microfinance in the Islamic world, show wide variations and therefore pose a majorchallenge for the Islamic microfinance sector. At times, such perceptions are rooted in theignorance of the clients about fiqhi rules governing the various riba-free mechanisms.

It is pertinent to note a few survey findings4 on the attitude of Muslim borrowers to-wards alternative modes of financing. One, borrowers display an initial preference for theprofit-sharing mechanism – that is, mudaraba as it is perceived to be more Islamic in spirit.Two, only some borrowers understand that the profit-sharing mechanism may, under certaindesigns, be more expensive for them than other alternatives within Islamic banking. Three,only some borrowers recognize the potential for conflict between the microfinance programmeand the borrower in determining profit. Four, some borrowers do not like the profit-sharing ofmudaraba because they do not want to reveal their profits to the programme (and their group).Five, borrowers initially express doubts about the appropriateness of the “buy-resell” mecha-nism (murabaha) because it appears too similar to the forbidden practice of fixed interest rates(riba). But once the mechanism is properly explained to borrowers and local religious leaders,it is accepted. Six, borrowers accept that a microfinance programme incurs costs and that thesecosts have to be recovered in order for the programme to continue offering financial services.Seven, borrowers also appreciate the simplicity and transparency of the “buy-resell” model,which allows repayments in equal instalments. It is easier to administer and monitor. This“blow-hot-blow-cold” attitude of clients towards alternative modes creates major problems forprofessionals engaged in product development for the Islamic microfinance sector.

Client perception towards qard hasan is no less worrisome. It is perceived to be “free” bymany borrowers even when Shariah clearly distinguishes between qard hasan and sadaqa.There are still others who are aware of the difference and realize the need to repay the loan,but assert that qard hasan in its “pure” form provides them with flexibility (right) in decidingwhen to repay.

The issue of divergent perceptions is directly related to lack of proper education among theclients and beneficiaries. Microfinance providers may seek the help of local religious leaders toconvey the exact nature of Islamic instruments and also to influence them for timely servicingof debt.

20.4.3 Agency Problems

Agency problems with profit-and-loss-sharing (PLS) in mainstream Islamic finance havealready been highlighted as a matter of grave concern that pushes Islamic FIs to opt fordebt-based products. They become particularly acute in rural settings. Other problems thatare usually cited with PLS-based modes as compared to sale-and-lease-based modes are asfollows: one, PLS mechanisms require long-term involvement by the microfinance institu-tions in the form of technical/business assistance which raises the cost of implementation.Two, the uncertainty about profits is a major drawback of the PLS models. Although mi-crofinance programmes have information on local market behaviour, weekly profits fluctuate.Fluctuating profits make it extremely difficult for institutions to predict their cash flows. Micro-entrepreneurs make the job doubly difficult by not keeping accurate accounts. Three, the PLSmodel is difficult to understand for loan officers and borrowers alike. Even in the hypothetical

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situation that profits were known, the borrower has to repay a different amount each period (andthe loan officer has to collect a different amount each period). This lack of simplicity – relativeto equal repayment instalments – is a source of confusion for borrowers and loan officers.

A rational response to the above problem with PLS financing would be to reduce uncertaintyaround profits by generating information. Given that microfinance projects deal with localproducts and markets, often dealing with a few known types of commodities and assets(such as poultry, bee-keeping, fisheries, dairy), it is possible on the part of the financier togenerate reliable business forecasts and develop products with realistic sharing ratios andexpected returns. While cases of negligence of mudarib leading to losses are taken care of inmudaraba, proper systems should evolve to establish such negligence and ascribe the lossesto the mudarib. Further, accounting skills could be imparted to the mudarib and made apre-condition to financing (as in case of the Sanadiq project).

There is indeed the need and considerable scope for Islamic microfinance providers todevelop new products as solutions to a variety of financial problems. However, the rightapproach to product development is a strategic one that takes a holistic view of microfinanceas a composite product meeting the needs for financing, savings and investment, insurance,remittance, and other services.

Financing products using bai-istijrar (typically suitable for micro-transactions), salam,istisna, and other permissible contracts are but a few of the potential products that offer achallenge to microfinance engineers.

It is important that deposit products using mudaraba should use realistic financial projectionsand a variety of product or sector-specific mudaraba products could be designed to raiseresources and provide a realistic return to depositors. Similarly, in lieu of simple qard-hasan, alinking of the same with specific physical commodities available locally (commodity selectedafter careful evaluation of price volatility) could be more attractive as a hedge against inflation.A problem typical to small deposits is that these savings do not qualify for investment, evenat a micro-level, and savers from the “economically active poor” with adequate amounts tobe invested, in most cases, lack the know-how and professional ability to decide on whom toinvest with. The answer to this problem is to treat micro savings as a pool for investment fundsto be operated on the basis of mudaraba, thereby yielding profits to savers.

Micro-insurance developed and offered successfully in many regions has shown the wayto development of micro-takaful along similar lines instead of inefficient holding of cashto meet unforeseen adversities. Given the overwhelming importance of risk management,micro-takaful is in urgent need of development. There is clearly a possibility of establishingcommunity-based micro-takaful schemes with the involvement of NGOs, zakah funds, anddonor agencies. Support from the mainstream takaful sector could come in the form of techni-cal expertise or financial assistance. The partner-agent model as in mainstream takaful couldalso be used for micro-takaful. A start has already been made in this regard by a handful oforganizations in Malaysia, Sri Lanka, and Indonesia. For example, a Malaysian takaful opera-tor, Etiqa, recently launched a product in association with ANGKASA, a secondary cooperativeorganization under which members are required to pay an extremely low premium to get adeath benefit apart from other benefits such as total permanent disability. ANGKASA hasbeen instrumental in disseminating the plan through its huge network of member coopera-tives, which are also entrusted with much of the managerial functions related to applicationsand claims. Etiqa also runs a corporate zakah responsibility (CZR) programme for distributionof zakah.

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20.5 MEETING FUNDING REQUIREMENTS OF ISLAMICMICROFINANCE SECTOR

In an ideal world with inclusive financial systems, domestic capital markets in addition tothe banking sector would supply the bulk of the funding for microfinance. Financial serviceproviders would rely on savings from the public, loans from the commercial banking sector,bond issues, and domestic stock markets. If microfinance is to help build inclusive financialsystems, it must develop strong linkages with the formal banking sector and the capitalmarkets. The absence of such linkages except in certain economies like Malaysia and Indonesiaconstitutes a major challenge to policy makers interested in bringing the “excluded” and “non-bankable” into the fold of formal financial systems.

20.5.1 Linkage with Banks

While Islamic financial institutions have experienced phenomenal growth in terms of numbers,funds mobilized and managed, their activity in the microfinance sector leaves much to bedesired. They have mostly been catering to high net worth individuals leaving out the poor.Indeed they have much to learn from commercial banks that have dedicated microfinancedivisions.

An important factor contributing to the lack of interest in microfinance is the absence ofinstitutional credit guarantee systems in most Muslim countries. The individual borrowerguarantee that is prevalent lifts the burden of loss of the business due to natural hazards, death,or disability of the borrower. Nevertheless, the “portfolio” guarantee approach, whereby theguarantor covers whole or part of the default of the microfinance institution according to aspecific agreement, is non-existent.

Commercial banks – both Islamic and conventional – have generally accorded low pri-ority to microfinance perhaps because of its distinct features. For example, the reliance onreputational collateral and lack of physical collateral are not easily comprehended as soundbanking by traditional bankers. The formal banking system, as it is structured at present, isnot designed to serve the financing needs of the poorer segments of the Muslim society. Astrategic response to this would call for a review of Central Bank policies in Muslim countriespolicies to encourage banks to engage in microfinance. This would necessitate formulationof modified banking regulations to accommodate special characteristics of the microfinancesector. The regulations should license new banks dealing exclusively with microfinance, andprescribe capital requirements, capital adequacy norms, and limits on unsecured lending andprovisioning of loans. The regulations should also encourage more effective microfinancedelivery through establishment of new specialized formal non-bank microfinance institutions,expansion of branch network for existing institutions, possible restructuring of existing banksto serve as rural specialized microfinance banks and allow for banks wholesaling to non-bankmicrofinance institutions, and using the non-profit organizations with a social agenda to reachout to the poor.

The limited provision of bank finance to micro-enterprises is mainly attributed, amongother factors, to the absence of a legal, policy, and regulatory framework for collaterals andguarantees appropriate for microfinance. The new framework should therefore allow for greaterflexibility in determining the type of non-conventional collateral that is more appropriate formicro credit. It should require that microfinance institutions, in general, and banks, in particular,change their procedures and branch structures to accommodate such changes.

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It also requires more reliance on reputational collateral that can be generated by creditbureaux through the provision of clients’ repayment history that could aid in assessment ofrisks. The different nature of the procedures with microfinance also requires a change inmindset of the physical-collateral-inclined traditional banker community.

A strategic response to increase the attractiveness of microfinance to commercial banks isthe establishment of credit guarantee schemes with the purpose of sharing credit risk withbanks. As indicated earlier, this product can be made Shariah-compliant in the frameworkof al-kafala. According to the accepted fiqhi opinion of scholars, the guarantor is allowed toreceive a fee to cover the administrative costs incurred in provision of the guarantee (accordingto some, the fee should neither be too high, nor in proportion to quantum of debt guaranteed).Another alternative form of credit guarantee scheme is possible via a zakah fund (since zakahmay legitimately be used to pay off the unpaid debt of the poor). However, care must betaken to ensure that the coverage of such a scheme is restricted to the extremely poor and thedestitute only.

20.5.2 Rating Services

Rating agencies play an important role in the raising of debt capital by providing indicatorsof default risk. However, such services are also conspicuous by their absence in the Islamicmicrofinance sector. An important initiative to resolve this problem would be to provide forrating services specific to Islamic microfinance. Presently a number of conventional ratingagencies undertake rating of credit quality for the MFIs. It is important that such agenciesdevelop rating methodology for Islamic microfinance instruments. In order to encourage suchagencies institutional donors can play a proactive role and establish a Rating Fund. This Fundcould initially reimburse to Islamic MFIs the entire cost of getting themselves rated by therating agency. Subsequently the share of the cost of rating borne by the Fund could be reducedwith an increasing share passed on to the MFIs concerned. The ratings would substantiallyreduce information costs and help Islamic MFIs to obtain financing from the market.

20.5.3 Islamic Microfinance Fund

A capital market product that has facilitated flow of funds to MFIs is a microfinance fund.The number of such funds that invest in bonds, equities, and quasi-equities or convertiblesof conventional MFIs are on the rise. These include equity funds, funds associated withmicrofinance networks, and the socially responsible funds. In a similar manner, dedicatedfunds could be established to invest in Islamic MFIs. The creation of such funds would involvea mechanism similar to that of the Islamic mutual funds in the framework of mudarabahor wakala. A recent initiative by the Jeddah-based Islamic Development Bank to create anIslamic Microfinance Fund in partnership with several conventional financial institutions hasgenerated considerable interest among observers.

20.5.4 Securitization

A process opposite to that of establishment of a fund is securitization. Conventionally,securitization relates to the converting of loans of various sorts into marketable securitiesby packaging the loans into pools and then selling shares of ownership in the pool itself.Islamic securitization, however, has a different connotation. Such a process results in issue

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of sukuk that are certificates of equal value representing undivided shares in ownership oftangible assets, usufruct, and services (as distinct from a pool of loans).5

Microfinance institutions that are liquidity-starved may explore approaching the capitalmarket and raise capital through Islamic securitization. For example it should be conceptuallypossible to establish an SPV (Special Purpose Vehicle) as a mudaraba or on the basis ofwakala that would purchase small ijara portfolios of microfinance providers and create a largeenough portfolio against which securities or sukuk could be issued in the capital market.

From an investor’s point of view, such sukuk as an asset class would have the followingcharacteristics:

• High-yield assets (typical yields between 20 and 36% per annum)• Unsecured (generally not backed by collateral)• Short-tenor assets (typically less than a year, even less than six months)• Very high granularity (very small tick size; can be scaled to size)• Good credit quality.

Indeed Islamic microfinance offers an acceptable risk–return profile to the investor community.The following issues are of relevance in this regard:

• An attractive feature of this sector is that investor returns are observed to be uncorrelatedwith other asset classes and are stable even in times of financial crises. The fortunes of thissector are believed to move more in tandem with that of the real economy as compared tothe mainstream financial system.

• On the flip side, investors may find it relatively more difficult to have ready access toinformation. The sector is deficient in terms of publicly available information. A solutionto this may be found in offering some kind of credit enhancement. A specialized ratingagency is another solution.

• Another issue related to such sukuk as an asset class is related to scale. Individual MFIs aresmall, and therefore could join together under an umbrella organization before attemptingsecuritization. However, aggregation processes, as in the above, would raise the issue ofnon-standardization of financing and procedures.

• Liquidity or easy entry and exit of the investor is yet another issue. There is no market atpresent for secondary trading of such sukuk. However, small tick size can be helpful for itsliquidity.

• In addition to liquidity risk, servicer risk is another important risk factor for investingin such sukuk. Microfinance assets are very sensitive to the risk of non-performance bythe servicer for a variety of reasons, such as wide dispersion and high number of clients,high frequency of collections, cash transactions etc. Impediments in the servicer’s abilityto perform can impair performance of the asset pool. However, on the positive side, therepayment rate has generally been quite high in this sector.

The most important step for such securitization and issuance of sukuk is to determine theunderlying pool of assets. The issuer must possess a pool of assets on its balance sheet that aretransferable to the investors. While physical assets on ijara constitute the best type of assetsto be securitized, the asset pool may have a blend of ijara and musharaka (equity) assetsand other Shariah-compatible assets (e.g. murabaha or istisna). It is important to ensure thatnon-debt assets dominate the pool. This is an important condition to accord liquidity to thesukuk by making them tradable at a market price.

P1: TIX



Before one concludes that Islamic MFIs can solve their funding problems by seekingrecourse to securitization, one must remember that such securitization at present is only atheoretical possibility. Practical implementation of this is therefore a challenge. Indeed manyof the challenges to Islamic microfinance emanate from the fact that these are untried andunproven.

NOTES

1. For a more detailed analysis of poverty in Islamic countries, see M. Obaidullah and Tariqul-lah Khan (2007).

2. For a detailed discussion of these norms, see M. Obaidullah (2005) Chapter 3.3. An excellent account of IRW experiment in Kosovo and Bosnia Herzgovina is provided in

Khan and Phillips (2010) and Ajaz A. Khan (2008).4. See Rahul Dhumale and Amela Sapcanin (1998).5. For a more detailed discussion on this issue, see M. Obaidullah and S. Ali Salman (2010).

REFERENCES

Dhumale, R. and Sapcanin, A. (1998) An Application of Islamic Banking Principles to Microfinance,Technical Note, A Study by the Regional Bureau for Arab States, United Nations DevelopmentProgramme, in cooperation with the Middle East and North Africa Region, World Bank.

Khan A.A. (2008) Towards Islamic Microfinance: A Primer, Islamic Relief Worldwide.Khan A.A. and Phillips, I. (2010) The Influence of Faith on Islamic Microfinance Programmes, Islamic

Relief Worldwide.Obaidullah, M. (2005) Islamic Financial Services, Scientific Publishing, King Abdulaziz University,

Saudi Arabia.Obaidullah, M. and Khan, Tariqullah (2007) Islamic Microfinance Development, Challenges and Initia-

tives, IRTI, IDB.Obaidullah, M., and Ali, Salman S. (2010) Accessing Capital Markets for Islamic Microfinance, IRTI,

IDB (Unpublished).

FURTHER READING

Harper, M., Rao, D.S.K. and Sahu, A.K. (2008) Development, Divinity and Dharma, Practical ActionPublishing: Rugby.

Karim, N., Tarazi, M. and Reille, X. (2008) Islamic Microfinance: An Emerging Market Niche, FocusNote 49, Washington DC: CGAP, August.

Obaidullah, M. (2008) Role of Microfinance in Poverty Alleviation, IRTI, IDB.

P1: TIX


428

P1: TIX/XYZ P2: ABC

ind JWBK508-Hassan February 2, 2011 19:37 Printer: Yet to come

Index

9/11 terrorist attacks 382

AAOIFI Standards 25, 26, 34–6, 42, 51–2, 81,84–5, 180–2, 192, 197, 211–12, 231, 292,309, 311–12, 315–17, 319–33, 338, 403–13

see also fatawa; Shariah frameworkaccounting standards 35–6, 81, 84–5, 180–2,

192, 197, 231objectives 35–6, 309, 311–12, 315–17, 319–33

Abd al-Razzaq al-Sanhuri 156Abdel-Khaleq, Ayman 299Abdullah ibn Umar 29Abi Waqas, Sa’ad bin 55ability-based focus, social responsibilities 75,

77abortions 127, 128Abrahamic family tree 137Abrahamic finance 125–43, 369–70, 382

see also Christianity; Islam; JudaismAbrahamic funds 131–7Amana Mutual Funds Trust 134–7comparison of faith-based screening 128conclusions 136–7definition 125global financial crisis from 2007 135–7Islamic funds redux 128–37Mizan Fund 133–4, 141performance issues 126–37quantitative results 132–4robustness benefits 132–7usury 125–6, 131–7, 391

ABSs see asset-backed securitiesAbu Bakr 168Abu Dhabi 286–7, 320–7Abu Dhabi Islamic Bank (ADIB) 286–7Abu Qatadah 28academic sphere, Australia 349–56acceptability principle, financial engineering

389, 390–2accountabilities 84–5, 123–4, 388

accounting standardsAAOIFI Standards 35–6, 81, 84–5, 180–2,

231, 311–12, 316–17AASB 139 346IAS 39 156, 346

accounts receivable prohibitions 53, 63–7acts, legal maxims 34adl (justice) 30, 76Adobe 134adultery, prohibitions 54Africa 127, 236–9‘after acquired’ annexures 7ahadith 52, 186

see also ghararAhmad, Abu Umar Faruq 341–57AICMEU 419AIG 302–3, 366AITAB 25

see also ijarahAka, Jahangir 132–3Al Baqara 43, 53–4, 369Al Bukari 29al dalil (evidence) 52al Darurah principles 51Al Gazali 31, 76, 130Al Hilal Bank 160–4Al Juma 29al mustafti 50–2Al Rajhi Bank 328–9, 331Al Safi platform 291–4Al Sukoor 241al-Amine, Muhammad al-Bashir 157–8al-Ansari, Habban 204Al-Azhar 316–17al-Baihaqi 29al-Duraini 155al-Faisal, Amr 366–7Al-Ghazzali 31, 76, 130al-Isra, Surah 54al-Jawziyya 156

429

P1: TIX/XYZ P2: ABC


430 Index

al-kali (debt) 158al-kharaj bil-daman (profit follows

responsibility) 201–2al-Maidah, Surah 54al-qabdh al-haqiqi (actual physical possession)

149al-qabdh al-hukmi (constructive possession) 149Al-Qasas 29al-rifq (gentleness) 82Al-Sanea, Maan 69al-Shafi’i 158al-Shatibi 130, 390Al-Suwailem, Sami 385–400Al-Talaq 29Al-Zuhayli 4, 14–21Albania 237–9alcohol prohibitions 54, 56, 57, 59–67, 80, 82,

128–37, 186–7, 235–6, 250, 369, 407,410

Algeria 237–9Allah 28–31, 43, 73–5, 87, 185–6, 196, 370, 387,

393Allais, Maurice 367–8Allianz 240–2alms 25, 55, 73, 75, 207–15alph levels, asset managers 401The Alpha and Omega of Abrahamic finance

125–43amal ahl al madina (practice of the people of

Madina), Sharia secondary sources 27Amana Ikhtiar Malaysia (AIM) 416Amana Mutual Funds Trust 134–7, 280,

296–303, 416amanah (given as trust) 73–4Amanie Business Solution 313America

see also Canada; USdemographic statistics 236–9

American Israeli Shared Values Fund 135American options 163–4, 203–15AMF, France 270–1analogy 27–30, 151–2, 185–7, 202, 204–15

see also qiyasAnchor Finance Group 293ANGKASA 423‘anti-family’ companies 127Antonio, Muhammad Syafii 327–8Apple 134aqd 151–3, 202, 204–15aql (reason) 130Arab-Malaysia Unit Trust Berhad Malaysia

128–9arbitrage 106, 202, 208–9, 215, 387–8arboon 291–2, 308–9, 325–7Arcapita Investments 283–6Ariff, Dr 345

arms manufacturing prohibitions 62–3, 82, 127,128, 369

artifices 153–4, 393Asia

see also Central . . . ; South . . .demographic statistics 236–9, 343

aslsee also qiyasdefinition 29–30

ASSAIF 130asset application, Saudi Arabian Mortgage

Law 6asset managers

Abrahamic finance 125–43alph levels 401Australia 347–56corporate governance 122–4Germany 241–2securitization 39, 171–84Shariah-compliant portfolio management

401–14asset-backed bonds (ABBs) 173, 177asset-backed securities (ABSs) 173–82, 224–33,

371–2, 406–7see also sukuk

asset-based investments, US 283–303‘association of the underlying debt’, rahn

principles 5, 8–13AT&T 408–9Audit Committees 48–9auditing standards, AAOIFI Standards 36, 84–5,

180–2, 311–12, 316–17Australia 24, 308, 341–57

AASB 139 346academic sphere 349–56asset managers 347–56banks 344–6, 349–56China 343conclusions 355–6demographic statistics 342–4, 348–9, 355economic relevance 342–3, 347education 349–56financial services industry 341–56future prospects 347–56international innovation index 24Islamic financing products 341–56Muslim Community Co-operative 308,

341–56Muslim immigrants 355–6opportunities for Islamic banking 349–56potential problems 343–6recommendations 355–6regulators and standard-setting organizations

341–56Shariah-compliant products 341–56sukuk 348–9

P1: TIX/XYZ P2: ABC


Index 431

taxation 347–56universities 349–56

Ave Maria Mutual funds 127, 130, 135, 140, 141awqaf (religious endowment) 84, 417, 420ayan 154–5ayn 151–3, 154–5, 208–15Azami, Mufti Talha Ahmad 125–43Azzad funds 296–7

‘bad’ risks in Islamic finance 375–8Bahfen, Nasya 344Bahrain 64, 117–23, 192, 196, 236–9, 282,

314–15, 316–19, 320–7, 330–1, 354,379–80

bai-istijrar 423Baitul Maal wat Tamweel (BMTs) 416–18

see also microfinanceBakar, Mohd Daud 311–12, 335–6balance principle, financial engineering 389–90balance sheet management, Australia 345Baltic/Balkan countries 236–9bancassurance 188–9Bangladesh 236–9, 317, 415–16, 419–20Bank Islam Malaysia Bhd v Lim Kok Hoe &

Anor and other appeals 107–11Bank Negara 34, 94–5, 108–9, 197, 230–1,

314–17, 318–19, 320–7, 333, 337, 350Bankamiz 241Banking and Financial Institutions Act (BAFIA)

1969, Malaysia 92, 94–5, 231bankruptcies 12–13, 69–72, 301–2, 366banks 23–68, 70–89, 91–114, 171–84, 222–33,

240–66, 271–7, 286–303, 308–39, 344–56,366–84, 386, 389–400, 424–7

Australia 344–6, 349Basel Committee on Banking Supervision

36–7, 346, 363, 378–9, 382–3‘conservative lenders’ 366–7critique 359–427dispute resolution framework for the

Malaysian capital market 91–2, 96–114education 70–1, 74–5failed banks 366, 373flow of the approval process 43–6Germany 246–7, 248–63, 308global financial crisis from 2007 3–4, 69, 91,

96, 124, 135–7, 171–4, 180–1, 236, 248–1,285–6, 329–30, 342–3, 359–427

historical background 70–1Islamic banks 70–1, 92, 94–5, 108, 222–3,

240–66, 271–7, 286–303, 308–39, 344–56,366–84, 424–7

microfinance 424–7product development/approval processes

23–68Saudi Arabia 3–4

‘saviour of last resort’ illusions 363–5secular laws 70–1, 268social responsibilities 70–89‘too big to fail’ illusions 365training 70–1, 349–50

Banques Populaires Group 276–7Barclays 291–2, 330Basel Committee on Banking Supervision

(BCBS) 36–7, 346, 363, 378–9, 382–3batil (inexistence) 201–15bay al dayn 311, 318–29, 332–3bay al muzayadah 325–7bay al wafa 325–7bay al-inah (sale-buybacks) 177–82, 267–77,

311, 318–27, 332–3bay al-salam 202

see also futures marketsbay al-urbun (sale with advance payment) 202,

204–15see also options

bay bithaman ajil 318–27, 332BBA contracts 39, 107–11bear markets 126, 132–7benchmarks 55–67, 79–84, 85–6, 135–7, 294–5,

378–84, 404Abrahamic funds 135–7examples 60–7fatwa 55image criteria 57–67one third 55Shariah-compliant portfolio management 404social responsibilities 79–84, 85–6

Bermudan options 163–4best practices 48–9, 225–33, 329–33Bhambra, Hari 130The Bible 125Bielefeldt, Heiner 243–4binomial models 214Black-Scholes options pricing model 214Black-Scholes-Merton framework (BSM)

214–15BMB Islamic funds 130–2BMELV, Germany 246BMTs see Baitul Maal wat TamweelBNP Paribas 162, 276, 282, 308Board of Grievances, Saudi Arabia 4, 16board memberships, corporate governance

115–24, 181–2, 197, 311–15bonds 14, 25, 39, 91–114, 173–84, 406–7, 425–7

see also fixed-income securities . . .Booz & Co. 401Bosnia-Herzeg 237, 420Botswana 380Bovis Lend Lease 281–2Bowen, Chris 347–53BRAC 419

P1: TIX/XYZ P2: ABC


432 Index

BRED 276Bretton Woods 152Brewster, Deborah 134–5, 141Brugnoni, Alberto 130–1Brunei 320–7, 330, 347, 420BSNC Corporation Bhd v Ganesh Kumar

Bangah 96BSR/GlobalScan State of Sustainable Business

Poll 69Buddhism 369Bulgaria 237–9bull markets 126, 132–7burden of proof, prohibitions 390–1Bursa Malaysia 53, 62–3, 66–7, 98–101, 229business purposes, social responsibilities 69–89,

370Business for Social Responsibility (BSR) 69business transactions, Maqasid al Shariah 32–3,

76, 398–9buy and hold strategies 134–7, 181

call centres 83call options 150–1, 163–4, 203–15, 395–6

see also optionsCalPERS 128Calvert 130Calyon 276Canada 24, 129, 135cancer analogy, debt 391–2capital adequacy requirements 37, 119, 388Capital Adequacy Standards for Institutions . . .

(IFSB) 37, 119capital flows, Germany 241–2Capital Market Development Fund (CMDF) 231Capital Market Law (CML), Saudi Arabia 102–4Capital Market Masterplan, Malaysia 92, 225–33Capital Market and Services Act (CMSA) 2007,

Malaysia 91–106, 224–33capital markets 14–15, 23–68, 91–114, 125–43,

145–215, 221–33, 235–6, 307–39, 349–56,361–84, 385–400, 403–14, 420–3

see also securitiesdispute resolution frameworks 91–2, 96–114flow of the approval process 43–6Germany 238–66, 401–3global financial crisis from 2007 135–7,

361–84Malaysia 58–62, 66–7, 92–114, 128–37,

221–33, 307–39, 347–8, 401, 424product development/approval processes

23–68, 91–2, 125–43, 227–33, 235–6,307–39, 385–400, 403–14, 420–3

Saudi Arabia 5, 6, 102–4Shariah-compliant portfolio management

401–14, 420–3trends 145–215

United Arab Emirates 104–5US 279–303, 401

capitalismcritique 69–89, 245–6, 387–8, 389–90historical background 71–2

Capitalism and Freedom (Friedman) 72cash prohibitions 25, 38, 63–7Catholic Church 125–43, 382Cattelan, Valentino 201–17CDOs see collateralized debt obligationsCDSs see credit default swapsCECEI, France 270–1Cekici, Ibrahim-Zeyyad 267–77Central Asia, demographic statistics 236–9central banks 34–7, 43, 44–6, 94–114, 314–15,

320–39, 366, 424–5see also regulators and standard-setting

organizationscentral depository, Malaysia 93–114chairman positions, corporate governance

116–23chalets 57charge card Islamic financing products 38charitable activities 47, 75, 77, 79, 81, 84, 87,

207–8, 389–90, 415–27Charles Schwab 134, 135child labour 125, 128, 130, 132China 196, 239, 330, 343, 347, 362–3Christ, Jesus 137Christian Brothers Investment Services Inc. 127Christian Dior 407Christianity 127, 128, 130–2, 134–7, 140, 236,

243–4, 369see also Catholic ChurchAbrahamic finance 125–43, 369, 382interest 131, 369, 382usury 131, 369, 391

CIMB-Principal Islamic Asset Management135–6

cinema prohibitions 64Citigroup 160–1, 282, 286, 315, 344, 366Civil Code, France 269, 272clearing houses 93–114, 211–15, 380

Malaysia 93–114options 211–15

clients and contractors, screening processes 82CME Group Index Services LLC 64

see also Dow Jones . . .Code Napoleon 268, 307–8Codexa Capital 294collateral security regimes 3–21collateralization 172, 174–84, 365collateralized debt obligations (CDOs) 174, 365,

372–3collective rationalization, group think dangers

123

P1: TIX/XYZ P2: ABC


Index 433

commercial banks 53–4, 59–67, 399, 424–5see also banks

commercial paper 177commercial rules 75, 187–9, 223–5, 310–39,

390–1, 405Committee for the Resolution of Securities

Disputes (CRSD), Saudi Arabia 103–4commodities 157–8, 256–63, 368–9Commodity Futures Trading Commission

(CFTC) 157–8common law, law of contract 99, 108–9communism, critique 389–90community banking 368–70Community Reinvestment Act (CRA), US 362companions 27–30, 393competitive advantages, financial engineering

388–9compliance risks 25–6computations 24

see also financial engineeringcondoms 56–7conflicts of interest

corporate governance 122–4securitization 172–5, 179

conformity pressures, group think dangers 123consensus, Sharia sources 27–30, 185–7‘conservative lenders’, banks 366–7consistency principle, financial engineering 389,

393–4Constitutional Council, France 267–9constructive possession concepts, Saudi Arabia

6–7contraception 128contractual arrangements 5–21, 25, 28–30,

37–41, 147–67, 309–39, 371–84, 385–400rahn concepts 5–21

contradictory contracts, Shariah-compliantproducts 42–3

conventional insurance prohibitions 52–3, 54,62–7, 129, 185–97, 369–70, 381–4

convertible securities 425converts to Islam, Germany 238, 247–50cooperative arrangements 389–400, 415–27corporate governance 34–7, 85, 115–24, 181–2,

197, 311–15, 363–5, 370–84dissenting views 123–4empirical research 115–24good points 118–23group think dangers 123network analysis 115–24requirements 123–4Shariah scholars in the GCC 115, 116–18

corporate social responsibility (CSR) 70–89see also social responsibilities

Cox, Ross, and Rubinstein options pricing model214

Crean, Simon 353–4creative destruction 387–8creativity 13, 23–68, 386–400

see also inventionsfinancial engineering 386–400Saudi Arabian Mortgage Law 13

credit crunch see global financial crisis from2007

credit default swaps (CDSs) 365, 372–3credit derivatives 364–5credit markets 171–84, 271–7

see also securitizationcredit rating agencies 172–84, 362–5, 425

critique 174–6, 362–5, 425microfinance 425

credit risk 171–84, 214–15, 425–7Credit Suisse Asset Management 242creditors, rahn principles 5–21Croatia 239cross-currency swaps 158–60CRPT 128CSR see corporate social responsibilitycultural issues

diverse cultures 307–39, 403, 421–2Germany 243–50

currency derivatives 39, 148, 151–3, 155–67customer services, social responsibilities 83customers 72, 83, 397–8customs, legal maxims 34Cyprus 236–9

Dalla al Baraka 30, 313, 333, 421Fatwa no. 19/4(1) (8) 371 30Fatwa no. 19/8 30

damanah (collateral) 418Dana Al-Aiman 128Danah Real Estate Portfolio 282–3Dar al Istithmar 313Dar al-Mal al-Islami 366daruriyyar (necessities) 31–2, 80, 130Day of Assembly 29dayn (incorporeal obligations/debts) 151–3, 311,

318–29, 332–3de Bono, E. 386de novo case-by-case enforcements 3, 5debentures 226debt 38, 53–60, 63–7, 128–37, 151–3, 171–84,

283–303, 362–84, 391–2, 407–10debt card Islamic financing products 38debtors 5–21, 53–60, 80–1

rahn principles 5–21deception prohibitions 42defaults and remedies, Saudi Arabian Mortgage

Law 11–13delivery, derivative products 148–9, 152–3,

202–15

P1: TIX/XYZ P2: ABC


434 Index

DeLorenzo, A. Usama 221–33DeLorenzo, Yusuf Talal 165–8, 294–5, 307, 314Delphi Trade 295demographic statistics, Islam 236–9, 303, 343–4,

348–9, 355, 415depositors 43–6, 59–67, 271–7‘Depressions’ 366deregulated financial markets, global financial

crisis from 2007 362–5derivative products 25, 39, 96–7, 147–70,

201–15, 235–6, 363–5, 376–8, 385–400,406–7

see also forward . . . ; futures . . . ; options;swaps

conclusions 167definition 156, 201delivery 148–9, 152–3, 202–15exchange-traded derivatives 157–8existence/ownership/possession concepts

148–67, 201–15, 371fair-value accounting 156, 211–12ISDA/IIFM Tahawwut Master Agreement

147, 155–67, 373–5, 382‘legal oxymoron’ 202, 204–5list of products 39OTC derivatives 157–8, 362–5, 380prohibitions 147–67, 201–15, 235–6, 376–8,

385–400separation of risk 392Shariah objections 147–67, 201–2, 376–8,

385–400, 406–7substantive objections/resolutions 153–8,

202–15trading obligations for obligations 158, 392–3US 157–8

Deutsche Bank 164, 166, 240, 251–63, 344Deutsche Borse 241developments, Saudi Arabian court hindrances

3–4dhimma (legal personality) 151–3DIK, Germany 242–3din (faith) 130DiNapoli, Thomas 128disclosures 84–5, 222–33, 388discos, prohibitions 54discretionary actions, social responsibilities 74–5dispute resolution frameworks

Malaysian capital market 91–2, 96–114Saudi Arabia 102–4United Arab Emirates 104–5

dissenting views, corporate governance 123–4diversity principle 35, 47–9, 307–39, 403, 421–2dividends

see also equity-based productspurification of investments 404–5, 410–12

El Diwany, Tarek 131

DJIM 64–7, 129, 135–6, 139, 165–6, 229, 286,296–7, 308

documentation issues, fatawa 51–2The Dolbin Company 281–2Dow Jones (DJ) indices 52, 63–7, 91, 129,

135–6, 139, 165–6, 229, 286–7, 296–7, 308,366

Drucker, Peter 72, 388DSAM Kauthar 292–3Dubai 70–1, 155–6, 160, 183, 230–1, 236–9,

282, 292–3, 312–13, 316–17, 320–7,329–30, 362

Dubai Islamic Bank 70–1, 160–1, 282, 312–13,324–7

due diligence efforts 7, 173–4duress prohibitions 42DWS Investments 241

e-murabaha 397E-Plus 240East Cameron Partners sukuk, US 300–3economic issues 3–4, 23–4, 43, 52, 69–89, 91,

96, 124, 135–7, 171–4, 180–1, 236, 238–9,244–6, 248–1, 272–7, 285–6, 307–39,342–3, 347, 359–427

‘Depressions’ 366fatwa consequences 52GDP 24, 238, 342–3, 347global financial crisis from 2007 3–4, 69, 91,

96, 124, 135–7, 171–4, 180–1, 236, 248–1,285–6, 329–30, 342–3, 359–427

innovations 23–4, 43, 307–39microfinance 83–4, 85–6, 197, 415–27Shariah-compliant products 43, 70–89socio-economic issues 69–89, 370–84,

389–400, 415–27economies of scale 83, 310education 70–1, 74–5, 118–23, 231–2, 243–4,

247–63, 349–56see also skillsAustralia 349–56corporate governance 118–23France 276–7Germany 243–4, 248–63social responsibilities 70–1, 74–5UK 261

Egypt 237–9, 244, 308, 313, 317–19, 415, 419einah 394–5

see also tawarruqEmployee Provident Fund (EPF) 230employees

equal employment opportunities 127social responsibilities 81, 83–4

enforcement processes, Saudi Arabia 3, 4–14enlightened self-interest 71–2Enron 129, 388, 393

P1: TIX/XYZ P2: ABC


Index 435

entertainment prohibitions 52–3, 57, 62–7,128–37, 369

see also gambling . . . ; hotels . . . ; pornographyentrepreneurship 70, 85–6, 176–7, 370–5environmental concerns 78–9, 82, 85–6,

125–43Epiphany Core Equity Fund 127equal employment opportunities 127equity-based products 25, 37–9, 177–82, 191,

229–33, 250–63, 370–84, 399, 404–14,417–27

see also musharakah . . . ; shares . . .list of products 38–9

Ernst & Young 401ETFs see exchange-traded fundsethics 32–3, 69–89, 122–4, 125–43, 262, 274–5,

294–7, 313–14, 356, 365, 368–84Abrahamic finance 125–43global financial crisis from 2007 363–5

Ethiopia 196, 239Europe 236–9, 347–8, 401–4

see also individual countriesdemographic statistics 236–9

European options 163–4, 203–15examination processes, product development

41–2exchange-traded derivatives 157–8exchange-traded funds (ETFs) 157–8, 279–80,

295–303Execution Law, Saudi Arabia 4, 10–13executive compensation scandals 127existence concepts, derivative products 148–67,

201–15, 371expenses of the mortgaged property, Saudi

Arabian Mortgage Law 5, 9–11external process, product approval 44–6, 47–9

factoring Islamic financing products 38fair-value accounting, derivative products 156,

211–12far

see also qiyasdefinition 29

fardh (obligatory duties) 73, 75–6, 77–9, 87Farhoush, Azadeh 235–66Farook, Sayd 69–89fasad al-zaman 55fasting 73, 248–50fatawa 47–52, 231, 310–12, 314–15, 324–33,

398–9see also AAOIFI Standardsdocumentation issues 51–2international hubs 327–33methodology and standards 50–2presentation methodology 51–2rules of engagement 49–52

fatwa 27–8, 30, 33–4, 47–52, 112, 122, 123, 181,186–7, 398–9

see also legal maximsbenchmarks 55empowering methodology 52

fatwq 48FDIC see Federal Deposit Insurance CorporationFederal Deposit Insurance Corporation (FDIC)

157–8Federal Reserve 157–8, 362Fidelity 134, 135, 240‘fiducie’, France 268–9finance industry, regulators and standard-setting

organizations 34–7Finance Laws in Saudi Arabia 4–21financial analysis, Shariah-compliant portfolio

management 402, 404financial engineering 23–68, 147–70, 385–400

see also derivative products; innovations;product development

acceptability principle 389, 390–2balance principle 389–90challenges 398–400competitive advantages 388–9conclusions 399–400consistency principle 389, 393–4creativity 386–400definition 23–4, 385–6Drucker’s critique 388examples 25failures 25–6gambling prohibitions 386imitation strategy 395–6innovations 385–6integration principle 389, 392–3Islamic perspective 24–6, 385–400mutation strategy 396–7principles 24–5, 388–94, 399–400R&D 25satisfaction strategy 397–8Shariah process 23–68, 398–400Shariah-compliant products 387–400‘solutions’ 386

financial innovations see innovationsfinancial institutions 3–4, 34–7, 41–60, 69–89,

122–4, 128–37, 147–67, 245–66, 291–303,309–39, 341–57, 363–5, 370, 372–84,399–400

broader social responsibility mandate 76–9corporate governance 122–4definition 77–8disclosures 84–5, 388dispute resolution framework for the

Malaysian capital market 91–2, 96–114diverse cultures 309–39, 403, 421–2France 267–77

P1: TIX/XYZ P2: ABC


436 Index

financial institutions (Continued )global financial crisis from 2007 3–4, 69, 91,

96, 124, 135–7, 171–4, 180–1, 236, 248–1,285–6, 329–30, 342–3, 359–427

IFSB principles 47–9, 115–24, 312–13mandatory responsibilities 79–84obligations 77–9, 372–5religious obligations 78–9, 84, 87, 125–43Saudi Arabia 3–4‘saviour of last resort’ illusions 363–5social responsibilities 69–89, 370–5, 389–400special obligations 77–9specialized institutions 399–400SSB resolutions 47–9US 279–80, 291–303

financial ratios, prohibitions 63, 65–7, 129–30,407–10

financial services industryAustralia 341–56Germany 244–66IFSB standards 26, 34, 36–7, 115–24, 312–13regulatory arbitrage 387–8social responsibilities 69–89, 389–400

Financial Times 134–5financing sources, Saudi Arabia 3–4FINCA 416fiqh (intelligence)

concepts 34, 52, 150–67, 181–2, 185–7, 202,203–15, 223–5, 271–2, 292, 310–39, 393,417, 420–5

definition 311–12First Leasing Bank 282, 288–9Fisher, Omar Clark 137, 142five pillars of Islam 73, 75, 248–50, 417fixed legs, swaps 158–67fixed-income securities based on securitization

see also sukuklist of products 39, 177–82

floating legs, swaps 158–67forgeries 8formalization issues, collateral security regimes

3–21forward derivative products 39, 148–9, 152–3,

203, 235–6, 372–8, 385–400France 24, 236–9, 244, 267–77, 307–8, 347,

380–1AMF 270–1banks 271–7CECEI 270–1Civil Code 269, 272Code Napoleon 268, 307–8colonialism factors 244, 275, 307–8Constitutional Council 267–9demand-side economics 273–5demographic statistics 236–9, 274economic relevance 267–8, 272–7

education 276–7executive power 269–71‘fiducie’ 268–9financial institutions 267–77future trends 271–2, 276–7international innovation index 24Islamic finance 268–77legal aspects 267–72Middle East 267, 275Muslim immigrants 236–9, 244, 267–77Muslim-specific products/services 240–1,

274–7North Africa 267, 276public authorities 268–72regulators and standard-setting organizations

240–1, 267–77, 347religious dimensions 267–8, 274–5research/studies 273–7Shariah-compliant products 267–77statistics 267–77sukuk 268–77supply-side economics 273, 275–7

free market capitalism 71–2, 387–8Friedman, Milton 72Friends Provident 127FSA 240, 245FTSE Bursa Malaysia EMAS Shariah index

62–3, 66–7, 229FTSE Bursa Malaysia Hijrah Shariah index

62–3, 66–7, 229FTSE Global Islamic Index Series (GIIS) 308FTSE indices 52, 62–7, 91–2, 135–6, 229, 308,

366fund managers 53–60, 95–114, 126–37, 225–33,

347–56, 401–14funding requirements, microfinance 424–7futures markets 25, 96–7, 148–9, 152–3, 166–7,

202, 203–4, 235–6, 372–8, 385–400, 406FX options 163–4

G7 381G20 381Galloux, Michel 312Gambia 314gambling prohibitions 52–3, 54, 57, 59–67, 82,

126–43, 147–8, 155–8, 169, 176–7, 179–80,186, 202–15, 307–8, 369, 372–3, 386,405–8

financial engineering 386Quran 54, 186speculation comparisons 156–7

gaming prohibitions 52–3, 54, 57, 59–67GCC see Gulf Cooperation CouncilGCIBFI 181–2, 329GDP, statistics 24, 238, 342–3, 347GE Capital sukuk, US 300–3

P1: TIX/XYZ P2: ABC


Index 437

Gemada Berhad 61–2genetic algorithms (GA) 396–7Germany 24, 155–6, 235–66, 308, 344, 380,

401–4asset managers 241–2banking attitudes 246–7, 248–63, 308capital flows 241–2capital markets 238–66, 401–3conclusions 260–3converts to Islam 238, 247–50cultural issues 243–50DIK 242–3economic relevance 238–9, 244–6, 401education 243–4, 247–63financial advisors 250–63financial knowledge 248, 250–63financial products 246–63financial services industry 244–66future prospects 258–63investors 241–2, 248–63Islamic Holding Scandal 241literature on Islamic finance 244–6market potential 255–63marketing activities 262Muslim attitudes/preferences towards financial

products 246–63Muslim immigrants 236–9, 242–3, 246–63Muslim-specific products/services 239–40,

246–63, 401prejudices 243–4, 246product development/approval 239–66prohibitions 250, 255–63qualitative results on Muslim attitudes

258–63quantitative results on Muslim attitudes

248–63regulators and standard-setting organizations

240–66religious dimensions 236, 243–4, 248–50,

253research/studies on Islamic finance 244–6research/studies on the Muslim population

242–63savings 238–9, 248–3, 256–63Shariah-compliant products 239–66statistics 235–66status quo of products/services 240–1

gharar (uncertainty) prohibitions 42, 54, 74–5,82, 85, 147–9, 150–1, 153, 154–8, 161,176–7, 179–80, 186–9, 193, 202–15, 235–6,307–8, 368–70, 372, 375–8, 391–2, 405–8,417

see also insurance; speculationcritique 375–8, 391, 392, 406–7definition 186, 376, 392, 406

ghubn fahish 55–6

ghubn prohibitions 42, 55–6ghubn yasir 56Gintzburger, Anne-Sophie 307–39global financial crisis from 2007 3–4, 69, 91, 96,

124, 135–7, 171–4, 180–1, 236, 248–1,285–6, 329–30, 342–3, 359–427

Abrahamic funds 135–7blame 365causes 171–3, 180–1, 361–5, 386CDSs 365credit rating agencies 362–5deregulated financial markets 362–5greed 363–5, 373, 386implications 365–7interest rates 362–84Islamic financing products 135–7, 361–2,

366–84Islamic theory of finance 367–75lessons learned 378–84macroeconomic roots and politics 362–5moral dimensions 365policy-fuelled markets hypes 362–5real estate 362–7regulators and standard-setting organizations

362–84securitization 362–5speculation 362–5

global inequalities, historical context 78–9Global Securities House 289–90global warming 127God 28, 31, 53–4, 73–9, 125, 185‘good’ risks in Islamic finance 375–8Goud, Blake 279–306Government Investment Issue (GII) 91–2Grameen Bank 83, 85, 416, 419, 421Greece 239greed, global financial crisis from 2007 363–5,

373, 386Greenspan, Alan 362Gresham’s Law 398–9group think dangers, complimentary boards 123guarantee (kafalah) contracts see kafalah . . .Guiding Principles on Corporate Governance

for Institutions (IFSB) 37, 118–23Guiding Principles of Risk Management for

Institutions . . . (IFSB) 37, 119Gulf Cooperation Council (GCC) 5, 115–24,

135, 179, 279, 286, 289, 291, 307–39,349–50, 401–14

conclusion 331–3Malaysia 307–39Shariah Boards 310–14, 316–17, 319–39,

403–4Shariah-compliant products 307–39, 401–14

Gulf Finance House (GFH) 164–5Gulf Investment House 286–7

P1: TIX/XYZ P2: ABC


438 Index

Hadi, Dr Fareed 164hadiths (do not sell what is not with you) 11, 29,

34, 54, 55, 139–40, 151–8, 168, 196–7,205–6

hajiyat (requisites) 80hajj (pilgrimage), five pillars of Islam 73, 75,

222, 232, 248–50, 253, 313–14, 420hakam 212–13halal profits

critique 375product development/approval processes

43–6, 58–65, 131prohibitions 52–3, 54, 57–65, 131, 176,

235–6, 369, 375, 405–6Halcore Group 286–7Hanafi school 9, 15–18, 56, 154–5, 208–11,

212–13, 223–5, 317Hanbali school 9, 11, 15–20, 154–5, 205–11,

223–5, 317Hannover Ruck 241haqq mali (pecuniary rights) 150–1, 204–5haraam securities 165–6haram (impermissible avoidance)

concepts 55, 58, 73, 80, 128–9, 131, 176–7,186–8, 228–9, 235–6, 369–70, 375, 406–7

critique 375harm, legal maxims 34Hasan Fund 418, 419Hassan, Hussein 166, 312–13Hassan, M. Kabir 23–68, 91–114, 279–306,

314–15, 341–57, 361–84, 385–400hawalah (assignment of debt) 37, 267–77,

326–7, 377–8hedging 25, 136, 155–8, 177–82, 198, 201–15,

291–303, 373–5, 382definition 155–6speculation contrasts 155–6

Helvetia 240–1Hewson, John 349Hezbollah 419hiba 207–15, 327–8, 417hila (artifice) 393Hinduism 369HIV/AIDS 127hiyal (questionable legal stratagems) 153–4,

393Hodeidah microfinance program 419home purchase financing 3–4, 25, 38, 40homosexuality 128honesty 370Hong Kong 303, 330, 347hotels activities 56–7, 59–65

see also chalets; resortshouse (asset) financing Islamic financing

products 38, 40HSBC 86, 240, 289–90, 308, 344, 366

hukm 29–30, 314see also qiyas

Hull, John 362human rights 128–37huquq ghair muslimin 55, 202husn al-khulq (pleasant speech and conduct) 82hybrid capital market model, Malaysia 105–6,

109–10, 227HypoVereinsbank (HVB), Germany 240

IAS 39 156, 346ibadah (worship rules) 75, 405, 407Ibn Abbas 28–9, 205Ibn al-Khattab, Umar 206Ibn al-Qayyim al Jawziyyah 130, 393, 394Ibn Ashur 30Ibn Hazm 27Ibn Majah 29, 205Ibn Qudama 149, 158, 208Ibn Rushd 4, 15–21Ibn Taymiyya 149, 156, 158, 390, 393ibrar 110, 325–7ICFAL see Islamic Cooperative Finance

Australia LtdICMA 382IDB see Islamic Development BankIdealRatings 293–4IFC sukuk 227IFSB standards 26, 34, 36–7, 47–9, 51, 115–24,

181–2, 188–9, 197, 231, 236, 312–14, 330,382

see also Shariah Boardsobjectives 36–7, 47–9, 115–24, 188–9, 312–13Principle 3.1 47–9Principle 3.2 49publications 37, 118–23SSB principles 47–9

IFSP 351–4ihsan (fair dealing) 82, 397ihtiyat 55IIBU Fund II PLC 282IIFM 147, 155–67, 329, 373–4, 382IIRA 181–2, 329ijara wa-hiba (IWH) 202, 206–15

see also optionsijara wa-iqtina 210–11ijara-istisna’a contracts, US 280–2, 286–303ijarah (leasing) contracts

see also AITABconcepts 25, 28–30, 37–9, 40–1, 177–82,

202–15, 229–33, 271–7, 280–303, 308, 309,317–39, 379–84, 396–7, 421–6

rulings derived from primary sources 28–30ijarah muntahiah bittamlik (leasing ending with

ownership) 38, 40–1ijarah thumma al-bay (sale-leasebacks) 177–82

P1: TIX/XYZ P2: ABC


Index 439

Ijma (consensus), Sharia sources 27–30, 185–7ijtihad 27, 28, 30, 33–4, 49–52, 109, 311–15,

327–8, 337see also legal maxims

illah 29–30, 151–2see also qiyas

illusion of invulnerability, group think dangers123

illusion of morality, group think dangers 123illusion of unanimity, group think dangers

123image criteria

benchmarks 57–67securities 55, 56–67Sharia principles 57–60

imam mujtahids (those who undertake ijtihad)185–7

imitation strategy, financial engineering 395–6immoral services, prohibitions 54inah 38, 267–77, 311, 318–27, 332–3incentives, commerce 390–1India 106, 236–9, 275, 308, 362–3, 403,

419–20individual/systemic effects of ‘bad’ risks in

Islamic finance 377–8Indonesia 236–9, 241, 245, 314–15, 317, 320–7,

347–50, 381, 415–18, 424Industry Classification Benchmark (ICB)

64–5inequality prohibitions 42inflation rates 368–9ING Funds 242innovations 23–68, 147–70, 307–39, 385–400

see also derivative products; financialengineering; product development

challenges 398–400competitive advantages 388–9conclusions 399–400creative destruction 387–8definition 23–4, 385–6Drucker’s critique 388economic benefits 23–4, 43examples 25, 308–9failures 25–6international innovation index 24principles to be considered 24–5, 388–94,

399–400Shariah process 23–68, 398–400Shariah-compliant products 387–400state of financial engineering 388tools 386–400value of innovation 386–7‘zero-sum games’ 388, 391

institutional investorssee also pension fundsUS 279–80, 291–303

insurance 25, 37–43, 52–3, 54, 65–7, 74–5, 92,95, 157–8, 176–7, 185–99, 235–6, 240–1,255–63, 310, 369–70, 376–8, 380–1, 389,418–27

see also takafuloperational models 188–93organizational structures 188–93

integration principle, financial engineering 389,392–3

interdependencies 389–90interest 3–5, 42, 52–4, 58–67, 70–1, 74–5, 80–1,

107–8, 128–37, 176–82, 185–6, 214–15,235–6, 253–63, 267–77, 307–8, 344–56,362–84, 389, 391–2, 405–10, 421

see also ribainterest rate swaps 161, 395–6

see also profit rate swapsinterest rates, global financial crisis from 2007

362–84interest-based financing, Saudi Arabia 3–5internal process, product approval 44–6, 47–9International Association of Insurance

Supervisors 36–7International Centre for Education in Islamic

Finance (INCEIF) 231, 350International Centre for Leadership in Finance

(ICLIF) 231international hubs, Islamic financing products

327–33international innovation index 24International Monetary Fund (IMF) 182, 382International Organization of Securities

Commissions (IOSCO) 36–7, 229–30,270–1

International Shariah Research Academy forIslamic Finance (ISRA) 231, 337–8

interpretations 30, 307–8, 311–15, 318–39,398–400, 407–10, 421–2

intoxicants 54, 57see also alcohol . . .

inventionssee also creativity; innovationsdefinition 23–4

Investcorp 282investment banks 285–6, 328, 399

see also banksInvestment Company Act 1940, US 298–9Investment Dar 183investment policy analysis, Shariah-compliant

portfolio management 402–4investment quotas, social responsibilities 83investors 43–6, 78–9, 91–114, 128–37, 365,

372–84Abrahamic finance 127–37dispute resolution framework for the

Malaysian capital market 91–2, 96–114

P1: TIX/XYZ P2: ABC


440 Index

investors (Continued )Germany 241–2, 248–63US 279–303

‘invisible hand’ 71–2IOSCO see International Organization of

Securities Commissionsiqta 325–7Iran 237–9, 245, 247Iraq 380IRTI study 415Isaac 137ISDA/IIFM Tahawwut Master Agreement 147,

155–67, 373–5, 382Ishmael, Prophet 137Iskan Finance Pty Ltd 341Islam 24–6, 32–3, 69–89, 236–9, 274, 303,

343–4, 348–9, 355, 370, 385–400, 415Abrahamic finance 125–43, 369, 382converts 239, 247–50demographic statistics 236–9, 274, 303,

343–4, 348–9, 355, 415diverse cultures 307–39, 403, 421–2five pillars of Islam 73, 75, 248–50, 417

Islamic Bank Bangladesh 416Islamic Bank of Britain (IBB) 240, 308, 330Islamic Banking Act (IBA) 1983, Malaysia 92,

94–5, 108, 222–3, 315Islamic banks 70–1, 92, 94–5, 108, 222–3,

240–66, 271–7, 286–303, 308–39, 344–56,366–84, 424–7

Islamic Capital Market Graduate TrainingScheme (ICMGTS) 231

Islamic Cooperative Finance Australia Ltd(ICFAL) 341–56

Islamic Development Bank (IDB) 70–1, 236–8,425

Islamic financing products 26, 34, 36–7, 38–9,47–9, 51, 115–24, 128–37, 149–53, 176–84,188–9, 197, 202–15, 230–1, 235–66,307–39, 341–57, 367–75, 385–400,401–14, 417–27

conclusions 380–4convergence with conventional industry 381–2critique 373–5, 380–4, 387–400future prospects 257–63, 280, 302–3, 347–56,

380–4, 398–400global financial crisis from 2007 135–7,

361–2, 366–84global trends 307–39IFSB standards 26, 34, 36–7, 47–9, 51,

115–24, 181–2, 188–9, 197, 231, 236,312–13

international hubs 327–33Islamic theory of finance 149–53, 202–15,

367–75list of products 38–9

market failures 373–5regional pockets 307–39Shariah-compliant portfolio management

401–14statistics 24, 177–9, 195–6, 221–33, 236–66

Islamic funds redux 128–37Islamic Holding Scandal, Germany 241Islamic indices, critique 403–4Islamic Markets Programme (IMP) 230–1Islamic microfinance see microfinanceIslamic Microfinance Fund 425Islamic perspectives

financial engineering 24–6, 385–400social responsibilities 32–3, 69–89, 370,

389–400Islamic Relief Worldwide 420Islamic securitization 176–82

see also securitizationIslamic theory of finance, global financial crisis

from 2007 367–75isnad (chain of transmission) 154–5, 158Israel 126–7, 135istihsan (juristic preference), Sharia secondary

sources 27, 30istijrar (sale of supply) 325–7, 423istishab (presumption of continuity), Sharia

secondary sources 27istisna (manufacturing) contracts, innovations

25, 38, 40, 148–9, 153, 158, 179–80,229–33, 271–7, 280–303, 309, 318–39,377–8, 396–7, 426

Italy 239Ivory Coast 239iwad 209–11, 214–15

Jabal al-Hoss microfinance project 416, 419jahl (ignorance) 183Japan 24, 347, 380Javelin Exchange Traded Series 296–7Jobst, Andreas A. 171–84, 211–12, 214–15,

244–5joint ventures, Australia 346Jordan 313, 314–15J.P. Morgan Chase 282juala 42–3, 326–7Judaism 125–43, 369, 382, 391

Abrahamic finance 125–43, 369, 382usury 131, 369, 391

justice 74–5, 76, 77, 78–9, 81, 388–94‘to educate and establish justice’

responsibilities 74–5, 76, 77, 78–9, 81

kafalah (guarantee) contracts 28, 38, 325–7, 418,425

Kamali, M.H. 74, 80, 154, 157, 168–9, 204–11,244

P1: TIX/XYZ P2: ABC


Index 441

kashrut (non-Kosher foods) 128Kayed, Rasem N. 361–84Kenya 380KeyBank, NA 281Khadem, Ali Rod 147–70khiyar ash-shart 202, 203–15

see also optionskosher investment funds 126–7Kosovo 237–9, 420KSLI 129Kuveyt Turk Bank 241, 380–1Kuwait 117–23, 162–3, 236–9, 282, 286–95,

313, 314–15, 317–19, 320–8, 331Kuwait Finance House (KFH) 282, 286–90, 302,

308, 313, 331, 341

La Trobe University 349–53Lahsasna, Ahcene 23–68lateral thinking 386law of contract, common law 99, 108–9LC 38leasing 25, 28–30, 37–9, 40–1, 177–82, 210–15,

280–303, 371–84, 397–9, 421–6see also ijarah . . .

Lebanon 418, 419legal framework, dispute resolution framework

for the Malaysian capital market 91–2,96–114

legal maxims 26, 33–4, 51, 109, 181–2, 187–8,310–39

see also fatwa; ijtihad; Shariah frameworkexamples 34

‘legal oxymoron’, derivative products 202, 204–5Lehman Brothers 171, 366lessons learned, global financial crisis from 2007

378–84letters of guarantee 38leveraging 362–5, 376–8, 407–10, 413Lewis, Mervyn K. 185–99LIBOR 129, 162–6, 294–5life insurance prohibitions 63, 185–97, 380–1lifnei iver (assisting moral misconduct) 126–7Lightstone Capital 133limited liability companies (LLCs) 280–3limited partnerships 280–3limited recourse project financing 3–4liquid/illiquid asset prohibitions 63list of products, Shariah-based products 37–9listed securities

see also securitiesproduct approval 53–67

Lloyd TSB 240, 344Lloyd’s 188–9LMC 329loans 30, 107–11, 131–7, 177–82, 257–63,

267–77, 362–84, 391–2, 415–27

London Metal Exchange 159, 270Luther King Capital Management 127Luxembourg 347

Macedonia 237–9McMillen, Michael J.T. 3–21, 281Maconda Park Apartments 280–2, 286–8, 297–8madhahib (schools of jurisprudence) 6, 8–9,

15–17, 107, 166, 207–15Madoff, Bernie 69mafsadah 30Maghreb 236–9Mahlknecht, Michael 361–84Mahmood, Dr Nik Ramlah Nik 221–33Majelle 4, 7, 15–21majhul 210–11Majma Fiqh 34mal (property) 130, 150–1, 201–15Malaysia 25, 36, 46, 52–62, 66–7, 91–114, 116,

128–37, 160–1, 191, 193–7, 221–33, 244–6,291, 307–39, 347–50, 401, 420, 424

Banking and Financial Institutions Act(BAFIA) 1969 92, 94–5, 231

BIMB cases 107–11Capital Market Masterplan 92, 225–33Capital Market and Services Act (CMSA)

2007 91–106, 224–33capital markets 58–62, 66–7, 92–114, 128–37,

221–33, 307–39, 347–8, 401, 424cases 96–7, 99–101, 107–11conclusions 106, 231–2, 327–33dispute resolution framework for the

Malaysian capital market 91–2, 96–114GCC 307–39High Court 96–113historical background 222–3, 227, 313–14hybrid capital market model 105–6, 109–10,

227IFSB host 36inadequacy of the existing legal reforms 101–2international linkages 230–1, 307–39Islamic Banking Act (IBA) 1983 92, 94–5,

108, 222–3, 315legal constraints/concerns 97–102legal framework 91–114, 221–33, 310–39nature of disputes 96–7practice notes 95regulators and standard-setting organizations

25, 36, 46, 52–62, 66–7, 91–114, 221–33,310–39

Securities Commission 58–62, 66–7, 92–114,221–33, 314–15, 320–39

Securities Commission Act (SCA) 1993 92,94, 97–8, 105–6, 222–3, 314–15

Shariah Advisory Council of Malaysia 52–60,93, 97–114, 223–33, 315–27

P1: TIX/XYZ P2: ABC


442 Index

Malaysia (Continued )Shariah Boards 52–60, 93, 97–114, 223–33,

310–15, 319–39Shariah court of appeal 97–9, 107–12Shariah-compliant products 98–101, 221–33,

307–39, 347–8, 401skill sets 231–2statistics 221–33sukuk 226–33Tabung Haji 222, 313–14, 420takaful products 193–7, 222–33, 310, 315,

318–19, 423Malaysian International Islamic Finance Centre

(MIFC) 230, 327–9Maliki school 154–5, 205–12, 223–5, 317Management (Drucker) 72mandatory forms, social responsibilities 79–84mandoob (discretionary activities) 75–6manfa (usufruct) 43, 150–1, 207–15manhaj (methodologies) 223–33Maqasid al Shariah 26, 31–3, 76, 130, 398–9

see also maslaha mursala (public interest);Shariah framework

business transactions 32–3, 76, 398–9definition 31principles 33product development 31–2, 398–9wealth 31–3

maqassa 151–3marhun 6–7market failures

see also capital marketsIslamic theory of finance 373–5

market risks 363–5marketing activities, Germany 262marriage 127Mary (mother of Jesus Christ) 137Marzban, Shehab 401–14masalih masyru’ah (legitimate interests) 30maslaha mursala (public interest) 27–31, 55–67,

76, 78–80, 147–8, 180, 202–15, 228–33see also Maqasid al Shariahdefinition 30, 31Sharia secondary sources 27–31, 55–67

maslahah rajihah (tangible deeds) 56, 58–67mathematics 24

see also financial engineeringmaysir (gambling)

see also gambling . . .concepts 42, 82, 155–8, 161, 176–7, 179–80,

186, 189, 190, 202–15, 307–8, 368–70,405–8

definition 186MCCA see Muslim Community Cooperative

Australia LimitedMed-Ex 109–12

MENA see Middle East; North Africamerchant banks 53–4, 94–114Merrill Lynch 134, 135, 366methodology used in the approval process

49–52Meyer, Eric 291mezzanine finance 178microfinance (MF) 83–4, 85–6, 197, 415–27

agency problems 422–3banks 424–7conventional models 416–17credit rating agencies 425definition 415divergent perceptions 421–2funding requirements 424–7global aspects 418–20Grameen Bank 83, 85, 416, 419, 421indigenous models 416–17instruments 417–18Islamic Microfinance Fund 425mobilization of funds 417–18modes 415–17product development 420–3regulators and standard-setting organizations

420–7securitization 425–7social responsibilities 83–4, 85–6sources of funds 417, 424–7sukuk 425–6

Middle East 236–9, 267, 275, 307–39, 349–54,419

see also Gulf Cooperation Councildemographic statistics 236–9France 267, 275microfinance projects 419

mindguards, group think dangers 123Minerals Management Service (MMS) 300–1minority opinions 51mixed companies

definition 55product approval 54–67, 403–14

Mizan Fund 133–4, 141money illusions 392, 398moral dimensions 32–3, 126–43, 365, 370–84MorningStar 241Morocco 237–9, 247Mortgage Law in Saudi Arabia 4–21

definition 14specific provisions 5, 6–13

mortgage-backed securities (MBSs) 172, 227,365

mortgaged properties 5, 7–8rahn principles 5–21

mortgages 3–21, 65, 172–84, 257–63, 293–303,362–84

see also rahn concepts

P1: TIX/XYZ P2: ABC


Index 443

global financial crisis from 2007 171–4,180–1, 362–5

Saudi Arabia 3–21types 18

Moses 137Mother Earth Inc. 130movable assets, Saudi Arabia 5–13Mozambique 239muamalat (commercial rules) 75, 187–9, 223–5,

310–39, 405Mu’assasat Bayt Al-Mal microfinance project

419mudarabah (trusts/profit-sharing) 37–9, 42–3,

177–82, 190–7, 229–33, 235–6, 250–5,267–77, 309, 317–39, 368–70, 372–84,417–27

critique 191definition 190–1

mufti 112muhtasib (Ombudsman) 106mukhatarah (risk-taking) 156–7, 267–8murabahah (synthetic loans/purchase orders)

37–9, 42–3, 159–68, 177–82, 295–303, 309,318–39, 379–84, 394, 397–8, 418, 419,420–2

Musa, Prophet 29musawama 167musharakah (equity-based) contracts

concepts 25, 37–8, 177–82, 191, 229–33,250–5, 301–3, 309–39, 346–56, 370,372–84, 417–18, 419, 426

critique 374music prohibitions 64Muslim Brotherhood 308Muslim Community Cooperative Australia

Limited (MCCA) 308, 341–56mustahab (recommended duties) 75–6mustasne 282mutation strategy, financial engineering 396–7mutual funds 38, 126–37, 176–7, 188–9, 241–2,

244–6, 256–63, 269–77, 279–80, 295–303,399

Mutual Recognition Agreements (MRAs) 230–1muzakara 320MyETF 229

nafs (life) 130Nakheel 182–3Napoleonic Code 268, 307–8Nappier, Denise 128NASDAQ 366nasl (posterity) 130National Australian Bank (NAB) 350–4national experiences 219–357The National Pilgrims Fund Board, Malaysia

222, 313–14

NCB Capital 135Netherlands

demographic statistics 237–9international innovation index 24

network analysis, corporate governance115–24

niche markets 23–4, 41–3, 232, 385–400Nigeria 237–9, 415NIKKEI 366NIO, Saudi Arabia 4nisab 368–70non-compliance risk, triggers 40North Africa 236–9, 267, 276, 330, 353, 419

demographic statistics 236–9France 267, 276microfinance projects 419

notes 39see also fixed-income securities . . .

nuclear power 128NYSCR 128

Obaidullah, Mohammed 415–27off-balance sheet transactions 173–84

see also securitizationoil prices 366Ombudsman institution 106The Omega, The Alpha and Omega of

Abrahamic finance 125–43on-balance sheet funding 173, 177

see also securitizationoperation, safety, and expenses of the mortgaged

property, Saudi Arabian Mortgage Law 5,9–11

options 39, 149–51, 152–3, 163–4, 201–17,235–6, 372–8, 385–400, 406

see also American . . . ; call . . . ; European . . . ;put . . .

bay al-urbun (sale with advance payment)202, 204–15

Black-Scholes options pricing model 214Black-Scholes-Merton framework (BSM)

214–15clearing houses 211–15Cox, Ross, and Rubinstein options pricing

model 214definition 163, 203FX options 163–4ijara wa-hiba 202, 206–15Islamic justice 203–6khiyar ash-shart 202, 203–15path towards legitimacy 215premiums 203–15pricing formulae 213–15Shariah objections/solutions 149–51, 152–3,

202–15, 372–8, 385–400, 406sukuk al-manfa‘a 211–15

P1: TIX/XYZ P2: ABC


444 Index

Organization of the Islamic Conference (OIC)308, 319–20, 333, 415

organizational structures, insurance 188–93Oseni, Umar A. 91–114OTC transactions 157–8, 362–5, 380Ottoman Empire 70–1, 212overdraft Islamic financing products 38overriding royalty interest (ORRI) 300–1ownership concepts 148–67, 201–15, 371

P&P 366Pakistan 236–9, 275, 293, 314–15, 317, 403,

415, 418–19parallel istisna, innovations 25, 38, 40parallel salam, innovations 25, 37–8, 40, 148–9pari passu creditors 12pass-through payments structures 177–82passive fund managers 242patents 23–4PB Securities Sdn Bhd v Lee Kwee Heng 96pension funds 128, 133–4, 253–63performance issues

see also returnsAbrahamic finance 126–37Shariah-compliant portfolio management 402,

405, 413–13personal financing Islamic financing products 38Philippines 239, 320–7, 420pilgrimage, five pillars of Islam 73, 75, 222, 232,

248–50, 253, 313–14, 420pledges

see also rahn conceptsdefinition 14Saudi Arabia 3–21

PLS see profit-and-loss-sharing transactionsPoland 239policy-fuelled markets hypes, global financial

crisis from 2007 362–5politics, global financial crisis from 2007 362–5pork prohibitions 54, 57, 59–65, 80, 128, 186,

369, 394, 407, 410pornography 63, 64, 125–43, 369portfolio construction issues, Shariah-compliant

portfolio management 402, 404–5portfolio management see Shariah-compliant

portfolio managementportfolio revision, Shariah-compliant portfolio

management 402, 405possession concepts 5, 6–7, 9, 148–67, 201–15,

371–84derivative products 148–67, 201–15, 371Saudi Arabian Mortgage Law 5, 6–7, 9

poverty 69–70, 78–9, 415–27see also microfinancestatistics 415

PR tools, social responsibilities 72, 85

practice notes, Malaysia 95Praesidium LLP 130praying five times, five pillars of Islam 73,

248–50preferred shares 405–6prejudices, Germany 243–4, 246premiums, options 203–15Prescott Capital Management LLC 284–5pricing formulae, options 213–15primary activities criteria, securities 53–67primary sources of Shariah 26, 27–30, 37, 50–1,

74–5, 185–7, 311–12, 317principal-agent issues 172–5, 178–83, 191–7,

422–3prioritization principles, collateral security

regimes 5–21private equity funds 38, 283–6privatization programmes 379–80product approval 23, 25–37, 43–67, 91–2,

125–43, 227–33, 236, 403–14benchmarks 55–67Dow Jones indices 52, 63–7, 129external process 44–6, 47–9flow of the approval process 43–6FTSE indices 52, 62–7, 91–2, 229, 308general rules and standards 50internal process 44–6, 47–9layers of the process 44–6methodology used in the process 49–52processes 43–60rulings 46–52securities in capital markets 52–67, 126–37,

227–33, 403–14securities in mixed companies 54–67, 403–14Sharia processes 23, 25–37, 43, 126–37Yasaar index 62–3, 313

product development 37, 39, 41–3, 52–60,70–89, 96–114, 125–43, 147–70, 176–7,181–2, 185–97, 307–39, 385–400, 420–3

see also financial engineering; innovationschallenges 398–400conclusions 399–400definition 23–4, 395derivative products 25, 39, 96–7, 147–70,

201–15, 385–400examination processes 41–2examples 25failures 25–6imitation strategy 395–6list of products 37–9Maqasid al Shariah 31–2, 398–9microfinance 420–3mutation strategy 396–7principles to be considered 24–5, 388–94,

399–400satisfaction strategy 397–8

P1: TIX/XYZ P2: ABC


Index 445

Sharia processes 25–37Shariah-based products 39–41Shariah-compliant products 39–43, 147–70,

385–400, 420–3strategies 394–400takaful 193–7, 302–3, 310

product proposals 44–6product ranges, Saudi Arabian Mortgage Law

13product submissions 44–6productivity benefits, innovations 23–4profit rate swaps 39, 161–3profit-and-loss-sharing transactions (PLS)

see also mudarabah; musharakahconcepts 368–75, 381–4, 389–91, 418–27critique 374, 422–3

prohibitions 42, 43, 52–67, 74–5, 77–9, 80–1,125–43, 147–67, 176–7, 185–8, 227–9,235–6, 250, 255–63, 307–8, 314, 319,369–70, 374–8, 387–400

Abrahamic finance 125–43, 369‘bad’ risks in Islamic finance 375–8burden of proof 390–1derivative products 147–67, 201–15, 235–6,

376–8, 385–400, 406–7financial ratios 63, 65–7, 129–30, 407–10mixed companies 54–67securities 52–67, 80–1, 125–43, 176–7,

185–8, 227–9, 387–400Shariah-compliant products 42, 43, 52–60,

74–5, 77–9, 80–1, 125–43, 147–67, 176–7,185–8, 227–9, 235–6, 253–63, 307–8, 314,319, 369–78, 387–400, 404–14, 417–18

project financing Islamic financing products38

ProLogis 283–5property sale agreements (PSAs) 110The Prophet Muhammad (pbuh) 28–9, 54–6,

74–5, 80, 87, 88, 137, 151, 154, 158, 168,185–6, 196, 201–2, 204–5, 208, 370, 393

prostitution prohibitions 54prudential regulations 34–7public interest 27, 30, 31–3, 43, 56–60, 76,

78–80, 147–8, 180, 202–15, 228–33pubs/clubs, prohibitions 54purification of investments 404–5, 410–12put options 150–1, 163–4, 203–15

see also options

qabdh (possession-and-delivery) 148–9, 152–3,202–15

qard hasan (gratuitous loans) 82, 191–2, 272–7,318–19, 326–7, 331, 417–22

Qatar 117–23, 277, 313, 314–15, 316–19, 320–8qawl al sahabi (opinion of the companion),

Sharia secondary sources 30

qisma 212–13qiyas 27, 29–30, 151–2, 166, 185–7, 205–6

see also analogy; asl; far; hukm; illahdefinition 29, 151–2four pillars 29Sharia sources 27, 29–30, 151–2, 185–7

Quakers 127Qualcomm 134qualifications 48–9, 123qualitative screening approach of securities

56–7, 59–67see also image . . . ; maslaha . . . ; umum

al-balwa; urfquantitative results, Abrahamic funds 132–4quantitative screening approach of securities

56–7, 58–62quimar 405–8quotas, social responsibilities 83–4Quran 27–30, 37, 53–4, 73–4, 81, 84, 125–43,

185–7, 311–12, 317, 369–70, 387, 390,410

alcohol prohibitions 54gaming prohibitions 54Ijarah (leasing) contracts 28–9kafalah (guarantee) contracts 28riba 53–4Sharia sources 27–30, 37, 185–7, 311–12,

317social responsibilities 73–5, 81, 84, 387, 390

R&D, financial engineering 25rabb al-mal 197, 417rahmad (mercy) 76, 82rahn concepts

see also mortgages; pledgesdefinition 5, 15Saudi Arabia 3–21specific provisions 5, 6–13

raqaba 207–13real estate 4–13, 95–114, 129–30, 224–33,

256–63, 280–303, 362–7global financial crisis from 2007 362–7Saudi Arabia 4–13US 280–303

Real Estate (RE) Funding Project, Saudi Arabia4–5

real-life islamic finance, challenges 381reassembled products, Shariah-compliant

products 42recessions 366recordation capabilities, Saudi Arabia 3–13recreation of trust 378–9regional experiences 219–357registration systems 3–21

collateral security regimes 3–21types 6–7

P1: TIX/XYZ P2: ABC


446 Index

regulators and standard-setting organizations34–7, 43, 44–6, 47–9, 115–24, 180–2,211–12, 240–1, 310–39, 371–84, 387–8,402–14

see also AAOIFI . . . ; central bank; IFSB . . . ;Securities Commission

Australia 341–56corporate governance 115–24, 197France 240–1, 267–77, 347Germany 240–66global financial crisis from 2007 362–84Malaysia 25, 36, 46, 52–62, 66–7, 91–114,

221–33, 310–39microfinance 420–7principles 35risk exposures 43, 388Saudi Arabia 102–4, 313, 323Shariah-compliant portfolio management

402–14social responsibilities 79–84, 388sukuk 180–2UK 240–1, 246–7, 261, 330, 344, 347US 279–80, 297–303

regulatory arbitrage 387–8REITs 38, 224–6, 232relationships, life cycle 390religious dimensions 32–3, 43, 78–9, 84, 87,

125–43, 248–50, 253, 370see also Abrahamic financeFrance 267–8, 274–5Germany 236, 243–4, 248–50, 253

religious obligations, financial institutions 78–9,84, 87, 125–43

remedies, Saudi Arabian Mortgage Law11–13

Remembrance of God 29rental income prohibitions 59–67, 369–70repayments, Saudi Arabian Mortgage Law 5,

8–13repos 177reputational risk 378–9, 424–5resorts 57retakaful (reinsurance) 190, 195returns 30, 36–7, 126–37, 345–6, 369–70,

373–5, 385–400, 405–6, 412–13see also performance issuesAbrahamic finance 126–37risk trade-offs 373–5, 385–6, 405–6,

412–13reverse engineering 395–6RHB/Unit Trust Management Berhad 129riba al-fadhl (forbidden interest) 42, 152–3riba al-nasi’ah 152–3riba (interest/usury) prohibitions 42, 52–4,

58–67, 74–5, 77–9, 80–2, 85, 107–8,128–43, 151–4, 161, 175–82, 185–6, 190,

202–15, 235–6, 255–63, 267–77, 307–8,344, 368–78, 389, 391–2, 405–10, 417–18,421

critique 374, 377, 391–2, 405–6definition 176, 186, 377, 391, 405Quran 53–4, 186

ribawi transactions 151–3risk 3–4, 24–6, 36–7, 43, 155–6, 171–84,

253–63, 345–56, 361–84, 385–400, 418–27‘bad’ risks in Islamic finance 375–8diversification 3–4‘good’ risks in Islamic finance 375–8individual/systemic effects of ‘bad’ risks in

Islamic finance 377–8management 155–6, 171–84, 345–56, 361–84,

388, 418–27product development/approval processes

24–6, 43returns 373–5, 385–400, 405–6, 412–13Shariah-compliant products 43

robustness of Abrahamic funds 132–7rukn 204–15Rule 144A, US 299–300, 302rulings

concepts 28–34, 46–52, 187, 309–39product approval 46–52

rural development schemes 416Rusd Investment Bank 328Russell 2000 Growth Index 133–6Russell-Jadwa Shariah Index 129Russia 236–9

S&P 129, 135–6, 240–2, 366–7SABIC 410SAC see Shariah Advisory Councilsad al darai (blocking the law full), Sharia

secondary sources 27, 30, 153–4sadaqa 207–15, 417, 422sadd al-dhara’i (illicit purposes) 27, 30, 153–4sadd zari’ah 56, 58–60safety of the mortgaged property, Saudi Arabian

Mortgage Law 5, 9–11salah (prayers) 80salam (forward investment) contracts,

innovations 25, 37–8, 40, 42–3, 148–9, 153,158, 166–7, 179–80, 272–7, 309, 326–7,376–8, 396–7

Salamah bin al-Akwa 28salat (praying five times), five pillars of Islam

73, 248–50sale and leaseback products 38–9, 422–3sale-buybacks 177–82SAMA Committee 4–5Sandwick, John 131sarf 152–3satisfaction strategy, financial engineering 397–8

P1: TIX/XYZ P2: ABC


Index 447

Saturna Capital Corporation 134–6see also Amana Mutual Funds Trust

Saudi Arabia 3–21, 102–4, 117–23, 192, 228,245, 282, 313, 316–19, 320–8, 331, 381,403

Board of Grievances 4, 16Capital Market Law (CML) 102–4cases 103–4collateral security regimes 3–21Committee for the Resolution of Securities

Disputes (CRSD) 103–4conclusions 13corporate governance 117–23dispute resolution frameworks 102–4Execution Law 4, 10–13financing sources 3–4formalization/registration/prioritization

systems 3–21Mortgage Law 4–21movable assets 5–13rahn concepts 3–21regulators and standard-setting organizations

102–4, 313, 323securities 5, 6, 102–4Shariah 3–13, 102–4, 228specific provisions of Mortgage Law

6–13stare decisis principles 3, 5, 13

Saudi Chevron petrochemical project 3,13–14

saum (fasting), five pillars of Islam 73, 248–50savings 83–4, 238–9, 248–3, 256–63, 417–27‘saviour of last resort’ illusions, financial

institutions 363–5Schauble, Wolfgang 242–3Schmidt, Nicolas 235–66schools of jurisprudence 6, 8–11, 14–19, 21, 30,

37, 56, 107, 147–67, 185–97, 207–15,223–5, 230–1, 236, 260–3, 294–5, 311–15,317, 331, 385–400, 403

Schwab, Daniel 126–7Schwartz, George 127Schwartz, Mark 126–7screening processes

Abrahamic finance 125–43clients and contractors 82qualitative approach 56–7, 59–67quantitative approach 56–7, 58–62securities 52–67, 80–1, 82, 125–43, 227–33,

403–14Shariah-compliant portfolio management

407–10SE see social entrepreneurshipSEC see Securities and Exchange Commissionsecond mortgages, Saudi Arabian Mortgage Law

7–8

secondary sources of Shariahconcepts 26, 27–31, 37, 50–1, 55–67, 185–7,

311–15, 317definition 27, 30interpretations 30, 307–8, 311–15, 318–39,

398–400, 407–10, 421–2secular laws, banks 70–1, 268secured debt, Saudi Arabian Mortgage Law 5,

8–13securities 52–67, 80–1, 82, 91–114, 125–43,

176–7, 185–8, 227–33, 235–6, 362–5,376–8, 387–400

see also bonds; capital markets; equity . . . ;listed . . . ; sukuk

Abrahamic finance 125–43benchmarks 55–67, 294–5buy and hold strategies 134–7, 181image criteria 55, 56–67Malaysia 58–62, 66–7, 92–114, 128–37,

221–33, 307–39in mixed companies 54–67, 403–14primary activities criteria 53–67product approval 52–60, 126–37, 227–33,

235–6prohibitions 52–67, 80–1, 125–43, 176–7,

185–8, 227–9, 376–8, 387–400qualitative screening approach 56–7, 59–67quantitative screening approach 56–7,

58–62Saudi Arabia 5, 6, 102–4screening processes 52–67, 80–1, 82, 125–43,

227–33, 403–14Shariah-compliant portfolio management

401–14United Arab Emirates 104–5

Securities Act 1933, US 299–300, 302Securities Commission Act (SCA) 1993,

Malaysia 92, 94, 97–8, 105–6, 222–3Securities Commissions 35–7, 44–6, 52–62,

66–7, 91–114, 221–33, 314–15, 320–39see also regulators and standard-setting

organizationsSecurities and Exchange Commission (SEC)

157–8Securities Industry Development Corporation

(SIDC) 230–1securitization 39, 171–84, 244–6, 269–77,

362–5, 425–7conflicts of interest 172–5, 179conventional securitization problems 171–6global financial crisis from 2007 171–4,

180–1, 362–5Islamic securitization 176–82microfinance 425–7principal-agent problems 172–5, 178–83

SEI 132–3

P1: TIX/XYZ P2: ABC


448 Index

‘self help’ domain, Saudi Arabian Mortgage Law10–11

self-censorship problems, group think dangers123

self-discipline 387–8separation of risk, derivative products 392Serbia and Montenegro 239services financing Islamic financing products 38Shafi‘i school 9, 18–19, 154–5, 208–11, 223–5,

314, 317shahadah (witnessing God and his final

messenger), five pillars of Islam 73Shamil Bank 288–9SHAPE 293Shar man Qablana, Sharia sources 27shareholders 23–4, 43–6, 72, 77–9, 190–7,

355–6, 405–6shares/equities 25, 37–9, 177–82, 191, 227–33,

250–63, 370–84, 399, 404–14Shari’a arbitrage 202, 215Shariah 23–68, 69–71, 76, 91–2, 130, 185–97,

235–66, 267–77, 307–39, 385–400, 405–14corporate governance 115, 116–18, 181–2,

197dispute resolution framework for the

Malaysian capital market 91–2, 96–114fragmented approach 398–400global financial crisis from 2008 366–84image screening criteria 57–60, 80–1Islamic securitization 176–82objectives 26–7, 32–3, 76, 130, 405–14primary sources 26, 27–30, 37, 50–1, 74–5,

185–7, 317product development/approval processes

23–68, 126–37, 147–70, 227–33, 235–6,385–400, 403–14, 420–3

Saudi Arabia 3–13, 102–4, 228secondary sources 26, 27–31, 37, 50–1,

55–67, 185–7, 311–15sources 26–37, 74–5, 151–2, 185–7, 311–12,

317Shariah Advisory Council (SAC) 34, 52–67, 93,

97–114, 223–33, 315–27see also Shariah Boards

Shariah Boards 28, 30, 35–6, 43–60, 70–1,115–24, 181–2, 197, 236, 241, 270–7,308–39, 345–56, 403–4, 421

see also IFSB standards; Shariah AdvisoryCouncil; Shariah Committees; ShariahSupervisory Board

abundance 236aliases 312, 334corporate governance 115–24, 181–2, 197,

311–15diverse cultures 309–39, 403documentation issues 51–2

GCC 310–14, 316–17, 319–39, 403–4Malaysia 52–60, 93, 97–114, 223–33, 310–15,

319–39objectives 43–7, 308–9, 311–15Shariah-compliant portfolio management

403–4terminology 312, 334

Shariah Capital 291–4Shariah Committees 44–6, 154–5, 312

see also Shariah BoardsShariah court of appeal, Malaysia 97–9, 107–12Shariah framework

see also AAOIFI . . . ; IFSB . . . ; legal maxims;Maqasid al Shariah

concepts 26–37, 40, 186–7, 235–6, 310–39,405–14

Shariah scholars in the GCC, corporategovernance 115, 116–18

Shariah Supervisory Board (SSB) 47–9, 64–7,70–1, 80–1, 84–5, 95, 197, 312–13, 320–7,345–56, 421

see also Shariah BoardsIFSB standards 47–9objectives 47, 312–13

Shariah-based productsconcepts 37–41list of products 37–9

Shariah-compliant portfolio managementbenchmarks 404concepts 401–14financial analysis 402, 404investment policy analysis 402–4Islamic indices 403–4performance issues 402, 405, 412–13portfolio construction issues 402, 404–5portfolio revision 402, 405purification of investments 404–5, 410–12regulators and standard-setting organizations

402–14screening processes 407–10Shariah Boards 403–4Shariah guidelines 405–14statistics 401, 404, 408–13tailored funds 403–4

Shariah-compliant products 37, 39, 41–3, 52–60,70–89, 96–114, 125–37, 147–70, 181–2,185–97, 201–15, 221–33, 235–6, 253–63,307–39, 341–56, 361–84, 385–400,401–14, 417–27

Australia 341–56benchmarks 55–67, 404call options 209–11, 395–6combination rules 42contractual terms/conditions 42–3, 309–39contradictory contracts 42–3economic benefits 43, 70–89

P1: TIX/XYZ P2: ABC


Index 449

financial engineering 387–400France 267–77GCC 307–39, 401–14Germany 239–66, 401list of products 37–9Malaysia 98–101, 221–33, 307–39, 347–8,

401product development processes 39–43,

147–70, 385–400, 420–3prohibitions 42, 43, 52–60, 74–5, 77–9, 80–1,

125–43, 147–67, 176–7, 185–8, 227–9,235–6, 255–63, 307–8, 314, 319, 369–78,387–400, 404–14, 417–18

put options 209–11reassembled products 42risk exposures 43securities 52–60US 157–8, 279–303, 401

Sherry, Nick 347–54Shikoh, Rafi-Uddin 69–89shirkat al-milk 212–13short selling dangers 364–5, 376–8Shura Council of Saudi Arabia 4, 197Sicily 236–9Siddiqui, Shahzad 125–43silk cloth 55sin, definition 393Singapore 196, 303, 320–7, 330, 347SIVs 177skills 48–9, 231–2

see also education; trainingslavery 127Smith, Adam 71social dimensions 32–3, 52, 310–39, 347–56,

368–84, 389–400, 415–27social entrepreneurship (SE) 70, 85–6, 176–7,

370–5social responsibilities 32–3, 69–89, 127–43, 370,

389–400, 415–27ability-based focus 75, 77benchmarks 79–84, 85–6broader mandate 76–9challenges 79–84charitable activities 47, 75, 77, 79, 81, 84, 87,

207–8, 389–90conflicting ideologies 70–1core motivations 71–2disclosures 84–5, 388discretionary actions 74–5employees 81, 83–4existing paradigms of discourse 76five pillars of Islam 73, 75individual/institutional responsibilities 75–6Islamic perspectives 32–3, 69–89, 370,

389–400lessons from current business practices 85–6

mandatory forms 79–84microfinance 83–4, 85–6, 197, 415–27PR tools 72, 85quotas 83–4Quran 73–5, 81, 84recommendations 79–84regulatory framework 79–84, 388‘taqwa-centricity’ (God consciousness) 73–4,

76, 77‘to educate and establish justice’

responsibilities 74–5, 76, 77, 78–9, 81socially responsible investing (SRI) 70–89,

125–43, 368–70definition 127–8Shariah correlations 131

Societe Generale 276socio-economic issues, social responsibilities

69–89, 370–84, 389–400, 415–27‘solutions’, financial engineering 386South Africa 127, 380South Asia

see also Bangladesh; India; Pakistandemographic statistics 236–9, 415microfinance projects 419–20

South Korea 24, 347South-East Asia 236–9, 307–39, 347–56, 415–27

see also Brunei; Malaysia; Philippines;Thailand

demographic statistics 236–9, 415microfinance projects 420

sovereign risk 171–2Spain 236–9, 379special obligations, financial institutions 77–9special purpose vehicles (SPVs) 3, 164–5, 173–4,

177–83, 229–33, 280–303, 362–5, 426specialization, integration principle 392–3specific equity-based products 38speculation 147, 155–67, 186–7, 201–15, 235–6,

253–63, 362–6, 371–84, 388–400, 406–8see also gharar (uncertainty) prohibitionsdefinitions 155–6gambling comparisons 156–7global financial crisis from 2007 362–5hedging contrasts 155–6

SPVs see special purpose vehiclesSRI see socially responsible investingSSB see Shariah Supervisory Boardstakeholders 23–4, 43–6, 71–2, 77–9, 96–114,

372–84, 405–6see also depositors; investors; shareholders

Standard Chartered Saadiq 160–2, 308, 344standard-setting organizations see regulators and

standard-setting organizationsstare decisis principles 3, 5, 13, 108–12statutory framework, rahn concepts 3–21Stella Capital 302

P1: TIX/XYZ P2: ABC


450 Index

stereotyping dangers, group think 123Stewardship Fund, Friends Provident 127stock brokers 30stock broking prohibitions 52–3, 62–7StoneCross Capital 294–5strategies, product development 394–400structured finance 171–84, 224–5, 362–84,

387–400see also securitization

sub-prime lending-led global financial crisis seeglobal financial crisis from 2007

Sub-Saharan Africa, demographic statistics236–9

Sudan 313, 314–15, 397sui generis 96–7sukuk 14, 25, 39, 91–114, 172–84, 197, 211–15,

226–33, 241, 268–77, 307–9, 314, 348–56,367, 379–84, 406–7, 425–6

see also asset-backed securitiesdefinition 176-7, 379–80economic challenges 181forms 177–9, 226–8, 229–33France 268–77Malaysia 226–33microfinance 425–6principles 179–81regulators and standard-setting organizations

180–2statistics 177–9, 227–8, 367US 279–303

sukuk al-manfa‘a 211–15see also options

sukuk ijarah fixed-income products 39, 177–82,229–33, 308, 319, 329

sukuk mudarabah fixed-income products 39,177–82, 229–33

sukuk musharakah fixed-income products 39,177–82, 191, 229–33, 301–3, 309–39

Sunnah 27–30, 37, 74–5, 185–7, 201–15,311–12, 317

Ijarah (leasing) contracts 28–9kafalah (guarantee) contracts 28Sharia sources 27–30, 37, 74–5, 185–7,

311–12Sunni schools of jurisprudence 6, 9–11, 14–19,

21, 30, 314Sunrise Senior Living, Inc. 284Suransi Allianz Life 241Sustainable Product Index 85swaps 39, 148, 151–3, 157–67, 202–4, 365,

372–5, 395–6see also cross-currency . . . ; profit rate . . . ;

total return . . .Shariah objections/solutions 151–3, 372–8,

395–6transaction types 152–3

Sweden 24Switzerland 379Syria 317, 380, 416, 419

tabarru (donations) 16, 38, 187–97, 207–15,325–7, 417

Tabung Haji 222, 313–14, 420tadhib al-fardh (education) 76, 78–9, 84–5tahkim (arbitration) 106, 208–9tahsiniyat (embellishments) 80tailored funds, Shariah-compliant portfolio

management 403–4takaful (insurance) 25, 37–43, 65–7, 92, 95,

176–7, 185–99, 213–15, 222–33, 302–3,310, 312–19, 332, 380–4, 389, 418, 423

challenges 196–7coverage 195definition 185–9family products 193–4features 189–90flow of the approval process 43–6general products 193–4historical background 185list of products 38–9, 193–4Malaysia 193–7, 222–33, 310, 315, 318–19,

423product development 193–7, 302–3product types 38–9, 193–4prospects 195–7retakaful (reinsurance) 190, 195statistics 195–6US 302–3

the Talmud 126–7Tamari, Meir 126–7Tanzania 239‘taqwa-centricity’ (God consciousness) 73–4,

76, 77tawakkul 196tawarruq 38, 307–8, 315, 318–19, 326–7, 332,

394–6Ta’widh (compensation) 34taxation 229–33, 245, 268–77, 279–80, 297–303,

347–56, 368–70, 404–5termination of the mortgage, Saudi Arabian

Mortgage Law 5, 12–13, 21terrorist attacks 382Thailand 320–7, 347, 420third parties, collateral security regimes 3–21Timothy Plan 134–5‘to educate and establish justice’ responsibilities

74–5, 76, 77, 78–9, 81Toan, Robert W. 298tobacco prohibitions 52–3, 59–67, 80–1, 82, 127,

128–37toleration principle 35‘too big to fail’ illusions, banks 365

P1: TIX/XYZ P2: ABC


Index 451

total return swaps 164–7trade

incentives 390–1permissions 53–4, 390–1

trade financing Islamic financing products 38trading obligations for obligations, derivative

products 158, 392–3training 70–1, 231–2, 349–50

see also skillstransaction costs 386TransOcean Capital 286–7transparency 32, 36–7, 47–9, 115–24, 127–43,

172–84, 222–33, 362–5, 370–84, 388Truman Park Apartments 280, 281–2, 286–8,

297–8trust, recreation of trust 378–9TSE 366TTMAMC 65–7Turkey 236–66, 381, 403

see also Germany

Uberoi, Priya 147–70UBS 289–90ujr 325–7UK 236–9, 240–1, 246–7, 260, 262, 274, 275,

303, 308, 330, 344, 347, 356, 380, 401colonialism factors 244, 275, 308demographic statistics 236–9, 274economic relevance 238–9, 246–7, 260, 262,

275, 303, 308, 330, 344, 401education 260international innovation index 24Muslim immigrants 244, 246–7, 275Muslim-specific products/services 240–1, 246,

260, 303, 330, 347, 356, 401regulators and standard-setting organizations

240–1, 246–7, 260, 330, 344, 347ummah (larger community) 43, 48, 55, 59, 77–9,

368–70umum al balwa (common plight) 54–5, 59–67,

228–33unal, Murat 115–24UNCITRAL Rules 101–5, 113underwriters 188–97Unicorn Investment Bank (UIB) 285–6unit trusts 38, 229United Arab Emirates (UAE) 104–5, 117–23,

183, 192, 196, 313, 314–15, 320–7, 329–31,353, 380

see also Abu Dhabi; Dubaicorporate governance 117–23dispute resolution frameworks 104–5

United Nations 101–5, 113, 128universities

Australia 349–56corporate governance 118–23

urbun (down-payment sales) 39, 150–1, 153,167, 202–15, 395–6

Urf (custom), Sharia secondary sources 27, 30,55, 59–67

US 24, 171–82, 196–7, 279–306, 401Amana Mutual Funds Trust 134–7, 280,

296–303Arcapita Investments 283–6capital markets 279–303, 401Community Reinvestment Act (CRA) 362conclusions 290–1, 302–3demographic statistics 236–9, 303derivative products 157–8East Cameron Partners sukuk 300–3exchange-traded funds 279–80, 295–303financial institutions 279–80, 291–303first entrants 282future prospects 280, 302–3GE Capital sukuk 300–3global financial crisis from 2007 362–84growth accelerates 286–90ijara-istisna’a contracts 280–2, 286–303institutional investors 279–80, 291–303international innovation index 24Investment Company Act 1940 298–9investors 279–303Islamic finance 157–8, 279–306Kuwait Finance House (KFH) 282, 286–90,

302, 308, 313Maconda Park Apartments 280–2, 286–8,

297–8mutual funds 279–80, 295–303Pax World Fund 127private equity entrants 283–6real estate 280–303regulators and standard-setting organizations

279–80, 297–303Rule 144A 299–300, 302Securities Act 1933 299–300, 302Shariah Capital 291–4Shariah-compliant products 157–8, 279–303,

401statistics 236–9, 279–303sukuk 279–303takaful (insurance) 302–3Truman Park Apartments 280, 281–2, 286–8,

297–8usury 125–6, 131–7, 185–6, 267–77, 368–78,

389, 391, 405–8see also riba . . .

validation of contracts 31–3value-based salam 396–7vehicle (asset) financing Islamic financing

products 38, 40venture capital 280, 283–6, 399

P1: TIX/XYZ P2: ABC


452 Index

vicegerents of God on earth (khilafah) 73–4, 77,130–1

Victron, Inc. 285–6Village Bank microfinance model 416virtual transactions 369, 372, 377–80Volland, Emmanuel 366

wa’ad (unilateral binding promise) 39, 150–1,153, 163–7, 202–15

see also swapsWachovia Bank/Wystar 134wadiah yad dhamana 318–27, 332, 417wakalah (principal-agent contracts) 38, 180, 183,

189–98, 212–15, 318–19, 332, 426critique 192definition 191–2

Wal-Mart 85Wall Street 69waqf (endowments)

concepts 25, 38, 155, 190–7, 296–7definition 192–3

water financing 86

Watermark Paddlesports, Inc. 283–4Wawasan Holding 60–1wealth 31–3, 55, 131–2, 253–63, 368–84, 391–2The Wealth of Nations (Smith) 71–2Weill, Laurent 267–77working capital financing Islamic financing

products 38World Bank Group 69, 86, 381–2Worldcom 129

YapiKredi, Germany 240–1Yasaar index 62–3, 313Yemen 314, 419yishuv ha olam (settlement of the world) 126–7Yusuf, Prophet 28

zakat (tithe giving), five pillars of Islam 25, 73,75, 81, 368–70, 389, 410–11, 417, 420,423–5

Zayan Finance 293–4‘zero-sum games’ 388, 391Zeus Capital Advisers 293–4

Index compiled by Terry Halliday

Islamic Capital Markets

Documents

Transcript of Islamic Capital Markets