By Iqbal Khan, Managing Director Head of Global Islamic Finance, HSBC Amanah Finance, UK
Introduction - Philosophical Foundation and Core Concepts
Islamic finance is an ethical, indigenous and equitable mode of finance, which derives its principles from the Quran (The revealed book of Muslims) and tradition of the Prophet Muhammad (pbuh). Shariah law (Islamic law), which is based on the Quran and Sunnah, governs Islamic finance.
It is a trend which is broadening the ownership base, creating more stakeholders and thereby bringing the hope of stability to more than 1.3 billion Muslims spread across the world.
Islamic Finance as a concept is based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing. These themes themselves are based on core ideas, which include individual responsibility, reliance on market mechanism, commitment to economic and social justice and mandatory care for the environment. These guidelines also include prohibitions from investing in areas such as Defence and Armaments, Casinos, Breweries - areas which are considered to be value destroyers.
In Islamic Finance Scholars say that everything is allowed except that which has been specifically forbidden. In essence the believing Muslims view of economics is based on Man's obligation to organise his affairs in accordance to the will of God as his representative and vice regent on Earth. The goal is not equality but an avoidance of gross inequality along with an injunction that wealth should not become "a commodity between the rich among you". Islamic Finance is firmly embedded in the commercial, real, value-producing economy.
The desire of enlightened Muslims to seek the moral equivalent of Modern Capitalism goes back to Egypt in the early 1960s. The pioneering effort, in Egypt, took the form of a savings bank based on profit-sharing in the town of Mit Ghamr. The Islamic Development Bank (IDB) was established in l975 by the Organisation of Islamic Conference (OIC), but it was primarily an intergovernmental bank aimed at providing funds for development projects in member countries. The IDB now also extends to private sector corporates for project and trade finance facilities.
In the mid-seventies, Islamic banks came into existence in Saudi Arabia and the United Arab Emirates. Since then, Islamic financial institutions have emerged in a large number of Muslim countries including Kuwait, Bahrain, Qatar, Turkey, Pakistan, Indonesia and a belt of other IDB member countries. These institutions have taken the form of commercial banks, investment banks, investment and finance companies, insurance companies, etc.
Islamic banking today is an industry that is still evolving. The industry manages approximately $180 Billion dollars today, growing at approximately 15% per annum. The growth of Islamic banking is a result of economic growth in the Islamic world, fuelled primarily by oil wealth. This growth created a growing middle-wealth segment and hence made banking a necessary service to the larger segment of the population rather than a service for the few, as had been the case some 10 to 15 years earlier.
Evolution of Islamic Finance
In the 1970s and 1980s, Islamic banking was characterised by a large number of commercial banks serving retail Muslim customers in their respective countries. However, since the late 1980s a shift towards investment banking has taken place. No where is this better witnessed than in Bahrain, which has the largest number of offshore Islamic investment banks in the Muslim world.
In the early years, investments and products used by most Islamic financial institutions were driven by the concept of Mudaraba (referred to as Trust Financing) and focused on short-term investments. During this period, Murabaha (cost-plus finance) emerged as the most widely used instruments by Islamic banks, accounting for over 80 per cent of a portfolio of an Islamic bank.
During the 1990s Islamic financial institutions have become increasingly more innovative, developing more complex instruments and structures to meet the demands of modern day business. The use of instruments such as leasing and construction finance have become far more widespread. Islamic finance tranches have also been structured into big-ticket syndication.
Equities have only recently opened up as an asset class to Islamic investors, following approval from the Islamic Fiqh (Islamic jurisprudence) Academy in Jeddah, one of the major legal bodies in the Muslim world. Islamic investors are now able to invest in equities subject to certain criteria. Over 100 Islamic equity funds have now been launched since 1995 with Assets under management in excess of $7 billion. Some of these funds are being sold in UK and it would be useful to make their ISA compatible.
The Markets and the Players
More than 2/3rd's of Islamic finance business is currently originated in the Middle East. The GCC countries, with the exception of Oman, are all major markets for Islamic finance. Bahrain is regarded as the hub for Islamic finance. Other major non-GCC markets for Islamic finance include Egypt, Malaysia, Turkey, Indonesia, and Pakistan.
Malaysia operates a dual banking system promoted by the government. This allows conventional financial institutions, investment banks, commercial banks and finance companies to launch separate Islamic banking divisions, competing alongside two Islamic banks, Bank Islam Malaysia and Bank Muamalat Malaysia. Bank Negara Malaysia (the central bank) has its own Shariah Advisory Board, which sets the rules for the entire Islamic banking sector, ensuring uniformity of products and services.
Over 150 Islamic financial institutions now operate in over 40 countries around the world, from commercial banks, investment banks, investment companies to leasing, and insurance companies.
The Products and Structures
Islamic banks around the world have devised many financial products based on the risk-sharing, profit-sharing principles of Islamic banking. For day to day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance, property and leasing. Almost every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and services and who have to provide a religious opinion of the bank's activities for year-end accounts.
Britain and Islamic finance
Muslims in Britain and throughout the world aspire to carry out their financial matters in accordance with the principles of Islamic law. Muslims are forbidden from obtaining the various conventional banking and insurance products and services in the forms currently offered due to their incompatibility with the principles of Islamic law.
It is estimated by various surveys that over 2 million Muslims are permanently residing in the UK. The community is predominantly composed of people from the Indian sub continent who have settled in Britain during the 1950s. Beside them, there are also Muslims of Middle Eastern and North African origins. Additionally there is a growing population of indigenous Muslims.
The UK Muslim community has now reached the "Second-Generation" stage. The first wave of immigrants having settled down, the second-generation Muslims are now slowly penetrating the different strata of the British society. It is not uncommon to find successful Muslim lawyers, chartered accountants, bankers, businessmen and even Members of Parliament, both at the House of Lords and the House of Commons.
The third generation of Muslims are also emerging from the educational system and is projected to increase the Muslims' presence in all strata of British society, especially, the educated middle class.
The vast majority of Muslims either is living in rented houses or has taken conventional interest-based mortgages. The total number of Muslim households as estimated by the Muslim Council of Britain is around 500,000. Of the 500,000 households, it is estimated by various market researches that approximately 40,000 families seek financing for home purchases each year.
We have regularly received enquiries regarding the availability of Islamic finance products, in particular Islamically compatible finance to purchase both residential and commercial properties. It is believed that a large number of Muslims have abstained from taking the conventional mortgage because of its incompatibility with the Islamic principles. The needs of these Muslims need to be served immediately.
Beside the market represented by Muslims living in Britain, there is potential for overseas investors to be introduced by HSBC. We understand that a considerable number of Muslims living abroad (mainly in the Middle East) had expressed their desire to own properties in Britain (mainly as a holiday residence) but have been reluctant to embark into an interest bearing financing facility. For these investors an Islamic home financing scheme will offer the opportunity to own a property in Britain.
Islamic Home Financing
The potential customer, having identified the property, will approach the Bank to finance the purchase of the property. The transaction structure will be as follows:
The above structure would allow British Muslims to get access to home financing without forcing them to choose between their religion and home ownership. It allows British Muslims to purchase homes without violating Islamic prescriptions on borrowing money on which interest is charged. Further, this initiative will be consistent with the well-established public policy of encouraging home ownership and making Muslim stakeholders in Britain.
Islamic Home Financing: Current Impediments
1. Risk Weighting
A key element, which will impact the pricing, is the FSA's approach to risk weighting for this product. FSA has provisionally ruled that the product is to be 100% risk weighted. This is essentially because the transaction is equivalent to a lease and leases are weighted 100%. This assumes that the house remains the property of the Bank throughout the term of the transaction and is treated as a fixed asset on its balance sheet. If we are obliged to weigh at 100% then pricing will be significantly higher than the conventional mortgage rate. Good Muslims should not be penalised for being good Muslims. The Muslims in the United States have approached the Comptroller of the Currency Administration of National Banks ("OCC") to seek the approval for Islamic home finance based on the above leasing structure. The OCC had in 1997 approved the Islamic home financing based on the above leasing structure and ruled, inter alia, that the banks' risks under the Islamic leasing structure are similar to the risks on traditional mortgage loans (see OCC's Interpretive Letter #806). We hope that a similar approval would be granted in Britain.
The transfer of ownership from vendor to bank at the commencement of the lease and from bank to customer at the end of the lease, may attract the payment of two sets of stamp duty. The second set would arise at the end of the term of the lease at the rate of stamp duty then applicable. The second set of stamp duty needs to be exempted because the true effect of the transfer is similar to the redemption of a conventional mortgage or charge: when the property finally vests with the customer without any encumbrance. If the second set of stamp duty is not exempted, the uncertain cost of the second stamp duty would make the Islamic home financing unattractive and cost prohibitive.
3. Legal Fees
Unlike the conventional mortgage the proposed product would require the appointment of two sets of Solicitors, thereby making the product more expensive. It is suggested that the Law Society should consider giving a general exemption as is done for the mortgage product.
For British Corporates
Britain has always been a major trading partner of the Muslim world. Trade volumes became increasing significant in some parts of the Muslim world in the 1970s following the oil driven economic boom.
The oil boom during this period brought about growth in the domestic economies of the oil producing countries. This brought opportunities for British firms to play a role in building the infrastructure of these countries. Surplus funds from the Muslim world found their way into the safe and stable environments in Britain to be managed by London-based banks.
Similarly, funds have also been channelled into direct investments. Good examples here are Kuwait Investment Office's acquisition of a 20% stake in BP stands out, the acquisition of Lotus the car manufacturers by Proton, the Malaysian car company and purchase of the Hartwell Group by a prominent trading family from Saudi Arabia.
The investment in the London property market by the investors from the Muslim world has historically been very important. Real estate analysts believe that in 1998 alone well over 20% of all such investments came from the Muslim world. In addition, a significant number of Muslim businesses in Britain are also seeking Islamically compatible finance to purchase commercial properties in Britain.
We are witnessing an increasing desire from Muslim investors that these funds be managed and corporate acquisitions be structured under Islamic financial principles. Here UK regulators can play an important role in facilitating the flows of funds and investments into Britain from the Muslim world through the introduction of "Islamic finance friendly" regulation.
UK corporates too, trading with their counterparties in the Muslim world need to be cognisant of the growth of this indigenous and ethical mode of financing and be aware of the characteristics, qualities and benefits of Islamic finance.
For British Exporters
Many of the Muslim countries throughout the world would be classified as developing markets. Consequently, cross-border funding for these countries from western financial markets may be either restricted or limited, thus hindering trade and investment flows between the UK and the Muslim world. Here Islamic financial institutions, who have a greater knowledge and understanding of these markets and consequently the risks, can play key role by providing financing in instances where western commercial financiers would be unwilling to lend.
British exporters and British export credit agencies would benefit tremendously by using this indigenous form of finance to gain access to precious cross-border lines in the 54 Islamic Development Bank Member Countries, These cross-border lines could become a tremendous source of competitive advantage for British exporters.
Today Islamic finance is a trend, which is broadening the ownership base, and creating more stakeholders. It offers a viable financial alternative that may run parallel to conventional finance. Regulators, bankers, asset managers and users of capital in Britain may capitalise on the opportunities afforded by this market and play a proactive role.
London already supports this form of finance by offering products and services through its financial institutions and through leading law firms. The regulatory authorities should come out proactively to introduce regulations which will allow these instruments to be established as an ethical alternative to other instruments which are available in the London financial markets, meeting the needs of Islamic fund providers.
This will require an understanding and appreciation of the roles which these ethical indigenous instruments play in keeping the commercial economy as close as possible to the financial economy. British exporters to the Muslim countries would be in a very favourable position if they could provide not only the exports but also export financing that meets the importers' religious requirements. HSBC is working together with the Export Credits Guarantee Department and other Export Credit Agencies in the EEC to provide Islamically compatible financing and guarantee for exports to Muslim countries. The proactive role of the ECGD is providing Islamically acceptable financing is essential to ensure that British exporters to the Muslim countries have an edge over others. This would lead to more trades between Britain and the Muslim countries, which could lead to a positive contribution to the British economy.
Islamic Finance has mainstream relevance for British Muslims, British Business and British Exporters. It is therefore important that relevant Government Institutions such as ECGD, FSA and DTI should pay attention to this corporate and social responsibility movement, which is becoming increasingly important for both Muslims in Britain and abroad.
Perhaps more important is the demonstration effect which such an effort may have for all of humanity.
Dr. Martin Luther King Jr. described the challenge, which we face:
"Through our scientific genius we have made the world a neighbourhood, now through our moral and spiritual genius we must make of it a brotherhood."
It is in this domain and in bringing the financial economy close to the commercial economy that Islamic Finance can make a real and lasting difference. Britain with its history and culture of trade, commence and community banking is well positioned to benefit from this growing trend of Islamic Finance.