Monday, January 4, 2010

Takaful -Insurance- Part IV (Authenticity, Supervisory Board & Status of Takaful)

Shari'ah Authenticity

Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product's authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.

Shari'ah Supervisory Board [Religious Board]

The role of Shari’ah Supervisory Board members is to review the takaful / retakaful operations, supervise its development of Islamic insurance products, and determine the Shari’ah compliance of these products and the investments. The Shari’ah Supervisory Board have to carry their own independent audit and certify that nothing relating to any of the operations involve any element that is prohibited by Shari’ah.

Islamic financial institutions must adhere to the best practices of corporate governance however they have one extra layer of supervision in the form of religious boards. The religious boards have both supervisory and consultative functions. Since the Shari’h scholars on the religious boards carry great responsibility, it is important that only high calibre scholars are appointed to the religious boards.

An Islamic financial institution is required to establish operating procedures to ensure that no form of investment or business activity is undertaken that has not been approved in advance by the religious board. The management is also required to periodically report and certify to the religious board that the actual investments and business activities undertaken by the institution conform to forms previously approved by the religious board.

Islamic financial institutions that offer products and services conforming to Islamic principles must, therefore, be governed by a religious board that act as an independent Shari’ah Supervisory Board comprising of at least three Shari’ah scholars with specialised knowledge of the Islamic laws for transacting, fiqh al mu`amalat, in addition to knowledge of modern business, finance and economics.

They are responsible primarily to give approval that banking and other financial products and services offered comply with the Shari’ah and subsequent verification that of the operations and activities of the financial institutions have complied with the Shari’ah principles (a form of post Shari’ah audit). The Shari’ah Supervisory Board is required to issue independently a certificate of Shari’ah compliance.

The day-to-day application of Shari’ah by the Shari’ah Supervisory Boards is two-fold. First, in the increasingly complex and sophisticated world of modern finance they endeavours to answer the question on whether or not proposals for new transactions or products conform to the Shari’ah. Second, they act to a large extent in an investigatory role in reviewing the operations of the financial institution to ensure that they comply with the Shari’ah.

The concept of collective decision-making, in other words, decisions made by more than one scholar, is especially important. Shari’ah Supervisory Boards function is to ensure that decisions are not unilateral, and that difficult issues of finance receive adequate consideration by a number of qualified people.

Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product's authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.

Status of Takaful

As Islamic finance continues to expand, there is likely to be a huge takeoff of other products such as pensions, education, marriage and health Takaful plans. There is also a huge scope for mortgage Takaful.

Islamic principles strong emphasis in Takaful on the economic, ethical, moral and social dimensions, to enhance equality and fairness for the good of society as a whole should also have appeal for the ethically minded.

[source: Institute of Islamic banking and Insurance (IIBI)]

Takaful -Insurance- Part III (How it Works, Interest & Reinsurance)

How does Takaful Work

All participants (policyholders) agree to guarantee each other and, instead of paying premiums, they make contributions to a mutual fund, or pool. The pool of collected contributions creates the Takaful fund.

The amount of contribution that each participant makes is based on the type of cover they require, and on their personal circumstances. As in conventional insurance, the policy (Takaful Contract) specifies the nature of the risk and period of cover.

The Takaful fund is managed and administered on behalf of the participants by a Takaful Operator who charges an agreed fee to cover costs. These costs include the costs of sales and marketing, underwriting, and claims management.

Any claims made by participants are paid out of the Takaful fund and any remaining surpluses, after making provisions for likely cost of future claims and other reserves, belong to the participants in the fund, and not the Takaful Operator, and may be distributed to the participants in the form of cash dividends or distributions, alternatively in reduction in future contributions.

Pricing Transactions linked to Interest-rate Benchmark

There are continuing debates on whether the spirit of Shari`ah is being violated by the practice of "benchmarking" linked interest rate benchmark such as London Interbank Offered rate (LIBOR) plus an agreed mark-up in also pricing returns on Islamic finance transactions . At a very fundamental level, the reason for the debates is the lack of understanding to clearly discern the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.

However, benchmarking touches upon the integrity of Islamic Finance as a whole, and the concept of Shari’ah-compliance vs Shari’ah-based approach in particular. There are practical challenges delaying a switch to participation-based structures, such as Musharakah and Mudarabah, that require financiers to participate in the underlying asset in a financing transaction.

Retakaful or Reinsurance

Frequently, the scale of insurance risks underwritten is too great for one insurer to carry safely. In these circumstances, companies use reinsurance to mitigate their own risk exposure. When insurers insure a risk again with another company, it is called reinsurance which allows the insurance industry to spread its losses, lessening the impact of claims on any one company.

There is currently a shortage of retakaful capacity and the lack of companies in the market presents a challenge as well as an opportunity. The challenge is to have a large enough Takaful market to justify ReTakaful business. There is also a global need for strong and credible retakaful operators to assist the growth and expansion of takaful business. Shari’ah scholars have allowed takaful operators to reinsure conventionally when no retakaful alternative is available, although retakaful is strongly preferred.

However, this conventional reinsurance represents a dilemma, as it is contrary to the customer’s preference of seeking cover on Islamic principles. Structurally retakaful operating principles are similar to the takaful operating principles, and the same Shari’ah principles apply.

[source: Institute of Islamic banking and Insurance (IIBI)]

Takaful -Insurance- Part II (Gambling and Insurance, Principles of Takaful & Conventional Insurance)


Gambling and Insurance


Gambling and insurance are two distinct and different operations. Gambling is speculative in its risk assessment whereas insurance is a pure risk and is non-speculative. In gambling, one may win or lose by creating that risk. In insurance, the risk is already there and one is trying to minimise the financial effects of that risk. Insurance shifts the impact of that risk to someone else and relieves the person of risk. The risk nevertheless still remains.

While gambling promotes dissension, ruin and hatred, insurance based on cooperative principles, enables the insured to lessen the financial impact without which it could drive the individual and his dependents to poverty, thereby weakening their place in the society. There is nothing in Islam that prevents individuals from making a provision for their dependents. Seen collectively for large groups of insured population, insurance strengthens the financial base of the society.

Islamic scholar, Yusuf Ali, in his translation of The Holy Qur’an, comments on Sura (chapter) Al-Baqara, ayat (verse) 219, "Insurance is not gambling, when conducted on business principles. Here the basis for calculation is statistics on a large scale, from which mere chance is eliminated. The insurers charge premium in proportion to the risks, exactly and scientifically calculated".

Basis and Principles of Takaful

Islamic insurance requires each participant to contribute into a fund that is used to support one another with each participant contributing sufficient amounts to cover expected claims.

The underlying principles of Takaful may be summarised as follows:

  • Policyholders co-operate among themselves for their common good.
  • Every policyholder pays a part of the contribution as a donation to help those that need assistance.
  • Losses are divided and liabilities spread according to the community pooling system.
  • Uncertainty is eliminated in respect of subscription and compensation.
  • It does not seek to derive advantage at the cost of others.

Theoretically, Takaful is perceived as cooperative insurance, where members contribute a certain sum of money to a common pool. The purpose of this system is not profits but to uphold the principle of "bear ye one another's burden."

Why No to Conventional Insurance

In modern business, one of the ways to reduce the risk of loss due to misfortunes is through insurance. The concept of insurance where resources are pooled to help the needy does not necessarily contradict Islamic principles.
Three important differences distinguish conventional insurance from Takaful:

  1. Conventional insurance involves the elements of excessive uncertainty (gharar) in the contract of insurance;
  2. Gambling (maysir) as the consequences of the presence of excessive uncertainty that rely on future outcomes
  3. Interest (riba) in the investment activities of the conventional insurance companies;
  4. Conventional insurance companies are motivated by the desire for profit for the shareholders;
  5. Conventional system of insurance can be subject to exploitation. For example, it is possible to charge high premium (especially in monopolistic situations) with the full benefit of such over-pricing going to the company.


The key difference between Takaful and conventional insurance rests in the way the risk is assessed and handled, as well as how the Takaful fund is managed. Further differences are also present in the relationship between the operator (under conventional insurance using the term: insurer) and the participants (under conventional it is the insured or the assured). Takaful business is also different from the conventional insurance in which the policyholders, rather than the shareholders, solely benefit from the profits generated from the Takaful and Investment assets.

[source: Institute of Islamic banking and Insurance (IIBI)]

Takaful -Insurance- Part I (Definition)

What is Takaful?

This concept has been practiced in various forms for over 1400 years. It originates from the Arabic word Kafalah, which means "guaranteeing each other" or "joint guarantee". The concept is in line with the principles of compensation and shared responsibilities among the community.

Takaful originated within the ancient Arab tribes as a pooled liability that obliged those who committed offences against members of a different tribe to pay compensation to the victims or their heirs. This principle later extended to many walks of life, including sea trade, in which participants contributed to a fund to cover anyone in a group who suffered mishaps on sea voyages.

In modern-day conventional insurance, the insurance vendor (the insurance company) sells policies and invests the proceeds for the profit of its shareholders, who are not necessarily policyholders. There is therefore a clear disjunction between policyholders and shareholders. Payouts to policyholders may vary depending on financial performance, but a minimum positive return is always contractually guaranteed.

Takaful is commonly referred to as Islamic insurance; this is due to the apparent similarity between the contract of kafalah (guarantee) and that of insurance.

However, takaful is founded on the cooperative principle and on the principle of separation between the funds and operations of shareholders, thus passing the ownership of the Takaful (Insurance) fund and operations to the policyholders. Muslim jurists conclude that insurance in Islam should be based on principles of mutuality and co-operation, encompassing the elements of shared responsibility, joint indemnity, common interest and solidarity.

In takaful, the policyholders are joint investors with the insurance vendor (the takaful operator), who acts as a mudarib – a manager or an entrepreneurial agent for the policyholders. The policyholders share in the investment pool's profits as well as its losses. A positive return on policies is not legally guaranteed, as any fixed profit guarantee would be akin to receiving interest and offend the prohibition against riba.

For some time conventional insurance was considered to be incompatible with the Shari’ah that prohibit excessive uncertainty in dealings and investment in interest-bearing assets; both are inherent factors in conventional insurance business.

However, takaful complies with the Shari’ah (which outlines the principles of compensation and shared responsibilities among the community) and has been approved by Muslim scholars. There is now general, health and family (life) takaful plans available for the Muslim communities.

Prohibitions of Gharar, Maysir and Riba

Gharar: An insurance contract contains gharar because, when a claim is not made, one party (insurance company) may acquire all the profits (premium) gained whereas the other party (participant) may not obtain any profit whatsoever. Ibn Taimiyah, a leading Muslim scholar, further reasoned "Gharar found in the contract exists because one party acquired profit while the other party did not". The prohibition on gharar would require all investment gains and losses to eventually be apportioned in order to avoid excessive uncertainty with respect to a return on the policyholder's investment.

Maysir: Islamic scholars have stated that maysir (gambling) and gharar are inter-related. Where there are elements of gharar, elements of maysir is usually present. Maysir exists in an insurance contract when; the policy holder contributes a small amount of premium in the hope to gain a larger sum; the policy holder loses the money paid for the premium when the event that has been insured for does not occur; the company will be in deficit if the claims are higher that the amount contributed by the policy holders.

Riba: Conventional endowment insurance policies promising a contractually-guaranteed payment, hence offends the riba prohibition. The element of riba also exists in the profit of investments used for the payment of policyholders’ claims by the conventional insurance companies. This is because most of the insurance funds are invested by them in financial instruments such as bonds and stacks which may contain elements of Riba.

[source: Institute of Islamic banking and Insurance (IIBI)]

Islamic Investment Products Available In The United Kingdom

By Professor Rodney Wilson,
University of Durham, United Kingdom

Introduction

London has become the largest international centre for Islamic finance outside the Muslim World, largely as a result of the City's role as a centre for Middle Eastern and Asian banking. Treasury management facilities are provided on behalf of Islamic banks in the Gulf, and Islamic fund management and promotion is becoming more significant. Possibilities for Islamic electronic financial services are opening up, and London is the major centre for information gathering and dissemination on the Islamic banking industry.

London's role in serving the British Muslim community has been disappointing and despite almost two decades of experience of Islamic financing, there are few retail products available. The aim of this article is to ask why this continues to be the case, to review the limited range of products on offer, and to see if there are any more hopeful signs for the future.

Islamic financial services in the UK

The Muslim community in the United Kingdom numbers more than 1.5 million British citizens and permanent residents, with up to another 500,000 temporary residents including students and visitors. The community is ethnically and linguistically diverse however, and geographically scattered, that makes marketing aimed at attracting the attention of the community a major challenge. The community is increasingly affluent, and comprises a growing number of professionals such as doctors, as well as a substantial small business component.

Although casual evidence suggests there is a greater propensity to use cash for transactions than with the population generally, the demand for banking and financial products is not markedly different from the national picture. Some devout Muslims avoid using conventional interest based banks, and others donate interest earnings to charity in an attempt to purify their income. The majority use conventional financing services, largely because they have little alternative, and tend, like the rest of the population, to have greater trust in large retail financial institutions with established brand names. For Islamic financial institutions to gain acceptance within the community there would need to be a substantial educational and marketing promotion.

HSBC Islamic Financing

In many respects the HSBC is the best placed British retail bank to potentially offer Islamic financial services to the local Muslim community, but so far it has been reluctant to take on the promotional and marketing risks. HSBC's advantage is that it already has an Islamic finance unit and extensive experience through its global operations in this type of business. It has a significant presence in many Muslim countries, including Malaysia, Pakistan and Bangladesh, and has become a major force in Middle Eastern banking since its acquisition of the British Bank of the Middle East. Its network includes six branches in Bahrain, six in Lebanon, fifteen in the United Arab Emirates, nine in Egypt, and five in Oman. HSBC also owns a minority stake in the Saudi British Bank that has 80 branches in the kingdom. These networks give the bank unparalleled business knowledge of different Muslim societies.

In the United Kingdom HSBC is the only high street bank to have a dedicated network of branches to serve the South Asian community with staff who speak Urdu and are themselves part of the community. It has teams of specialist business banking managers who profess to understand the needs of small Asian businesses. Its South Asian network has 11 branches in Blackburn, Glasgow, Harrow, Leeds, Leicester, London (2), Manchester, Preston, Walsall and Uxbridge. Islamic products could potentially be offered through all these branches.

It is however easier for HSBC, like other British retail banks, to offer conventional loans and savings products rather than to introduce differentiated products for a potential market of Muslim clients who do business with the bank in any case. The gains from cross selling Islamic products to existing clients are not thought to be great, and the potential to attract new clients limited due to the inertia of most retail account holders. HSBC therefore has concentrated on serving foreign Muslim clients of high net worth through its international operations, and in serving Islamic banks through wholesale business, rather than the domestic market. The HSBC's Amanah Global Equity Fund is marketed to foreign investors, for example, rather than the British Muslim community.

United Bank of Kuwait's Islamic Investment Banking Unit's Manzil Scheme
The most significant Islamic financial product to be launched for the Muslim community in the United Kingdom was the Manzil home purchase plan. Manzil can be translated as home, or in spiritual terms as the house or dwelling of the soul. The original scheme, which was introduced in 1997, provides for murabaha financing through a trading mark-up contract. The Islamic Investment Banking Unit that runs the scheme is a part of the United Bank of Kuwait, which was established in London in 1966 to serve Kuwaiti overseas financial and commercial interests. In August 2000 it was taken over by the Al-Ahli Commercial Bank, which formed a new institution, the Ahli United Bank. This has been registered as an offshore banking unit in Bahrain with its shares listed on the stock exchange in Manama.

Once the client has chosen a suitable property and agreed a price he approaches the bank for Manzil financing. An application form is completed together with a direct debit mandate for the monthly payments if the request for financing is approved by the bank's credit committee. The client must pay 0.1 percent of the purchase price of the property, or a minimum of £176.25 including VAT, so that the bank can commission an independent valuation of the property. The IIBU will also seek references regarding the client's financial position, usually from an employer or accountant and current bank. The client's solicitor will be expected to liase with the IIBU's solicitor who will seek assurances regarding the legal title of the property, which may involve legal searches.

For murabaha to be legitimate under Islamic law, the bank, as financier of the property, must be the first owner. It is therefore the bank, and not the client, who contracts with the vendor and pays the deposit required when contracts are exchanged. The sale price from the IIBU to the client has to allow for administrative expenses, a return to the bank's investors and a profit margin. The client pays the purchase price through fixed monthly payments over a period of up to 15 years.

The Manzil Ijara Home Hire Purchase Plan

The Manzil ijara scheme, which was introduced in March 1999, has proved much more popular than original murabaha house purchase plans. It is the flexibility that seems to appeal to clients, who can repay larger amounts as and when they can afford to do so to reduce their rental payments. They have the right to purchase the entire property from the bank at any time, but few are likely to choose to do so in the first few years, largely because they lack the funds. Those with the necessary funds to purchase a property outright would not have sought a Manzil home purchase arrangement in the first place.

Under the Manzil ijara scheme the property is registered in the bank's name, not just initially, but throughout the period of the lease that may extend to 25 years. The tenant or lessee agrees at the outset to eventually purchase the entire property, but at the original price that the bank paid without any mark-up. The monthly payments by the client comprise three elements. The first represents the repayments of the funds that the bank has used to purchase the property. The second is the rent on the property, which is the source of the bank's profit. The rent is reassessed annually to ensure the bank is making a reasonable return and adjusted downward to reflect payments already made. The third element of the monthly payment, referred to as insurance rent, is to recover the cost of the insurance that the bank has to pay on the property. Over time the monthly payments may increase or reduce or both, depending on the size of the first repayments element that the client decides he can afford. Early repayment could be potentially unprofitable for the bank, unless it can obtain a higher return by reinvesting the funds.

The Success of the Manzil Scheme

Although there has only been limited marketing effort put into the Manzil schemes there are between 50 and 80 potential clients a week who phone to enquire about Manzil house purchase and a further 40 who respond by email to the Web pages. This translated into around 20 applications per week for Manzil house purchases. The majority of applications are for housing purchase in the South East of England, but there is also a steady stream of enquiries from the Midlands and the North. Because of the different conveyancing system under Scottish law, Manzil financing is not available for house purchases north of the border. A down payment of 20 percent of the value of the property is required for all Manzil financing, which is higher than for conventional mortgages, but ensures that the client has a significant equity stake in the property from the outset. The minimum value of the property purchased is £50,000, which is a very modest sum in relation to property values in the South East, but which has applied to some of the inner city properties acquired in the Midlands and the North.

Under the Manzil ijara scheme clients can convert existing interest based mortgages. The banks shariah board's members, Justices Shaikh Muhammed Taqi Usmani and Shaikh Nizam Yaquby, have approved a conversion plan whereby the IIBU purchases the property from a client for a sum sufficient to repay the current loan plus certain costs and expenses, with the bank's payment being repaid over a period of years by the client. The bank's profit is derived from the rent the client pays over under the ijara wa-Iqtina hire purchase scheme.

Fund Management Possibilities

London is the major European centre for fund management, both for funds listed onshore and offshore funds listed in the Channel Islands, Dublin, Luxembourg and other centres. There are seven Islamic funds that are promoted in the Muslim world but managed from London and four that are both promoted and managed from London. All of these are designed for clients in Saudi Arabia and the Gulf, with the prices denominated in dollars and the funds administered from offshore tax havens. The HSBC Amanah Global Equity Fund is typical of these offerings, being listed in Luxembourg and managed to provide exposure to leading companies worldwide with a particular focus on major multinationals whose primary listing is in New York.

There have been mixed fortunes for Islamic funds managed from London with Kleinwort Bensons' Islamic Fund, the first to be established in 1986, being wound up in 1989 because of poor subscriptions. Flemings Oasis Fund was launched with great promise back in 1996, but was liquidated in 2000 following the take-over by Chase of Flemings. The Institutional Investor of Kuwait, which managed the Ibn Majeed Fund that was listed in Dublin, decided to close its London office in 2000 and focus its operations in the Gulf.

The only sterling denominated fund was the Halal Mutual, also listed in Dublin, and managed by the Gulf based Al Tadamon Group. It was designed to provide income from commodity trading rather than equity investment, the price being fixed at £250, but with the income dependent on trading profits, which in practice was always around 3.6 to 3.8 percent gross, a very modest return.

None of these funds is of much interest to the British Muslim community, who as United Kingdom residents have potential tax liabilities on both income and capital gains, and therefore cannot take advantage of offshore funds. For local Muslims what is required is an Islamic fund that can qualify for tax exemptions under the Individual Savings Account (ISA) scheme. This provides for exemption from capital gains and income tax for up to £7,000 invested in any tax year for qualifying funds in a maxi ISA. This has proved popular with ethical and ecological investors, with funds such as the Friends Provident Stewardship and the Jupiter Merlin Ecology qualifying for this status. Similar on-shore funds that complied with the Sharia law could potentially appeal to British Muslim investors if a major fund management group was willing to take the initiative.

Conclusion

Although London has emerged as the major western centre for Islamic finance so far it has failed to serve the United Kingdom Muslim community. The major retail banks and fund management institutions seem reluctant to take the initiative by promoting shariah compliant products for the local market. Whether the new on-line financial services groups such as ii-online.com or ihilal.com break into this market remains to be seen, but this may be one way forward.

Issues and Relevance of Islamic finance in Britain

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.

Early Beginning


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.

Market sizing


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


Community Banking

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:


Structure


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 customer chooses the property for purchase and agrees the purchase price with the owner of the property ("Seller"). The bank buys the property from the Seller at the agreed price. The customer will be requested to provide a deposit against the purchase price, but the Bank will remain the sole registered owner.
  • The customer signs a lease agreement with the Bank. The lease will be for a period of up to 25 years with the lease rentals to be reviewed annually to reflect the capital repayment. The terms of the lease agreement will stipulate that in the event of a default the Bank will have the right to repossess and sell the property.
  • The customer/lessee will give an undertaking that in the event of a default under the lease agreement, the Bank/lessor will have the right to compel the customer to purchase the property for the purchase price (which shall equal the amount of principal outstanding).
  • There will also be an undertaking whereby the Bank/lessor promises to sell the property to the customer/lessee at the end of the agreed lease period (i.e., when the whole of the principal portion has been repaid). There will also be a provision for certain other specified instances including when the customer desires to sell the property.
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.

2. Taxation

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.

Conclusion

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.