Islamic FinanceETHICAL UNDERPINNINGS, PRODUCTS, AND INSTITUTIONS

Abul Hassan and Sabur Mollah

Islamic Finance

Abul Hassan · Sabur Mollah

Islamic FinanceEthical Underpinnings, Products,

and Institutions

Abul HassanKing Fahd University of Petroleum

and MineralsDhahran, Saudi Arabia

Sabur MollahAccounting and FinanceSwansea UniversitySwansea, South Glamorgan, UK

ISBN 978-3-319-91294-3 ISBN 978-3-319-91295-0 (eBook)https://doi.org/10.1007/978-3-319-91295-0

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v

Preface

Concept of Islamic finance has been considered as a financial system in consonance with the ethos and value system of Islam. Therefore, it is governed, in addition to the mainstream system of good governance and risk management rules, by the principles laid down by the Shari’ah (Islamic laws). Based on its core Islamic ethical values, Islamic financial system has often been compared with the theme of ethical finance, cor-porate social responsibility and socially responsible investment. A supple-mentary component, however, escorts the value proposition of Islamic financial system, the religious factor. The foundation of the Islamic eth-ical paradigm is in fact founded on ‘adl and qist (justice and equity); a second element is amanah (trust) and a third is Ihsan (benevolence) which establish the socially responsible apparition and objectives of the Islamic Financial Services industry. Therefore, essence of Islamic finan-cial requires all financial products to be structured and implemented in compliance with Shari’ah and has offered a unique customer base tempt-ing opportunity to conduct business according to Islamic ethics. Indeed, facts show that Islamic finance does not only appeal to Muslims but also to non-Muslims equally.

The goals of Islamic financial systems are often stated in socially laud-able terms such as promotion of economic well-being, poverty allevia-tion, fulfilment of basic human needs, optimization in the utilization of natural resources, fulfilment of spiritual needs and promotion of uni-versal brotherhood and economic and social justice. Within the Islamic worldview, the Shari’ah is believed to set the guidelines on all aspects

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of human life. As such Shari’ah compliance is considered a prerequisite requirement of the fulfilment of economic and financial transactions within the Islamic believe—whether at the individual, societal, institu-tional and governmental levels. To achieve this means, Shari’ah stipulates and advises people to adopt permissible and productive activities (halal) to promote public interest (maslahah) and reject prohibitive and harmful activities (haram) to prevent harm. Further, with Islamic finance model, all the stakeholders whether investors, customers, savers, borrowers, buy-ers, sellers, employees, management and traders are attributed a socially responsibly role. The expectation is that Islamic faith, which instils a con-cern for the Hereafter (akhira), will influence an individuals’ level of per-sonal motivation such that people behave altruistically and pursue their self-interest within the bounds of social interest. Therefore, unlike the individual who is guided by self-interest under the homo-economicus prin-ciples in neoclassical economic literature, the individual guided by the norms of Islam would exhibit altruism, humanism and social responsi-bility. Indeed, individuals within Islamic norms are accordingly given the special name of homo-islamicus in the Islamic economic literature.

On the other hand, Islamic epistemological notions of “human accountability before God,” “man’s role as vicegerent (Caliph) on earth” and “promotion of socio-economic justice” are further assumed to be the drivers which restrain self-interest, motivate individual to make care-ful use of limited resources belong to God, care for the environment and fulfil their social obligations. Hence, individual within the Islamic norm is also expected to be socially responsible with respect to their finances. Islamic investors are concerned with not just what kinds of activities are being financed but also the way they are funded. They would seek the deployment of funds in lawful (halal) way. This search for Shari’ah permissibility in one’s decisions contributed to putting market pressure on businesses to produce and market lawful (halal) products. Within the financial arena, it sets the basis for the development of the Islamic Financial Services industry.

IslamIc fInance ProhIbIts Riba, GhaRaR (UncertaInty) and MysiR (GamblInG)

Socially responsible goals of the Islamic financial system are based on some prohibition and encouragements. The prohibition of Riba (inter-est) and permission to trade, as enshrined in the Al-Quran (2:275),

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says: “God has allowed profit from trade and prohibited Riba,” derive the financial activities in an Islamic economy towards asset-backed busi-ness and transactions. This implies that all financial transactions must be representative of real transaction or the sale of goods, services or bene-fits. Islam also has prescribed a moral standard that is almost common in all civilized societies of the world. The structure of Islamic finance revolves around the prohibition of any return derived on a debt (Riba) and legality of profit. Riba is an increase taken as a premium from the debtor. It represents the return on transactions involving exchange of money for money or an addition, on account of delay in payment, to agreed price on sale of loan/debts. The Shari’ah has prohibited it as it generates imbalances in the economy. As all transactions involving inter-est payments are strictly prohibited. So debt contacts cannot be sold at a premium or discount, and exchange tractions of money or goods resent-ing money like gold and silver must be equal for equal and hand to hand. While the term “equal for equal” is obviously, meaning that any increase in one side would be Riba, the exchange of money as business must also be hand to hand, because otherwise, a person can take benefit by the use of money which he or she has received while he or she has not given its counter value from which the other party could take benefit.

Second prohibition is Gharar (uncertainty). In compliance with the principles of Islamic ethics, Islamic finance avoids Gharar (uncertainty). Gharar refers to entering into a contract in absolute risk or uncertainty about the ultimate results of the contract and the nature and specifica-tion of the subject matter or the rights and obligations of parties. Gharar is also involved if there is a lack of adequate value-relevant information or there are inadequacy and inaccuracy of any vital information which leads to uncertainty and exploitation of any of the parties. Dishonesty, fraud or deliberate withholding of value-relevant information is tantamount to Gharar. Islamic Financial Institutions (IFIs) should not engage in any bargain in which the results are hidden, as they would not be cer-tain whether the delivery could or would be made, which is necessary for the completion of any genuine business transaction. The contemporary practices of conventional financial institutions and insurance companies in the futures and options markets are not Shari’ah compliant because of the elements of Gharar, interest, gambling, etc. The transaction of current stock markets, if cleansed of these elements, would be termed as Shari’ah-compliant stock market.

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Third kind of activity which IFIs have to avoid is gambling (mysir). Gambling is involved in a number of financial transactions and conven-tional banks’ products, which IFIs have to avoid. Conventional insurance is not Shari’ah compliant due to the involvement of both Riba and mysir (gambling). Governments, public- and private-sector corporations mobi-lize resources on the basis of lotteries and draws which come under the hammer of gambling and are, therefore, prohibited in Islamic financial system. Current futures and options contracts that are settled through price differences only are covered under gambling. Similarly, a scheme wherein the money of investors is safe and intact but the prizes to be given are related to interest generated from capital accumulated through it, does not conform the Shari’ah due to involvement of both Riba (interest) and gambling.

sIGnPosts of IslamIc fInance develoPment

Today, Islamic finance has been developing so vigorously that it has evolved from a nascent industry in a global market, where Muslims and other non-Muslim communities are working together and learning from each other for the development of relevant products and services. It has passed the significant milestones of existence, recognition by the global financial regulators and central banks and most recently in delivery of sophisticated and lucrative financial services with competitive pricing and sufficient care of Shari’ah compliance. All of this was achieved within just 35 years. Until early 1970, Islamic banking and finance was an academic dream of which a few people were aware, even educated Muslims, now it has become a widely known practical reality. It has made headway in 1985 as a new system of financial intermediation, in spite of an unfavour-able environment and without the help of the auxiliary or shared institu-tions needed for its successful operation. It recognition around the world relates to its workability and viability.

Islamic finance has also attracted the attention of mega international financial institutions, regulators like Federal reserve Board, Financial Services Authority of UK, IMF and the World Bank and prestigious aca-demic centres of higher learning like Harvard University, John Hopkins University and MIT in the USA; and London School of Economics, Durham University, Aston University and Oxford University in UK; and all most all Universities in Middle East and South East Asia. Islamic finance is being experienced in over 80 countries around the world, with

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about 500 IFIs in the field. A number of international institutions and regional financial centres are playing a crucial role in the standardization of Islamic finance products and this enhancing its credibility.

It may specially be mentioned here that almost all multinational con-ventional financial institutions and their subsidiaries are offering Islamic financial products through Islamic windows or full-fledged subsidiaries. Indeed, it is strong sign of good and ethical business in future that will increase the prosperity and peace of mind of millions of people who were earlier either keeping away from the conventional banking and financial system or feeling guilty due to the association of interest in their trans-actions, which is forbidden at least in the three monolithic religions (Judaism, Christianity and Islam). This has provided a paradigm shift for financial services by installing a moral compass for the banking and financial system based on Islamic ethics and by linking them with the real economy.

Islamic finance standard-setting bodies and global facilitators like Islamic Financial Services Board (IFSB), the Accounting and Auditing Organization for Islamic Financial Institutions, Islamic International rating Agency (IIrA) and the International Liquidity Management Centre (ILMC) are proving reorganization for Islamic finance and enhancing its credibility to both customers and regulators. Middle Eastern countries like Bahrain, Saudi Arabia, Kuwait, Qatar and South East Asian Countries like Brunei, Malaysia and Indonesia have been serv-ing hub of Islamic finance for about three decades. Currently, cities like London, Luxembourg and Singapore are also striving to serve centres for Islamic finance.

Demand for Islamic finance is on the rise both in Muslim countries and in non-Muslim countries. In the Britain for example, there are 6 full-fledged Islamic banks and 18 conventional banks are providing Islamic products. In UK, more than 10% customers of Islamic Financial Services are non-Muslims. In Malaysia, about 38% customers of Islamic banks are non-Muslim. In North America, a large number of institutions are proving Islamic Financial Services mainly to the Muslim community. No doubt, the projections in Islamic finance for the future are expected to be better, particularly if the volatility prevails in the international financial system and continues to highlight like credit crunch/financial crisis from time to time and lead to apprehension that it cannot be removed by making cosmetic changes in the conventional financial system but rather

x PrEFACE

by injecting into the system greater market discipline. It may be noted that this discipline is deep-rooted in the principles of Islamic finance.

ratIonale for the book

Indeed, there is a destitute concern to enlighten stakeholders, such as the students, academics, general public and financial intuitional personnel about Islamic finance. Further, those particularly interested are students of business, and finance who intend to study or take up a career in the growing Islamic banking and finance industry. As Islamic financial prod-ucts introduced in this emerging industry, all stakeholders should know that what Islamic finance is and what its products and institutions. They should understand the ethical foundation of Islamic finance, the appli-cation of the principles of the Shari’ah in Islamic banking and finance instruments, markets, products and their salient features and legal posi-tions and functions, the mechanism of CSr, Shari’ah-compliant cor-porate governance, risk management and BASEL accord applicable in Islamic banking and finance industry. Unfortunately, despite the rele-vance of these components of Islamic finance, which remain unclear to most stakeholders, there exist only a few reference sources and acquaint them with the theory and practice of Islamic finance. This book related to one part of the agenda prescribed above and this pondering upon its ethical underpinning, products, markets and institutions. Further, the Shari’ah principles, accounting, CSr, corporate governance and other performance standards as being developed by the standard-setting bodies like the AAOIFI and IFSB are based on the mainstream view and inter-pretation of the Shairah.

The policy makers, bankers, the business community, industrialist, Shari’ah scholars, students of the universities and general public at large need to know what Islamic finance is, what is its philosophy and features and how it works. This book is an attempt to simplify and explain in clear terms. In particular, the product developers, those responsible for imple-mentation as well as financial experts, need to be familiar with the essen-tial requirements of Islamic ethical norms in products, services, CSr, governance and risk management.

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orGanIzatIon of the book

The nature, scope and objectives and main moral features of Islamic finance are discussed briefly, just to lay a foundation for the discussion which studying and understanding the Islamic financial system. Main body of the book is devoted in explaining moral foundation in its prod-ucts, markets and its operation, and institutions. Due attentions are given to regulatory, supervisory and governance issues that are relevant to Islamic finance industry. The book comprises two parts, each part span-ning a number of chapters.

Part I (Chapters 1–14): The first part of the book provides discussion on Islamic finance and its ethical underpinning, Islamic financial markets and their different products, portfolio performance and Islamic finance customer loyalty. Brief details of the break-up each chapter in the Part I are:

Chapter 1: This chapter devoted some important concept on the inter-relationships between ethics and economics and finance in Islam. Largely, it is stated that ethics establish endogenous portents in Islamic economics and finance.

Chapter 2: A discussion about Islamic finance would not be complete if the historical overview of its development has not been provided. This historical perspective is provided about the Islamic financial markets, value propositions and their growth.

Chapter 3: Shareholders, employees and management form the first priority group of the stakeholders of an Islamic bank. Whereas traditional stakeholder theory fails to explain because of its non-moral approach, Islam explicitly asserts that the introduction of moral reasoning may con-tribute to an organization’s effectiveness rather than undermine it.

Chapter 4: The Islamic ethical investment industry claims that while assessing a company’s social and environmental record, a better insight into an organization’s financial performance can be gained. The two models in this chapter demonstrate that the use of Islamic ethical criteria in the selection of a portfolio of shares could have a variety of positive and negative effects upon investment performance. The combination of all these factors may have the overall effect of broadly similar financial performance to conventional funds.

Chapter 5: As customers in the banking industry are becoming more demanding and increasingly mobile between competing financial provid-ers, simply being customer-focussed is not enough. Since customers are

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the driving force of Islamic Financial Institutions, hence customers’ satis-faction is a very important aspect in the competitive market. This chapter emphasized that Islamic Financial Institutions need to take seriously their products marketing aspect in consonance with Islamic business ethics.

Chapter 6: This chapter scrutinizes the causes of the contemporary financial crisis and assess the notions that drive to the very core of capi-talism that may have the potential to cause such crisis. It assesses several issues that have also backed to the economic disaster. The Islamic inter-pretation of such factors is offered to show how an Islamic economic and banking system might help to carry the stability that the world desires seriously.

Chapter 7: This chapter primarily deliberates the characteristics of Islamic equities and the financial instruments which are used in the Islamic equity markets.

Chapter 8: While the development of Sukuk originated from the idea of finding an alternative to interest-bearing bonds, today with the rising Shari’ah concerns about the Sukuk structures, emphasis is being placed by fiqi (Islamic jurisprudence) councils to ensure that Sukuk structuring aligns closely with the principles of the Shari’ah. This chapter demarcates clearly the differences between Sukuk and conventional bonds in terms of the structure, design, utilization of proceeds and overall objective of supporting genuine activities and economic development.

Chapter 9: Islamic mutual funds provide opportunity to small inves-tors, who do not have access to capital market, to participate in the economic development of the country. It is simply a mechanism for diverting extra funds available with the public to the Islamic capital mar-ket. This chapter focused main feature of the Islamic mutual fund that it allows diversification of portfolio for the small investors who may not be able to do so due to lack of financial knowledge.

Chapter 10: In the field of Islamic corporate finance, private equity provides an attractive outlet for Musharakah-based investments in insti-tutional Islamic funds, culminating in an increasing trend of Islamic banks getting involved in private equity deals by setting up their own pri-vate equity funds. The chapter discusses about the untapped market for private equity in the Muslim world in general and the Middle East in particular. Since most of the Middle Eastern big individual investors and Islamic banks have had excess liquidity over the recent year, therefore, the importance of private equity in the region has been gradually real-ized.

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Chapter 11: In this chapter, the instruments like financial futures (stock index futures), option and warrant are examined in Islamic per-spectives. It also explained the impediments to structure these instru-ments as part of Islamic capital market instruments and suggested the ways to overcome the obstacles.

Chapter 12: The main aim of this chapter is two fold: firstly, it checks the relationship between Islamic microfinance and the socio-economic welfare of women, and secondly, to explore the perspective in which Islamic microfinance packages function and the system of their perfor-mance how can be enhanced. The main results show that growth in women’s revenue and resources played an important role in improving women’s financial freedom and sense of self-possession.

Chapter 13: This chapter focused on the popularity of Shari’ah-compliant mortgages is being reflected in the greater range of products, which will assist in building customer confidence in the Islamic mortgage market. It seems that the UK is now leading Europe in the development of Islamic finance products in general and Shari’ah-compliant mortgages in particular.

Chapter 14: This chapter covers the basic conceptual framework of takaful and re-takaful and their operational framework.

Part II (Chapters 15–25): This part focused on the regulation, risk management, CSr of Islamic Financial Services, accounting, governance and their international Islamic infrastructure institutions.

Chapter 15: Shari’ah is best characterized as moral guidance or a set of principles governing all aspects of the day-to-day activities of Muslims. The tradition of Shari’ah laws has a long history, but implementation of Shari’ah law in modern commercial activities in general, and particularly in the contemporary financial system, is at the developing stage. While several leading Islamic financial centres around the world have adopted IFSB and AAOIFI standards, but much needs to be done to standardize Islamic financial products and regulation at the international level.

Chapter 16: This chapter describes that there is need for unified inter-national best practices and prudential standards for supervision and regu-lation of Islamic banking to ensure a legal framework for the functioning and supervision, adequate risk management, disclosure of information and corporate governance in Islamic banks and financial institutions.

Chapter 17: This chapter discusses risk involved and how to deal with these risks within the Shari’ah framework and risk management tools and mechanism available in the IFIs.

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Chapter 18: This chapter elaborates on the risk management in IFIs with an empirical fieldwork by analysing the implications of the Basel III Accord to Islamic Banks in the light of IFSB guidelines.

Chapter 19: This chapter focused on CSr as a framework in which businesses align their core values with the expectations and needs of their stakeholders. The developments of CSr in IFIs sector should drive the Islamic Financial Services industry towards greater financial and Shari’ah discipline, sophistication and integration with the international financial markets.

Chapter 20: The chapter argued that Islamic accounting for Islamic finance ensures compliance with Islamic objectivity which fulfils the Maqasid al Shari’ah (goal of Islamic law). By setting clear objectives for financial accounting of Islamic financial system and institutions, it helps to make sensible judgements for choice among alternative accounting treatments.

Chapter 21: This chapter devoted to explain the principles of Islamic accounting which is grounded in principles of fairness, justice and equity between parties—as well as a fundamental sharing of risk and profit of investment.

Chapter 22: Corporate governance has gained momentum in recent years, due to uniqueness to their nature, Islamic banking and financial system is subject to additional layers of governance, since the suitability of its investment and financing must be in strict conformity with Islamic business ethics and the expectations of customers. Therefore, corporate and Shari’ah governance are the main concern of this chapter.

Chapters 23–25: Islamic Financial Services industry has been a num-ber of international Islamic infrastructure institutions established to sup-port its global development. These chapters provide overview of the formation of Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFIs), Islamic Financial Services Board (IFSB), Islamic International rating Agency (IIrA) and International Islamic Liquidly Management Corporation (IILM).

Dhahran, Saudi Arabia Swansea, UK

Abul Hassan Sabur Mollah

xv

contents

Part I Islamic Financial Markets, Its Ethical Foundation, Portfolio Performance, Customer Loyality and Products

1 The Ethical Underpinnings of Islamic Economics and Finance 3

2 Islamic Finance: A Global Alternative 19

3 Justice, Balance, Trust and Benevolence: The Relationship of the Islamic Bank to Its Shareholders 31

4 Following the Rules: How Do Islamic and Ethical Investing Impact Portfolio Performance? 35

5 A New Perspective: Islamic Business Ethics and Islamic Finance Customer Loyalty 45

6 Unprecedented Opportunity: The Global Credit Crisis and Islamic Banking 53

7 Shari’ah Compliant Equity 87

xvi CONTENTS

8 Sukuk—Shari’ah-Based Asset Securitization 97

9 Islamic Mutual Funds: A Vehicle for Mobilization of Small Savings 111

10 Joining Forces: Islamic Finance and Private Equity 117

11 Financial Futures, Stock Options and Warrants in the Islamic Capital Market 131

12 Small Solutions: Poverty Alleviation Through Islamic Microfinance 149

13 Home Sweet Home: Islamic Housing Financing 183

14 Operational Mechanism of Takaful and Re-Takaful 193

Part II Regulation, Risk Management, CSR of Islamic Financial Services, Accounting, Governance, and Their International Islamic Infrastructure Institutions

15 Courting Change: Development of Islamic Legal System Could Bring Growth 209

16 Gaining Strength: Prudential Regulations in Islamic Banking 217

17 Risk Management in Islamic Financial Institutions 223

18 The Basel Accords in Relation to Islamic Finance 231

19 CSR Disclosure for Islamic Financial Institutions 265

20 Just and Balanced: The Importance of Accounting in Islamic Finance 275

CONTENTS xvii

21 Bigger Than the Bottom Line: Islamic Principles of Accounting 285

22 Rich Architecture: Briefing on Shari’ah-Compliant Corporate Governance 295

23 International Islamic Financial Infrastructure Institution: AAOIFI 301

24 International Islamic Financial Infrastructure Institution: IFSB 305

25 International Islamic Financial Infrastructure Institution: IIRA 309

26 International Islamic Financial Infrastructure Institution: IILM 315

Index 317

xix

lIst of fIGUres

Fig. 1.1 Ethical dimensions in Islamic economics and finance 11Fig. 2.1 Shari’ah compliant banks (Source

https://www.thebankerdatabase.com/Maris Strategies) 28Fig. 2.2 regional asset growth (Source

https://www.thebankerdatabase.com/Maris Strategies) 29Fig. 4.1 Effects of ethical behaviour on company share price 38Fig. 4.2 Effects of Islamic ethical investment on a portfolio 41Fig. 5.1 Consequences of sales behaviour upon the customer

based on Islamic Ethics 49Fig. 8.1 Structure of Mudarabah Sukuk 100Fig. 8.2 Structure of Mushrakah Sukuk 101Fig. 8.3 Murabahah Sukuk 102Fig. 8.4 Ijarah Sukuk 103Fig. 8.5 Global Sukuk Issuance (Source S&P Global ratings,

Eikon. Copyright @ 2018 by Standard & Poor’s Financial Services LLC. All rights reserved) 105

Fig. 8.6 Worldwide Investment in Sukuk (Source S&P Global ratings. Copyright @ 2018 by Standard & Poor’s Financial Services LLC. All rights reserved) 106

Fig. 10.1 Private equity 119Fig. 10.2 Structure of Islamic private equity fund 126Fig. 10.3 Islamic funds growth over the years (Source Eurekahedge) 126Fig. 13.1 The Islamic mortgage structure/process in the UK 184Fig. 13.2 Tiered financing programme 186Fig. 14.1 Basic concept of takaful or Islamic insurance 194Fig. 14.2 Timeline of takaful development 195

xx LIST OF FIGUrES

Fig. 14.3 Mudarabah-based takaful model (Source IFSB (2009). Guiding Principles on Governance for Takaful (Islamic Insurance) Undertakings (p. 30). Luaala Lumpur: IFSB) 198

Fig. 14.4 Wakalah model of takaful 200Fig. 14.5 Hybrid Wakalah–Mudarabah model of takaful 201Fig. 14.6 Hybrid of Wakalah–Waqf takaful model 202Fig. 25.1 IIrA sovereign ratings of Turkey (Source IIrA) 312

xxi

lIst of tables

Table 6.1 Major subprime losses by banks/financial institutions (as on June 30, 2008) 68

Table 10.1 Financial screening ratios 124Table 11.1 Making money with stock options 135Table 11.2 Pricing 137Table 12.1 Growing of Islamic microfinance programme: rDS 154Table 12.2a results of correlation 165Table 12.2b results of correlation 166Table 12.3 regression analysis 167Table 12.4 Validation hypothesis 169Table 13.1 Important Islamic mortgage projects 189Table 13.2 UK legislation addressing Islamic finance 191Table 14.1 Example of facultative re-takaful operation 204Table 18.1 Difference of risk implications between conventional

and Islamic banks 248Table 18.2 Difference of trading book between conventional

and Islamic bank 250Table 18.3 Difference of banking book between conventional

and Islamic bank 250Table 18.4 Minimum capital requirement and buffers

(amount in Saudi riyal) 256Table 18.5 Leverage ratio (amount in Saudi riyal) 257Table 18.6 Case study liquidity coverage ratio-stock

of high-quality liquid assets (Saudi riyal’000) 259

xxii LIST OF TABLES

Table 18.7 Case study liquidity coverage ratio-cash outflows (Saudi riyal’000) 260

Table 18.8 Case study liquidity coverage ratio-cash inflows (Saudi riyal’000) 261

Table 18.9 Case study coverage ratio (Saudi riyal’000) 261

PArT I

Islamic Financial Markets, Its Ethical Foundation, Portfolio Performance,

Customer Loyality and Products

3

The objective of this chapter is to devote some important concept on the inter-relationships between ethics and economics and finance in Islam. Largely, it is stated that ethics establish endogenous portents in Islamic economics and finance. In Islam, economic behaviours and commercial dealings cannot be detached from values and ethics. The Islamic values are intended to rule, direct and govern human beings’ conducts in their day-to-day economic lives. They are intended to serving people to differ-entiate between bad and good things while performing their economic action. It may be noted that the ethical values in Islamic economics and finance are resulted from the key bases of Islam namely: Al-Quran (Divine book of Islam) and Sunnah (the behaviours and teachings of the Prophet Muhammad, peace be upon him). Both represent the main pil-lars of Shari’ah (Islamic ethical guidelines and laws), which is understood by Muslims as an appropriate way to contentment, not only in economic and financial life but also in all facets of life. The designers of Islamic finance proclaimed that an economy based on Islamic ethical values and principles should produce a moral economic system serving the wants of not only Muslims but also humanity at large, as its morals are rooted in cultures and dogged by a variety of factors such as upbringing, different aspects of human life and environment.

CHAPTEr 1

The Ethical Underpinnings of Islamic Economics and Finance

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_1

4 a. hassan and s. mollah

1.1 backGroUnd

Ethics is defined as moral, etiquette, morals, norms, rules of conscience, courtesy, manners, values and alike. Etymologically, Frankena (1988) defines that it is a discipline that describes good or bad, duty or moral obligation, or a set of principles or moral values. It derives from the Greek word ethos, in the plural form (ta etha), which means custom or habit. In this case, it is related to values, good way of life, good rule of life and all the habits adopted and passed on from one person to another or from one generation to another. In a firmer meaning, it is a systematic study of the nature of the concept of value, good, bad, right, wrong and so forth and of general principles that justify us to apply it on anything. Ethics, according to Naqvi (1981), is a science that describes the mean-ing of good and bad, explains what a person should do to another, states the purpose of life addressed by humans in their actions and points which way they should take. Frankena (1988) understands ethics as a science which explains what to do or as knowledge about local customs. In addi-tion, it can be defined in three terms: (i) it is used in terms of value and moral norms which control the behaviour of a person or a group. (ii) Second, it is understood as a set of principles or moral values or code of ethics. (iii) It is the science of good and bad, as said by Harahap (2011).

The study of ethics covers all fields including economics and finance. Ethics and economics share close relationship concerning norms or legal–illegal actions in economics activities. According to Naqvi (1981), economics means the same in terms of a science or an activity. The only difference between one economic system to another is its economic eth-ics. It means economics and economic and financial practices are essen-tially the same although they are in different settings, but economics is different from the aspect of moral values that builds it. The economic and financial ethics in Islam should be different from other economic and financial ethics from other religions (Naqvi 1981). The difference of ethics starts from the source and methodology of ethics itself. According to Frankena (1988), economics ethics is a thought or reflection about morality in economics. Morality means good or bad, commendable or reprehensible and therefore allows or does not allow human behav-iour. It is always related to what humans do including economic and financial activities. Also, the economic and financial ethics turns into a serious study in various parts of the world. The ways of positivistic eco-nomic study per se are no longer adequate nor capable of responding the

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 5

challenges of today’s global economic and financial issues. As the result, the economics and finance are unlikely to separate itself from the aspects of ethics.

1.2 ethIcs of economIcs

The ethics of economic is to be studied bearing in mind that the con-ventional economic development ignores the ethics aspect. Critics of economics have been addressed by many parties. The recent concept of economy is not able to lead to the desired welfare and justice in the society. Paradoxically, it brings poverty and widens the gap between the poor and the rich. According to Franken, such circumstances happen as a result of the economy which ignores the ethics aspect. In this regard, economic ethics is important to learn for three reasons.

Firstly, embedding or increasing awareness of the ethical dimension in economics and business.

Secondly, introducing moral arguments, especially in the econom-ics and business field and supporting economics and business players to maintain proper moral arguments.

Thirdly, supporting economic and business players to determine proper moral attitude of their profession.

Islam is a religion of single powerful God pronounced by Al-Quran, a book which the Muslims claims to be the exact word of God (in Arabic is Allah) and by the wisdoms and normative model (which is called Sunnah and collected of Hadith) of the Prophet Muhammad peace be upon him (570–632 AD), the final Prophet of God. Muslims have faith in that God is unique sovereign Master of the universe and one; the aim of existence is to adore God. Also, Muslims trust that Islam is the univer-sal and complete form of a primordial belief that was revealed previously several times all over the globe, including particularly through Adam, Abraham, Noah Moses and Jesus, whom Muslims believe that they were prophets of Islam. Further Muslims uphold that the preceding reve-lations and messages have been partly altered and misinterpreted over time, but believe that the Arabic Al-Quran to be unaltered and the last revelation of God. Spiritual practices and concepts contain the five pillars of Islam. These are basic notions and mandatory doings of worship and succeeding. Shari’ah (law of Islam), which traces on virtually each facet of society and life, giving guidance on diverse are as from welfare and banking, to warfare and the environment.

6 a. hassan and s. mollah

Ethics establishes the keystone of Islamic economics. The wisdoms of Islam purpose to enable ethical values in all facets of human life together with economic activity. As a religion, Islam is not limited to worship—fasting and praying—but rather it includes the entire of human life. Therefore, Islam is understood as a comprehensive method of life; sub-sequently, it recognizes both the spiritual and the secular. In contrast to conventional economics system, Islamic economics bases its philosophy on faith, the principle of balance in meeting worldly and religious needs, not in focusing a mere pleasure, the principle of wealth distribution and a support for the poor by creating jobs (Khan 1995). In addition, it is con-sidered as divine, morality, humanitarian and middle-class-based econom-ics (Al-Qaradawi 1980). In this regard, the ethics of divinity, humanity, cooperation and justice is an important part of the foundation of Islamic economics (Naqvi 1981). The Islamic economics maintains a balance between individual and social interests, between this world and the here-after and between wealth and charity. As the result, this ethical and moral foundation is what makes the Islamic economics distinctive from other systems. Unlike the capitalist, socialist, welfare-based state economic sys-tem which abstains from morality, the Islamic economics system offers religious ethics. Naqvi (1981) believes that this ethics-based economics system becomes the main character of Islamic economics.

1.3 What Is IslamIc economIcs and fInance?Economics is usually defined as the theory of human behaviour relat-ing to production, consumption and distribution of goods and services. Modified to suit the tenets of Islamic ethics, as Mannan (1970) has given a simple but very useful definition on Islamic economics, “a societal sci-ence which studies the economic problem of the individual sins tilled with the morals of Islam” (p. 131). Further, Ahmad (1992) has defined Islamic economics as “an organized efforts to try to comprehend the economic problem and men’s behavior in linking to that problem from an Islamic perspective” (p. 19). It may be pointed out that Islam is not merely a religion but a complete code of life and that human behaviour, or more precisely, human economic behaviour which is subset of Islamic ethical code. In this light, Islamic economics can be well-defined as that part of Islamic ethical code which studies as a process of economic, social and moral human behaviour in an integrated manner in relation to pro-duction, distribution and consumption of goods and services. We can draw four facts from this explanation:

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 7

Firstly, Islamic economics deals with only a part of Islamic ethical code which is defined primarily in terms of Al-Quran, the Sunnah (tra-dition of the Prophet) and through ijma (Muslim juristic consensus) and Ijtihad (an Islamic lawful term denoting to an independent reasoning or the comprehensive efforts of a jurist’s intellectual faculty in finding an Islamic explanation to a legal inquiry).

Secondly, Islamic economics is a process which refers to the study of behaviour of producers and consumers. This aspect of Islamic econom-ics becomes particularly relevant when we consider the case of economic development in Islamic perspective.

Thirdly, it presumes that economic values cannot be separated from either the social or the moral values, which is done in the case of capital-istic and socialist economics.

Fourthly, it studies human behaviour with particular reference to pro-duction, distribution and consumption of goods and services (Mannan 1984).

On the other hand, Islamic finance is a financial system that oper-ates according to Islamic law (which is called shari’ah), and therefore, it is Shari’ah-compliant. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms and insurance companies. However, these entities are governed both by Islamic law and the finance industry rules and regulations that apply to their conventional counterparts (Jamaldeen 2012).

Although the Islamic finance industry itself is quite young, Islamic theories of economics have existed for more than a millennium; by the mid-twelveth century, in fact, many Muslims scholars had presented key concepts of Islamic economics that are still relevant today. But political and social turmoil put the brakes on Islamic finance for a very long time; only in the twentieth century did Muslim scholars and academics seri-ously begin to revisit these topics. By doing so, injecting Islamic ethics in financial activities set the stage for the modern Islamic finance industry to emerge in the 1970s.

1.4 featUres of IslamIc economIcs

It is very important to know the main features on which the whole Islamic economics structure depends. It is important to deliberate about the main features in effect demonstrate the necessity and credibility to studying Islamic economics as a distinct area of social science in the con-temporary world. Islamic economics is considered by its own structures

8 a. hassan and s. mollah

which make it diverse from any other form of economics (Boutayeb et al. 2014). The important features of Islamic economics are:

Divine-based discipline: Islamic economics is eventually based on belief and moral because its guidelines and values represent the teachings of Islam. Also, this is because Muslims denote to the divine guidelines once they deal with the issues of economics; that is, they obey God wherever and whenever they exercise any type of economic action.

Ethical: Islamic economics is mainly based on morale and ethics. Consistent with Islamic ethics, economics should not be detached from ethics. This matter is a vital element of Islamic philosophy of life, because Islam is largely an ethical guidelines from God to humans. The Prophet Muhammad (peace be upon him) stated: “I have been guided just to complete the moral values” (Hadith, quoted from Boutayeb et al. 2014).The relationship between economics and Islamic ethics should reflect clearly in different economic doings such as manufacture, consumption, distribution and so on. For example, Muslims cannot consume or pro-duce what is prohibited, like alcohol or drugs since they may harm their health.

Humanistic: Islamic economics is based on heavenly guidance, as pointed out previously, but equally it concern for human values and wel-fare. There is no ambiguity between these dual features, although the bases of Islamic economics are essentially from Al-Quran and Sunnah (sayings and practicing of the Prophet). Their wisdoms are a priori addressed to a person who is mutually the means and the end of them. The devotion to humanities characteristic of Islamic economics is signi-fied in a set of ethics which have been tinted by Islam such as broth-erhood, justice, freedom, compassion, cooperation, dignity and private ownership.

Modest: The essence of Islamic economics is the values of equilibrium and moderation. In feature, the Islamic economic method arbitrates socialism. While capitalism places a excessive importance on the individ-ual rather than society, socialism, by disparity, reverses the depiction. The goals of Islam are to make balance between the society and individual. It permits both public and private ownership.

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 9

1.5 ethIcal featUres of IslamIc fInance

One of the main features of Islamic finance is that it is important for ethical investors to be attracted by the appeal of Islamic principles. The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

• Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation.

• Investments are made in permissible activities.• Investments must be separately approved by an independent

Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penal-ized, for example, in Islamic finance require penalties to be paid to charity.

These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a religious (Shari’ah) Supervisory Board may have prevented Islamic Financial Institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system. It may be mentioned here that the Vatican’s official newspaper Osservatore romano said in an article its latest March 2009 issue: “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.” (IIBI 2012, p. 4).

1.6 ethIcal dImensIon In IslamIc economIcs

Islamic economics stance mostly on faith and values. In fact, Muslims do perform their economic doings in the line of what their religion Islam recommends as guidelines and instructions. Muslims follow Islam because they strongly believe that God helps them to differenti-ate between bad and good and between what is forbidden and what is allowed. Freedom, justice, brotherhood, moderation, and compassion are among them orals that help Islam stand itself in the day-to-day life of Muslims in the society as well as whole mankind. In order to do that, Islamic economics provides a number of alternative tools that can help to accomplish those values. For example, Muslims give periodically charity

10 a. hassan and s. mollah

and Zakah to destitute orphans and people, and they have to shun Israf (widespread use of resources through luxury), Riba (interest) and Iktinaz (hoarding of wealth).

In fact, ethical values are an endogenous factor of Islamic econom-ics because they characterize the essential pillars on which Islam stands. Contrasting other economic systems, the Islamic economic structure depends on the spiritual teachings that establish an everlasting ethical structure. Consequently, it is frequently labelled as an ethic-economic structure. Islamic economic system is possibly the only recognized social directive that has robust features of moral endogeneity. This is because it has unique principles and goals of this system and the set of gifted strat-egy and instruments for achieving these objectives (Choudhury 1990).

Nienhaus (2000) notes: “While Western economists have inclined to suppress value judgments and have only initiated to reoccurrence to the behavior of normative queries in the past few years, Islamic economics, in disparity, has always established itself as a science which creates une-quivocal value judgments and associated them to the outcomes of posi-tive economics” (p. 86).

The Fig. 1.1 exemplifies a synthesized opinion of the close relation-ship between financial instruments and Islamic ethical principles in an Islamic economy. The main Islamic values are specifically: belief in the Hereafter, unity of God and God’s sovereignty of the universe. Then, for financial tools, Islamic teachings comprise several of them. One-fifth of Quranic verses are dedicated to commercial dealings or transactions. Further, Fig. 1.1 shows how ethical standards work within the Islamic economic scheme. It may be noted that the principal of faith establishes the basis in Islamic economics. The spiritual issue is powerfully existing in Muslim’s day-to-day life in general and at their economic activities in particular. Subsequently, Muslims have faith in that God is only one and that He is the creator of all creations and sovereign Master of the uni-verse, so it is obligatory to follow what the Creator, God, commended them to do so.

In Islamic system, all the guiding principles and commands aim to establish a healthier life that stances on ethics and morals. The human races cannot live blissfully in the globe without divine wisdoms. In this connection, every Muslims should understand that there would be a Hereafter (life after death) where they will be questioned and judged. In case they neglect the divine instructions in their life, as a result they will

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 11

be penalized. This indication spurs that Muslims to behave properly in their economic actions according to the Islamic plans. They will commit to do only what is virtuous.

1.7 objectIve (maqasId) of IslamIc economIcs

According to Mohammad and Shawan (2013), the purposes of Islamic economics hypothetically should be guiding principles of the objectivity of Islamic banking and finance. However, Chapra (1979) underlined four important goals of Islamic economics are prevailing the values and all- inclusive purpose of Islamic economic system. The four goals are to attain the economic welfare within the agenda of the ethical norms of Islam, to maintain justice and universal brotherhood, to achieve equitable circula-tion of income and to attain freedom of the individual within the setting of social well-being (Mohammad and Shawn 2013). Most of the scholars defined the objective of Islamic economics is characterized in various terms. For example, some use the term “objective” (Maqasid) and some others use the word “feature,” “principle,” “axiom” and philosophical-based objectives as well as operational-based objectives. We will discuss below in brief on philosophical-based objectives and operational-based objectives:

Fig. 1.1 Ethical dimensions in Islamic economics and finance

12 a. hassan and s. mollah

Philosophical-Based Objective

The philosophical-based objectives are those objectives that relate to the internal features of Islamic economics in general and particularly to drive these features towards its infinite goals. By familiarizing the aims of Islamic economics, Ahmad (1986) divides the philosophical-based objec-tives into fours themes, namely Khilafa (vicegerent), Tawhid (oneness of God), Rububiyyah (God is provider and sustainer) and Tazkiyah al Nafs (purification of self). Interpreting these terminology, Ahmad (1986) fur-ther elaborates, Khilafa means the matter of accountability of human as God’s vicegerent, Twahid is the state of human acknowledging the unity of God, Rububiyyah refers to human awareness that God is provider and sustainer of all creations, and Tazkiyyahal Nafs refers to purifying of human personality in the light of God’s guidance’s proved in Al-Quran. All these important four themes signify a vertical and horizontal relation-ship between human and God as well as human and their complete lives.

Operational-Based Objective

It is pointed out that the philosophical-built objective is generally in the direction of vertical type association which occurs in the illustration of the word “al-falah” (Mohammad and Shahwan 2013). In the several contemporary literature on Islamic economics, “al-falah” have been operational objective of Islamic economics (Khan 1984; Choudhury 1999). It covers the spare of human activities for the sake of God and also accomplished through fulfilment of the operational-based objectives. These objectives therefore need a tangible valuation process to ensure its effectiveness and accomplishment. Due to this awareness, Muslim scholars also have underlined different methods in fixing the goals of Islamic economics. Basically, operation objectives are those objectives which are measurable, testable outcome and directly relation to human worldly activates (Mohammad and Shahwan 2013). Grounded on Islamic economics literature, ethically the operational-based objectives may be divided into six kinds of headings, namely social-based objec-tive, economic-based objective, justice-based objective, enjoying good- and forbidding evil (nahianilmunkarwaamrbilmaruf)-based objective, self-based (inner-self) objective and state participation objective. Khan (1995), Chapra (1979) and Zaman (2008) have revealed that economic goals and societal aim are the key component in the operational-based

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 13

intent. remaining objectives are similarly significant like justice (Chapra 1979; Choudhury 1999), inner-self (Khan 1984; Chapra 1979), enjoy-ing good and forbidding evil (Khan 1995; Maududi 1984) and social participation in state’s order (Khan 1995).

1.8 examPles

1. A distinctive example adapted from the study of Mohammad and Shahwan (2013) who have shown that a significant correlation of the implementation of the objectives (Maqasid) framework in determining the aims of Islamic economics and Islamic banks. It is revealed that proper attention is specified to guard the dignity (al-Muru’ah), safety of mind (al-aqal) as well as protection of wealth (al-Mal). Mohammad and Shahwan (2013) show that this outcome is reliable to the aim of Islamic banking as depicted by the Association of Islamic Banking Institutions Malaysia (AIBIM) in directing Islamic banking towards socio-economic justice. They came into conclusion that from the research that each objective of Islamic economics and Islamic banking gives due attention with reference to the study of human or the stakeholder’s behaviour. There is reasoning from the finding that Islamic economics was sel-dom associated with the human welfare, while the stakeholders are the main group of actors of the events.

2. In respect of the association and disparity on the objectives of Islamic economics and Islamic banking, this study leans the entire of objectives of Islamic economics and Islamic banks lie on the God-related objectives and human-related objectives. Almighty God as the one and only Creator of the cosmos is considered as a significant element in establishing the route of these two fields. This connection is also seconded by a range of literature that places return to God as the final goal of human beings, means life after death (Ahmad 1984; Khan 1995).

1.9 Why IslamIc economIcs and fInance?Given the present state of conventional economics and its failure to deal with the socio-economic problems facing the contemporary world, par-ticularly the Third-World countries, the study and the development of Islamic economics and finance have become more important than ever

14 a. hassan and s. mollah

before. The study of Islamic economics is important not only for its own sake but also for the sake of bridging the missing link of the modern eco-nomics itself. As a result, there is a requirement of an independent disci-pline of Islamic economics for whole mankind for the following reasons:

1. Bridging the Missing Link: Contemporary economic system is evolved in purely materialist Western developed societies. It is true that the spiritual, cultural, social and political set-up in the Islamic society is dissimilar from the Western societies; therefore, the Western-style economic analysis should not be fitting for the whole community of the universe. Because contemporary capital-istic economic system is value neutral. Ahmad (1992) states that “During the pre-eighteenth century phase, the economic problem, economic analysis and its relation with ethical values and norms are intertwined. They were merged into each other. It is in the post-eighteenth century developments, despite its moral origins that economics seems to have grown into self-contained discipline (p. 21).” Further, Sen (1987) has rightly emphasized that “moral taking of rights (particularly rights that supported and valued and not just appreciated in the shape of constraints) may consider for systematic departure from selfishness behavior” (p. 29). Sen went on to add, “Even a limited and partial selfishness in conduct can tremble the behavioral foundation of normal economics theory” (p. 30). Therefore, the study of Islamic economics is expected to establish linkage between economic values with socio-moral values. This integration between economic and socio-moral values implies, among other things, equitable distribution of income and resources among all human beings and also among all living creatures.

2. Resolving the Economic Crisis: Mostly, the Third-World countries, particularly the Muslim countries, are facing financial crisis and conflicts in their development and modernization process. It is widely believed that the contemporary international order which is the state of crisis seems incapable of explaining and influencing the course of current events. It is believed that only Islam which can give solutions to these problems. Herein lies the importance of the society’s socio-economic problems in an Islamic perspective and hence Islamic economics and finance (Chapra 2000).

3. Meeting Islamic Responsibilities: Muslims are under obligation to comply with the Shari’ah ethics diktats of Al-Quran and Sayings of

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 15

the Prophet Mohammad (peace be upon him). These dictates have universal appeal such as help to the poor and the needy or to pay Zakah and Sadaqa. It is here that the Islamic economists should come forward, identify the relevant socio-economic prescriptions in Islamic perspective and make use of them in making Islamic eco-nomics and finance a scientific discipline. This explains the reason why the study and development of Islamic economics and finance are so vitally important.

4. In the conventional economics framework, economics is a positive science. It has no concern for ethics and norms. Contemporary conventional economists are concerned only on the analysis of pro-cedures as they take place contrary to economics. Islamic econom-ics has a normative feature, which is evenly vital as positive aspect. An Islamic economist critically analyses the economic observable fact, makes statement of its consequences and suggests the superior ways and means conforming the Shari’ah.

5. Conventional economics carried out studies on human behaviour in the context of the “market.” In economic modelling, some eco-nomic factors were incorporated which may be qualified but did not include into account of social system and made a sharp divi-sion between non-market and market variables. Conversely, Islam considers life as a unity where economic scheme is only sub-system of complete Islamic code of conduct. Several variables which are considered as exogenous variables in the conventional economies are considered as endogenous variable in case of Islamic economic system. Also, variables like sociocultural in the Islamic economic models and the rewards in life Hereafter have been incorporated. It provides Islamic economics a broader range of study in comparison with the scope of study of contemporary mainstream economics. Nevertheless, the study of Islamic economics would be regarded as crucial for translating the various principles of Islamic economics through institutions building into action.

1.10 conclUsIon

At the conceptual level, the Islamic economics is seeking for the ideal system. The economics is built on the principles of Shari’ah (at the phil-osophical level)—which are distinguished from secular conventional eco-nomics—and economic behaviour of Muslim communities at the level

16 a. hassan and s. mollah

of practice (positivistic). In fact, the development of Islamic economic norms is dominated by Islamic jurisprudence aspect (legal formal). The today’s Shari’ah rulings as the single standard of Islamic economics are characterized by halal-haram, acceptable–unacceptable and legal– illegal in responding to economic activities. It considers the ethics of Islamic economic, whereas ethics is fundamental aspect of economics. Consequently, the principles of divinity, justice, cooperation, trust and humanity remain within parameter of Islamic economics.

Islamic economics is designed to realize the ideals of Islamic teaching, namely to meet the objectives of Shari’ah (maqâsiid al-sharî’ah). The most basic purpose of Shari’ah is the achievement of welfare and protec-tion for the five basic principles. These five basic principles include pro-tection for AD-DIN (way of life or religion), life, intelligence, lineage and wealth. To realize these principles, the scholars have formulated the foundation of Islamic economics and which consist of four aspects: to attain the economic welfare within the context of the moral standards of Islam, to maintain cooperation, justice and brotherhood, to accom-plish just allocation of earnings and to achieve freedom of the individual within the framework of social justice and well-being.

Islamic finance is normally considered as ethical finance based on Islamic ethics. This reproduces the fact that self-described ethical finance is a large and growing sector of the market. It has a very positive image with which Islamic Financial Institutions seek to associate themselves. Yet, the claim that “Islamic” and “ethical” are synonymous is rarely seri-ously examined, and nor is the claim that there happens a consistent and usually understood definition of “ethical” practice (Kameid 2015). On the other hand, subsequently, ethical finance is a difficult term to define and it is easy to define its scope from an Islamic perspective, to note that ethics is difficult to define in conventional businesses. For an example, according to the Observatoire de la Finance, a very limiting way to describe it would be as an “umbrella concept” for a philosophy of investing based on a mixture of financial, environmental, social and sustainability criteria, while Euro-based National Sustainable Investment Fora (Eurosif) defines this philosophy with the term of Sustainable and responsible Investment (EUrOSIF) (https://www.eurosif.org/).

Being ethical is essentially required of an Islamic firm, not just expected. Ethics is considered a key for Islamic financial practice. The pioneers of ethical finance asserted that an economy based on Islamic ethical values and principles would produce a moral economic system

1 THE ETHICAL UNDErPINNINGS OF ISLAMIC ECONOMICS … 17

serving the needs of not only Muslims but also humanity at large, as morals are embedded in cultures and determined by a variety of factors such as upbringing, education, religion and environment. Islamic eth-ics encompasses all sectors of life such as social ethics, medical ethics, political ethics and environmental ethics. Indeed, there are no funda-mental differences between Islamic business practices derived from reli-gious teaching and the ethical practices designed to appeal to the masses. Those involved in Islamic finance would consider their ethics as being distinctive and enduring, as ultimately they are based on holy revelation which moralizes the social values appeal to the human’s own conscience derived from faith. The pioneers of Islamic ethical finance asserted that an economy based on agreed-upon norms, values and virtues would pro-duce a moral economic system, serving the needs of not only Muslims but also humanity at large.

references

Ahmad, K. (1984). First International Conference on Islamic Economics: Selected Papers. Delhi: Amar Prakashan.

Ahmad, K. (1986). Keynote Address. In Z. Ahmad, M. Iqbal & M. F. Khan (Eds.), Fiscal Policy and Resource Allocation in Islam. Islamabad: IPS.

Ahmad, A. (1992). Macro-consumption Function in an Islamic Framework: A Survey of Current Literature, In A. Ahamd & K. r. Awan (Eds.), Lecturers in Islamic Economics. Jeddah: IrTI-IDB.

Al-Qardhawi, Y. (1980). Dawr al-Qiyamwa al-Akhlâq fi al-Iqtisâd al-Islâmy. Cairo: MaktabahWahbah.

Boutayeb, F., Benhamida, M., & Saoud, D. (2014). Ethics in Islamic Economics. Annales. Ethics of Economic Life, 17(4), 211.

Chapra, M. U. (1979). Objectives of the Islamic Economic Order. Leicester: The Islamic Foundation.

Chapra, M. U. (2000). The Future of Economic: An Islamic Perspective. Markfield: Islamic Foundation.

Choudhury, M. A. (1990). The Humanomic Structure of Islamic Economic Theory: A Critical review of Literature in Normative and Positive Economics. Islamic Economics, 2, 52.

Choudhury, M. A. (1999). Methodological Conclusion. Chapter 21 of Comparative Economic Theory: Occidental and Islamic Perspectives. Norwell, MA: Kluwer Academic Publishers.

Frankena, W. K. (1988). Ethics (2nd ed.). Harlow: Pearson.Harahap, S. (2011). Ethics in Islam and Business (p. 15). Jakarta: Salemba

Empat.

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Haron, S. (1997). Islamic Banking Rules and Regulations (pp. 2–4). Kuala Lumpur: Lemur Publications.

IIBI. (2012). recommendation for a Moral Code Conduct in Islamic Finance, International Thematic Workshop held in London on September 12, 2012.

Jamaldeen, F. (2012). Islamic Finance for Dummies. Chichester: Dummies—A Wiley Brand.

Kameid, r. (2015). Islamic Finance vs Ethical Finance. http://www.bobsguide.com/guide/news/2015/Oct/29/islamic-finance-vs-ethical-finance/. Accessed March 6, 2018.

Khan, M. F. (1984). Macro-consumption Functions in an Islamic Framework. Journal of Research in Islamic Economics, 1(2), 1–24.

Khan, M. F. (1995). Essays in Islamic Economic (pp. 5–11). Marlfield, UK: The Islamic Foundation.

Mannan, M. A. (1970). Islamic Economics: Theory and Practices. Lahore: Sh. Mohammad Ashraf.

Mannan, M. A. (1984). The Making of Islamic Economic Society: Islamic Dimension of Economic Analysis. Cairo: International Association of Islamic Banks.

Maududi, S. A. A. (1984). Fundamentals of Islamic Economics. Lahore: Islamic Publications.

Mohammad, M. O., & Shahwan, S. (2013). The Objective of Islamic Economics and Islamic Banking in Light of Maqasid Al-Shariah: A Critical review. Middle-East Journal of Scientific Research, 13, 74–84.

Naqvi, N. H. (1981). Ethics and Economics: An Islamic Synthesis. Leicester, UK: The Islamic Foundation.

Nienhaus, V. (2000). Islamic Economics: Dogma or Science. In K. Hafez (Eds.), M. A. Kenny (Trans.), The Islamic World and the West (p. 86). Leiden: Brill.

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Development research Programme Birmingham: University of Birmingham.

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Islamic finance has been registered not only in the Muslim countries but also across East Asia and Western Europe where the growth is driven by commercial and business considerations. Also, non-Muslim countries such as Hong Kong, Singapore and the UK have introduced Islamic finance in their markets. France and Japan have made changes to their laws and regulatory frameworks to facilitate the introduction of Islamic financial products in their markets. The Central Asian coun-tries like Kazakhstani, Kyrgyzstan and Tajikistan are emerging and pro-active in developing Islamic finance in their markets. Kenya, Tanzania and Uganda have reported growing interest in Islamic finance while Australia, Mauritius and Sri Lanka have introduced Islamic Financial Institutions within their conventional markets. This trend is expected to contribute towards greater cross-border flows in terms of increased trade and investment transactions.

2.1 theoretIcal develoPment

Islamic finance concept came into reality through a long theoretical exer-cise of several renowned Islamic scholars and economists. Although clas-sical Islamic scholars like Imam Abu Yousuf, Imam Gazzali, Imam Ibn Taimiyah, Ibn Khaldun and many other Islamic scholars wrote on differ-ent aspects of Islamic economics system, but as far as intellectual devel-opment of Islamic economics and finance is concerned, prolific Islamic thinkers from Indo-Pakistan subcontinent took initiative to develop

CHAPTEr 2

Islamic Finance: A Global Alternative

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_2

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full-fledged theory of Islamic economics and finance in the contempo-rary setting. In this context, first of all, one could mention the contri-bution of Hifzur rahman whose Urdu book “Islam Ka Iqtisadi Nizam” (Economic System of Islam, published by Nadawatul Musannafin in 1942) was the first book in the area of Islamic economics as a discipline. Next contribution in this area was followed by Manazir Ahsan Gilani’s “Islamic Economics” (Osmania University in 1945). Great Islamic thinker Sayyid Abul A’la Maududi and a renowned economist Anwar Iqbal Qureshi made first theoretical attempt to throw the idea of Islamic banking in a confined manner in the late forties.

In 1952, Sheikh Mahmud Ahmad, in his book “Economics of Islam,” emphasized for establishing Islamic banking in the form of joint stock company. The contribution of Mohammad Uzair in his book “An Outlines of Interest-less Banking,” published in 1955, vigorously envis-aged to incorporate the Mudarabah principle as the operational meth-odology of Islamic investment. Similarly, S. A. Irshad and Abdullah Al-Arabi also prescribed Mudarabah principle for the operational mechanism of Islamic financing in their brochures in the year 1964 and 1966, respectively. The structured framework of Islamic banking developed by Nejatullah Siddiqi in his book “Banking without Interest” (published by Markazi Maktaba Islami in 1968). He introduced first time the two-tier model of Islamic banking based on Mudarabah princi-ple which presented a detailed framework of Islamic banking in modern setting.

On the other hand, in order to the practical implement of the the-ory of Islamic banking, Ahmad Al-Najjar played the pioneering role in establishing the first Islamic bank in the modern world in 1963, namely Mit Ggamar Bank at Mit Gamar in Egypt. This was followed by Islamic Development Bank, Jeddah and Dubai Islamic Banking in the year 1974 and 1975, respectively. After that, Faisal Islamic Bank and Kuwait Finance House were established in Sudan and Kuwait, respectively, in 1977 and Jordon Islamic Bank was established in 1978. Later, many Islamic banks and financial institutions have been established in differ-ent countries based on the resolution of the Foreign Minister’s con-ference of OIC Countries held in Islamabad in 1980. The conference recommended to have at least one Islamic bank in each Muslim country in order to facilitate the trade and commerce. Since that time, Islamic banks and institutions have grown at a considerable pace and history has not shown any trends to reveal any slow down. In fact, many experts

2 ISLAMIC FINANCE: A GLOBAL ALTErNATIVE 21

have indicated that the industry should continue to grow at a rapid pace annually over the next few years.

2.2 foUndatIons of IslamIc fInancIal system

Islamic financial system is rooted in the rules and norms of Islam, and in particular Shari’ah law, which emerges out of the Qur’an, and the say-ings of Prophet Mohammed (peace be upon him) which is called as the Sunnah. In the Shari’ah, there are two broad concerns that structure the practices of Islamic banking and finance and provide some points of con-trast with conventional banking and finance.

Firstly, the prohibition of interest (Riba) is viewed as exploitative and unfair in Islam. The prohibition of Riba does not mean that money may not be lent under Islamic law, but merely rules out what might be con-sidered unearned profit. The provider of capital is not permitted to fix a predetermined rate of interest, but should be allowed an adequate return by having a financial stake in the project to be undertaken. That is why money is not considered a commodity in Islamic economics, but rather a bearer of risk.

Secondly, the concerns relate to affect Islamic finance because of the prohibition of excessive risk or uncertainty (gharar). Islamic financial institutions shun not only investments into gambling, but also certain kinds of businesses, especially those involved with pork-related products, alcohol, prostitution and unethical entertainment deemed unacceptable. More generally, Shari’ah law discourages speculation and stresses the “asset-based” qualities of Islamic financing practices. A key aspiration in Islamic financing—in sharp contrast to interest-based finance—is a close coupling of the financial and the real economy.

Islamic finance always encourages the financiers to invest in promising projects, to share profits and losses with entrepreneurs and, in so doing, to promote development. Money is to be tied to real (material) assets to make them grow. Neither it can be used as a commodity or nor be allowed to use as collateral.

If it is not clear whether a particular financial practice is acceptable based on a ruling from the Qur’an and the Sunnah, then authority is given to Shari’ah scholars to invoke Ijtihad (means “effort,” but is essen-tially the interpretation the matter in the light of Qur’anic texts).

The concept of ijtihad is vital to the contemporary practice of Islamic banking and finance. Shari’ah scholars meet communally to arrive at

22 a. hassan and s. mollah

decisions and issue a fatwa (opinion), and these become part of Islamic jurisprudence. In practice, this means that Islamic financial institutions are governed by Shari’ah boards, comprising more than one Islamic scholar. They offer a statement of guidance interpreting Islamic law which is known as Fatwa. When all Shari’ah scholars of a particular time period agree on an interpretation, this is referred to as ijma (consensus). However, such decisions through ijma cannot be inconsistent with the Qur’anor the Sunnah. Nevertheless, Shari’ah scholars can also rely on qiyas (reasoning by analogy) to use the rulings of one event and apply them to another, so long as one can grasp an underlying principle within both events. Together, ijma and qiyas constitute two other sources of Shairah law.

The Shairah law also considers the local custom (‘urf), public interest (maslaha) or necessity (darura) which must not be clearly against the broad guide lines of Quran and Sunnah. The urf, maslaha and daruara are imported and can be invocated at the decision-making process as and when it will be required. For example, until recently Islamic schol-ars have invoked darura to permit Muslims’ use of conventional insur-ance to purchase a home in the USA and UK because of non-availability of Islamic insurance (Shari’ah-compliant insurance) products at that time.

Considering these Islamic legal underpinnings, Islamic financial sys-tem has developed financial products that avoid charging interest and shun excessive risk or speculation. The profit- and loss-sharing (PLS) contracts are consistent with the moral economy of Islam. The PLS con-tracts give Islamic financial institutions a long-term stake in the success of different ventures, while freeing entrepreneurs to concentrate on run-ning their businesses and not simply servicing debt.

2.3 dIstInGUIsh betWeen conventIonal and IslamIc fInancIal system

The basic principles of Islamic financing are built upon the avoidance of interest (Riba), Gharar (uncertainty), mysir (transaction similar to gam-bling) and the prohibition of impermissible businesses as stated in the Quran. Therefore, Islamic investment models are built upon the foun-dation of compliance with Shari’ah. The popular interpretation of Riba is that it is one and the same with the concept of Usury, and is therefore

2 ISLAMIC FINANCE: A GLOBAL ALTErNATIVE 23

unlawful and forbidden. Instead of Riba, the concept of profit and loss sharing is practiced—essentially the concept of sharing risk, as opposed to transferring it.

Gharar is the ambiguity and uncertainty present in a contractual rela-tionship, to the extent that it might provide one of the parties of a con-tract with an unfair advantage over the other. In Islamic financing, any contract undertaken where Gharar exists is null and void. On the other hand, Gharar is the sale of probable items whose existence or character-istics are not certain, due to the risky nature that makes the trade similar to gambling (mysir).

The main difference between conventional and Islamic financial sys-tem is the enforcement of contracts and rules—which comply the Islamic Shari’ah rules. It is a faith-based financing which is in turn influenced by Islamic business ethics. Islamic business ethics emphasizes on establishing an ethical and fair socio-economic system. It is this feature that distin-guishes Islamic financing from conventional financing.

Another one factor distinguishes Islamic financing is that its empha-sis on the trading of goods and services and its advocacy for profit- and risk-sharing in businesses supported by a variety of partnership arrange-ments mentioned above. This stands in sharp contrast to the credit- or loan-based financing of conventional banks. By virtue of these charac-teristics, Islamic banking and financial system offers prudent financing options being asset-backed and equity-based. Therefore, Islamic banking offers promising potential for providing all segments of the population with alternate avenues for saving and investment.

The Islamic banking and financial system encourages risk management and provides confidence through the explicit disclosure and transparency of the roles and responsibilities defined in the Islamic laws (Shari’ah) of contract. In Islamic financing strategies to minimize and manage risk involve integrating such risk into real activities. These activities thus need to generate sufficient wealth to compensate for such risks. In con-trast, conventional instruments generally separate risk from the under-lying assets. Therefore, risk management and wealth creation will move in different or opposite directions. Furthermore, conventional banking and financial system allows for the commoditization of risk, leading to its proliferation through multiple layers of leveraging and disproportion-ate distribution. This may result in higher systemic risks, increasing the potential for instability and inequitable concentration of wealth.

24 a. hassan and s. mollah

2.4 fInancInG PrIncIPles In IslamIc fInancIal system

In the absence of interest as a basis of financing, Islamic financial sys-tem has a number of techniques and tools to do their business. Briefly, they will invoke the participation and sharing principle applicable in Musahrakah (partnership finance), Mudabarah (trust financing) and their variants, the deferred trading principle applicable in respect of credit and forward sales such as Murabahah or Muajjal (credit) and Salam (for-ward) a combining of techniques like Shirkah (partnership) and Ijarah (leasing).

In brief, we discuss below major forms (instruments) of Islamic finance:

1. Mudarabah: It is a partnership arrangement in which one part provides capital to the partnership while the other party provides entrepreneurial skills. Any loss is borne by the financier, and any profit is shared by the partners according to a pre-agreed ratio.

2. Musharakah: It is another profit- and loss-sharing (PLS) arrange-ment and may take the form of a permanent equity investment—a partnership in specific project having a fixed duration or a dimin-ishing partnership. In this system, bank’s share is reimbursed over time by the company acquiring funds. Examples in this case are housing and other fixed asset financing that could be leased.

3. Murabahah–Muajjal: It involves acquiring goods upon a custom-er’s demand or otherwise and their credit sale at a profit margin. It results in debt covering the cost plus a profit margin. This debt has to be paid back irrespective of profit or loss to the person or insti-tution that purchased on credit and suffered loss.

4. Salam: This type of contract involves providing funds against the forward purchase or precisely defined goods with prepayments.

5. Ijarah: This involves leasing an asset and receiving rental, so long as the asset is on lease, the lessor owns the asset and the risk and reward of its ownership.

6. Istisna: This contract involves engaging a person that could also be a financing agent to manufacturer or construct and supply an item at some future date for an explicit sum on periodic payment. The agent contracts with a manufacturer to produce the commodity, and the customers make payments to cover the production price and the profit margin.

2 ISLAMIC FINANCE: A GLOBAL ALTErNATIVE 25

2.5 socIal Goal

Islamic financing system emphasizes on just and equitable financial sys-tem. It offers distinct appeal for Muslims to be attracted to this option. Appeal of Islamic ethical financing mechanism is also likely to be a pow-erful tool for enhancing access to development finance and empowering the poor and vulnerable groups, if Islamic finances extend their reach in poverty elevation programme which is currently not effectively served by conventional banking and financial system. It may be mentioned once again here that Islamic model investments abstain from indulging in any unethical and antisocial activities based on interest, gambling, specula-tion, pornography, wine making and selling and such like.

Islamic financial institutions promote a market-based mechanism wherein available investment alternatives are appraised on their merits in terms of bringing marked improvements to the allocation and distribu-tion of wealth and resources. The ban on interest payments and receipts and the levy of zakah (a tax deduction of 2.5% on Muslims’ wealth that remains idle or unused by business and investment throughout the Islamic calendar year) leave little scope for capitalists to retain funds for profiteering, which could seriously handicap the desirable and natural flow of funds into the market.

Islamic banking and finance confines itself to largely social and devel-opment projects and that Islamic financial institutions are not permitted to invest in socially undesirable investments. An emphasis on Islamic eth-ical issues and rigorous self-regulation in terms of Shari’ah supervision ensures fair play and justice and offer a superior consumer protection model.

Providing qard-hassan (benevolent or interest-free loans) for socially beneficial causes is an important social contribution that Islamic financial institutions which make, especially to the local community in where they operate.

It is a unique feature of Islamic financing that it does business with weaker groups and the poor. It specializes in financing small- and medi-um-sized business enterprises to promote sustainable economic growth with justice. It embraces the social and religious responsibility to mobi-lize charitable funds and donations from its shareholders, clients and oth-ers to help needy and disadvantaged groups in the community.

26 a. hassan and s. mollah

2.6 emerGInG as alternatIve fInancIal oPtIon

Islamic finance is emerging as an alternative financing option which coexists alongside the conventional financial industry. Products develop-ment is one of the potent tools of Islamic financing and key driver to attracting global economic and financial player’s interest which will be critical for competitiveness and sustainability of Islamic financial system. Increasingly, scholars, academics and practitioners have worked with global financial institutions to offer wide range of wholesale, retail and trade financing solutions.

Moving from traditional Islamic products, the industry is now also offering consumer financing for residential purposes and structuring financing vehicles in support of infrastructure and housing finance pro-jects, among others. Vanilla Sukuks are now being compliment by range of hybrid Sukuks: Sukuk al-Ijara, Sukuk-musharaka, Sukuk-morabahah and so and so forth. As per IMF recent study, there are today over twenty odd different variants of Sukuk.

On the other hand, Islamic derivative market now offers Islamic equivalent of interest rate swap/option called profit rate swap/option and Islamic cross-currency and FX swap and options. This is apprecia-ble development given that Shari’ah compliant transaction has to fulfil existence of underlying real assets and generally it does not approve of uncertainty (jahala) and speculation or undue risk-taking (Gharar). The Takaful and Re-takaful institutions as alternative of conventional insur-ance and reinsurance are observed to take off in the financial markets of the different countries. These will allow Islamic financial institutions to offer richer and multiple options to customer, while allowing banks opportunities for proper fund mobilization and asset diversification.

Islamic financing is getting popularity day by day, and it attracts global banks in Asia and Europe to use their skills to augment the application of Islamic financing principles. As expected, the approach and level of enthusiasm and pro-activism have varied in Europe and USA. For instance, the policy of the Financial Service Authority (FSA) of UK is to strike a balanced strategy “no obstacle and no favours” for Islamic financial institutions. recognizing its secular framework, UK has been upfront, practical and candid requiring financial institutions to find mechanisms for conforming to FSA basic regulatory framework. To con-form to FSA requirements, Islamic financial institutions have to ensure

2 ISLAMIC FINANCE: A GLOBAL ALTErNATIVE 27

structures evolved are in compliance with FSA requirements. Meanwhile, UK provides the necessary flexibility and the required relief to its regu-lation on case-to-case basis. Equally supportive has been UK rationali-zation of multiple taxes applicable in purchase and sale of properties to facilitate Sukuks and Islamic mortgages.

Islamic financing is becoming popular, and it is increasing the busi-ness network all over the world. According to an estimate of Asian Development Bank, the average annual growth of Islamic banking and financial sector is more than 15%. Islamic banking and finance is now among the fastest growing financial segments in the international finan-cial system (Fig. 2.1).

During the 1990s, Islamic financing was regarded as an infant indus-try striving to prove its viability and competitiveness. Within a decade, it has recorded dramatic growth, having a presence now in more than 75 countries both in Muslim and non-Muslim dominated communities. A growing number of international financial centres—such as London, Singapore and Hong Kong—are beginning to offer Islamic financial products and services. There are more than 300 Islamic banking/finan-cial institutions worldwide, including conventional banks that are offer-ing Islamic banking services. The total value of Islamic financial assets under their management is now estimated to exceed $1 trillion, about fivefold the magnitude of five years ago.

A significant trend in global finance over the last 15 years has been the rapid growth of Islamic banking and finance which has gathered momentum to become a significant feature of the financial landscape in the twenty-first century. Almost 25% of Islamic financial institutions now operate in the secular countries, and conventional banks have opened up “Islamic windows” to attract the growing number of Muslims living in Europe and North America. The global character of Islamic banking and finance is further visible in the creation of the Dow Jones Islamic Market Index and FTSE Islamic Index in 1999 and of the Dow Jones Citigroup Sukuk (Islamic Bond) Index in Kuala Lumpur in 2003.

The Islamic banking industry has grown at a double-digit rate over the last decade, reaching $3.5 trillion in the year 2017 alone. But despite this growth, Islamic finance has typically been seen as a specialist or niche activity in the West. Sukuk—an Islamic bond, structured to generate returns for investors while adhering to Shari’ah, which prohibits taking interest—is a key part of the Islamic finance system. Total international

28 a. hassan and s. mollah

Sukuk issuances reached $95 billion in 2017, after achieving $85 billion the year 2016, a clear indication the industry is in its early stages and offers enormous potential for growth (Fig. 2.2).

Fig. 2.1 Shari’ah compliant banks (Source https://www.thebankerdatabase.com/Maris Strategies)

2 ISLAMIC FINANCE: A GLOBAL ALTErNATIVE 29

2.7 UnIversal accePtabIlIty

Islamic financial system has gathered momentum to become a consider-able feature of the financial landscape in both Muslim and non-Muslim countries in the twenty-first century.

The key drivers for enhancing efficiency and competitiveness of Islamic finance globally are:

1. Innovative products including financial futures, stock options and warrants.

2. Financial markets all over the world and their regulators support for Islamic finance industry.

3. Standard corporate governance, prudential regulation and supervi-sory guidance.

4. Flexible and practical application and enforcement of Shari’ah prin-ciples and injunctions and its acceptability by the customers as well as community leaders.

Fig. 2.2 regional asset growth (Source https://www.thebankerdatabase.com/Maris Strategies)

30 a. hassan and s. mollah

2.8 conclUsIon

The global financial crisis has presented the Islamic finance industry with a golden opportunity to expand its appeal beyond Muslim investors as a safe haven from the speculative excesses. In order for one to understand how Islamic financial institutions have virtually escaped unscathed from this financial crisis, it is essential to have a grasp of the basic fundamentals of Islamic finance. Islamic finance is based on Shari’ah, or Islamic law, which in essence requires that gains be derived from ethical and socially responsible investments and discourages interest-based banking and investments.

Consequently, the conventional financial institutions will proba-bly have to examine and consider Shari’ah-compliant finance as a viable alternative in the light of the current economic situation around the world. Consumers who have suffered tremendous losses are now looking towards a more conservative and stable banking system, and the Shari’ah-compliant products may provide them with such stability. The primary challenge is for financial institutions to offer products that conform not only to Shari’ah but also to secular banking regulations of that country where the financial institution operates its business.

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Whereas traditional stakeholder theory fails because of its non-moral approach, Islam explicitly asserts that the introduction of moral reason-ing may contribute to an organization’s effectiveness rather than under-mine it.

Shareholders, employees and management form the first priority group of the stakeholders of an Islamic bank. The next group include customers, and the final group is made up of other external parties. There are several sources upon which Islam relies when dealing with human behaviour in general and with respect to Islamic banking business in particular that can shed light on the relationship of Islamic banks with their stakeholders.

3.1 IslamIc ethIcs crIterIa

There are several criteria in the Islamic ethical system that come into play from a stakeholders’ perspective: justice and balance, trust and benevolence.

Islamic ethics describes the first element of justice with two words: ‘adl and qist (justice and equity); a second element is amanah (trust) and a third is Ihsan (benevolence).

In the Islamic way of life, Muslims are encouraged to behave justly towards all. Just behaviour is tied to an individual’s very faith as a Muslim: “Be just! For justice is nearest to piety” (Qur’an, 5:8). On the one hand, the term ‘adl also applies to the concepts of “balance” and

CHAPTEr 3

Justice, Balance, Trust and Benevolence: The relationship of the Islamic Bank

to Its Shareholders

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_3

32 a. hassan and s. mollah

“equilibrium.” This means doing things in a proportionate manner, avoiding extremes. Thus, a “balanced” transaction is also just.

On the other hand, qist means “share, portion, measure, allotment, or amount.” Furthermore, qist means to give everyone and everything their proper due. Overall, justice as described by ‘adl and qist means main-taining the balance between the needs of the body, mind and soul while providing everyone and everything their due.

The second criterion of Islamic ethics relates to the concept of amanah (trust). According to Islam, every human being is God’s trustee on earth and as such must bear responsibility for his/her actions. More importantly, the wealth and other resources that mankind has access to are not his, but have been loaned to him by God as tools to fulfil the responsibilities of the trusteeship.

The third criterion of Islamic ethics is Ihsan (benevolence or excel-lence). Benevolence or kindness to others is defined as “an act which benefits persons other than those from whom the act proceeds without any obligation.” Another meaning of Ihsan is excellence. Thus, Islam stresses not only productivity but also excellence at work. Al-Qur’an emphasizes that reward should be commensurate with effort (3:136, 99:7, 48:19).

3.2 takInG resPonsIbIlIty

In Islam, the fact that an organization or Islamic bank is a business entity does not diminish the responsibility of its owners (shareholders) or their representatives (managers) for its actions. For example, should an Islamic bank invest in areas of business that are prohibited in Islam, such as the production/sale of alcohol and pork, then a shareholder should with-draw his/her investment from that bank and invest in permissible areas of business. As the representatives of the shareholders, managers too are responsible for safeguarding the investments of the shareholders. They need to ensure that the Islamic bank engages only in lawful activities, and that day-to-day business activities are conducted in a transparent and ethical manner along the criteria of adl, qist, amanah and Ihsan. Instead of trying to maximize profits by any means in any type of investment activity, the primary stakeholders (especially shareholders) of an Islamic bank are to seek value maximization within the ethical parameters of Islam.

3 JUSTICE, BALANCE, TrUST AND BENEVOLENCE: THE rELATIONSHIP… 33

Like conventional banks, Islamic banks have to be profit-oriented. Because they have amanah (trust), they have to work hard for the inter-est of the shareholders.

An explicit example of an Islamic bank’s balance of the need to max-imize value while respecting the needs of other stakeholders is seen in the prohibition of interest. In Islam, a shareholder’s capital is not consid-ered as a factor of production and cannot earn a return until it is turned into physical assets. Capital expansion through lending on interest is prohibited.

Yet, it is important to note that Islam does not forbid a return of capital; what is not allowed is a predetermined rate of return on capital regardless of the outcome of the enterprise. This principle stresses the criteria of ‘adl and qist: the shareholders cannot receive income with little or no risk while other stakeholders bear all the risk.

To avoid interest-based transactions, Islam encourages business part-nerships where all parties share equally in the risk of gain or loss. For example, in one such type of partnership (sharikah), the Islamic bank provides part of the required capital while the businessperson provides the balance. The businessperson is also responsible for supervision and management. The two parties agree to share any profit or loss in propor-tion to their investment participation. Should there be a loss, it is consid-ered sufficient if the businessperson forfeits remuneration for his labour.

Moreover, trust plays an important role in business, e.g. in partner-ships. Al-Qur’an says “Do not devour one another’s property by false and illegal means” (2:188). The partner who uses another’s property in trust should be a trustworthy person. Because of his integrity, honesty, sincerity and faith in God, he does not “devour” his partner’s property by “false” or “illegal” means nor does he substitute his partner’s supe-rior possessions with something inferior. Prophet Muhammad (peace be upon him) said: “God, Most High says: I make a third with two partners as long as one of them does not cheat the other, but when one cheats, I depart from them.”

3.3 a trUe joInt ventUre

A different type of partnership that avoids interest-bearing transactions is Musharakah—a joint enterprise in which all the partners share in the profit or loss of the venture. An excellent contemporary example of

34 a. hassan and s. mollah

Musharakah is Islami Bank Bangladesh Limited (IBBL) in rural devel-opment. The IBBL targets small farmers, rural women, craftsmen, arti-sans and small entrepreneurs. The major obstacle usually facing the small farmers is their inability to provide an acceptable collateral before any financing can be provided. Under Musharakah, no collateral is required a priori. Instead, the IBBL owns the equipment through Islam Bank Foundation Trust, e.g. tractors and water pumps, and operates and maintains them, thus providing services to the farmer at cost. The farm-ers contribute their land, management and labour. The IBBL even makes available the services of agriculturists. In any net profit distribution, the farmer receives 75%, whereas the bank receives 25%. In case of crop fail-ure resulting from any natural calamity, all losses are born by the bank. The result of this partnering programme has been quite positive: farmers and families have been able to increase their income and standard of liv-ing, and yields of different food crops have increased.

3.4 a Way of lIfe

The Islamic business ethics approach is centred around criteria that are in common with stakeholder theory such as justice and balance, and includes unique additional criteria such as trust and benevolence. Islam is a way of life. Therefore, business ethics cannot be separated from ethics in the other aspects of a Muslim’s daily life. The Islamic business ethics is balanced, fair, just and benevolent and seeks to respect the rights of both primary and derivative stakeholders of Islamic banks without allowing for exploitation and other human ills.

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In many ways, Islamic investing is not different from the origins of socially responsible investment (SrI) or ethical investing. Both Islamic finance and SrI have much in common. The ethical principles derive from the recognition that economic transactions create the potential for abuse by certain members of a community towards others and thus require ethical standards and practices that can be applied to the details of any given set of financial dealings. These standards are grounded in principles of fairness, justice and equity between parties—as well as a fundamental sharing of risk and profit. The Arabic saying “al ghorm-bi’lghonm” translates roughly as “with profit comes risk.”

The example provided by Islamic finance has gained notice from com-munities quite outside the Muslim world—not least of all from the cen-tre of an entirely different faith-based community. On 4 March 2009, Bloomberg News reported a statement by the Vatican through its official newspaper “Osservatore romano” that “banks should look at the rules of Islamic finance to restore confidence among their clients at a time of global economic crisis.” These rules, in other words, are not particu-lar to Islam nor to the roman Catholic Church nor to any other indi-vidual faith or belief system—but to the ethics and values that should support the financial dealings of any and all communities in any and all marketplaces.

CHAPTEr 4

Following the rules: How Do Islamic and Ethical Investing Impact Portfolio

Performance?

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_4

36 a. hassan and s. mollah

4.1 IslamIc screenInG crIterIa

In Islamic investing, Shari’ah law allows investment in company shares (common stock) as long as those companies do not engage in lending, gambling or the production of alcohol, tobacco, weaponry, pornography and environment pollution. Investment in companies may be in shares or by direct investment (private equity). Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (inter-est-bearing instruments). One set of filters excludes companies that hold interest-bearing debt, receive interest or other impure income or trade debts for more than their face values. A further distillation of these screens would exclude companies whose debt/total asset ratio equals or exceeds 33%; companies with “impure plus non-operating inter-est income” revenue equal to or greater than 5%, or companies whose accounts receivable/total assets equal or exceed 45% or more.

4.2 socIally resPonsIble Investment screenInG crIterIa

SrI uses negative criteria to avoid investing in companies that are involved in specific areas. This screening is largely subjective, often depending on individual consciousness, but a general look at those screenings shows a similarity to the screens used by the Islamic world when selecting suitable investments—with Riba (interest) probably being the major difference between the two sets.

Ethical screenings in the conventional banking world rule out many of the same kinds of firms as are screened out of the Islamic finance world, such as those involved in gambling, alcohol, arms manufacture, tobacco, pornography and the like.

Ethical investments tend to use negative criteria to avoid investing in companies involved in areas such as:

• Trading with oppressive regimes and countries with poor human rights records.

• Environmentally damaging practices.• Pornography and offensive advertising.• Gambling.• Tobacco and alcohol production.

4 FOLLOWING THE rULES: HOW DO ISLAMIC … 37

• Unnecessary exploitation of animals.• Unsafe products and services.• Genetic engineering, abortion and embryonic research.• Armaments.

4.3 somethInG In common

One can see that in ethical and Islamic screening criteria, there are some things in common. The difference, of course, is the Islamic prohibition on interest-based transactions and interest-based finance. As far as con-ventional ethical schemes are concerned, this does not even register.

In order for Islamic finance to play a greater role in the investment field, there is a need to stress what the Islamic model has in common with the socially responsible investment community of the conventional world and to point out that the industry is already pre-screened so that it inherently meets the needs of the ethically conscious market.

Islamic finance has the potential, and appeal, to be used outside of the Muslim community. In serving the Muslim community, the differentia-tion of Islamic financing from conventional financing must be stressed, showing the faith-oriented differences between Islamic modes and con-ventional ones. But to the non-Muslim market, similarities should be stressed because to that market, financing is just a commodity item.

4.4 ethIcal factors In Investment

Investment managers stand a good chance of improving their portfolio performance and reducing their risks if they pay closer attention to the social and environmental performance of the companies in which they plan to invest. Ethics-related factors which may serve to depress invest-ment returns include the cost and availability of capital; increased liabil-ity claims; expanded rules on disclosure; greater emphasis on social and environmental factors in credit risk ratings; corporate governance; the emergence of environmental taxes; and the increasing use of economic arguments by ecological pressure groups. Ethics-related factors that could benefit companies include increases in resource productivity and market share growth and new business development due to companies recognizing the potential offered by ethical investment.

There are many ways in which company strategies perceived as ethical or Shari’ah compliant and can impact share price both at the company

38 a. hassan and s. mollah

and at the portfolio level. Let us examine the different ethical influences through two descriptive models in order to understand how risk and return can be affected in financial performance. Both ethical and Islamic investors can learn from these two models.

The Effects of Ethical Behaviour on Company Share Price

First, let us examine which company strategies perceived as ethical can impact on share price. The model (Fig. 4.1) shows the main links between the company, shareholders, employees, customers and govern-ment and how ethics can impact a company’s cash flow in terms of costs, sales and the cost of capital.

Company Policies

Improved social and environmental performance can lead to cost savings by preventing environmental liabilities and reducing materials and energy consumption. At the same time, it should be recognized that some of

Company costs -Productivity -Costs -Supplier

Cost of capital

SHARE PRICE

Company sales -Price -Volume -Market share

Employee motivation

Government legislation

COMPANY STRATEGY

Customers Shareholders

Fig. 4.1 Effects of ethical behaviour on company share price

4 FOLLOWING THE rULES: HOW DO ISLAMIC … 39

the behaviours that ethical investors favour is very unlikely to be more profitable for a company, at least in the short term. A good example is a company decision to turn down a lucrative military contract with an oppressive regime; that is not likely to increase profits unless the com-pany can find an equally profitable contract elsewhere or the long-term effects on reputation prove more beneficial. Similarly, not all efforts to reduce impact on the environment may save money or earn a reward in the marketplace.

Reputation

It may be mentioned that ethical or unethical behaviour can have an impact on reputation and share price. A good example is how an oil- exploring company such as Shell can be hampered by wider social issues. The boycott of Shell in 1995 resulting from the company’s attempt to dump its Brent Spar oil platform in the North Sea showed a willingness by the consumer to favour companies which have policy to respect the environment. Later, Shell found itself at the centre of international con-troversy for its operations in Nigeria in relation to that country’s poor human rights record. Shareholder and consumer pressure forced Shell to recognize that separation of business from the wider society is not healthy for business.

Consumers

In the business world, companies are increasingly recognizing that they have to pay attention to all their stakeholders. In 1996, MOrI con-ducted a poll that found that three out of 10 people had chosen or boycotted a product or company for ethical reasons. Campaigning organizations are increasingly targeting their campaigns against large multinationals and using the power of consumers and investors whose awareness of ethical issues is growing to persuade companies to change.

Regulation

Government regulation plays an important role in promoting ethics in business. Managers of environmentally ethical funds, for example, say that because of the environmentally proactive stance of the com-panies they select for investment—whether that means using the latest

40 a. hassan and s. mollah

environmental technology, minimizing damage to the environment or employing “best practices”—these companies will benefit from future regulation by being ahead of the game.

Employee Motivational Training

Human resources development, or the motivational training of employ-ees, can create a pleasant working environment and sound work practices which have a positive effect on productivity and efficiency. Motivational training can provide profitability within the company. A 1996 MOrI survey found that 41% of the employees satisfied with their jobs will rec-ommend their employer’s products or services without being asked. On the other hand, not all attempts to invest in better stakeholder relations can be expected automatically to yield a greater return.

4.5 effects of IslamIc ethIcal Investment on a PortfolIo

The Islamic ethical criteria of Islamic equity funds, along with their man-agers, are the key influences on portfolio performance. The Shari’ah supervisory board defines the ethical universe from which the fund man-ager can invest. In the case of a passively managed fund, it is only the Islamic ethical criteria and the index construction rules that are the key influences, though very few passively managed Islamic ethical tracker funds exist. A model (Fig. 4.2) depicts the ways in which Islamic ethical investment criteria can impact portfolio performance.

Diversification

The use of Shari’ah principles to define the investible universe at the portfolio level may lead market players to assume that there may be some degree of lesser diversification. However, portfolio variability does not reflect the average variability of its components because diversification reduces variability. In finance, even a little diversification can provide a substantial reduction in variability, and the investor can get most of the benefit with relatively few stocks. Therefore, the negative diversification effects of selecting stocks from an Islamically constrained universe are likely to be very tiny.

4 FOLLOWING THE rULES: HOW DO ISLAMIC … 41

Sector and Stock Effects

Islamic ethical restrictions will have an impact on the size and structure of the resulting investible universe. It is often said that Islamic invest-ment funds exhibit a smaller-companies effect since they tend to invest in smaller or medium-size companies. Larger companies may be more likely to be ruled out by Islamic ethical screening as they tend to be involved in a larger number of areas of which investors might disapprove. Smaller companies may be more volatile than larger companies, which matters in

Commitment Style

Fund manager “fit”

Research cost

PORTFOLIO PERFORMANCE

Islamic Ethical Criteria Monitored by Shari’ah Supervisory Board

Diversifi-cation

Volatility Tracking error

Concen- tration

Sector and stock effects

Missed opportunity

Fig. 4.2 Effects of Islamic ethical investment on a portfolio

42 a. hassan and s. mollah

the short term, although a portfolio of smaller companies will diversify away the specific risk of individual stocks.

Furthermore, Islamic ethical funds are often overweight in some sec-tors such as technology and construction, etc. The Islamic ethical uni-verse completely avoids sectors such as tobacco, conventional banks, pornography, alcohol, gambling and polluting industries which are against Islamic ethical criteria. In the short term, these sector-related effects will come into play as some sectors do better than others. This can have a positive or negative effect depending on the balance of sectors in the portfolio compared with the unconstrained universe. Nevertheless, sometimes sectors viewed as unethical will have inherent long-term liabil-ities, for example the tobacco sector. Overall, the likelihood is that indi-vidual-sector effects will balance out, at least in the long term.

Tracking Error

The tracking error of an Islamic ethical fund against unrestricted (con-ventional) indices (such as MSCI, FTSE or CrSP) compared with that of an unconstrained fund is also likely to be higher. Shorter-term perfor-mance may diverge widely from that of funds using more conventional approaches and from unrestricted (conventional) indices. But the track-ing error may not matter to the investor concerned about the balance of return and risk measured by the volatility of a fund.

Concentration

Like mainstream ethical funds, a few Islamic ethical funds claim that because they have fewer companies to invest in, they know those com-panies better and are more focused on their activities and, as they are often long-term investors, this pays off over time. If Islamic ethical funds have fewer companies to invest in and a tendency to invest in them for longer, there will be less churn in the portfolio and lower trad-ing costs.

The style of fund manager and experience may or may not fit with a particular Islamic ethical approach. A particular style may suit restrictions better than others, or Islamic ethical criteria may interfere with some fund managers’ strategies. For example, suppose a fund manager’s strat-egy calls for an overweighting of chemical stocks: in this case, Islamic screening may interfere with implementation because of environmental

4 FOLLOWING THE rULES: HOW DO ISLAMIC … 43

considerations. A possible source of underperformance could therefore be a mismatch between the skill and style of the fund manager and the requirements of the particular Islamic ethical approach adopted.

The research cost into company activities may be passed on by fund managers to the investor because increased management costs may impinge on the financial performance of some Islamic ethical funds. However, while Islamic screening may represent an extra layer of cost, this is more than compensated for by the high level of customer reten-tion that Islamic ethical funds appear to have.

Management of Funds

The Islamic ethical investment industry claims that while assessing a company’s social and environmental record, a better insight into an organization’s financial performance can be gained. Some behaviour also positively viewed from an ethical standpoint (such as the implementation of an environmental management system or good employee relations) can be a proxy for a generally well-managed company.

Many Possibilities

There is a wide range of ways in which ethical or unethical behaviour could influence a company’s commercial success and its share price. The two models above demonstrate that the use of Islamic ethical criteria in the selection of a portfolio of shares could also have a variety of positive and negative effects upon investment performance. The combination of all these factors may have the overall effect of broadly similar financial performance to conventional funds. It is not true that Islamic ethical cri-teria will always lead to a good performance, nor will it always lead to a bad one.

45

In a changing marketing environment, any commercial organization is required to be customer oriented. As customers in the banking industry are becoming more demanding and increasingly mobile between com-peting financial providers, simply being customer-focussed is not enough. Since customers are the driving force of Islamic Financial Institutions (IFIs), hence customers’ satisfaction is a very important aspect in the competitive market. Therefore, IFIs need to take seriously their products marketing aspect in consonance with Islamic business ethics.

5.1 IslamIc ethIcs ensUres harmony In bankInG bUsIness

The principles behind Islamic marketing are a value-maximization con-cept based on the principles of “justice” and “welfare” of the people in general and the customers in particular. These principles offer a means to create value and help to achieve customers’ satisfaction through com-mercial pursuits. The guidelines of Islamic business ethics ensure respect for, and the individual freedom of, both Islamic bankers and custom-ers. Furthermore, Islamic business ethics dictates that under no cir-cumstances should Islamic banks exploit their customers or in any way involve themselves in dishonesty, fraud or deceit. Any unethical market-ing practice does an injustice which, by definition, negates the concepts of welfare, justice and equality of humanity which are the core vision of

CHAPTEr 5

A New Perspective: Islamic Business Ethics and Islamic Finance Customer Loyalty

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_5

46 a. hassan and s. mollah

Islam. Thus, adopting Islamic marketing ethics ensures that the seeds of harmony are planted and a proper order in commerce is provided thereby enhancing the dignity of, and upholding the rights of, the peo-ple in general and customers in particular.

5.2 cUstomer sUPPort advIsory—an ImPortant factor

In view of the above, in Islamic banking and financial institutions, the Customer Support Advisors (CSAs) are the most visible represent-atives for the institutions. Frequently, a CSA is the primary—if not sole—contact point for the customer both before and after the pur-chase. Consequently, the sales force of the Islamic Financial Institution is critical to its service delivery process. At the same time, salespeople or CSAs are exposed to greater ethical pressures than individuals in many other jobs. They work in relatively unsupervised settings and are pri-marily responsible for generating the revenues of the Islamic Financial Institution or bank. This duty at times can be very stressful because CSAs are often evaluated based on short-term objectives. It can happen some times when a CSA behaves unethically while interacting with different stakeholders such as customers, competitors or their employer. However, in the hierarchy of stakeholder importance, it sometimes appears that a CSA regards ethical transgressions against customers as being more seri-ous than any controversial actions taken against competitors or their employer.

5.3 sharI’ah—basIs of cUstomers’ satIsfactIon

When competition intensifies, IFIs start to offer more or less similar products and services. There is no doubt that the customer’s perception of satisfactory service provided by the CSA will influence the perfor-mance of an Islamic Financial Institution and determine its competitive-ness and success. Therefore, the need to be customer-focused in the rapidly changing marketing environment has never been more important for Islamic banks and financial services than now. However, under the present circumstances, when customers are becoming more demanding and increasingly mobile between competing financial providers, being customer-oriented is not enough. Islamic Financial Institution and more

5 A NEW PErSPECTIVE: ISLAMIC BUSINESS ETHICS … 47

specifically their contact employees (CSrs) need to be perceived by their customers as ethically Islamic.

IFIs should offer a complete range of Shari’ah-based products and services. Moreover, IFIs should aim to satisfy their customers by let-ting them choose what is most suitable for them in line with Shari’ah. In other words, customers’ satisfaction from an Islamic Financial Institution’s perspective is an important issue. Therefore, this article will highlight possible Islamic ethical sales behaviour as may be perceived by the customers of IFIs.

5.4 csa role vIs-à-vIs servIce exPectatIon

We seldom see that a CSA’s behaviour reflects in the interaction between a CSA and a customer of an Islamic Financial Institution. Islamic ethics requires an individual to behave according to the rules of Islamic moral philosophy. It is a standard for judging the rightness not of an action per se, but of the action of one person relative to another, i.e. Islamic ethics is a basis for judgement in personal as well as collective interaction. It is some time observed that unethical sales behaviour as CSAs’ short-run conduct that enables them to gain at the expense of the customers. Examples of such activities include lying or exaggerating about the benefits of a product/service, lying about the competition, selling products/services that people do not need, giving answers when the answer is not really known and adopting manipulative influence tactics or high- pressure selling techniques.

There are several distinct, separate “objects” based on which consum-ers will make judgements of their satisfaction. We frequently observe that the level of customers’ satisfaction, customers’ trust and loyalty to the Islamic Financial Institution’s core services like Islamic mortgages, Islamic investment funds, Islamic insurance (takaful) and credit cards depend on the CSA’s efficiency in terms of Islamic marketing eth-ics. There is no doubt CSAs are the backbone of an Islamic Financial Institution in the customer’s eyes because they are the frontline service employees. However, in some cases, the contact employees are also the service providers. Even if some of the contact employees do not per-form the service entirely, they may still personify the Islamic Financial Institution in the customer’s eyes. Each of these customer contacts has the potential of positively or negatively impacting customer’s satisfaction

48 a. hassan and s. mollah

with the services of IFIs or banks. More specifically, the services literature has widely recognized the importance of contact employees’ behaviour for customer satisfaction and loyalty. For example, customer satisfaction and repeated patronage may be determined solely by the quality of the personal encounter.

It always happened that customers make a comparison between ser-vice expectations and performance that will result in either confirmation or disconfirmation. Customers’ expectations are confirmed when an Islamic financial product or service performance exactly meets expecta-tions. Disconfirmation will be the result of a discrepancy between expec-tations and performance. Positive disconfirmation occurs when product/service performance exceeds prior expectations, and negative disconfir-mation occurs when expectations exceed performance. Confirmation and positive disconfirmation will be likely to result in satisfaction, whereas negative disconfirmation leads to dissatisfaction.

Therefore, customer expectations regarding the core service are highly dependent on the CSA’s presentation in the service encounter. If the CSA behaves according to Islamic ethics, they are more likely to pro-vide realistic expectations about the core service and are less likely to push the customer into buying a service that a customer does not need. Consequently, these actions may result in confirmation or even positive disconfirmation between expectations and service performance, thus resulting in customer satisfaction with the core service.

5.5 sales behavIoUr model based on IslamIc bUsIness ethIcs

A contingency model of Islamic ethical sales behaviour on customer sat-isfaction is shown in Fig. 5.1. Islamic ethical sales behaviour, as perceived by the customers, is proposed to directly influence level of customer sat-isfaction by core service (H1) to high level of satisfaction (H2) as well as loyalty (H4) to IFIs or banks. As for the indirect effects, it is sug-gested that the customers’ satisfaction with core service (H1) influences the satisfaction of customers’ loyalty (H4) level to Islamic banks. These two variables, in turn, lead to customers’ trust (H3). Finally, customer’s trust (H3) directly influences the increase in customers’ loyalty (H4) to Islamic banks. Details are explained in the following:

5 A NEW PErSPECTIVE: ISLAMIC BUSINESS ETHICS … 49

Customer Satisfaction with the Core Service (H1)

The customer satisfaction with CSAs increased when the customer felt the advisor had been fair in the transaction—something, which is asso-ciated with Islamic ethical sales behaviour. Figure 5.1 shows that the perceived ethical standard of CSAs had a positive impact on customer satisfaction. In some service settings, discriminate validity between sat-isfaction with the CSA and the Islamic Financial Institution should not be necessarily expected. Taking this matter into account, we sometimes see that in a service context the CSA and the selling Islamic Financial Institution or banks’ products are often indistinguishable in the mind of the customer. Hence, a positive association exist between core service and level of customer satisfaction with an Islamic Financial Institution.

High-Level Customer Satisfaction (H2) Leads to Trust (H3) and Loyalty (H4)

research in services marketing has widely shown that customer satis-faction leads to customer loyalty. For instance, in the mainstream liter-ate on marketing, there are many examples that whether customers had

Fig. 5.1 Consequences of sales behaviour upon the customer based on Islamic Ethics

50 a. hassan and s. mollah

replaced their insurance policies or allowed them to lapse depended on their prior satisfaction with the whole life coverage. Similarly, the core-service satisfaction is positively associated with repurchase inten-tions. Furthermore, customer satisfaction with IFIs has a significant and positive effect on loyalty. Literature on customers of Islamic Financial Service industries provides evidence of the positive influence of customer satisfaction both with the Islamic Financial Institution as service provider and the core service on customer intention to use the facility’s services again and recommend the service to a friend.

With respect to the relationship between satisfaction with the Islamic bank and trust in the bank, the later may be viewed from a global per-spective as an overall impression of the Islamic financial system. There is a long-term orientation in this variable, since trust is also conceptualized as a cumulative process that develops over the course of repeated, suc-cessful interactions. Satisfying encounters are hypothesized to reinforce customers’ trust in IFIs. A highly satisfying experience with the Islamic Financial Institution may not only reassure the customer that their trust in the service provider is well placed, but also enhance the trust and loyalty.

Customer Trust (H3) to Islamic Banks

Customers’ trust relates to a belief on the part of customers that the obli-gations of IFIs are fulfilled. In other words, the customers believe and feel that a CSA of an Islamic Financial Institution selling products can be relied upon to behave in such a manner that the long-term interest of the customers will be served. Therefore, trust in an Islamic Financial Institution may be defined as customer confidence in the quality and reli-ability of the services offered by the Islamic Financial Institution. This conceptualization of trust corresponds to the concept of post-trust that derived from the principles of “mu’amelat” based on Islamic business ethics. Service employees (such as CSAs), with whom the customers interact, confirm and build trust in the Islamic Financial Institution or detract from its reputation and ultimately destroy trust. Figure 5.1 sug-gests that Islamic ethical sales practices, as perceived by Islamic Financial Service customers, have increased customers’ trust (H3) in CSAs.

Therefore, there is a positive association between Islamic ethical sales behaviour and customers’ trust (H3) in the Islamic financial system. This can be explained by taking into account the important role of

5 A NEW PErSPECTIVE: ISLAMIC BUSINESS ETHICS … 51

salespeople (CSAs) in the service setting. It means CSAs of IFIs are always working as their backbone. Consequently, if the behaviour of the CSAs of a financial institution is perceived by customers as Islamic, the institution is also likely to be perceived as Islamic, because customer per-ceptions of contact employees will affect their perceptions of the Islamic Financial Institution.

Customer Loyalty (H4) to Islamic Bank

An important consideration in a service financial institution’s customer base is the degree to which its customers are loyal. Based on the princi-ples of Islamic marketing ethics, customers’ loyalty to IFIs is conceptual-ized as a combination of a customers’ intention to maintain an ongoing relationship with IFIs and their willingness to recommend IFIs to other consumers. Customers’ perceptions of face-to-face interaction with CSAs have traditionally been considered one of the most important determi-nants for loyalty.

Islamic ethical sales behaviour is likely to play a major role in devel-oping customer loyalty. On the other hand, unethical sales behaviour is a short-run, expedient perspective devoid of any sense of social respon-sibility. Islamic ethics encourages sellers to foster long-term relation-ships with buyers. Building based upon the principles of equity, justice and welfare; Islamic ethical sales behaviour can be considered to be an investment in the equity formulation. If customers feel they are being treated unfairly by the CSA (because of unethical behaviour), perceptions of inequity will emerge which in turn may translate into a desire of the customer to leave the relationship with the IFIs as represented by the CSA. Therefore, it may be stated that the greater the CSA’s Islamic ethi-cal behaviour as perceived by the customer, the greater the customer loy-alty to IFIs.

5.6 conclUsIons

Islamic ethical behaviour will have a major impact on the development and maintenance of the buyer–seller relationship. Therefore, IFIs should create long-term relationships with their customers. In doing so, the management of an Islamic Financial Institution should take action at the following points:

52 a. hassan and s. mollah

1. They need to create, communicate and enforce a thorough cor-porate code of Islamic ethics. Employees in general and CSAs in particular should know that management is taking serious action to ensure that the code is followed. When a violation arises, it is extremely important that employees are informed of punitive actions taken against the violator.

2. The code of Islamic business ethics must form the basis of ongo-ing training regarding the handling of ethical dilemmas. The man-agement of an Islamic Financial Institution needs to design sales training programmes where the sales manager can present to CSAs several different potential Islamic ethical scenarios and solicit how they would respond to each one. The CSAs can then discuss how the Islamic Financial Institution desires such situations to be handled.

3. The managers of an Islamic Financial Institution should try to communicate with their CSAs, assisting and guiding them in accu-rately reviewing their day-to-day sales activity from an Islamic per-spective and should be given appropriate rewards. Further, IFIs should also provide various incentives to them. They should use a combination of base salary plus incentive pay in the form of com-missions, bonuses or both based not only on the sales performance but on how well long-term objectives such as customer satisfaction have been achieved.

Given the key importance of customer trust in the Islamic Financial Services sector, it is recommended that IFIs should emphasize frontline employees’ Islamic ethical behaviours that particularly lead to customer trust.

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The global financial crisis and food scarcity have together have tinted the brittleness of capitalism. Today, as the effect from the credit crunch and the larger economic crunches linger, it is widely believed that demands for alternative choices will automatically grow. Therefore, this paper seeks to scrutinize the cause(s) of the contemporary financial crisis and assess the notions that drive to the very core of capitalism that may have the potential to cause such crisis. It shall also assess several issues that have also backed to the economic disaster. The Islamic interpretation of such factors will be offered to show how an Islamic economic and bank-ing system might help to carry the stability that the world desires seri-ously. We have already heard some commentators predicting that the Islamic finance and banking industry should have a cure and this fast-est-developing industry can drive onwards to resolve the credit crunch. While the fairly small extent of Islamic banking and financial industry might make this seems impractical at this instant, but there does exist an extraordinary prospect the Islamic economic system to offer, along with the answers to Islamic banking and financial system has for certain of the contemporary hitches.

6.1 IntrodUctIon

The whole ecosphere is in the centre of economic disaster that looms a universal economic downturn. The “financial crisis” as it does come to be recognized, got shock and chaos latest in the year of 2007 to

CHAPTEr 6

Unprecedented Opportunity: The Global Credit Crisis and Islamic Banking

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_6

54 a. hassan and s. mollah

the global financial markets, instigating the US subprime market from bubble to burst. The financial crisis now hovers an international eco-nomic downturn, potentially carrying to a standstill after a decade of growing economic success including employment for economy of the developed countries and potentially smearing an amazing $1 trillion off of the worth of the economy the world (Boeri and Guiso 2008). The final crisis began to taste, as banking and financial institutions exposed. They bought hundreds of thousands of housing loans made to citizens of the USA who might not be able to make settlements.1 Consequently, the banks/financial institutions have had to write down to the tune of $US 476 billion and according to the International Institute of Finance, a vast amounts of their assets demonstrated worthless (Cecchetti 2008a).

The recent financial crisis held during 2007–2008 has had two main adverse effects in the USA. First, the banks became fewer enthusiastic to lend money, lashing up the price of loans. The price of bonds deliv-ered globally against mortgages, for example dropped from $1.9 billion for the year 2007 to $500 m in the year 2008. Second, some banking and financial institutions were distressed—the monoline insurers which insure the bonds dispensed to raise money for private finance initiative (PFI) projects (Cecchetti 2008b). They were, nevertheless, remorse-ful of buying dubious mortgage-based securities and consequently vanished the extraordinary credit ratings they might lend to bond ini-tiators. Also, the developing world has not been spared. For instance, African countries, Bangladesh, Indonesia, Malaysia, Pakistan, South America as well as the Middle Eastern countries were earlier vended the notion of free markets, and all of these counties now have the finan-cial markets under capitalistic system where huge sums of capital are the focus of speculation on the matter of the economy and forthcoming income streams.

Like all preceding crisis, considerable literature has been engraved about the main causes of contemporary financial crisis too. Various econ-omists and analysts have painted the reasons of credit crisis due to lack of suitable transparency, regulation and legislation (Adrian and Shin 2008; Cecchetti 2008c; Goodhart 2008).

1 Bank of England Financial Stability report, April 2007, p. 7.

6 UNPrECEDENTED OPPOrTUNITY: THE GLOBAL CrEDIT CrISIS … 55

Though, the contemporary crisis shares numerous resemblances with preceding crisis that have happened subsequently—the Great Depression held during the 1930s. There are present a whole multitude of exact fac-tors intrinsic in capitalism that produced the credit, food and oil crisis. Those factors linger to outbreak the economies of the developed coun-tries and all those developing countries who followed them. Also, the credit crunch has tinted the brittleness of the free-market economy and capitalism. As the outcome from the financial crisis as well as the wider economic crisis endures, demands for substitutes are certain to cultivate.

Several Islamic economists (Bagsiraj 2009; Siddiqi 2009; Chapra 2009) chronically refer to the worldwide economic crisis as a conse-quence of the high rate of interest (riba) in the financial system from the Great Depression to the credit crunch in the developed countries’ economy.

Immense budgetary imbalances, disproportionate monetary enlarge-ment, huge balance of payments shortages, inadequate foreign aid and insufficient transnational collaboration may all be linked to defects in the concept of riba (interest), which is correspondingly the root cause of the crisis. Essential values of Islamic economic system are equity, welfare and justice. Islamic economy looks for in launching a broad-based economic welfare with superlative rate of economic growth and full employment. It promises to move into equitable distribution of income and wealth and socio-economic justice. Also, Islamic economics will safeguard the stead-iness in the value of money to allow the medium of exchange should be a consistent unit of account and a steady store of value. In addition, Islamic financial system keeps a balance between oversight and flexibility. The proponents of the Islamic banking system believe that financial crisis would not occur in the Islamic banking and financial institutions, since this system functions on partnership between the banks and the clients. There is a societal obligation contained by the noble principles of Islamic banking and finance.

The main aim of this study is to make in-depth analysis on the flim-siness of capitalism and assess some adverse effects that can go to the temperament of capitalism that caused such a financial crisis. Also, it will evaluate the several factors that have all supported to the credit crunch and examine why capitalism frequently brings the economic cri-sis. Islamic viewpoints on that factors would be presented for solution through Islamic economic system that would bring the much-needed steadiness that the world desires.

56 a. hassan and s. mollah

6.2 delIcateness of caPItalIsm

Capitalism system has been attributed for generating capital that has been extraordinary in past. In the eye of the historians, the fight between communism and capitalism for global authority has been estab-lished through the aptitude of capitalism to produce massive quantities of wealth and affluence for the individuals. The clash between the two creeds caused in free trade, free markets and the elimination of state interference in the economy flattering fundamentals for twenty-first- century economies (Boeri and Guiso 2008).

However, the economically developed world commanded by the USA lingers to vend capitalism and its acceptance as the only method of progress. Further, capitalism has originated to be considered by the systematic boom and bust, downturn and at the level economic down-fall. The 1997 Asian crisis had been ascribed to free-market-type finan-cial markets, conjecture and several countries such as Indonesia, Vietnam and Thailand-an era advanced, have been incapable to improve from the crisis (Gorton and Souleles 2005). Worldwide credit crunch has also highlighted the flimsiness of capitalism. There are a number of factors preserved surrounded by capitalism regularly effect such glitches. Some of these factors are discussed below:

The Money Illusion and Debt

In the economies in the developed countries, especially in the Western world to exertion that the consumers want to constantly masticate through. This is attained by building sensory indulgence the rational worth for life. Corporations could then accomplish this claim by mak-ing the needed goods which may be attained by engaging people. Such workers during the working days of the week are the labour/workers who are producing the identical products which explain life. In the week-ends, the workers become the customers of those products. This chain is then given numerous tools to protection that it preserves for poignant, the utmost significant being debt.

During the 1950s, there was no credit card system in Britain. The USA presented first time credit card in the world in the year 1950 with vivid realization, letting people to purchase goods that perhaps could not be imagined before to many people (Cecchetti 2008a). But, primarily it was problematic to persuade the people to receive credit cards. Several

6 UNPrECEDENTED OPPOrTUNITY: THE GLOBAL CrEDIT CrISIS … 57

techniques were used to pause the resistance. This comprised initiation credit cards by way of “shopping card,” initially. The Banks prolonged the payback times as it should be more gainful for the bank when cus-tomers did not refund in full instantly, but in its place pay in a smaller portions, since the interest that must be paid additionally. In the 1960s, when there was tinted in Britain to become rich and appreciating new trends, new developments, new thoughts and then credit cards have been well acknowledged among millions of consumers, instead of being considered negatively equally in the prior years.

Perhaps, the credit card system is one type of debt and that debt now has come to show a dominant role in the mechanism of the economy of capitalists. As a consequence, finance through debt turns out to be main bases of capital at fresh start-ups and also growth plans of sev-eral multinational firms (BIS 2008). Furthermore, many speculators got opportunity to make investment at the capital and stock market. In this process, as companies and individuals may not have essential money for exclusive growth plans, they are needed to borrow money to expand the businesses. In debt finance, the real money that has been arranged as debt by banking and finance sector really does not occur. This debt causes high degree of depression in the state economy since the actual money, as said, does not exist. The banking and finance sector simply accepts the money would be present when the time arises for people to refund their debts. Though in the preceding time the economy has developed immensely, this was mainly through loans, henceforth debt has focused such economic progress. Such debt sustained to raise fund-ing progress in the diverse layers of economy. It has now touched a place where this has been comprehended that the loan may most prob-ably not be refunded. This awfully fragile drill has been in the core of the recent crisis.

Also, investment banks and hedge funds consider the loans which dis-bursed to the clients—they make by way of assets. Consequently, they then reprocess such debt (loan) at high speed by producing turbo‐debt. As a result, the companies, financial and banking institutes borrow cash to finance, whereas such investments comprise a wide reality of diverse debt-centred products. This debt obligation is then utilized as a base to borrow extra money; for example, $1 of debt could use as equity to make investment in excess of $100 of credit. Whatever this actually meant is that debtors in turn to be investors by efficiently providing loan out of the borrowed money. As a result, it discharges a huge financial

58 a. hassan and s. mollah

energy via a chain to retort of a small amount of original equity that cer-tainly not existed at the original place.

On other side, fractional reserve of the banking system makes illusion-ary money that may essentially lead to volatile progress in the USA sub-prime segment and the broader economy. But such features are not real, self-confidence changes regularly and that is why the bases the shrill fluc-tuate in the capital and financial markets. The deposits, public pensions and bonds, interest rates are on basis of the performance of the finan-cial markets, and this may be the reasons for consistent instability and uncertainty. The net result of it is that this type of negative effect on the banking and financial markets’ self-confidence will unavoidably have an impact on the tangible economy. The crucial to this are anticipations—that the businesses will regulate their costs, recruitment and investment strategies conferring to what they suppose to happen inside the economy in the upcoming years. In case, if they are supposing a significant down-turn or a collapse, then they will initiate to spend less and lay off staff. As more companies do this, then consumers would fall into the vicious circle of a smaller amount expenses, higher unemployment rate and ulti-mately a recession.

Consequently, the repairing needed to create a treaty with such a genuineness that the Central Banks would confirm that the system leftovers steady and act the role of the lender of last resort (LLr), if the bank looks a run. In view of this, it has promoted dishonest lend-ing and greedy strategies by banks since they know that they would be rescued by their LLr, i.e. central banks in the case of risky invest-ment spun sour.2 This type of moral hazard problem ascends because the banks do not tolerate the consequences of their own actions. Eventually, action was much madly than it would otherwise have if not cloistered from the risk, in case they were entirely open to the risk. Also, subprime market was predatory on the feeble who have no earn-ings to purchase a house, they have been sanctioned loan at high inter-est rates, and then, when the market turned bitter, the central banks pushed billions of dollars in order to shore up the banks who made dodgy loans.

2 Please see the key Address by Jean-Claude Trichet at the Session of the European Parliament on January 23, 2008 in Brussels which has been Published by the European Central Bank Under the Title “Enhancing the EU Arrangement for Financial Stability,” Published in 2008.

6 UNPrECEDENTED OPPOrTUNITY: THE GLOBAL CrEDIT CrISIS … 59

Inevitable result is that all efforts to deal with the economic crisis have been intended to be unsuccessful as the banks will endure to use small quantities of solid cash to lend huge amount of money. But in the quest of returns though mainstream banks are permitted to make money as the contemporary currencies of the all countries are fiat monies that do not have any intrinsic value. In an estimate, in the year 2006, the USA did use $US1.3 trillion (M1) by printing new notes and coins to extend lending over $US11 trillion internationally.

Real Economy and Financial Economy—Twin Economy Dilemma

The growth of the modern capitalism was the powerful engine for progress of industrialized revolution. Till the 1960s, the advanced world was mostly involved in producing various goods, with a record number of the labours employed in the different industries. Capitalist countries competed with other countries for development of latest technology for producing addi-tional goods with the limited wealth existing in the domain. The economies of the Western countries over the past 30 years have moved their attention from manufacturing to services. This service sector nowadays represents above 80% of the economy of the USA, with the banking and financial seg-ment being the major service. This progress of the financial market does not have in any way of the production of the services and goods but deliv-ers a new type of service. Instead of working in the physical world, mem-bers gamble on what is working to occur in the actual world—by betting or gambling on how trades are carrying out and by gambling or betting upon their profits. Therefore, financial sector is a corresponding economy that be existent together with real economy and creates nothing actual.

Actually, the real economy comprises of land, cars, goods, factories, housing, etc. These are physical goods that may be leased, sold or traded. In other term, they are real goods which are manufactured; people are hired to produce them. However, the financial economy contains nego-tiable instrument with financial prices which fall and rise based on the value individuals give them, frequently with no actual asset signified. Unfortunately, financial economy is currently appreciated more than the real or actual economy. For example, the value of the global bond market is projected at $45 trillion. And the value of the stock markets globally is likely at $51 trillion. Further, globally, the derivatives market has been projected at $480 trillion, greater than 30 times of the size of the US economy and 12 times of the value of the whole world economy.

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The UK along with the USA is broadly regarded as post‐indus-trial economies which has restrained manufacturing goods in support of “hyper‐finance” and consumption. The financial market sector now surpasses the real economy several times, and this has caused this sec-tor swaying government policy all over the global. The financial sectors have become consequently separated as of the actual or real economy; therefore, the investors no longer pursue to collect a dividend, but to take benefit of exaggerated price upswings. This has commanded to spec-ulation of huge proportions, plus gambles on the ruin of economies. In currency exchange rate, speculators acquired huge points from the cur-rencies of developed countries’ economies in the year 1997. They were gaming on the rate currencies failing and in partnership with other sev-eral investment companies. They dragged the currency out of the cur-rency, shares, assets and real estate of the South East Asian countries as a consequence heading towards collapse of economies in the subcontinent. The Hedge Funds earned billions of dollars from the gloom of millions. So the financial crisis is to be identified as the (South) Asian financial crisis.

The Boom and Bust VirusThe global credit and commodities crisis have raised the argument—why a “speculation (bubble) was endorsed to repeatedly grow to unjustifia-ble sizes and why such type of ‘boom and bust” sensations has become a common happening in the Western markets? The economic cycle or boom and bust is reflected always together from capitalism as well as part of the contemporary life. But, the effects of collapses, bursts and down-turns have far accomplishment of concerns, and as a consequence, the mass people suffer terribly. The reason for the boom and bust sequence and its magnitudes are a straight outcome of the ultimate capitalistic efforts to attain with the economy, and this is of uninterrupted economic progress. Based on this theory, capitalist economies have been designed towards manufacturing the product and consumers would purchase what the labours produced. The recent crisis focuses this very evidently as con-sumers and investors similar are repeatedly blasted with information in the matter of what to purchase and the subsequently big boom.

Like the UK, the USA skilled in economic development that has been powered by the enlargement of individual debt, which is fired by the tall expense of real estate. When the cost of house price increased, owners of

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the houses began progressively taking out individual debt, submission of the equity on their houses as collateral. In this method, the re- mortgaging houses to fund for wasteful lifestyle have been a countrywide practice in the USA. Provided that the house prices continual to increase, customers would be capable to take out additional debt against their houses. This phenomenon has been developing since the year 1990. Currently, the cir-cumstances have reached at such circumstances where house values are so tall that they have exceeded their salaries by a number of times. The condition touched a risky edge that such debt holders begin to struggle to repay and their houses were gradually becoming expensive to buy by the other customers.

This condition was never justifiable. House prices increased not because of customer’s request but due to speculation. The specula-tors are looking for profits by purchasing homes and then hoarding and selling these houses for higher prices. This practice of speculation is powered utterly by the boldness of speculators maintain that house price continues to increase. Besides that, they are pumping money for this speculation through borrowing money from the market sometimes even at a lower rate as the speculators have confidence and shaped the basis of the so called economic boom are to be experienced by econo-mies of the Western nations. It is sure that they are subject to ambigu-ity. This dignity may perhaps be devastated if adequate persons consider that economic pointers in the most important economies of the globe are not observing decent. And this is what uncalled for happened in the month of August 2007 with alarming vending the financial markets of the world.

As a consequence, both large banks and individuals were not able to invest at their debts. In case the enough people professed to be so, then the housing market would initiate to be engulfed with publics trying to quickly make cash on their houses beforehand prices begin to crash. As the more houses enter to the market, then a descending curve is pro-duced as the further supply of homes on the market makers prices turns down. This might cause yet further people to create fear and attempt to sell their homes which should remain in the cycle. This will have a knock-on result for the economy that so heavily depends on this appar-ent confidence within the housing sector, which will then influence the world that depends on the US economy for maximum of their exports of goods. This is precisely what has occurred subsequently in August 2007.

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As the speculators drew their money from the real estate and sub-prime sector, this caused in the worth of house prices failing and all the customers who have mortgages might emerge reimbursing well above the actual worth of the property or house. This situation is analogous to what headed towards Great Depression of the economy where the developed countries observed the collapse of the whole economics. The problem started in the USA later of the World War I while the USA instigated a period of seclusion. The USA focused on individuality, which was labelled as the US dreams that endorsing the procuring of goods as the resources to pleasure. The demand was contrived by new publicizing techniques, and it perceived an unparalleled phase of economic develop-ment, where several persons come to be billionaires overnight because of the huge growth in nationwide production.

In order to fuel the economy of the USA after the World War I under the headship of Herbert Hoover, they took the initiative to boost the demand of goods by procuring the luxurious consumer goods to achieve the ultimate level of pleasure. As a result, there was an enormous rise in the acquisition of consumer and extravagance goods. This guaranteed firms enlarged to manufacture goods progressively and the US population should catch jobs (Galbraith 1993). The lavish American standard of living was being backed by debt, and then, over a span of seven years, extra and more people of the USA recycled the debt to finance their luxuries lifestyles. In the year 1927, many Americans started to realize the crush and started to use their monthly pays to pay their debt which they had gathered. The consequence of this lifestyle resulted ultimately; the shop shelves of stores continued kept unsold the consumer stuff, since a big number of the pop-ulations’ throwaway salary was being cast-off to service their accrued debt.

In view of the above, this situation had a domino effect in the other sections of the economy by way of dealers to department stores no longer gives orders. The producers at a standstill getting orders from dealers and then producers were enforced to lay employees off. The key indicator of unsustainability of the capitalism was on October 27, 1929 while the stock markets crashed on a single time and 87% of the stock market prices were wiped off—the unsustainability of capitalist systems created bubble and burst.

As each segment of the capitalistic economy depends on the sched-uled section, the system is built on by creating false necessities to retain consumers buying increasingly stuff to hang onto the main-section (cat-alyst) working. This is the reason that the developed countries watched

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consistent recessions as soon as adequate people have consumed fur-ther than their incomes. There would unavoidably be a decrease in total spending by customers as a huge chunk of throwaway income was spent to service debt. In this way, this cycle of expenditure—rise in the pro-duction, therefore, no more job in the market because of buying more goods is certainly not maintainable and therefore, has to end somewhere.

6.3 the credIt crUnch

Generally, the commercial banks used simply the money they get from depositors, the same use to give loan to borrowers. The banks are inca-pable to acquire money from the people other than the depositors. Yet, nowadays, banks are able to depend on not only on savers but also on money markets, where the banks can borrow money from the other banks and the borrowing banks and then lend it to the debtors at a greater interest rate. So this type of secondary market transaction is completed by the creating a product which termed as “credit default swaps”—in short form it is called “CDS.” The system permits a bank to successfully insure the CDS against such risk that a borrower perhaps may not be able to pay back the loan. As a result, this makes an impres-sion that loans are now much lesser risk and allowable such loans to be sold and bought. This then headed to create another product that is branded as “collateralised debt obligations” or CDOs, which are credited by the banks as interest-bearing investments.

As a result, the consequence of the banking modernization creates a huge rise in the quantity of money which being operated by the banks. Maximum customers are not known that the mainstream banks only hold as deposit roughly $1 for every $20 on loan given to customers. The other $19 is made falsely by banks via a procedure branded as “frac-tional reserve”. The fractional reserve in the past few years have been lowered; therefore, banks characteristically lend out not just $20 but $30 or even $40 of debt for every $1 of deposit held from each customer by the bank. As a result, after certain period, the credit crunch starts to bite, and then the customers hurry to withdraw deposits from the banks. This “run” on the financial institutions or banks has had a massive effect on the financial institutions or banks’ capacity to lend money, as for each $1 of deposits banks loss, and then, they have to cut their lending not just by $1 but essentially by $30 or $40. Therefore, this in turn compelled the banks not to lend money massively.

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Grounded on such tendencies, it is ostensible that if this condition is permitted to linger, public will loss all self-confidence not just on the banking system but also in the economy. In this situation, as banks will virtually halt loaning money to the borrowers, and will come to be stuck in a vicious circle as they decline to lend money, this situation will turn to a sustained descending spiral in housing prices. This problem has begun to affect adversely on property prices, as many financial institutions and banks have stated to reclaim house/property or other systems of collat-eral in order to resell them to solvent customers. This permits the banks to decrease their unpaid loans and progress their liquid assets which will invest in the other ventures. Nevertheless, there are big numbers of recaptured homes for sale, and their prices have to drop abruptly, every so often many times less their purchase prices. It means that such houses will be incapable to accumulate the actual sum of money lent. These problems may have serious concerns for the economy and will decrease the worth of the security detained by the financial institutions or banks. In this way, the capitalistic system finds itself in a stark economic fall, as was occurred during the 1930s. Therefore, credit crunch had been the major economic and financial crisis to smash the economies of the developed counties from the time when the Great Depression occurred during the 1930s. Practically, publics and businesses have been adversely affected indirectly or directly by the market collapse, and therefore, foremost commentators in the world have questioned every time about the sustainability of the fractional reserve in the banking and the capitalistic system.

Subprime Market

The subprime is real estate market which contrasts from the primary market. Subprime market contains all those individuals of the society who do not fulfil the norms or conditions for a mortgage in the nor-mal financial market. The implementation of the Depository Institutions Deregulatory and Monetary Control (DIDMC) Act 1980 was portion of the deregulation effort which removed several limitations to lending (Sengupta and Emmons 2007). This caused in loans getting record levels leading to the conventional mortgage market fetching soaked and arriv-ing its highest of productivity. Those customers with low income and occasional credit histories were curved from conventional mortgages at a time while the market was floating due to customer’s spending based on borrowing. The subprime market was turned out after the point as

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25% population of the USA chop down into this type and characterized a market prospect. Therefore, the lenders of the USA offered the mort-gages to those people who have little means to repay for a mortgage and charging them with an interest ratio of much upper than the commercial mainstream rate because of higher percentage of default risk. Hence, the recent credit crunch is extensively held responsible on the “sub-prime” crisis, originated from USA, where financial institutions and banks gave mortgages to those customers who do not have any income and were known in the industry as unemployed. Such class of customers often had very poor financial trajectory records. They were issued the mortgages with the objective that if the customers are defaulting, then the banks would be able to reclaim the property and selling in a floating property market. As of 2007, the value of the subprime market was more than $US 1.3 trillion.

Securitization

Furthermore, the subprime loan providers then designed one more method of earning money in a segment which was even now extremely risky. Several lenders desired to make sure that they must not fail out at potential money earning chances in the subprime market. Financiers settled a number of multifaceted products. This has been attained by vio-lating the ethics and rules of the mortgage/sub‐prime mortgage market.

In the line of the securitization (an off-balance sheet activity), debt is traded to the third party, which should then obtain the loan settlements and pay a charge for this freedom. Hence, debt turns into a tradable commodity, just similar to a car. The aptitude to securitize loan or debt providing a mode for risk to be diced, sliced and spread, letting more secured loan to be sold out. Since 1994, securitization or off-balance sheet rate of subprime debt rises from 32% to above 77% of whole sub-prime loans. This procedure effectively increased the figure of financial institutions or banks with a stake claim in the subprime mortgage mar-ket. It was endorsed to occur due to the way in which the real sub-prime loans are debt were securitized.

The mainstream Wall Street investment banks and many other institu-tions turn into be holders of the collateralized debt obligations (CDOs). These are the bond-type products produced by a procedure of re‐engi-neering and deconstructing asset‐based securities. It principally func-tions by allowing investors with right of entry to the consistent payments

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receiving from debt clients in return for giving to have entree to the CDO as well as administrative charges or fees. Consequently, investment banks in the Wall Street make investments in the assets’ cash flows, rather than a straight investment in the underlying asset.

On the other hand, many organizations and institutions also turn into the proprietor of MBS (mortgage-backed securities) which is produced out of the subprime loans’ repackaging. In modest terms, it is where a bank trades a set of debts as a product. By charging a fee, the new holder of this debt obligation collects regular loan payments. In utmost cases, such a debt forms slice of a bunch of mortgage-based debts endured together into a type of bond or asset—each bears diverse degrees of risk involved to it. Thus, possessors of MBSs really do not distinguish where the payments are pending from or even which parts they are being uncovered to. As on June 30, 2008, the MBS market was approximately an amount of $6 trillion more than the Treasury bonds of the USA.

The main difference amid CDOs and MBSs is in the later as the asset which is retained as collateral. In any occasion of a recession in the real estate market, it should not only be the subprime suppliers who would drop out, but then again all those who acquired collateral products should also be uncovered.

Collapse of Subprime Market

Owing to the appetite for housing by the citizen and residents of the USA, the housing sector sustained to inflate. Therefore, the subprime sector is also constant to grow. Many mainstream commercial banks come into what they treated a buoyant market. Numerous Americans refinanced their houses by accepting second mortgages alongside the added value to employ the funds for consumer spending. On April 2, 2007, it was observed that the US real estate bubble was in suffering when New Century Inc.—the major subprime mortgage lender in the USA confirmed bankruptcy because of the growing number of default-ing from borrowers. Earlier, 25 subprime lenders were announced as bankrupt, declaring substantial losses, by some placing themselves up for auction. It was in reflection the start of the end.

Gradually, the crisis blowout to the holders of collateralized debt. They were in such situation where the payments they were assured from the debt they had bought were being failed to pay. By being hold-ers of several multifaceted products, the fundamental elements of such

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products caused in many owners of such debt to trade other investments because balance loss incurred from experience to the subprime area (Adrian and Shin 2008). Due to extreme fall in share prices across the globe in August 2007, the market started receiving into a vicious circle of prices fall.

The matters became worse when numerous investors were trapped in this vicious spiral of decreasing prices. In this situation, the investors not only sold subprime and associated products, but also traded anything that could be sold (FSA 2007). This is why share prices dropped across the globe and not just in those straight linked to subprime mortgages. International institutional investors who poured their money into the US real estate sector realized that they would not be able to recover the mon-ies what they loaned out because the individual subprime mortgage own-ers were default on mass on such loans due to lack of repaying capacity.

It was for this cause that central banks all over the world interfered in the world economy in an unparalleled manner, providing huge amounts of cash to safeguard such banks should not go insolvent. The Australian Central Bank, Bank of England, European Central Bank, Federal reserve of the USA and the Japanese central bank—the Bank of Japan—shoot up over $300 billion into the banking system in 48 hours in a bid to prevent a financial crisis. They marched in when banks, such as Sentinel, a large American investment company, stopped investors from drawing their money, startled by rapid and unforeseen losses from bad loans in the US mortgage market. Other financial institutions tailed suit and adjourned normal lending. Interference by the world’s central banks in order to prevent crisis already charges them over $800 billion. The fol-lowing table displays the major subprime losses (Table 6.1).

The preliminary difficult with “sub prime” debts prompted a minor problem where banks depend on for cash flow mainly on retrieving funds from another bank through the wholesale market. Then, banks suddenly show that they could no further borrow adequate money to supply the cash flow which needs to. This abruption in inter-bank loaning leads to banks significantly plummeting the money they provide lending to the customers and dramatically rising the cost of standing loans. This in turn considerably abridged demand for property, and that led to the crash of the real estate market. As a result, this situation was feeding back to gen-erate a yet larger problematic for the banks since the property was what they typically held as collateral for the entire debts mortgage customer owes them.

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Self-Interest

The consumer is essential for capitalism. In the capitalistic economy, the consumers not only should buy, but also should buy more and more every year. In this way, the consumption is occupying such a cru-cial role in the operative of capitalism that individuals have derived to be signified by what they eat, ware and drive. Henceforth, physical sat-isfaction has been developed as aim of life. It is declining world capitals and ever cumulative numbers rivalry for of sensual satisfaction that greed has become to be characterized in the capitalist societies. The capitalism has faith in that if people in the society chase their self‐interests then the exact capitals are created for those who seek them and it is the finest way to distribute resources.

Furthermore, the self-interest is reflected a necessary attribute for the twenty-first-century entities. Therefore, the sleaze can currently be perceived in the social order. Greed is the impetus that commanded to greedy mortgage brokers marketing mortgages to individuals that have

Table 6.1 Major subprime losses by banks/financial institutions (as on June 30, 2008)

Source reuters

Name of financial institutions Amount (US$ bn)

Citibank Group $46.40UBS $38Merrill Lynch $36.80HSBC $18.70Bank of America $14.9 bnMorgan Stanley $12.6 bnroyal Bank of Scotland $16.50JP Morgan Chase $9.7 bnWashington Mutual $8.3 bnDeutsche Bank $7.5 bnWachovia $7.3 bnCredit Agricole $6.6 bnCredit Suisse $8.13Mizuho Financial $5.5 bnBear Stearns $3.2 bnBarclays $9.2AIG $20.23HBOS $7.5MBIA $8.14Ambac $9.22

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no means in paying back. Then, they are growing the interest rates till the purchaser defaulting. Also, greed is the incentive that headed the credit rating organizations to rate the funding or investments fewer risky than they truly were. In this case, it was obscured that the risk was grounded on subprime mortgage debt (FSA 2007). Also, Hedge funds confirmed greed in the mode that they pursue to provide surpris-ing returns to their clients. It is true that the greed is the key enthu-siasm even for single shareholders that seek to take advantage of on the dropping share prices in the economy; however, it can lead to dif-ficulties for many people. The outcome of this development is shock-ing, since all elements within the public place their profit before morals and ethics. With this reason, such circumstances have been bent where even if the consequence of the decision of investment can progress to a recession in the economy. The corporate sectors are ready to take those resolutions.

Capitalistic market economy makes an attitude which only upkeeps for profits only they are earned. A little consideration is made to the misery, and suffering of such arrangements may cause, and irrationally, a circum-stance has been fashioned in Africa and a few countries in Asian region where firms prey on the misery of the publics. In quest for profits, the transnational companies forcibly eliminate people, contaminate the trop-osphere and test on host inhabitants from the countries like Nigeria to Indonesia. Also, companies of the developed countries brutally target on the collective consumers.

Moreover, the subprime mortgage segment is precise that this mat-ter is an action of manipulation as firms offer huge loans to people with wicked credit histories given that they compromise their houses as collat-eral. Subsequently, the beleaguered people are the utmost likely to have a expenses difficulty, and these loan firms will then recapture the homes and sell the same to get their money in addition to the inflated interest rate further on the top. The furthermost pathetic on the side of the point is that the incentives of all these actions are perceived as a benefit. They think that greed is necessary and good for contemporary life. Therefore, the greed is an organized problem. This is preserved in the contempo-rary capitalistic economy. There is no legislation or regulation which can pact with this since it is a type of the attitude comes straight from the capitalistic faith.

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Impact on Global Economy

Generally, all over the world, the banks invest the widely held of their loaning by borrowing money from other banks through inter-bank bor-rowing or by rising money from the financial markets (Bernanke and Lown 1991). The money borrowing among the banks is accepted on a regular basis to balance their books. In comprehension emerged that subprime mortgage sponsored securities happened across the bank-ing institutions in the portfolios of hedge funds and banks around the world, several lenders halted proposing loans and some only gives loans at extraordinary rate of interest. Also, some of the banks blocked loan-ing to other banks to shoreline their books. Almost all banks certainly distinguished how much banks were uncovered to the subprime crisis; therefore, many banks declined to lend to another bank. It led to a credit crisis where those banks who made the bulk of their loans from the money borrowed where they felt that the credit was drying up.

The financial crisis was not only going to distress the USA but also blow out to the broader worldwide economy, for example the break-down of Northern rock in UK which was the 5th biggest mortgage provider in the UK. The Northern rock financed its lending by 80% borrowing from the financial markets.3 As the credit or money markets halted, Northern rock demanded the LLr, the Bank of England, for a liquidity backing ability due to difficulties in hovering funds in the inter-bank borrowing system. This generated a run on the bank as investors lost all self-confidence with the banks—leading to lines developing all over the nation as savers withdrew their liquid money in fear.

Later, the government of the UK owned the Northern rock as its failure would have unavoidably blown out to other banks as fright-tor-mented depositors tried to pull out their savings—the entire banking sector would have collapsed.4 Parallel situation happened in March 2008 with the Bear Stearns—one of the largest investment banks in the world.

3 BBC TV Documentary Series Titled: “Million Dollar Traders: Financial Crisis.” Produced by E. Davis and S. Byers Which Were Screened Between November 16 and December 20, 2008.

4 Not only Northern rock collapsed but also verge collapsed of royal Bank of Scotland (rSB), HBOS and some others banks in UK along with the bankruptcies of nearly all of the subprime provides in USA. Please see Bank of England Statistical release, December 2008.

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The Bear Stearns was enforced to write off three of their investment funds in the subprime market. The problems of the Bear Stearns intensi-fied when rumours spread out about its liquidity problem which in turn worn investor self-assurance in the companies.

The failure of the subprime market in the USA’s economy will have simple consequences across the world economy as much the banking sector of world positioned their money via multifaceted securitization process in the subprime market. With the economy of the USA well-thought-out even now in recession, this will have global touches as its economy energies the world economy due to its enormous consumption.

Economic Recession

Just as several factors have triggered the credit crunch, the effect is far realization. Financial institutions or banks will include more inflexible loan procedures and stiffen the drainage of funds. Yet, the credit crunch will effect further than home loans and credit cards. Initially, the mort-gage market and home constructors will be careful, and home purchas-ers will be even extra cautious. Fresh construction will come to a halt and may not restart until the extra stock of houses is sold, which may take some months. The shrinking of funds will stumble into day-to-day consumer expenses that are by this time negatively wedged by sustained upper energy prices.

All these dints finally make their road into the employment mar-ket (Boeri and Guiso 2008; Gorton and Souleles 2005). With declined demand for services and goods due to upper prices, derives the need for corporations to curve the costs, which will in turn need to job cuts. Consequently, the eventual increase in joblessness sets the point for a possible recession.

6.4 IslamIc economIcs as solUtIon to fInancIal crIsIs

With the worldwide economy fronting the actual prospect of infla-tion and recession—particularly food inflation hit the roof. The most important and most traded resource of the world is food and its infla-tion reached record levels. The unexpected rise in worldwide commod-ity prices happened in almost the similar period as the worldwide credit crisis held. The banking sector in the Western countries, politicians and

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economists have all failed to openly associate the crisis and have rigidly accused the greedy speculators and in absence of proper transparency and regulation. The credit crunch and food crisis have further tinted the brittleness of capitalism. As the result of the wider economic crisis and credit crunch remains, demands for changes are certain to grow.

This section will outline some aspect of Islamic economies and show how Islamic economies and banking system will bring the much desira-ble steadiness of the world economy. Islam has a totally diverse philoso-phy for the economy that brings different consequences in a society from a capitalist one. To focus on the whole Islamic economic system in this paper is out of the scope, but some aspects of Islamic economics will be discussed and show how it will help to solve the current global financial problems.

The economic strategy in Islam or the complete way of the Islamic economic structure is to protect the simple needs for each individual wholly and to empower them to gratify their wants as much as possible. Consequently, from this perspective, Islam looks at people independently rather than the whole of the public. It means economic policies will look after to supply for all rather than just leaving gratification to the market. This may be attained by a number of rules Islam has in guaranteeing wealth circulation and government participation in the economy that safe-guards the economy transfers in the direction that Islam has titled for it.

Riba Is Unlawful But Trade Is Lawful

Islam declared a clear division between riba (interest) and trade where trading is permitted and riba is forbidden. Islam does not ponder money as a goods or commodity such that there would be a price for its use. The money is documented in Islam as a means of conversation or exchange. This may not officially be stared as goods for exchange. The significant dissimilarity between riba and trade is that the business risk in transaction is permitted more consistently amid all the parties involved; where in riba processes, the business risk lies severely, if not exclusively, on the debtor. In its broadest general inference, riba implies any rise of capital not defensible by a risk accepted.

rates of interest (riba) contribute impairment at the macroeconom-ics level. Islamic economists covertly refer to the worldwide economic crisis as a consequence of the rates of interest (riba) from the prodi-gious depression to the worldwide credit crunch. Enormous budgetary

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disparities, large balance of payments deficits, inadequate foreign aid, inadequate international cooperation and disproportionate mone-tary expansion can all be linked to weaknesses in the theory of interest, which is also the main cause of the crisis. Islamic economists consider the demand for economic growth as corresponding to exaggerated inter-est rates and worldwide economic crisis. The most emerging countries, which in the way of shifting to a market economy, had established some kind of crisis in the initial phases.

Inflation frequently happens as an outcome of a fast developing econ-omy; henceforth, constricting the monetary policy is indispensable to offset inflation. It increases in interest rates which would only enhance to the unemployment level. The Keynesian school of economics thing emphasized the problem of tall interest contributes to unemployment; consequently, there is needed to emphasizing of plummeting interest rates to the lowermost possible.

Al-Qur’an evidently stated that riba (interest) and trade are not similar. “As for those who consume interest (riba), they act as the one whom Satan has perplexed with his trace. Apprehended in this state they say: ‘Buying and selling (trade) is but a kind of interest’, even though God has made selling (trade) and buying legal, and interest (riba) ille-gal. Hence, he who takes this warning from his Lord, and then gives up (involving in interest), may retain his preceding gains, and it will be for God to justice him. As for those who return to it, they are the people of Fire, and in it shall they abide” (al-Baqarah, verses 275).

Assuming this stanza from the Al-Quran, one can see the connec-tion between allowing trade and forbidding interest (riba) as a strong and clear reference to business loans. It can be stated here that trade offers risk where businesspersons incur the risk of either gaining profit or incur losing. In dissimilarity to this, interest (riba) deals no risk to the lender. Investors who do not desire to accept the risk are allowed to only the principal amount and nothing more. Seemingly, riba is basically in clash with the perfect and unequivocal Islamic, Keynesian or Marxian socio-economic justice.

The main motive for why Al-Qur’an has brought such a punitive verdict contrary to interest (riba) is that Islam desires to institute an economic system where all types of manipulation are eliminated, pre-dominantly the injustice preserved in the system of the banker being assured of an optimistic return without joining any effort sharing in the risk, whereas the entrepreneur, in addition to his hard work and

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management, is not guaranteed of such an optimistic return. Islam desires to establish justice among the entrepreneurs and bankers.

No Twin Economy in Islamic System

The Islamic economy in spirit is a pool of guidelines which provide for entire society by eliminating all hindrances to the delivery of wealth. This may be attained by the Islamic economy system, not requiring a twin economy with a financial area that functions in analogous to the real economy. Mainstream financial markets dispute the Islamic laws of con-tracts. The Islamic economy does not identify the financial economy in their present form due to the following:

Firstly, financial economy creates debts. Galbraith (1993) states that “Financial processes do not provide loan themselves to innovation … all financial innovation contains, in one system or another, the making of debt protected in lesser or greater competence by real assets” (p. 19).

Secondly, the commercial world has numerous different thoughts on finance and the real economy. Supporters of the real economy, in distinc-tion to Briys and de Varenne (2000), say that investors and finance must focus on helping the real economy: actual assets and persons working with them to yield real worth. role for derivatives hedging is not firmly regulated to safeguard they were not being used for simple speculation. Podur (2008) favoured that some of the financial activity should be banned because these products create hurdle for the development of the real economy and be banned. Due to lack of strict regulations, there have been several types of bubbles from happening and overflowing which cannot match investment to real production requirements. Furthermore, financial economy does not stop dislocation of economically poor people and peasants from their societies, abuse of workers, environmental oblite-ration by extractive productions, toxic waste by manufacturing industries, the exhaustion of resources and ecologies by consumption, or change of climate since these are all relics of the real economy (Podur 2008).

Thirdly, rules and regulation by which the financial economy func-tions are not unbiased. In element, the rule favours some players over others. The capitalistic structure favours capital over labour, the first world over the Third World and business companies over peoples. Moreover, at a more superficial level, the rules have been set to favour speculators and their doings rather than the trades the speculators are needed to serve by management of risk. By varying the rules of the

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game, speculators weaken the value of real economy, real business and their subsidiary that give benefit to their own.

Fourthly, the ultimate absorber of any risk is constantly society at large. That is what ensued with every financial bailout in the past, regardless of the pretence of a private enterprise method. Governing financial market on the basis economic life is prearranged by the market performers to offer state support for companies and leaders to accumu-late huge shares of power. The banking sector in particular and finan-cial market in particular have been deregulated to enable gambling in the tag of financial economy. Subsequently, after market crash, the rules are altered to try to guarantee it does not occur again. But crash occurs even if the rules were altered to restate the economy.

Proper Distribution of Wealth

Islam has comprehensive rules on the wealth distribution, and this is its eventual aim with the economy—to guarantee circulation of wealth around the economy so that everybody can a share in the wealth which is generated. A major part of Islamic economics is devoted to safeguarding the distribution of wealth (Chapra 2000). Islam distinguishes the variances in the strength of people and ability and does not leave the stuff entirely to the “market.” As and when required, Islam lets government interference in the economy to carry the market equilibrium. Al-Quran says, “Whatsoever (from the belongings of the people of the towns) God has conferred on His Messenger belongs to God, and to the Messengers, and to his kins-folk, and to the orphans, and to the needy, and to the wayfarer so that it may not merely circulate between the rich among you. So accept whatever the Messenger gives you, and refrain from whatever he forbids you. And fear God: verily God is Most Stern in retribution” (Al-Hashr:7). This verse talks about the Head of the state who should safeguard that wealth is not circulated in a way where it leftovers among the wealthy people alone. For instance, when monopolies grow, limiting entree to markets so prices grow or the discovery of mineral or resources on land belongs to an individual who limits its circulation, etc. In both cases and among others, the state should interfere to keep a balance between the elementary requirements of individuals and unsatisfactory distribution that has happened.

In the Western developed countries, entire host of policies are for-mulated in the light of capitalism which hamper the wealth distribution. That is why these lead society for borrowing to funding its elementary

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wants. On top of this, most of the Western countries suffer from an enormous wrong distribution of wealth where wealth circulation is left to the free market where the powerful and rich people take a greater share.

Circulation of Wealth

The Islamic economy aims to eliminate all restrictions in the wealth cir-culation. In order to do this, Islam has permitted individual proprietor-ship of services and items. But it limited the means that can be used to gain ownership. Also, it has allowed the individual to easily dispose of what he or she preserves and clearly delineated the diverse means this could be attained. An important characteristic of capitalist economies is the extensive wealth and income holes between the poor and rich (Chapra 2000). This is mainly due to the presence of policies which cru-elly hamper economic activity. Considering the status of wealth move-ment is finest known by observing every person and all companies’ earnings initiating from another company or person.

Taxes imposed by the state are viewed as income for the state and expenditure to people. The monies used up on developments by govern-ment and salaries remunerated would be wages for the persons and an expenditure to the state. The money paid out by employees on goods is expenditure to them and income to firms. Hoarding the money or leav-ing the money in a bank account will in fact take it out of flow. This may lead to a decrease in expenditure, which will reduce in produc-tion and consequence in the comprehensive inactivity of the economy. Consequently, Islam always stresses for movement of wealth.

Limited Taxation

The load of taxation shows a significant role in the flow of wealth. The expenses arrangements of society are to some extent exaggerated by the amount of taxation which is responsible to pay. Taxation is reflected a vast liability by all whom are liable, particularly where taxation is both indirect and direct. Tax scheme of the most of the advanced countries is named progressive taxation with the taxes rising as one earning more; society is liable to pay tax on their earnings rather than wealth.

On the other hand, the Islamic economy has no theory of taxation on income; thus, there should be no income tax. Islam rather taxes only on wealth. The money is held for one year or more in a certain threshold.

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The wealth should meet these two conditions, and then, only a person would be liable to pay tax at a flat rate of 2.5%. It means there will essen-tially be considerable more money at the hands of society. In lack of riba (interest), this may further act as an impulsive to finance money which results in non-stop flow in the economy.

In an Islamic economy, the load of taxation is much lesser. This will effect in a greater chunk of people’s earnings being available as throwa-way income. Hence, two or three people can easily come into a business contract to fulfil some of the mandates in the economy for consumer- or factory-made goods, thereby generating more employment of people in the economy.

Islamic Monetary Policy Curbs Inflation

The vital problem with growing inflation is that it corrodes the purchas-ing capacity one has. When prices increase and one’s earnings remain the similar, then the quantity one could buy prior to increase the price will be much lesser after the price increases. Therefore, it is likely that an economy might be growing, but growing inflation essentially means the social order is worse off. Inflation may always persist a problem in the Western economies owing to their capability to print currency at their wish. The capability to print money at their wish will create an under-mining outcome in the economy.

Assets such as land and property carry intrinsic values, but due to the special effects of extra printing money, the amount one can be buying with their money carry on to fall. What we see in the Western countries presently is due to the fact that the money can be produced freely; gov-ernments frequently print extra money, which is then rushing the same quantity of goods. The gross outcome of this is that even though there is extra cash in the economy, the buying power decreases. Therefore in actual terms, prosperity is essentially falling, since money is being undervalued.

The Islamic economy has comprehensive guidelines on the permitted tender which may have the upset of encompassing inflation. Islam enti-tled Gold as the key monetary standard of money and has certified other metals to be alongside Gold. Also, it made the issuing of currency—the responsibility of the government, which does not let the banks to print money. It means that, in Islamic perspective, the printing of money is stripped from banks.

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In Islam, when it arises to trading a commodity with an explicit mon-etary element, Islam has shown us to the monetary entity by which the conversation is taken place. The Islamic indications have chosen gold and silver as the prime measuring unit for labour and prices. This is agreed from the arrangements of Prophet Muhammad (peace be upon him) when he charged taxes, collected Zakah and levied fines, all had been measured according to silver and gold. In Islamic economy, therefore, the currency should be pegged to both silver and gold. This should mean the coins and notes circulating in the economy should be backed by silver and gold. It will no longer be permitted in printing of money as the government would prerequisite to rise the genuine holdings of sil-ver and gold. This would end the difficulty of inflation as it has contin-uously been downcast to the aptitude of governments to spontaneously print money. The restriction of inflation in this way will safeguard the steadiness of prices from corner to corner of the economy, and any rise in prices may be short-lived and down to extraordinary conditions such as quaking and war-destructive crop fields, etc.

Promotion of Businesses and Creation of Jobs

Many people are not aware that the Islamic economy gives a motivation to invest since there is no interest (riba) in an Islamic economy because Islam endorses investment and depends on the factors which indorse real wealth. Therefore, the investments made under the Islamic economy are not riba or interest bearing and shall have no choice other than to invest in the businesses, i.e. trading in services and goods. Accordingly, one’s wealth should be reinvested in trade or businesses in the economy which will be recycled to invest in labour and land, making more employments in the economy. These will create an active economy which generates more employments. As extra employments are created, additional money is used up in the economy or re‐capitalized in the economy that may cre-ate extra employments in turn.

In principle, in absence of the corresponding financial economy, one can invest only in the real economy. In absence of all plans which limit wealth flow, consumers should have possessed considerable money to spend which should rise domestic consumption. The demand for services and items beyond the necessary stuff means that this will be a vast region for invest-ment prospects. Further, the Islamic taxation scheme does not tax on earn-ings, but taxes on wealth. It means that an average individual should have

6 UNPrECEDENTED OPPOrTUNITY: THE GLOBAL CrEDIT CrISIS … 79

extra disposable income to use on services and goods, and will be responsi-ble for tax on whatsoever wealth is left at the close of the year. The result of it is that this will rise demand for services and goods all over the economy which would rise in trade and in turn rise in wealth for trade and industries.

Islam Encourages Spending

The capitalistic economy emphasizes the consumption of goods. But Islamic economics has emphasized spending which is a virtue. As per Hadith Qudsi, Allah said, “Spend, Oh! son of Adam and I will be spend-ing on you” (An Nawawi, p. 9). Islam recognizes the necessity for spend-ing to retain the economy dynamic. It means the Islamic economy will be taking a form and shape much dissimilar to what we perceive in cap-italist countries. Since the capitalism looks up to consumption, this has formed a society immersed in individualism and greed where a few see the interest of society. They are even ready to earn money from the sad-ness of others. The consequence of such selfishness has led to several gov-ernments of Western countries to set up supervisory bodies and enacting legislation as a counter-consequence. As a result, the governments are enacting regulations against the difficulties generated by the capitalism.

Moreover, Islam treasured the spending, and the government does not require enforcing this; subsequently, it will occur within the temper-ament of people active under an Islamic economy. Consequently, Islamic economic arrangement has checks and balances that guarantee the cir-culation of wealth everywhere in the economy and does not stay in the influences of a few well-off people which occur in the free‐market ide-ology. Furthermore, the Islamic economy signifies a convincing model which safeguards wealth supply repeatedly occurs unimpeded generat-ing a multiplier outcome with several investment prospects. Since the Islamic economics system have been theorized based on the principles of Al-Quran and Hadith, and hence its adherence is an action of worship which will ensure that the greed, corruption and individualism should not creep into the attitude of the people.

Challenges Before Islamic Banking

Islamic economic system and Islamic financial system are grounded on a set of ideals, morals and values such as clear evidence, transparency, cooperation, honesty, credibility, complementarities, solidarity and

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facilitation. These ideals and morals are essential because they safeguard security, safety and stability for all those are players in financial trans-actions. Moreover, the Islamic Shari’ah forbids economic and financial dealings that involve interest (riba), Gharar (risk or uncertainty), gam-bling, lying, cheating, exploitation, greed, monopoly, unfairness and tak-ing the money of the people unfairly.

In theory, Islamic banking approach is like investment associates to those who want money to businesses. An Islamic bank would there-fore become a joint owner of the trade. Furthermore, the banks would only be capable to recoup their unique money by reselling their seg-ment of the business/mortgage at the usual market value. However, as actual partners, Islamic banks must have no hostility to owning actual assets and henceforth would be prepared to share the significant risk. This scheme, while seemingly inconsequential, institutes a major help for Islamic bank’s customers as they would no lengthier live under the bur-den of debt and fear of recovery. A financial disaster of the contemporary kind would not be occurred if the necessities of Shari’ah were correctly applied, for example the matter of risk-sharing and risk management. If mainstream banks were necessary to share the profits and losses of their customers, whether on mortgage or project investments, they should be much more cautious when selecting to a financial deal. For this reason, their financial yields would depend on the performance of the ventures which they invest.

A banking and financial system grounded on true Islamic values would forbid both the giving and getting of interest (riba), also the simulated formation of money through the procedure of “fractional reserve.” Within the fractional reserve banking process, the banks lend extra money than the banks really have had in deposits. It creates a huge difficulty in the economy as actually a little equity has been used as col-lateral to derive big sums of money and it is what produces an economic bubble. In an Islamic economy, financial institutions/banks function in a parallel style to venture capital firms gathering people’s money and investing it in the economy and then by allocating the profits among its depositors, together with normal deposit roles. In the Islamic economy, simply the money in the Islamic bank has in their custody should be lent consequently eliminating the capacity of banks to make money and relo-cating it to the treasury.

Still, Islamic banking and finance sector is in its beginning stage, and it definitely faces numerous experiments due to the circumstance that

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Islamic banks function in an economy which is obsessed and operated by interest. In a financial economy, the financial or banking sector is main-tained and controlled by the central bank. The regulations of the cen-tral bank and its policies are formed for mainstream commercial banks, and it acts as “lender of last resort.” regrettably, record Islamic banks do not relish such advantages. Extra challenge confronting Islamic banks is that this sector works under working processes that are different from those of the mainstream banks; the subsequent non-compatibility stops the central banks from regulatory or providing backing to Islamic banks if a liquidness gap rises.

Since the Islamic banking and finance industry is operating under the conventional secular structure, it should suffer from the similar general difficulties that current mainstream financial institutions are suffering. For instance, due to lack of appropriate regulatory body, Islamic banks do not sincerely involve in risk-sharing. It means defaulting customers of Islamic banks face the same concerns as clients of interest (riba)-based banks. In case Islamic banks involve in money creation, there is no doubt that they may also face the same inflation and boom and bust cycle which is apparent in Western economies.

The lending of conventional banks protected by collateral considera-bly splits bankers from their customers’ risks and creates hefty battles of interest. Mainstream banks also twist the provision of assets to those cus-tomers who are by this time rich. Economically poor people with good notions but no surety often be unsuccessful to draw finance within this system. As a result, the wealth disparity rises from one generation to the another. The risk-sharing finance of Islamic banks should do away with such encounters which bring larger steadiness to economic movement. If the worth of liabilities of an Islamic bank is single-minded by the act of its assets, then there should be no subprime or financial crisis.

regrettably, risk-sharing practices do not prevail in the world of contemporary finance. It is true that the intent is habitually the reverse. The conventional bankers and entrepreneurs like to rise extreme risk, and then protect themselves from the situation for increasing their profit on capital. In this manner, an entrepreneur will be able to borrow from a bank at stable interest and then finance in the businesses which make profit. In this investment, the entrepreneur holds profit on loan money. This type of incentive inspires entrepre-neurs in borrowing money deeply and raises their commercial func-tioning. One concern of this tactic is that a limited number of large

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business groups use to come to lead the commercial landscape. The hefty indebtedness of such companies means that a modest increase in the interest rates jointly with a modest reduction in returns may rapidly erode a whole profit margin. In this reason, the share prices do change so intensely over quite short periods. Also, interest imposes on bank’s investment is a cost element in the investment procedure and, conse-quently, acts to raise the price of services and goods. The interest rates that people accept from the mainstream banking structure is funded by the public themselves.

The greatest powerful weakening feature of all in contemporary financial markets is the movement of money creation by the mainstream banking sector. By producing money out of nothing and placing it into circulation, the commercial and central banks have together triggered a sequence of speculative bubbles which may be traced back about 300 years ago in the developed world. When afresh produced money is spent on assets, for example in shares and properties, their prices obvi-ously tend to grow. Equally, when banks decrease the amount of new money design, customers vanish from the markets and prices instigate to drop. The aptitude to create money is consequently a massively influen-tial economic and political tool, conversely one that is practically always ill-treated in due course.

Here are the two points in the Shari’ah regulations particularly which work to avert moneymaking or creation by the banking system. Firstly, the law of “trust” and secondly, the injunction of interest (riba). By dis-pensing “promises to repay” that are in surplus of their cash reserves, and by loaning these promises at interest, contemporary conventional banks have broken both these two Shari’ah points to earn excessive money by exploiting the customers.

A few critics predict that the Islamic banking and finance system has capability to solve the contemporary financial crisis. However, this antic-ipation is unrealistic. Firstly, the Islamic banking and finance sector is comparatively small compared to its mainstream conventional counter-part, and one of the most important problems that this sector is experi-encing—still in an infancy stage—can therefore be determined typically in private. Secondly, Islamic stocks and Islamic ethical funds evade invest-ing in the shares of the companies which are deeply indebted with inter-est-bearing loans. These are the factors which reproduce a core variance of moralities between the domains of Islamic and interest-based main-stream banking and finance.

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6.5 conclUsIon

The global financial crisis and food crisis have highlighted the brittleness of capitalism. The capitalistic economy depends on the arranged seg-ment, and the system is erected in fragment (catalyst) which is going on. This is the reason that the developed world observes regular economic recessions when sufficient people have consumed beyond their means; therefore, there would unavoidably be a decrease in aggregate expendi-ture by consumers as a huge. The contemporary financial markets have been separated from the real economy where the savers investing in a business where there is no longer assumed to accept a dividend but to take benefit of exaggerated price growths. This situation leads to specula-tion of huge sizes to take place together with risks on the failure of econ-omies. Together, the bankers of the Western countries, politicians and economists have all failed to provide any truthful solution so far.

Contemporary credit crunch has established very evidently that the ostensible power of current financial markets is illusionary. The carefree mood disappeared rapidly, with the note down of losses escorted by the dis-missals of executives and shadowed by more severe lending for the actual losses of the financial crisis. Also, financial crisis was escorted by growing inflation—as the demand of the food hard up prices rises worldwide. This financial crisis has shocked both the left and the right of the several eco-nomic schools of thinking and political spectrum. Numerous policy makers and economists have recommended more transparency and regulation, with only a few pointing the havoc role played in speculation and greediness.

The contemporary financial economics varies from Islamic economics in several precarious features, of which the characteristic of money is one of them. While both systems receive money to be a medium of exchange and a store of value, the financial market grounded the economic sys-tem which allows money to be considered like any other commodity that can be traded for a profit and riba (interest). In contrast, most Islamic scholars argued that the money to be completely asset based or backed and also treat it non-permissible to let money be traded for money but at par value. In an Islamic perspective, an important significance of author-izing both creation of interest-based lending and credit money is to let financial institutions and banks to create huge amounts of capital at the expense of the rest of community in the humanity, particularly the poor, resulting in the unavoidable charge that the economic system obstinately errands the rich people over the poor.

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Islam neither sanctions the socialistic nor the capitalistic financial model. But, both the socialist and capitalistic systems have similarity in certain features with Islam, such as inspiring people to make efforts together, to earn and be productive as much as they can. Islam endorses the consciousness of the Hereafter in the minds and hearts of devotees and teaches them not to be overwhelmed by greediness or dispropor-tionately fond of money. A real Islamic principle forbids in paying or receiving of interest (riba), as well as the non-natural money creation via the procedure of fractional reserve. Thus, this fractional reserve makes a big difficulty in the economy as very lesser amount of equity may be used as collateral to borrow big amounts of money and that is what makes a financial bubble. Within such an extraordinary crisis, Islamic banking and finance is observing remarkable growth with the global presence of Islamic finance upcoming $1 trillion. This led to some interest in the academic research. Within Islamic economy, Islamic banks operate in the line of venture capital companies gathering people’s money and investing it in the economy, then allocating the profits among its depositors.

In the Islamic economy, the money a bank needs to have its ownership can be made investment in real economic activities, thus eliminating the aptitude of a bank to make artificial money. Islamic economy necessitates money to be completely asset based and also treat it non-permissible to let the money to be traded for money except at par value. In Islamic perspec-tive, a crucial significance of allowing both creation of money/credit and riba (interest)-based lending is to permit financial institutions and banks to engender enormous amounts of money at the cost of the rest of the public.

Exponents of Islamic banking industry have by this time foretold that the industry would have a solution and this fastest growing industry can come onwards to resolve the credit crunch. Although the moderately small size of the Islamic finance sector can make this impractical at the instant, however, there exists an unparalleled benefit to offer the par-ticulars of the Islamic economic system along with the answers of which Islamic finance has for some of the contemporary financial crisis.

In view of the above, it is the right time for outlining of collective Islamic values to the market performers, commentators, economists and the com-mon people. They ought to see that Islam is considerably more than the Riba or interest but is a complete system to accomplish society’s elemen-tary requirements (food, shelter and clothing). Islamic system calls to fulfil lawful direness of people and their wants, rather than unlimited production. Islam, in fact, has a fruitful history of dealing with the economic glitches.

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Bagsiraj, M. I. (2009, January 4). Financial and Economic Crisis an Alternative Indian Approach. Radiance Viewsweekly, XLVI(38). http://www.radianceweekly.com/137/3039/GLOBAL-MELTDOWN-Its-Viable-Alternative/2008-12-14/Cover-Story/Story-Detail/Current-Financial-Crisis-and-Islamic-Economics.html. Downloaded on January 5, 2009.

Bank for International Settlements. (2008, April 7). Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience. http://www.fsforum.org/publications/r_0804.pdf.

Bank of England. (2007, April). Financial Stability Report, p. 7.Bank of England. (2008, December). Statistical Release.BBC TV Documenters Titled: “Million Dollar Traders-Financial Crisis”. Produced

by Evan Davis and Seven Byers, Screened November 16–December 20, 2008.Bernanke, B. S., & Lown, C. S. (1991). The Credit Crunch. Brookings Papers on

Economic Activity, 2, 205–247.Boeri, T., & Guiso, L. (2008). The Sub-Prime Crisis: Greenspan’s Legacy. In A.

Felton & C. reinhart (Eds.), The First Global Financial Crisis of the the 21st Century. www.voxeu.org/index.php?q=node/1352.

Briys, E., & de Varenne, F. (2000). The Fisherman and the Rhinoceros: How International Finance Shapes Everyday Life. Chichcester: Wiley.

Cecchetti, S. G. (2008a). Sub-Prime Series: Part 3: Why Central Banks Should Be Financial Supervisors. In A. Felton & C. reinhart (Eds.), The First Global Financial Crisis of the 21st Century. www.voxeu.org/index.php?q=node/755.

Cecchetti, S. G. (2008b). Sub-Prime Series: Part 4: Does Well-Designed Monetary Policy Encourage risk-Taking? In A. Felton & C. reinhart (Eds.), The First Global Financial Crisis of the 21st Century. www.voxeu.org/index.php?q=node/758.

Cecchetti, S. G. (2008c). Federal reserve Policy responses to the Crisis of 2007–8: A Summary. In A. Felton & C. reinhart (Eds.), The First Global Financial Crisis of the 21st Century. www.voxeu.org/index.php?q=node/1048.

Chapra, M. U. (2000). The Future of Economics, an Islamic Perspective. Leicester: Islamic Foundation.

Chapra, M. U. (2009, January–March), Global Islamic Financial Crisis, Can Islamic Finance Help? NewHorizon (170). http://www.newhorizon-islamic-banking.com/index.cfm?section=archive&action=view&id=81. Downloaded on January 2, 2009.

European Central Bank. (2008, January 23). Enhancing the EU Arrangements for Financial Stability. Centre for Economic Policy research, Keynote Address

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by Jean-Claude Trichet at the Session “European Financial Supervision, Crisis Management on Financial Markets”. Brussels: European Parliament. www.ecb.eu/press/key/date/2008/html/sp080123.en.html.

Financial Services Authority. (2007, January). Financial Risk Outlook 2007 (p. 29). London: FSA.

Galbraith, J. K. (1993). A History of Financial Euphoria. New York: VikingPr.Goodhart, C. A. E. (2008). The Background to the 2007 Financial Crisis.

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Sengupta, r., & Emmons, W. r. (2007, June). What Is Sub-Prime Lending? Federal Reserve Bank of St. Louis Monetary Trends. http://research.stlouisfed.org/publications/mt/20070601/cover.pdf.

Siddiqi, M. N. (2009, January 4). Current Financial Crisis and Islamic Economics. Radiance Viewsweekly, XLVI(38). http://www.radianceweekly.com/ 137/3039/GLOBAL-MELTDOWN-Its-Viable-Alternative/2008-12-14/Cover-Story/Story-Detail/Current-Financial-Crisis-and-Islamic-Economics.html. Downloaded on January 5, 2009.

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The equity market is a market where company shares, securities and oth-ers instruments are traded under a stock exchange or in the over-the-counter market. The equity market facilitates the flow of funds from individuals and intuitional investors to corporations as well as between investors. Further, the equity market allows those with surplus funds to put their money into investments which gives them returns and enables corporations to finance investments and new business ventures.

It is noted that Islamic equity products are structured according to Shari’ah whereby the features of the products follow the rules of specific underlying concepts or contracts of the products. Islamic equity-based contracts involve partnership and the sharing of risks and reward in a venture. Islamic contracts involved in such profit and loss-sharing fea-tures are usually classified under Mudarabah (trust financing) and Musharakh (partnership basis). The profits are derived from capital gains when the purchased shares or securities are later sold at higher prices. Profits are also be obtained through dividends if and when there are dis-tributed by the issuing companies.

7.1 Investment In IslamIc eqUIty

When investing in any avenue, Islamic equity investors need to take into account not only the structure of the transaction but also the nature of the counter-party. An investor in the share capital of a company becomes technically a part-owner of the company and therefore responsible for its

CHAPTEr 7

Shari’ah Compliant Equity

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_7

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internal structuring as well. As a result, in case of investment in equi-ties traded on the stock exchanges, the investor needs to consider further issues of the company itself being involved in Shari’ah-non-compliant financing and structuring. Due to this, initially Shari’ah scholars tended to completely rule out investment in listed equities. Over time, however, realization has seeped in that a more balanced view needs to be taken.

For one, the general prevalence of conventional banking operations makes it inevitable that but for a miniscule percentage, all companies have to transact with banks in some way or other and, to some extent at least, rely on interest-based finance. Secondly, portfolio investment in equities on the stock markets is a convenient and often the main invest-ment avenue open to ordinary Muslim investors, and it is also close to the ideal Islamic profit and loss-sharing paradigm for financing. Hence, the consensus is now veering towards accepting a degree of compro-mise in the definition of Shari’ah-compliant commerce and trade. The Shari’ah supervisory boards of various organizations such as investment and banking organizations, official regulators and market intelligence providers have put forth various criteria to define the maximum degree of compromise which could be considered acceptable under Shari’ah, given the current business environment.

In order to assess whether a specific investment proposal is compliant with Shari’ah requirements, it needs to be examined from two angles, i.e. the nature of the instrument/transaction itself and the nature of the con-tracting (counter) party. For instance, a trading transaction can be con-sidered from two aspects:

(a) Whether there is any gharar (uncertainty), Riba (interest), etc., involved in the structuring of the transaction and

(b) The nature of the counter-party (business).

While examining a transaction for gharar (uncertainty), Riba (interest), etc., is done as a matter of course, the same extent of systematic atten-tion is perhaps not devoted to examination of the aspect of whether it would be correct to deal with a particular counter-party. A few instances will perhaps clarify the issue. Consider the following:

(a) Working for a conventional bank or a casino;(b) Leasing premises to a conventional bank, casino or insurance

company for its business;

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(c) Printing of propaganda tracts for an evangelical organization;(d) Leasing of premises or equipment for holding worship involving

blatant idol worship;(e) Providing commercial transportation or printing cartons or labels

for liquor bottles, etc.

In all the above activities (transactions), there is an interface with an unlawful activity carried out by any organization or corporations. The commercial transaction by itself is not unlawful. But it involves associ-ating or providing goods or services at a price, to an individual or insti-tution engaged in an unlawful activity. Such association in some of the instances discussed above may not be a regular occurrence, but may comprise a varying proportion of the regular business activities engaged in, ranging from a minor or negligible portion to being the sole activity. Under such conditions, is it permissible under Shari’ah to transact with such a party, even if the structuring of the transaction itself is valid?

Equity Shares

In case of investment in equities, the structuring of the transaction itself appears unobjectionable as equities do not confer any assured benefits on the holder. In fact, the shareholder could even stand to lose his entire capital in the event the company in which he has invested suffers massive losses. Nor does equity investment necessarily involve the element of ran-domness and uncertainty associated with gambling and games of chance. The rights and obligations of the parties too are clearly defined and do not involve exploitation or injustice. There could, however, be a problem as far as the nature of the counter-party’s (i.e. company’s) business itself is concerned. As holder of equity shares, the investor is the owner of the business—though only part-owner. As an owner, the holder of equity is responsible for any infringement of Shari’ah by the company. However, as a minority shareholder (the usual case), the person cannot realistically expect to influence the policy of the company as to the nature of its busi-ness and how it carries on its business. Both these can change too over time and breach Shari’ah stipulations.

At the same time, in many different milieus share investment rep-resents a viable non-interest-based investment avenue for sleeping investors. Moreover, with the modern advances in computing, com-munications and information dissemination, even lay investors can now

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easily invest on the stock exchanges. There are many countries which offer hardly any viable Islamic banking and investment options. These include some wherein Muslims form a majority or a substantial portion of the population. At the same time, they have a thriving and well-or-ganized and regulated sector of listed equities or equity-based mutual funds. In the absence of sufficiently safe modes of genuine profit-shar-ing investment, equity markets represent an important investment alter-native that is close to the Islamic profit- and loss-sharing investment ideal. ruling them out leads both individual investors as well as Islamic Financial Institutions to turn to other fixed return modes of invest-ment and financial leases, which are close to the same old debt-financing methods, under a different terminology. In fact, this is an unfortunate development which has led to a shift of focus in Islamic banking from profit-based investment and stunted the emergence of profit-based financing and instruments.

Further, in contemporary times, the sectors of listed companies and mutual funds are closely monitored and regulated by the authorities with the objective of obviating accounting manipulation and financial malfeasance, thereby assuring the ordinary small investors of a reason-able protection against being cheated—something the investors cannot hope to assure for their investments on their own. There is therefore a strong element of public interest (maslahah) in permitting equity invest-ment under Shari’ah, provided the nature of the business and the way it is carried out are such that even in case there is a violation of Shari’ah stipulations, it is kept within certain limits. The permission could be con-ditioned on the absence of sufficiently prevalent and credible Islamic investment alternatives in the given environment.

Equity Funds

Equity funds or equity-based mutual funds are the financial institutions which mobilize investments from the public against the units of their fund and invest all these funds in listed equity shares. Thereafter, they calculate the Net Asset Value (NAV) of the fund units on a daily basis and may allow investors to exit or enter the fund at or around NAV. The fund may declare dividends periodically and even liquidate itself at a certain stage and pay off the investors on the basis of the final break-up value of the units. The expenses of this fund and the remuneration of the fund Mangers are defrayed from the earnings of the funds. A mutual

7 SHArI’AH COMPLIANT EQUITY 91

fund unit thus closely resembles an equity share in that it too does not guarantee any fixed returns to the investors or an assurance of return of any part of the initial investment. In addition, it gives the investors the benefit of a diversified investment portfolio and the services of expert investment advice. The downside for investors from an Islamic point of view is that their investments go into shares of a large number of com-panies engaged in different businesses and with varying types of finan-cials, over the selection of which investors have no control, except to the extent the offer document of the fund defines the investment policy of the fund.

Thus, though the investors can normally ensure (by selection of the right fund) that their money is invested only or overwhelming in equi-ties, they cannot be certain that all the companies in which their mon-ies go are in permitted businesses or have financial structures which are Shari’ah compliant.

7.2 the comPany’s bUsIness and Its strUctUre

In judging the Shari’ah compliance of the company invested in, one has normally to consider the nature of the business it is engaged in. However, when the transaction is one of investment in equity, the inves-tor is also responsible for the way business is structured.

Enterprise’s Business

The Shari’ah categorizes certain commercial activities as impermissible (haram) for Muslims. Hence, investment in the shares of any company engaged in such haram activities as its main business is clearly impermis-sible under the Shari’ah law. There would be instances of business firms which are not primarily engaged in impermissible activities. As part of their operations however, they may indulge in activities which are not permissible according to Shari’ah. Alternatively, a firm involved in a per-missible activity may have a subsidiary or have an investment in another company, which may be involved in non-Shari’ah-compliant businesses. The utmost traditional Islamic scholars do not permit investment in the equity of a company which is invested in unlawful business to any extent. Others allow investment in equities of companies which derive a minor part of their income from unlawful activities, provided such activities are not their main area of interest.

92 a. hassan and s. mollah

Yet other Islamic scholars agree to such relaxation only if the same can be justified on grounds of public interest (maslahah). Yet others make an exception if the unlawful activities are so pervasive in the society as to be a commonly prevalent evil, difficult to avoid. An instance of the for-mer may be the serving of alcoholic drinks in planes of a national carrier, whereas earning interest through treasury management is an instance of the latter.

Structure of the Company Business

While studying the structure of the business from a Shari’ah viewpoint, there are three aspects that need to be considered:

(a) Debt availed by the company;(b) Interest and other suspect earnings of the company;(c) Extent of cash and receivables with the company.

Obligation of the EnterpriseIn the contemporary world, most structured businesses rely on banks to obtain finance for their activities. Partly, this is due to the need for fluc-tuating working capital and ready availability of bank capital for financing and maintaining ongoing trade and its expansion in the face of unfore-seen needs of business. Such pressures include natural calamities, political and industrial relations developments and disputes, business slowdowns and downturns, sudden variations in costs, prices, availability and demand, etc.—all of which could lead to an unforeseen roaring up of the business cycle and draining out liquidity from the business. In such circumstances, banks ease liquidity pressures by providing the additional working capital required by the corporation. Apart from working capi-tal needs, banks also finance acquisition of fixed assets in case of major expansion and diversification of business.

Due to fluctuating conditions, it becomes almost inevitable for even a moderately sized business to access bank capital, at least for working capital purposes. This is stressed by the fact that with Islamic banking in its infancy, there is often no viable Islamic alternative to bank capital. But bank finance is interest-based and, therefore, impermissible (haram). Hence, while investing in the equities and becoming part-owner of such a company may be against Islamic norms. However, the principle of pub-lic interest (maslahah) may permit some degree of flexibility and allow investment in equities of companies in which debt is below a certain

7 SHArI’AH COMPLIANT EQUITY 93

level. In this connection, a measure which conventionally used to assess the level of indebtedness of a company is the debt–equity ratio. There is no reason the same ratio should not also be used to assess the indebt-edness of the company in terms of its compliance with the Shari’ah. Undeniably, many institutions do use it in such a context. Alternatively, one can use the related ratio, debt: total capitalization. Now some insti-tutions use the ratio, debt: market capitalization.

Earnings from Unlawful (Haram) ActivitiesBanks play a major role in facilitating transactions in modern times. All cash flows of the enterprise are routed through banks. As a result, all companies have to maintain accounts with banks. These accounts attract some nominal interest. In addition, at times, enterprises have to keep security deposits with banks and others to cover performance-guaran-tees and assurances. These accounts too fetch the enterprise some inter-est. The company may also, at times when it is flush with funds, deploy excess short-term liquidity in bank deposits and securities as a measure of treasury management. For an outsider investing in the equity of an enterprise, it is difficult to judge, whether, and to what extent, interest accruing to a company is unintentional and involuntary and to what extent planned and deliberate. It is not feasible to expect the investor to investigate this aspect. At the same time, to ensure that the inter-est-earnings of a company do not substantially contribute to its revenue, it is essential to set certain limits to the proportion of interest-earnings to the total revenue of the company. For this purpose, the measure used is interest (and other haram income) earned as a percentage of total rev-enue (income). Various Shari’ah boards fix this percentage at different levels, generally between 5 and 10%.

A further aspect of Shari’ah compliance on this score involves removal or facilitating removal of the interest component from the earnings of the company, either by the company itself or more frequently by provid-ing the necessary information to the shareholders. For the latter purpose, the company also includes in the ratio communicated to the sharehold-ers, if applicable any earnings received from any other Shari’ah-non-compliant activities, such as sale of alcoholic drinks in a hotel or resort.

Cash and Receivables or Payables of the CompanyFinally, there is the Shari’ah requirement that cash and debts cannot be traded except at par value. It appears that the Shari’ah scholars have con-sidered a company as the bundle of assets and liabilities which reported

94 a. hassan and s. mollah

on its balance sheet, including fixed assets, investments, cash, inventory, receivables, payables and debts. The traded price of its equity can hence be considered as representing value paid for the underlying assets and liabilities. If the fixed assets and investments of a company are negligible, then the remaining assets and liabilities mainly comprise of debts, depos-its and stocks. In equity trading, the price of scrips traded is driven by future expectations of prices and not by the book value of the company.

Henceforth, if stocks or inventories are valued at market prices, one can end up with a residual value for the cash and debts of the company which can be way out of line with their par values. As a result, it would be unacceptable to be involved in the trading of such scrips. To minimize the possibility of landing in a deliberately non-compliant situation of this nature, particularly if the equity is being publicly traded, most Shari’ah scholars like to place a limit on the proportion of current assets in the total assets of the company. In this connection, the measure or parame-ter most commonly used to judge compliance on this score is percentage of assets or net current assets to total assets (total capitalization) of the company. Alternatively, the numerator can be net receivables instead of net current assets. The cut-off value of the parameter is usually set in the range of 40 to 50%

7.3 conclUsIon

This chapter primarily deliberates the characteristics of Islamic equities and the financial instruments which are used in the Islamic equity mar-kets. It looks at modern-day business corporations and discusses how businesses can be structured according to the Shari’ah principles. Jeddah Organization of Islamic Cooperation (OIC) Islamic Fiqh Academy has approved share companies and by doing so has accepted to conventional legal concepts—judicial entity and limited liability of the partnership basis businesses. Islamic equity products must be structured according to the Shari’ah whereby the features of the products must follow the rules of specific underlying contract of the products. Instead of emphasizing fixed return on capital, profits are shared on pro rata basis in Islamic shares or equities. Neither the principal nor rate of profits can be guar-anteed. The principles of profit and loss sharing depend on the kind of contract, where it is Mudarabah or Musharakah. Trading in the second-ary markets is crucial; otherwise, liquidity concerns will severely limit the attractiveness of equity markets. While Islamic scholars encourage

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trading and markets of all frangible goods, it restrains of trading financial interests. Question may be raised that given the frangibility and liquidity of shares, would a share be construed as interest (riba) item? It means shares are equivalent to money. If this is the case, then Shari’ah laws will impose strict constraints in the manner of trading, and this would diminish the efficiency and effectives of an Islamic equity market. In this regard, most of the Islamic scholars permitted secondary market trading of shares by advocating one of two methods: (i) shares as reflecting part-nership interest and (ii) shares as ownership of enterprise.

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Sukuk in general may be understood as Shari’ah-complaint certificates which can be seen as an Islamic equivalent of a bond. Sukuk is a prod-uct of the Islamic capital markets. It is one of the fastest growing seg-ments of the Islamic capital market. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines Sukuk as: “Certificates of equal volume representing, after closing subscrip-tion, the receipt of the value of the certificates and putting it to use as planned, common title in shares ad rights in tangible assets, usufructs and services or equity of a given project or equity of a special investment activity” (AAOIFI Standard 17). Sukuk general implies transferrable certificates representing a share in the ownership of assets or businesses ventures that give entitlement to the Sukuk holders to receive periodic fixed returns and full redemption upon maturity of the Sukuk. Sukuk can be structured based on the principles of contracts of exchange such as Ijarah, Murabhah, Istina and contracts of participation such as Musharakah and Mudarabah.

8.1 secUrItIzatIon and sUkUk

Securitization is a process of transforming on otherwise illiquid asset into a liquid one In more technical terms, securitization can be defined by Devidson as “the process of packaging financial promises and transform-ing them into a form whereby they can be freely transferred among a multitude of investors” (p. 3). The goal of securitization is to transform

CHAPTEr 8

Sukuk—Shari’ah-Based Asset Securitization

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_8

98 a. hassan and s. mollah

the promise of individuals and corporation to make future payments into freely transferrable securities that are appealing investors. The securiti-zation has a number of benefits. Though securitization is illiquid asset which transforms into tradable securities that give the illiquid asset the liquidity feature by the deployment or creation of some market mecha-nism which allows:

• The originator of the asset to have direct access to the capital market.

• The investors to liquidate their positions by the creation of a sec-ondary market.

The contemporary equivalent Arabic terminology of securitization is as follows: tawriq, tasnid and tashik. These terms are rather recent and were not used before in classical fiqh manuals and books at least not in the context of securitization as it is technically understood in contem-porary finance. Islamic scholars used term for securitization—tasnid—as the transformation or illiquid debts into negotiable papers. The negotia-ble papers are called as sanadat. Another Arabic term for securitization is taskik. Usually, it refers to the process of diving assets into papers such as Sukuk or certificates. Technically, taskik in contemporary financial ter-minology refers to the securitization of assets into papers, securities or certifies with the features of liquidity, tradability and cash equivalence. The papers, securities or certificates are termed as Sukuk, which is plural form of sak.

The term Sukuk is used to refer to normal securities or bonds that comply with Shari’ah principles, with the intention of creating returns similar to those of conventional fixed-income instruments like bonds. Unlike a conventional bond (secured or unsecured), which repre-sents the debt obligation of the issuer, a Sukuk technically represents an interest in an underlying funding arrangement structured according to Shari’ah, entitling the holder to a proportionate share of the returns generated by such arrangement and, at a defined future date, the return of the capital. It is stated that compliance with Shari’ah means that: (i) any profits derived from these funding arrangements must be derived from commercial risk-taking and trading only; (ii) all forms of conven-tional interest income is prohibited; and (iii) the assets that are subject to the funding arrangement must, themselves, be permissible (halal).

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The overall risk profile and economic return for the investor is similar to a conventional bond where the bondholder is a debtor of the issuer.

8.2 tyPes of sUkUk

The Sukuk issued in global capital markets have been predominantly structured as trust certificates, typically governed by English law. Some civil law jurisdictions that do not recognize the concept of trust have sometimes issued Sukuk structured as participating notes under legisla-tion similar to that used for asset-backed securities.

Trust Certificates

In a typical trust certificate transaction, the entity trying to raise funds (the obligor) will establish a special purpose vehicle (SPV) in a suit-able jurisdiction. The SPV issues trust certificates to investors and uses the proceeds to enter into a funding arrangement with the obligor, and the rights of the SPV as financier are held under an English law trust in favour of the certificate holders. The most common structures for funding arrangements in the Islamic capital market include: Mudarabah (trust financing) Sukuk, Musharakh (a joint-venture equity invest-ment), sale and leaseback (Ijarah) structure and a form of trade finance (Murabahah).

8.3 mUdarabah sUkUk

The investor will supply the entrepreneur with funds for his busi-ness venture. In return, the investor will get a return on the funds he puts in based on a profit-sharing ratio. The main principle in a Sukuk Mudarabah is that the investors are dormant business partners who do not participate in the management of the underlying asset, business or project. The party who utilizes the funds on the other hand (the issuer) is the working partner. The profit from the investment activity is shared between both parties based on a pre-agreed ratio depending on how well the asset or project performs. Losses suffered will be borne by the inves-tor. However, Mudarabah Sukuk should not contain a guarantee from the issuer for the capital or a fixed profit, or a profit based on any per-centage of the capital (Figs. 8.1 and 8.2).

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8.4 mUsharakah sUkUk

Musharakah Sukuk structure is a partnership between two or more parties to finance a business venture. All parties contribute capital to it either in the form of cash or kind for the purpose of financing this venture. The profits for the venture will then be distributed based on a pre-agreed profit-sharing ratio. However, losses are shared based on the basis of capital contribution. The Musharakah contract supports a joint business venture. All parties contribute capital either in cash or in kind for the purpose of financing a project or business venture must be Shari’ah-compliant.

The process begins with an obligor (issuer) signs a Musharakah contract. A Musharakah contract is a contract between partners—whether the contract is between the issuer and the Sukuk holders, or a Musharakah contract among Sukuk holders. The contract specifies a profit-sharing ratio and indicates that the obligor will contribute assets

Fig. 8.1 Structure of Mudarabah Sukuk

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(such as cash or property) to the joint venture. Profit from the ven-ture is shared based on a pre-agreed profit-sharing ratio, but losses are shared based on the capital contribution. In Musharakah contract, Sukuk

Fig. 8.2 Structure of Mushrakah Sukuk

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holders (investors) are the owners of the joint venture, asset or business activity.

8.5 mUrabahah sUkUk

Murabahah is a contract of a sale and purchase of assets where the cost and the profit margin (the marked up price) is made known to all par-ties. It is an agreement between a buyer and seller for the delivery of an asset. For example, the Sukuk holder buys an asset in order to supply it to the Sukuk issuer who has no capacity to purchase the asset directly (Fig. 8.3).

The holder then sells the asset to the issuer for the cost-plus profit—a markup that both have agreed to upfront. The issuer then makes pay-ments to the holder on an instalment schedule (Fig. 8.4).

Fig. 8.3 Murabahah Sukuk

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8.6 Ijarah sUkUk

Ijarah Sukuk are the most widely used type of investment Sukuk. They constitute certificates that carry equal value and are issued either by the owner of an underlying leased or leasable asset, or by the owner’s agent, to the effect that the leased/leasable asset would be sold and its value would be recovered from subscription so that the Sukuk holders become

Fig. 8.4 Ijarah Sukuk

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owners of the leased/leasable assets. A Sukuk holder will assume the rights and obligations of the owner/lessor in proportion to his holdings of Sukuk. Ijarah Sukuk are usually structured in two different ways: (1) Sukuk are asset-backed and (2) Sukuk are asset-based.

Asset-Backed Ijarah Sukuk

This is the most popular and widely accepted type of Sukuk because it is structured through an asset-backed securitization and not as a debt obli-gation. In other words, this type of Sukuk is backed by tangible assets where the originator company sells specific tangible and leasable assets to a SPV for the principal amount required for the financing. However, the SPV itself does not pay the price of the underlying assets. rather, it raises funds by issuing Sukuk to the investors and then uses the proceeds to purchase the assets. The Sukuk represent the investors’ proportionate ownership in the assets and the lease. Thereafter, under an Ijarah agree-ment, the SPV will lease the assets back to the originator or company for a pre-specified fixed amount and a particular maturity. The Sukuk hold-ers pay subscription proceeds to the SPV in return for their Sukuk which will make period distributions. These distributions will be made out of the rental payments over the Sukuk term which is concurrent with the lease term. The originator has the option to either pay the rentals peri-odically with a repayment of the principal at maturity, i.e. normal Ijarah or to repay the principal along with the rental payments periodically. The Sukuk has the right to receive a portion of the rent according in their proportional ownership in the leased asset while they bear losses to the extent of their ownership.

8.7 Global sUkUk market Performance

According to S & P Global ratings, Sukuk issuance in 2017 increased by 45.3%, reaching $97.9 billion, up from $67.4 billion in 2016, under-pinned primarily by the jumbo issuances of some Gulf Cooperation Council (GCC) countries. Driving this performance were good liquidity conditions in the GCC and, more generally, globally, as well as activity by some countries with the goal of further developing their Islamic finance industries. What is more, some issuers (particularly in Saudi Arabia) were able to choose Sukuk over bonds because they were less pressed for time to raise funds. It is observed current trend in the market that is likely to

8 SUKUK—SHArI’AH-BASED ASSET SECUrITIZATION 105

shape its performance in 2018 and onwards. These include a more strin-gent application of the profit- and loss-sharing principle and a broaden-ing of the investor base to include retail and Waqf money (Fig. 8.5).

According to Moody’s Investors Service, sovereign Sukuk issuance volume will continue to grow in 2018 as governments look to diversify their financing mix and satisfy the liquidity needs of Islamic retail banks, says Moody’s Investors Service. Total Sukuk issuance will reach around US$95 billion by the end of the year 2017, after more than US$85 bil-lion in 2016, including more than US$50 billion of Sukuk issuance by sovereigns (Fig. 8.6).

Further, Moody’s report stated that sovereign Sukuk issuance gains momentum, with new players entering the market. Despite Malaysia’s falling share of sovereign Sukuk issuance, it remains the largest Sukuk market with an estimated 43% of total sovereign Sukuk outstanding in

Fig. 8.5 Global Sukuk Issuance (Source S&P Global ratings, Eikon. Copyright @ 2018 by Standard & Poor’s Financial Services LLC. All rights reserved)

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2016. Strong demand for Sukuk from the Islamic jurisdictions in the GCC countries including Bahrain as well as Malaysia, Indonesia, Turkey, Pakistan, Sudan, Brunei, Islamic Development Bank, etc., is the main force in driving the Sukuk market towards the rapid growth. Further impetus to international Sukuk market is provided by recent entry of UK, Luxembourg, Hong Kong and South Africa.

In recent years, several Islamic jurisdictions mentioned above regu-larly issued benchmark Sukuk in domestic as well as international mar-kets. Moreover, several jurisdictions including from Africa have followed the strategy adopted by Bahrain (year 2001) and by regularly floating short- to medium-term Sukuk to support the liquidity and investment requirements of Islamic institutions based in its jurisdiction. According

Fig. 8.6 Worldwide Investment in Sukuk (Source S&P Global ratings. Copyright @ 2018 by Standard & Poor’s Financial Services LLC. All rights reserved)

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to the IIFM Sukuk report 2017, Sukuk is firmly emerging as one of the main alternative sources of funding, not just for the Islamic markets but with interest gathering from Europe, African continent, Asia and the Commonwealth and Independent States (CIS) countries. The mar-ket has witnessed many milestones benchmark Sukuk issuances such as Sukuk issued by Emaar Malls, Sadara Chemical, Saudi Electric company, Government of Turkey, Sukuk issuances from Saudi Arabia, Qatar and UAE, debut domestic Sukuk by Senegal, debut international issuances by Europe and Asian countries, Tier 1 Perpetual Sukuk by Al Hilal Bank and GEMs School Perpetual Sukuk.

8.8 aaoIfI’s concern on sharI’ah comPlIance of sUkUk

In 2007, Bahrain-based Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) raised three main criticisms against Sukuk relating to the following issues:

(i) Sukuk holders not having real ownership interest in the underlying assets;

(ii) The regular distributions to Sukuk holders not being based on actual performance of the underlying assets; and

(iii) Guarantee of the return on capital via the use of purchase undertakings.

The first criticism pertained to asset-based Sukuk where there is no legal sale of the underlying assets and as such no real transfer of ownership of the assets to Sukuk holders from the originating company. Legal doc-umentation in asset-based Sukuk indicates that the Sukuk holders do not have an interest in the underlying asset, which conflicts with Shari’ah principles that require Sukuk investors to have rights over the Sukuk assets.

The other two criticisms focused mainly on the structural features of the Sukuk al Musharakah, Sukuk al Murabahah and Sukuk al Wakalah structures—the so-called equity-based Sukuk. The criticisms highlighted the use of Shari’ah-compliant funding to make up for any shortfalls in actual profit below the stipulated percentage to Sukuk holders; the pay-ment of any excess profit realized beyond the expected profit percentage

108 a. hassan and s. mollah

as incentive fees to the manager; and the use of purchase undertakings to guarantee the Sukuk holders’ principal such that it is expected that the issuer will buy back the underlying asset at the expiration date of the Sukuk or in the event of default at face value regardless of their true value on that day. Such practices convert the equity-based Sukuk to debt-based structures whereby the Sukuk are redeemed at par value at the maturity date and Sukuk holders are paid a guaranteed periodic return on capital throughout the duration of the Sukuk.

As a response to the various Shari’ah concerns, the AAOIFI issued additional guidelines on Sukuk structures in February 2008, stating that the following are prohibited in equity-based Sukuk:

(i) The use of Shari’ah-compliant financing to smooth out periodic income distribution amounts to Sukuk holders; and

(ii) The use of purchase undertakings in order to guarantee the return of the principal amount to Sukuk holders at its par value. The AAOIFI resolution, on the other hand, does not prohibit the use of purchase undertakings in Sukuk al Ijarah, if the lessee is not an investment partner, mudharib or agent.

Moreover, the AAOIFI resolution stated that the use of a reserve account to cover shortfalls is permitted and so is distribution on account, so long as the latter is subject to reconciliation prior to a final distribution.

The resolution of the International Islamic Fiqh Academy (IFA), a branch of the Organization of Islamic Cooperation (OIC), in its 20th session (2012) also restated, similar to the resolution of the AAOIFI (2008), the non-permissibility of purchasing equity-based Sukuk at their nominal value or at a predetermined price, which leads to the capital of Sukuk holders being ensured and of providing loans to Sukuk holders when actual Sukuk revenue is less than expected, although it allows for recourse to reserve accounts to redress potential shortfalls. regarding Sukuk al Ijarah, the Islamic Fiqh Academy prohibited the current struc-ture of asset-based Sukuk al Ijarah as it is a form of inah (sell and buy back arrangement).

The Islamic Fiqh Academy pronounced the impermissibility of selling an asset on a cash basis on the condition that the seller leases the asset via a lease ending in ownership whereby the total rental payments and repur-chase price (paid by the Sukuk issuer) would be more than the cash price

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(paid by the Sukuk holders). Such stipulation is impermissible, regard-less of whether it is mentioned explicitly or implicitly, because this would be a form of the prohibited inah, and therefore, Sukuk cannot be issued using this structure.

The Islamic Fiqh Academy also placed emphasis on the fact that Sukuk should establish genuine ownership of the underlying assets, in line with both the Shari’ah and conventional law, along with enabling its attendant legal effects, such as the power of disposal of the assets and bearing the liability associated with ownership.

8.9 conclUsIon

While the development of Sukuk originated from the idea of finding an alternative to interest-bearing bonds, today with the rising Shari’ah con-cerns about the Sukuk structures, emphasis is being placed by fiqh coun-cils to ensure that Sukuk structuring aligns closely with the principles of the Shari’ah. The aim is to demarcate clearly the differences between Sukuk and conventional bonds in terms of the structure, design, utiliza-tion of proceeds and overall objective of supporting genuine activities and economic development.

Different Sukuk structures have been emerging over the years, but most of the Sukuk issuances to date have been Ijara Sukuk, and since they are based on the undivided pro rata ownership of the underlying leased asset, it is freely tradable at par, premium or discount. Tradability of the Sukuk in the secondary market makes them more attractive. Although less common than Ijara Sukuk, other types of Sukuk are also playing significant role in emerging markets to help issuers and inves-tors alike to participate in major projects, including airports, bridges and power plants. The sovereign Sukuk issues, following Malaysia and GCC’s lead, are enjoying widespread and positive acclaim among Islamic inves-tors and global institutional investors alike.

Although Sukuk market progression is quite impressive, in order to maintain orderly growth, and robust and transparent Sukuk market, there are several challenges which need to be addressed, and role of standard setting bodies will be critical as issues facing the Sukuk primary and secondary market need to be addressed through harmonization of practices and guidelines.

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In recent years, mutual funds have become a major vehicle for mobi-lization of savings particularly from small household sector. In Muslim countries, such mechanism is of special significance where mode of oper-ation is in consonance with Mudarabah/Musharakah mode of financ-ing. The term, mutual fund or sometimes referred to as unit trust, is an institutional device through which the investors pool their funds to invest in a diversified profile of securities, thus spreading and reducing risk. It is an investment vehicle through which small and large inves-tors pool their funds under the direction of an investment or fund manager. Islamic mutual fund is a type of co-partnership between the public and the financial institutions. Islamic mutual funds therefore pro-vide opportunity to small investors, who do not have access to capital market, to participate in the economic development of the country. It is simply a mechanism for diverting extra funds available with the pub-lic to the Islamic capital market. In the other words, the Islamic mutual fund is a form of collective Shari’ah compliance investment that is use-ful in spreading risks and optimizing returns. The main feature of the Islamic mutual fund is that it allows diversification of portfolio for the small investors who may not be able to do so due to lack of financial knowledge.

CHAPTEr 9

Islamic Mutual Funds: A Vehicle for Mobilization

of Small Savings

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_9

112 a. hassan and s. mollah

9.1 IslamIc mUtUal fUnd Is manaGed Pool of caPItal

An Islamic mutual fund is a managed pool of capital for individuals to invest their surplus money. It offers investors the twin benefits of their funds being managed by specialized investment institutions and the assurance that the fund is in compliance with Shari’ah guidelines. It must be in strict conformity to the Shari’ah investment principles and, there-fore, regulates its selection of investments, its own operations and its trading practices.

9.2 tyPes of IslamIc mUtUal fUnds

Any Islamic mutual fund falls within one of two categories as shown below. Before proceeding to invest in any Islamic mutual fund company or asset management company, it is essential to know the different types of Islamic mutual funds available and whether it is suitable for investor’s financial objective:

• Income Funds Income funds aim to provide the investor with a regular income

(monthly/quarterly) by investing in Shari’ah-compliant securities that provide income such as dividend paying stocks. The apprecia-tion of capital is of secondary importance.

• Growth Funds The main aim of this type of fund is to grow the capital invested by

appreciation of the underlying Shari’ah-compliant securities and not to provide any annual/quarterly income.

9.3 PrIcInG of IslamIc mUtUal fUnds

Knowing how an investment is priced is an essential knowledge in the decision-making process when investing in the stock market. To under-stand how mutual funds are priced, the first concept one must under-stand what is the Net Asset Value (NAV). It is calculated by aggregating market value of the assets and divided it by the total number of units the fund has issued to investors.

9 ISLAMIC MUTUAL FUNDS: A VEHICLE FOr MOBILIZATION … 113

9.4 IslamIc Investment

Islamic investment can be defined as an investment in financial services and investment products that adheres to the principles established by the Shari’ah (Islamic law as revealed in the Quran and Sunnah). These prin-ciples require that:

• Investments must be in Islamic approved sectors. In other words, profits cannot be made from prohibited activities such as alcohol production, gambling and pornography. Also investing in interest (Riba)-based financial institutions is not allowed.

• All wealth creation should result from a partnership between the investor and the user of capital in which rewards and risks are shared. returns on invested capital should be earned (i.e. tied to the profits generated by the capital) rather than be predetermined (as in interest-based returns provided by bank deposits).

One of the implications of Islamic investment principles is in the selec-tion of the type of financial instruments available in global financial mar-kets today. Interest-based securities (e.g. bonds and bank deposits) are not acceptable as Shari’ah-compliant investments, since these securities provide returns that are predetermined, and unrelated to the underly-ing performance of the asset that is generating the returns. By the same way, equity securities (shares) are considered permissible by a consensus of contemporary scholars as well as Jeddah-based Islamic Fiqh Academy, because the profits an investor makes on equity securities are tied to returns of the underlying company and hence are risk related.

9.5 IslamIc Investment crIterIa

Islamic investment is done through screening of the companies. There are two types of screening in the Islamic investment process which are given below:

1. Qualitative Screens

Qualitative screens are part of the general rules followed by Shari’ah scholars in determining what is halal (lawful) and haram (prohibited) for investment purposes.

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There are two types of qualitative screens, and they are:

(i) Industry screening: Is the company in an industry prohibited in Islam? Examples of industries that are haram or involved in unlaw-ful activities are alcohol production, riba-based financial institu-tions, gambling and entertainment.

(ii) Business practices: Is the company exploitative in its relationship with customers and suppliers or unethical in its trade practices?

2. Quantitative Screens

Quantitative screens are part of the general rules followed by Shari’ah scholars in determining what is halal and haram for investment pur-poses. The following are some of the guidelines set by the Shari’ah board members of the Dow Jones Islamic index:

• Debt/asset ratio: Has the company borrowed funds on interest either in fixed or floating interest rate? It is clear that there should ideally be no interest-based debt, but based on the Islamic legal principle “li al-aktharhukm al-kul” (to the majority goes the verdict of the whole) and subsequent scholarly opinions, a company is not a permissible investment if debt financing is more than 33% of its capital (according to the Shari’ah board members of the Dow Jones Islamic).

• Interest-related income: Does the company generate any interest or interest-related income? This includes those companies who do not make earning interest their business, but place their surplus funds in investments that yield interest income. As in the previous case, ide-ally no income should come from interest-related sources.

• Monetary assets: There are substantial portions of the company’s assets which are monetary such as accounts receivables and liquid assets such as bank accounts and marketable securities. Various min-imums have been set for the ratio of illiquid assets (assets that are not in the form of money) necessary to make an investment permis-sible. According to the principle of “li al-aktharhukm al-kul” (to the majority goes the verdict of the whole), some set this minimum at 51%. A few cite 33% as an acceptable ratio of illiquid assets to total assets.

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9.6 tradInG and InvestInG PractIces

In addition to the criteria for selection of securities, Shari’ah principles are also found in investing and trading practices and are also applicable to Islamic mutual funds. These practices include:

• Investable funds must be free of interest-based debt: The investor can-not borrow on interest to finance his investments and therefore can-not trade on margin—i.e. borrow to purchase shares. Conventional funds such as hedge funds, arbitrage funds and leveraged buyout (LBO) funds borrow heavily in order to finance their investment practices, and they are therefore prohibited for Islamic investors.

• Prohibition of speculation: Unlike conventional investors, Muslims are prohibited from basing their investment decisions on short-term speculation. As a Muslim, the logic of sound analysis is paramount before making an investment decision. Trading is important and should be well timed to take advantage of market prices, but these considerations should go hand in hand with the fundamental value of the companies in which you invest.

9.7 GroWInG ImPortance of IslamIc mUtUal fUnds

Islamic mutual funds play an important role in developing Islamic capital market by providing a lot of capital information. The process of invest-ing through Islamic mutual funds will benefit the individual savers. This is because individual savers who purchase shares in the Islamic mutual funds acquire access to capital market investment. Therefore, they will enjoy a better opportunity to match their long-term liabilities such as retirement and education with long-term investment assets (Islamic stocks and Sukuk). Thus, there is a need for a nascent Islamic mutual fund industry in global to mature and develop to provide the necessary link between private savings and its prospective Islamic capital market. The Islamic mutual funds which will be domestic nature can enhance the liquidity and stability of the prospective Islamic capital market in the dif-ferent Muslim countries. The Islamic mutual funds will in turn provide the means for investors of the globe to align their assets and liabilities in better way.

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9.8 IslamIc mUtUal fUnds WorldWIde

According to the Eurekahedge Global Islamic Fund Database, there are 828 live and obsolete Shari’ah-compliant funds worldwide in the differ-ent countries which provide their investors exposure to financial markets inside a framework that is deemed ethical under the principles of Islamic jurisprudence. Islamic funds constitute a fast-growing sector of the wider Islamic finance industry and reach US$2 trillion mark by the end of 2015. As on December 31, 2017, there are 516 live Islamic funds. Out of 516, 88% of the strategies are represented by Mutual Fund/Unit Trust (367 funds), Equities (25 funds), Investment Trust (23 funds), Structured Product (22 funds), Closed Ended Investment Company (CEIC) (15 funds). As on February 28, 2018, the most popular fund size of Islamic fund-investing managers is in the US$0–US$50 million range with 261 global Islamic fund managers running funds of this size. There are 6 funds that are greater than US$1 billion. The average mini-mum investment size for Islamic funds stands at US$1087 million.

Almost half of the Shari’ah-compliant funds invest with a Middle East/Africa mandate, followed by 33% that invest in Asia Pacific and 26% that have a global mandate. The majority of the funds are based in either the GCC countries or South-East Asia, with the next major hub being the UK.

An Important Issue to Address

Islamic mutual funds can only invest in assets and securities that have been pronounced as compliant to Shari’ah principles and guideline. One of the most important issues in popularizing Islamic mutual funds is sales and marketing practices which need to receive due attention. The moral dimension should not be overlooked since principles of Islamic eth-ics are a core aspect contains within Islamic finance. There is anecdotal evidence of unethical practices observed in the selling of Islamic mutual fund products. All the crux of it is the use of emotion to displace rational thinking. Misleading representations and lack of complete disclosure in the form of sweeping statements about potential returns should be cur-tailed. For an Islamic mutual fund to be completely ethical, distribution channels should address any lack of adequate explanation and the impli-cations of fee structures, as well as the lack of investor education about the realities in terms of risks and the long-term investment horizon of Islamic mutual funds.

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One of the most remarkable corporate phenomena of the last 11 years has been the growth of private equity. A decade ago, private equity was known as venture capital. Private equity is now arguably at the very cen-tre of corporate finance and mergers and acquisitions (M&A) activities worldwide. What was perceived only a few years ago as an alternative asset class on the fringes of unrestrained financial capitalism is now a mainstream and accepted Shari’ah-compliant investment activity, provid-ing returns not only for private equity professionals and their investors, but also for managers, shareholders and providers of debt finance alike. At its core, private equity remains one of the most potent means of creat-ing corporate value and represents around one-quarter of all M&A in the area of corporate finance globally.

Private equity has been soaring in Western countries, especially in the USA, where private equity outperformed the US stock market over both the short and long terms. In the USA alone, the pool of private equity funds surpassed $950 billion in 2007, from $5 billion in 1980.

In the field of Islamic corporate finance, private equity also provides an attractive outlet for Musharakah-based investments in institutional Islamic funds, culminating in an increasing trend of Islamic banks getting involved in private equity deals by setting up their own private equity funds. The market for private equity in the Muslim world in general, and the Middle East in particular, has been untapped. Most Middle Eastern big individual investors and Islamic banks have had excess liquidity over the recent year, and therefore, the importance of private equity in the

CHAPTEr 10

Joining Forces: Islamic Finance and Private Equity

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_10

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region has been gradually realized. Funds managed by private equity firms in 2006 were approximately $19 billion, and by the end of 2007, they were estimated to have risen to $26 billion.

However, due to the global financial crisis, the market has been disappointing for private equity participants worldwide since 2008. During these challenging times, and with equity and debt availabil-ity so restricted, investment managers are inevitably focused on their existing portfolio assets. The majority of investment portfolios include businesses that are under strain as a result of the financial crisis, which in turn will impact valuations and the level of anticipated returns. This concern is contributing to a widely held belief that a number of other types of funds have also suffered. But private equity as an industry is certainly robust enough to see out this crisis. This is because long-term growth opportunity is an inherent feature of private equity, and there-fore, its future equity participants are more optimistic for long-term investment.

Due to the present financial crisis, with an increasing number of banks and corporations struggling to find funds to support their businesses, private equity firms represent a potential solution to bridge the liquidity gap in the US market. recently, the US regulator, the Federal Deposit Insurance Corporation (FDIC), laid down ground rules for acquiring troubled banks by private equity investors. However, only those pri-vate equity firms that have significant expertise in bank acquisitions will lead these deals. The new policy statement reaffirms the need for private equity firms to have either in-house expertise with bank acquisitions or partner with established players in the field.

10.1 ventUre caPItal vs. PrIvate eqUIty

Generally, venture capital is defined as a firm which invests in early-stage start-ups, whereas private equity is a firm which invests in later-stage companies or public companies, including stock market listed companies. However, both have the same investment style. They invest in companies in exchange for equity in the business. Venture capital is actually a subset of private equity investment. Private equity investments include leveraged buyouts, distressed investments and mezzanine capital. Due to the eco-nomic crisis, venture capital firms have been more conservative, so a lot of venture capitalists are investing more in later-stage companies where the risks are lower.

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Furthermore, the lines between venture capital and private equity investments have been blurred by increased competition in the capital markets. The increased pressure on the part of money managers, invest-ment advisers, fund managers and capital providers to place funds is at an all-time high. This increased competition among investors has forced both venture capital and private equity firms to expand their respective horizons in order to continue to capture new opportunities (Fig. 10.1).

10.2 PrIvate eqUIty and the mUslIm World

The Middle Eastern region is seeing increased interest from overseas players attracted by the impressive growth rates in the region from 2003 to 2007. During these years, several multinational banks set up offices in the Gulf. The Emerging Markets Private Equity Association conducted a survey in 2007 and found that out of 300 limited partnership capital providers contacted, 65% of respondents to its survey on limited partner interest in emerging markets private equity expect to increase their com-mitments to the emerging markets over the next five years.

In fact, the concept of private equity does not contradict Islamic norms or Islamic financial contracts. Therefore, it is very straightfor-ward to carry out normal private equity activities in a Shari’ah-compliant manner, with acquisition targets ethically screened, debt-to-equity and

Fig. 10.1 Private equity

120 a. hassan and s. mollah

income ratios curved within the specified Shari’ah boundaries. In this way, Shari’ah-compliant financing can be used for the acquisition and funding.

The Islamic financial market could successfully pioneer a form of financing similar to conventional private equity, but addressed with Islamic tenets firmly in place, to result in the best of both practices. Partnering with established European and US firms presents an attractive proposition for many Middle Eastern Islamic investors. Musharakah or equity financing, if the price and structure are right, could provide a use-ful source of diversified funding for private equity firms.

10.3 strUctUrInG PrIvate eqUIty

Private equity firms are typically structured as partnerships with two key components: the “general partnership” which is management team responsible for making investment decisions, and the “limited part-nership,” which is the provider of the capital. The limited partnership commits the funding, allowing the general partnership to draw down as required for investments that meet the agreed profile. Sometimes, lim-ited partnership capital providers set a hurdle rate, which represents a minimum investment return target. The returns in excess of this are split with the general partnership at a predetermined rate.

It is observed that some Middle East-based private equity funds use a sell-down model where the limited partnership is represented by a con-sortium of typically tiered high net worth individuals. The general part-nership identifies the target, undertakes the due diligence, agrees on principal terms with the investor group and then makes the acquisition. Normally, the general partnership marks up the price before selling down the stake to the various investors on pre-agreed terms.

In structuring private equity for Islamic investors, a few issues need to be taken into consideration. First, Islamic investors conduct their invest-ment activities in accordance with Shari’ah law. The Shari’ah prohibits the charging or paying of interest (riba); investment in certain forbid-den industries such as conventional financial services, armaments, gam-ing(gambling) and alcohol; contractual uncertainty (gharar); and the guarantee of a fixed return on investment.

One of the most important principles of Islamic finance is that of profit and loss sharing, both in the Musharakah and Mudarabah modes of finance. As per Shari’ah principles, losses must be shared between the

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rabbul maal (investor) and mudarib (entrepreneur) in proportion to their invested capital, whereas sharing the profit can be set at agreed levels. Therefore, the Islamic model for business financing is based on profit and loss sharing through equitable financial and contractual arrange-ments. The private equity model, on the face of it, seems to provide a natural Musharakah-based solution with a proven track record of success in the conventional system.

It should be noted here that structuring a Shari’ah-compliant private equity fund usually requires the management to comply with the princi-ples set out by the Shari’ah supervisory board. The fund documentation, such as the limited partnership agreement and private placement mem-orandum, normally consists of rules for compliance which restrict the management in the use of the funds provided by the Islamic investors. It is common to include investment guidelines based on Shari’ah law, for instance, regarding investment in only lawful (halal) companies. The Shari’ah supervisory board has approval rights on the intended invest-ments of the fund and supervises the fund‘s ongoing compliance with its investment guidelines.

Moreover, the fund transactions are structured in such way that its money flows start from the investors to a fund and then to the target company. The Shari’ah supervisory board members act as advisers who model the clauses and mechanisms to meet the requirements of the Shari’ah in general and the principles of Mudarabah or Musharakah PLS partnerships and Wakalah in particular. These structures appeal to Islamic investors.

As in the Musharakah structure, there is one party, the sponsor of the fund, providing the management and one financier, that is, the investor, providing cash to the fund. There may be alternative struc-tures, for example Mudarabah. However, using the Musharakah struc-ture will best fit the requirements set by local laws and the desired tax transparency. In addition to these, the structure can be open-ended or closed-ended. Practically, most Islamic private equity struc-tures are closed-ended, which is sometimes perceived as more Shari’ah compliant.

However, Islamic private equity structures may vary from a stand-alone corporation with an internal or external management team to a real fund structure holding the monies which is managed by an outside management company. This type of structure may act as a general part-ner or limited partnership in an overall partnership structure.

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10.4 deal and screenInG Process

Private equity is medium- and long-term finance, usually from three to seven years, providing returns for an equity stake in potentially high-growth companies. During the holding period, the focus of the private equity firm is to improve the profitability of the company with a view to increase value upon exit.

Therefore, the jurisdiction and legal structure of the private equity fund are important. Attention should be paid not only to the types of fund structures available in the host country of the private equity, but also to the potential funds that may be marketed to investors in their home jurisdictions and the type of investments they are allowed to ven-ture into in the jurisdictions of the target companies. It is important to consider cross-jurisdictional issues between the investors, private equity funds and target company home markets.

The final decision on what legal vehicle to use for the private equity will be influenced by, among other things, the legal structures available in any specific jurisdiction, tax requirements and specific Shari’ah con-straints. After the initial fund-raising, the promoter of the Islamic private equity usually becomes the general partner of the management team. The management team will identify the target companies, conduct due diligence reviews, obtain the investor agreement and undertake the ini-tial equity acquisition in the target company. The general partner is also responsible for managing target companies and to ultimately conduct the exit strategy on behalf of the Islamic private equity fund.

In Islamic private equity, target companies may be identified through contacts within the Islamic private equity network, soliciting by the tar-get companies themselves and sector tracking. A thorough due diligence on financial and non-financial issues, projected return on investment, synergy and timing may help to single out Islamic investments. Smaller companies with the potential for significant growth are high on the list of priorities of Islamic private equity firms. Because small and medium enterprises have little interest in leverage, there is still considerable scope of negotiation room for structuring and asserting Shari’ah compliance.

In general, when a general partnership of a conventional private equity firm admits an Islamic investor into its fund, it will have to adopt a Shari’ah-compliant investment policy which includes business prohibi-tions incorporated into the fund documentation. Subject to fine-tuning

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by the Shari’ah supervisory board of the Islamic private equity firm, these may include:

• Banking and other financial services based on riba (interest).• Gaming, gambling casinos, lotteries and related games or activities.• Production/slaughter or distribution of pork and pork-related

products.• Engagement in pornography or obscenity in any form.• Engagement in the entertainment business, such as immoral films,

video, theatre and cinema.• Conventional insurance.• Weapons industry.• Production or distribution of alcoholic beverages or related

products.• Production or distribution of intoxicant products such as drugs and

tobacco.• Environmental-damaging activities.

In the global financial market where the conventional financial system commands the market, it is very difficult to find target companies that are completely Shari’ah compliant. In order to invest in stock market listed public companies, it is generally accepted that any unlawful income of a Shari’ah-non-compliant target company that does not exceed 5–15% (subject to the approval of the Shari’ah scholars) of overall gross income is considered marginal or incidental. Most Shari’ah scholars have recog-nized and accepted the following screening criteria or financial ratios of stock-listed companies:

• Total debt: Excludes investment in companies when total inter-est-based debt divided by 12-month average market capitalization exceeds or is equal to 33%.

• Total interest-bearing securities and cash: Excludes investments when total cash and interest-bearing securities divided by 12-month aver-age market capitalization exceed or are equal to 33%.

• Accounts receivable: Excludes investments in target companies if accounts receivable divided by total assets are greater than or equal to 33% (Table 10.1).

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Although the Islamic market indices screening criteria above are designed for listed companies, they can also be applied to private equity investment criteria. In fact, these norms of financial ratios are used by some private equity investors in the UK and USA.

Any Shari’ah-prohibited income from unlawful activities also needs to be minimized. In other words, private equity fund documentation may also require modification to prevent the manager from charging interest on monies due but unpaid in relation to investors’ drawdown obligations and in relation to investing surplus cash in interest-bearing temporary investments. To the extent that a fund or a portfolio company conducts Shari’ah-compliant activities, most Islamic investors will tolerate inter-est income, provided that such income does not exceed 5% of the total income of the fund or portfolio company. In practice, such investors will “purify” this income by donating it to a charity.

Apart from this, for certain Islamic investors, there will also be a need to address issues in relation to the exercise by the fund of redemption rights and liquidation preferences attaching to preference shares, which may not be acceptable in a form familiar to Western investors.

The use of interest-bearing debt at both the portfolio company level and at the level of any special purpose financing vehicle in the merger and acquisition (M&A) structure is of particular concern to Islamic

Table 10.1 Financial screening ratios

aGuide to DJIM Indexes 2008. Trailing 12-month average market capitalisationbGround rules for the Management of FTSE Shari’ah Global Equity Index Series 2008. Total assets consideredcS&P Shari’ah Indices Index Methodology 2008. Market value equity has been taken into considerationdMorgan Stanley MSCI Islamic Index Series Methodology 2008. Total assets have been taken into considerationeHong Kong Islamic Index. Trailing 12-month average market capitalisationfJakarta Islamic Index. Market value equity has been taken into consideration

Debt ratio (%)

Receivable ratio (%)

Cash and interest-bearing ratio (%)

Unlawful income/total income (%)

DJIMa 33 33 33 ≤5FTSEb 33 50 33 ≤5S&Pc 33 49 33 ≤5MSCId 33 70 33 ≤5HK Islamic Indexe 33 49 33 ≤5Jakarta Islamic Indexf 33 33 33 ≤5

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investors, given the Shari’ah prohibition on riba. In principle, Shari’ah-compliant funds are restricted with regard to leveraging their investments in comparison with conventional private equity funds. Depending on the legal view of the relevant Shari’ah supervisory board, leveraging may be totally prohibited or allowed to a certain extent. For instance, the board may allow the fund to use leverage within a certain limit, such as 33% of the balance sheet of the target.

However, Shari’ah-compliant private equity funds must also com-pete with conventional private equity funds as to their rate of returns, in addition to Islamic investors’ expectation of investing their money in products that would provide market returns. This requires the fund to leverage its investments to a certain extent. To ensure that lever-age is Shari’ah compliant, one can use those Shari’ah structures typi-cally used for acquisition finance such as ijarahwaiktina or Murabahah. These structures are always subject to the approval of the Shari’ah board, and additionally, they would have to be reviewed from the local legal perspective regarding feasibility and avoidance of detrimental tax consequences.

10.5 cUrrently IslamIc PrIvate eqUIty

As of 2007, the Eurekahedge Islamic fund maintains 112 different prod-ucts in its database (accounting for over 20% of the total universe, cur-rently estimated at 550 funds across all asset classes), with other classes of assets, including real estate funds, now representing 330 (60%, leas-ing funds being a 10% subset) and 220 private equity funds (40%). Figure 10.2 outlines the industry’s consistent growth in recent years (Fig. 10.3).

Islamic private equity has been boosted by the investment and advi-sory firm Corecap launched its first $150 million in the year 2008. Corecap Islamic Private Equity Fund I (CIPEF I) to fund Shari’ah-compliant private equity investments in the Middle East and North Africa (MENA) region. The CIPEF I was said to be one of a kind as the first private equity fund that offers a Shari’ah-compliant mezzanine struc-ture worldwide (Source: Eurekahedge).

Major private equity investors in the Middle East include Gulf Finance House and Investment Dar of Kuwait, Investcorp of Bahrain, Shuaa Capital and Millennium Private Equity of Dubai. Most of these invest-ment companies have Shari’ah supervisory boards.

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Malaysia has also become an attractive destination for private equity investments, with a sizeable population of 27 million and a robust inter-national business community. Actis Capital LLP and iSpring Capital Sdn Bhd in Malaysia are leading private equity firms in Kuala Lumpur.

Indonesia, Southeast Asia’s largest economy, is increasingly becom-ing an appealing investment destination for private equity firms. With a population of over 235 million and healthy real GDP growth rate over the last decade, it presents some compelling investment opportunities in sectors such as financial services and telecommunications. The country is also rich in natural resources, giving rise to its own set of related invest-ment opportunities. There are only a handful of private equity firms operating in Indonesia presently. These include Quvat Management, Saratoga Capital and TPG-affiliate Northstar Pacific Partners. Affinity

Fig. 10.2 Structure of Islamic private equity fund

Fig. 10.3 Islamic funds growth over the years (Source Eurekahedge)

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Equity Partners is a new buyout firm set up in Jakarta which focuses on leveraged buyouts and control investments on a selective basis.

Islamic private equity in Europe and the USA currently does not have the volume of conventional private equity. Although Islamic finance and Islamic private equity are increasing by approximately 10% per year, funds provided for Islamic investors are much smaller than conventional funds. To support this industry, Western governments will have to learn more and provide a better environment for Shari’ah-compliant invest-ments. A few countries, for example the UK, Germany and, recently, France, are well ahead of the others by resolving some detrimental tax consequences for Shari’ah-compliant transactions. Transaction structures such as private equity, Islamic mortgages and Sukuk that are Shari’ah compliant, feasible and enforceable under local law as well as provid-ing adequate tax treatment have been gaining popularity in the Western market.

Fast Growth Ahead

Private equity has come a long way in the global financial market. With regard to the spirit of entrepreneurship which lies at its core, it seems fair to forecast that it will remain central to the twin fields of corporate finance and M&A for many years to come.

Private equity is one of the most interesting asset classes for Islamic investors due to its natural fit with the Shari’ah principles. Private equity and Islamic investment share a few common principles: Both of them are based on investment in the real economy and on the principle of shar-ing risks and rewards through partnership. Private equity takes a long-term view on investments and aligns the interests of stakeholders, which are also among the key principles of Islamic investment. This acceptable ethical investment product for Islamic investors offers high performance, portfolio diversification, superior risk-adjusted returns and diverse invest-ment opportunities.

Although there are only a few Islamic private equity funds in the market, it promises to be one of the fastest-growing areas both within the private equity and Islamic finance space over the coming years. Islamic private equity focuses on acquiring majority stakes in privately held Shari’ah-compliant companies. In doing so, it enables investors to maintain control and ensure the company’s adherence to Shari’ah principles.

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In order to effectively engage in private equity deals in Western mar-kets, Islamic banks need to ensure that they have the right resources, use experienced individuals with proven track records, consider partner-ing with existing boutiques or deploy a fund-of-funds approach. They should consider that the private equity model requires a broader mindset beyond financial engineering to include operation improvements, as this is a key area for driving value.

Western countries especially may want to take advantage of the immense liquidity available to Islamic investors. In order to have joint collaboration in private equity funding, they could structure a fund-like master-feeder fund. In this case, the feeder vehicle provided for Islamic investors may decide whether to take part in a proposed investment or not. Here, a challenge for Western sponsors or private equity firms is the requirement of establishing a Shari’ah supervisory board at the level of the fund. This mechanism would facilitate intense communication between the sponsor and Shari’ah supervisory board well ahead of any M&A. Evidence shows that sponsors would be willing to accept such processes, as Western countries’ private equity structures provide for an investment committee consisting of independent financial experts who are not part of the management.

Most of the Muslim countries are developing their economies, and crossover into retail as well as the small- and medium-sized enterprises market remains a key challenge. Perhaps this is a segment that Islamic finance can pioneer by adapting early-stage private equity techniques to the owner-managed small-business market. This is where the needs of the majority of the grass-roots business community lie.

10.6 develoPment of PrIvate eqUIty

The growth of private equity is typically traced back to the founding of buyout firm Kohlberg Kravis roberts & Co. (KKr), a leading global alternative asset management firm with two primary business segments: private equity and fixed income in the USA in the mid-1970s and the development of the leveraged buyout (LBO) model. The LBO model involves buying a business through borrowing money from a third-party bank or other financial institution. The company’s cash flows are used to make the loan repayments and, together with the company’s assets, provide security to the lenders until the debt is repaid. In the early days of private equity, and indeed for the majority of financial investors today,

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the driver for returns in the classic LBO model was to buy the greatest amount of assets with the least amount of personal (or equity) invest-ment. In short, a company’s future was mortgaged in favour of being able to service debt from the company’s existing cash flows. There was often little margin for error and so usually the companies which found themselves attractive to private equity firms were mature businesses enjoying leading market positions in their sectors and stable cash genera-tion without any seasonal swings.

Over time, as the private equity space became more crowded given the personal rewards involved, other variants on the classic LBO model emerged. There were “break-up” LBOs where asset sales were seen as the main means of repaying acquisition debt, since existing cash flows would not be sufficient to service the company’s debt. “Strategic” LBOs would target fragmented industries so that a number of unglamorous (sometimes loss-making) single-entity companies could be consolidated or “rolled up” into a more attractive whole before being offered for sale on the public markets by way of IPO.

During the late 1980s, a number of leading buyout firms were estab-lished in the USA. They were able to tap into the increased demand for private equity product among US state pension funds which had been disappointed by relatively unexciting performances of their investments in the US stock and bond markets during the late ‘70s and early ‘80s and had turned instead to alternative investments such as private equity. During the ‘90s, private equity firms continued to expand their own operational capabilities and investment skill sets to cope with changes in the economy and more difficult conditions in which to find and produce superior returns.

“Turnaround” private equity firms emerged where the ability to run businesses for cash and to restructure their operations became even more important than a consideration of which financing multiples could be applied to the company. Often, these private equity firms would hire key senior personnel or distinguished chief executive officers from established blue-chip companies, whom they would then “parachute” into an exist-ing portfolio business. The main purpose of this type of hiring executive staff was often to supplement the skills of existing managers and at other times to replace them entirely. In these firms, managing each portfolio business post-acquisition and extracting value became at least as impor-tant as, or sometimes more important than, acquiring the business in the first place.

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When the events of September 11, 2001, highlighted the systemic deficiencies in the world economy caused by a consumption-led con-sumer boom, private equity was a global business, intrinsically linked with, and hostage to, the global worlds of corporate finance and M&A. It is not surprising, therefore, that private equity, as with M&A, has remained relatively quiet as the world economy has gone through the global financial crisis starting in 2007.

Within the European market, private equity players were relatively unscathed by the ravages of the 2001–2004 collapse of the nascent European high-yield market and energy space which was caused by deregulation. Although some LBOs had been conducted in the tele-communications and cable sectors, European private equity had largely invested elsewhere, meaning that while there were one or two examples of portfolio firms defaulting on their loans, most of their asset classes were less troubled.

The importance of private equity to the overall corporate finance and M&A market in the West is also underpinned by an examination of the shifting attitudes of the boards of public companies to offers to be taken private by private equity firms, or their reaction to their own manage-ment teams’ desire to become owned by a financial sponsor as part of a management buyout.

131

As Islamic finance continues to develop, the development and growth of capital markets, including secondary markets for securities and invest-ments that are compliant with the principles and precepts of Islamic Shari’ah, are being witnessed. Attention has now turned towards apply-ing Islamic principles in the capital markets. Common stocks are a legit-imate form of instrument in Islamic financial system, but many of the practices associated with stock trading are not. In this chapter, the instru-ments like financial futures (stock index futures), option and warrant are examined in Islamic perspectives. It also explained what are the impedi-ments to form these instruments as part of Islamic capital market instru-ments and suggested the ways to overcome the obstacles.

11.1 IntrodUctIon

Islamic financial market is a market where commercial and financial activities are conducted in accordance with the Shari’ah. The Shari’ah is a guide to how a Muslim leads life and is Islamic religious law which applies to commercial and financial activities. The practical rules of Shari’ah is determined by the Shari’ah scholars based on: (i) the Qur’an, being the holy book of Islam and the revealed word of God (notably, less than 3% of the Quran is legal in nature); (ii) the Sunnah of the Prophet Mohammed (peace be upon him), which are the binding authority of his dicta and decisions; (iii) the ijma or “consensus” of the Muslim of scholars; and (iv) the qiyas or analogical deductions and reasoning.

CHAPTEr 11

Financial Futures, Stock Options and Warrants in the Islamic Capital Market

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_11

132 a. hassan and s. mollah

A closely related development in this aspect has been the development of consensus among the Shari’ah scholars and among the Muslim busi-ness community and the scholars. Despite questions, reservations and doubts among some critics of the process, a degree of ijma’ has been achieved, with profoundly beneficial impacts on the Islamic finance industry. Consider, for example, the beneficial impact on the Islamic finance industry of the deliberations and unifying and standardizing pro-nouncements and issuances of the OIC Fiqh Academy, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB), among many others.

In an Islamic financial system, common stock is considered as a Mudarabah, or profit- and loss-sharing certificates. The idea of divid-ing capital into small portions in the form of stocks may appear to have its origin in the early stages of the development of Western conventional economies. However, robertson (1933) traces the ori-gin of stocks to medieval Muslim traders. Common stock repre-sents an ownership claim on a company and stockholders are owners of the business. As such they are entitled to share the profits of the firm. Other ownership rights include the right to elect the directors of a company and to vote on important issues at meetings of stock-holders. However, stockholders bear the residual risk associated with ownership. In the event of the winding up of a company, all third-party claims must first be met before stockholders become entitled to any return of capital. Islamic economists and scholars agree that these features make common stocks acceptable securities within Islam. Common stocks have also been approved as an instrument for invest-ment by the OIC Islamic Fiqh Academy at its seventh meeting in 1993 (JIBF 1994).

Later, in this way, the development of Shari’ah-compliant capital markets instruments, in its modern incarnation, began in approximately 2002, and since then, it has continuously accelerated. This process is the result of a confluence of factors. Some of those factors are: (i) the evo-lution of modern Islamic finance, particularly since the mid-1990s; (ii) the efforts of multilateral institutions, such as the Islamic Development Bank (IDB), AAOIFI and the IFSB, among others; and (iii) transac-tional developments since the mid-1990s.

The modern financial system contains at least two types of capital mar-kets: stock market and the commodity (derivates) market. In an Islamic economy, stock market will work based on the Islamic Shari’ah, which in

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 133

essence should be treated as an important and necessary vehicle to trans-fer funds from surplus to deficit units. One of the main objectives of the Islamic stock market also to ensure that there exists a mean of attracting surplus funds for worthwhile investments in accordance with the own-ers’ preferences in terms of the extent of risk involvement, rate of return as well as the period of investment preferred in accordance with Islamic business ethics.

Islamic capital market and its products are fastest growing area in the field of Islamic finance. One of the important issues of the capital market activity is risk management aspect. Islamic finance now manages risk in several ways, but Islamic Financial Institutions (IFIs) need more tech-niques to manage risk of various kinds, particularly market and currency risk in order to compete with their conventional counterparts. The main problem is that conventional tools for risk management and derivatives (futures, forwards contracts, option, etc.) are presumptively not allowed in Shari’ah laws. Therefore, Islamic risk management devices using deriv-atives face serious challenges.

Many important issues such as stock index futures, stock options and warrants, etc., in the stock market are extremely complex and are sub-ject to the interpretation provided by scholars from the main schools of Islamic jurisprudence. The objective of this paper will therefore be to provide a better understanding of selected issues such as stock index futures, stock options and warrants, etc. This chapter will discuss on the research question: What are the impediments of their practice in the Islamic stock market? It is important that these issues are widely under-stood and debated in order to overcome problems in the way of find-ing Islamic alternatives to these mechanisms. Furthermore, a healthy and intellectual debate will be helpful to create a congenial atmosphere for a well-functioning Islamic capital market.

11.2 strateGIes for the soPhIstIcated conventIonal Investors: stock oPtIons, Warrants and fUtUres

Structured products and derivatives now play a hugely important part in today’s international financial markets. Investors’ drive for yield, challenging capital market conditions as well as growth in funds under management have pushed the move towards increased innovation in derivative instruments. The Islamic finance sector is no different and has witnessed enormous development. Derivatives are now increasingly

134 a. hassan and s. mollah

being applied to Shari’ah-compliant products, which present exciting opportunities for issuers and investors alike. There are, however, cru-cial important point here to understand the basic concepts what are the conventional stock options, warrants and futures before going to discuss about the problems in conversion of some of the selective derivatives instruments from conventional to Shari’ah-compliant products.

Options

Options are contracts that give the holder the right to buy or sell a stated amount of a particular security at a fixed price (also known as exercise price or strike price) within a predetermined period of time (expiration date). Options expire on the third Friday of each month. Investors pay a premium for the right to hold an option, and one option contract repre-sents 100 shares of stock. Options are not issued by the underlying com-pany. There are four basic option plays (Hull 1995):

Buying CallsBuying PutsSelling CallsSelling Puts.

Stock OptionsA stock option is a legal contract that gives the holder the right to buy a fixed number of shares of the employer’s stock at a fixed price that may be exercised during a fixed period of time. A stock option is granted when the employer, usually through action of its Board of Directors, sets the number of shares, exercise price and duration of the option. But the option contract can state a later effective date for the option. The exer-cise price (sometimes called the “strike price”) is how much the option holder must pay to buy the optioned stock. Usually (but not always), the exercise price equals the value of the optioned stock on the date the option is granted. If the value of the stock increases after the date of grant so that it becomes greater than the exercise price, the employees can buy the stock at a lower price (the exercise price) than other inves-tors must pay (the market price). They can then sell the stock for cash and realize a profit. The holder of a stock option generally has none of the rights of a shareholder like voting or dividend rights unless and until the stock option is exercised and the stock is issued. The exercise of an option occurs when the option holder pays the exercise price and buys

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 135

the shares. At that point, shares of stock are actually registered in the option holder’s name and shareholder status begins.

Stock options are almost always granted subject to a vesting require-ment. This means that certain conditions must be met before the option becomes exercisable and the employee can actually buy the shares. In most cases, vesting occurs just due to continued employment (“time-based” vesting), but in some cases vesting requires that individual or company performance goals be attained (“performance-based” vesting). All stock options have a stated exercise period, which is the period of time within which the option must be exercised. If the option is not exercised within this period, the option expires. Ten years is the most common exercise period for employee options.

In most option plans for employees, an employee’s option exer-cise period can be cut short if employment terminates. In some cases, option plans provide that all options just automatically expire when the employee terminates employment. Other plans allow the options to continue for a short period after termination—like 90 days—or make exceptions for certain types of terminations, like death, disability or retirement. The normal way for an employee to actually exercise his or her option after it becomes vested is to pay the exercise price to the employer by check. Some plans allow employees to pay the exercise price in forms other than cash. For example, companies can loan the exercise amount to the employee, or the employee may be permitted to pay the exercise price by delivering previously acquired shares of employer stock.

Making Money with Stock OptionsThe “spread” is the excess of the value of the option stock over the option exercise price. For example, if the exercise price is $10 per share and the current value of the stock is $25 per share, the spread is $15 per share. To understand some of the pay-off stock options may be “out of the money,” “at the money” or “in the money.” (Table 11.1).

Table 11.1 Making money with stock options

Where K = Strike price, S = Current stock price

Call Put

Out-of-the-money K > S K < SIn-the-money K < S K = SAt-the-money K < S K > S

136 a. hassan and s. mollah

The “spread” is the excess of the value of the option stock over the option exercise price. For example, if the exercise price is $10 per share and the current value of the stock is $25 per share, the spread is $15 per share.

An option is “in-the-money” if the value of the stock is greater than the exercise price (i.e. the spread is a positive number).

An option is “out-of-the-money” if the value of the stock is less than the exercise price (i.e. the spread is a negative number).

An option is “at-the-money” if the value of the stock equals the exer-cise price (i.e. the spread is zero).

In many ways, the option programs of privately held companies are the same as those of public companies. The obvious difference is that when an employee of a private company exercises an option and buys the stock, he or she does not have a ready market for the stock.

Question may be raised here that how can the employee of a privately held company profit on the option. In this case, some private compa-nies may agree to buy the stock from the employee, particularly if the employee is terminating employment. In other cases, the employee must wait for some significant event to occur, like an initial public offering (IPO) or sale of the company, before realizing a profit.

PricingThe price at which an option sells is called the “option premium.” The main factors that determine the price, or the premium, of an option are (Hull 1995):

• The price of the underlying stock• The length of time the option remains open• The volatility of the underlying security• The exercise or strike price at which the underlying stock can be

bought or sold• Interest rates.

However, there are some advantages of commodity options over stock options. Incidentally, it may be pointed out that the commodity options work the same as stock options. Both give the buyer the right, but not the obligation to purchase or sell at a predetermined price during a pre-determined time frame. However, inherent in commodity options are numerous advantages in respect of diversification, implementation of strategies and fair pricing (Table 11.2).

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 137

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138 a. hassan and s. mollah

Warrants

Warrants are another derivative security with their value “derived,” or based on the value of an underlying security. Warrants, like call options, give the holder the right to buy a fixed number of shares of stock at a predetermined price during some specified time period. As with calls, warrant holders hope to see the price of their stock investment rise (bull-ish). Despite their similarities, warrants are different from calls because they are issued directly by the corporation whose stock they are based on, rather than by an independent option writer. Also, the terms govern-ing a warrant are specified in detail in a legal contract called a “warrant agreement.” This agreement stipulates the details surrounding when and how the warrant can be exercised. Warrants are like options, but they are issued directly by a corporation, rather than an outside issuer.

Futures ContractsA future is similar to an option, and except that with futures, investors must exercise their right to purchase the underlying financial instrument or commodity (metal, grain, cotton, oil, gas, etc., but not stocks) at the settlement date. Hence, it is truly a contract that obligates an investor to transact with another party. For this reason, the downside risk is basi-cally unlimited because investors are obligated to fulfil their end of the transaction regardless of how market prices move. Entering into a futures agreement does not require that investors pay a premium; it is merely an agreement to transact at a later date. Because of this, it is important to sell the contract before the settlement date. That is the way investors can avoid having a truckload of grain delivered to their doorstep on the day of the settlement.

Although futures are not recommended for novice investors, they are widely used by portfolio managers to both speculate and hedge. An investor needs a futures account in order to transact with this prod-uct. Speculation implies that the investor is willing to accept great risk in anticipation of great rewards. In other words, an investor might buy a future because they believe that its eventual pay-off will outweigh the risk. The USA has the largest, most sophisticated and best-developed futures market in the world. As the financial markets mature and grow more sophisticated, new futures markets are created all the time.

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 139

Futures are contracts that must be exercised at a future date. There is no premium charged to enter the futures contract, and money only changes hands at the time of expiration. Unlike options, which give the holder a right to transact, futures obligate the parties to transact. Because of the complexity of trading derivative securities, investors must have an approved option and futures account before transacting these products.

Hedging, on the other hand, is a strategy used to offset risk (Al-Suwailem 2006). For example, a cereal manufacturer might fear that their ingredient costs will rise, so they will “hedge” their risk by purchas-ing a futures contract on grain. In this case, they use the futures contract to lock in a price for grain today so that they would not stick paying the higher prices later.

11.3 sharI’ah bans MaysiR, GhaRaR and Dayn bi-Dyan

It has long been assumed that a range of Shari’ah precepts will preclude the development of Shari’ah-compliant derivative instruments. The prin-cipal precepts that give rise to these assumptions are: (i) that a person cannot sell something that is not owned by that person (thus preclud-ing short sales) and (ii) that only tangible assets can be bought and sold (thus precluding the sale of options and derivatives). Shari’ah laws also ban maysir, gharar and dayn bi-dyan which place main obstacles in the way of finding Islamic alternatives to stock index futures, stock options, hedging, etc.

In view of the above, one of the most difficult aspects of designing instruments in an Islamic stock market (Islamic capital market) is the issue of maysir, or gambling. This concept covers speculation in the stock market, that is trading in securities purely for short-term gains resulting from uncertainty in the market. In conventional markets, moderate lev-els of speculation are regarded as quite acceptable. Speculators keep the market more watchful of what is happening and their trading improves liquidity. The interaction of rationale investors, those that trade on “true” information relating to the stock, and speculators, who trade on “noise,” help to keep the market efficient in a conventional market sense. A wide range of issues to do with speculation will need to be resolved before we can contemplate a fully functioning Islamic capital market (stock market).

140 a. hassan and s. mollah

Another unacceptable practice related to speculation is the creation of excessive uncertainty, or Gharar. Entering into a contract, in this case a purchase or sale of stocks, with another party when there is excessive risk associated with the transaction, is not acceptable. This may apply in a very volatile market. Both a buyer and a seller should not transact busi-ness when the outcome of the deal is highly uncertain. However, stocks are risky and market participants are attracted to them because the higher the risk of a stock, the higher the expected return. Stock market regula-tors in an Islamic market would have to consider whether it is acceptable to permit trading to continue in a period of high price volatility.

Another issue related to stock trading is whether certain transac-tions could be arranged as Ikrah. This relates to imposing a contract on an unwilling party, or imposing conditions that are unacceptable to them. From a mainstream conventional perspective, it is difficult to see any problem in this regard. Market participants choose to buy and sell stocks and take positions in derivative markets. On the other hand, par-ties are willing to enter into such contracts in the full knowledge of the terms and possible outcomes. From an Islam perspective, this would not be a problem in the case of traditional stock trading as a trade involves two willing parties. However, in the case of options written on stocks, the very nature of the contract implies that option buyers will exer-cise the contract only when it is beneficial to them, while being poten-tially loss-making for sellers. Even though both the buyer and seller of an option enter into the contract willingly, the very fact that the buyer can impose a loss on the seller may make such a contract unacceptable in Islam. In addition to the fact that the loss relates to a derivative position, and not directly to a clearly identifiable transaction in goods or services, create further difficulties.

The issue of derivatives which brings attention one further area is the question of hedging or insurance. Mainstream conventional-style insur-ance is restricted in Islam and hedging, using derivatives, which is a form of insurance. Investors may seek to protect their underlying investments by buying and selling derivatives such as options and futures. The ques-tion to be considered is whether this practice is acceptable in the Islamic market or not. Derivative markets also have an element of speculation, because a well-functioning derivatives market depends on the interaction of speculators and hedgers.

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 141

11.4 obstacles to PractIce stock Index fUtUres, stock oPtIons and Warrants In the IslamIc market

Modern financial institutions, such as stock and derivative markets, or instruments such as shares, bonds, futures, options and swaps cre-ate problems when they are utilized in an Islamic economy. The rea-son stems from a lack of clear Shari’ah guidance on their acceptability. Although stock markets are permitted in Muslim countries, that in itself does not mean that the instruments and trading practices of the mar-kets are in accordance with Shari’ah. Interest-based banks are permit-ted in the majority of Muslim countries, yet there is general acceptance that interest is forbidden in Islam. The approach used in Islamic finan-cial system to examine the acceptability of anything that is unclear is to break the issues into their components and consider each within available Shari’ah guidance. In this section, instruments like stock index futures, stock option and warrants are reviewed in Islamic perspectives.

Stock Index Futures

The main purpose to use of stock index futures by equity investors is to fine-tune the risk–return profile of their portfolios. While commod-ity futures have a long history, the use of financial futures, such as stock index futures, have only become common in financial markets since the year 1980. Stock index futures are now a feature of all major stock mar-kets in the world. The contract permits investors to trade a dollar value of the stock index for future delivery. Some practical reasons settlement takes place in cash rather than physical delivery of all stocks compris-ing the index. Stock index futures provide investors with the means by which they can protect themselves from market fluctuations. It is a good hedging device for diversified stock market investors as futures prices are typically highly correlated with the underlying market (Jones 1996). To hedge risk, investors must take such position that profits and losses in the stock index futures offset changes in the value of their underlying stock portfolio.

In an Islamic stock market, the potential to use stock index futures depends first on whether the concept of future delivery of a commodity is an acceptable practice. Islam does not forbid an agreement to sell a

142 a. hassan and s. mollah

commodity in the future, although there are restrictions on how it is to be done (Kamali 2005). For an example, the contract of Istisna provides for an agreement to manufacture a commodity where both delivery and payment will be in the future. It is a requirement that a clearly defined commodity is specified in the contract. It is unlikely that a stock index future would meet these requirements because a dollar value of an index is unlikely to be regarded as a clearly defined commodity. Without a clearly defined commodity, the ability to physically deliver anything is in doubt. The end result of a modern stock index future is an exchange of cash representing the difference between the opening and closing price of the contract on the day of maturity.

Islamic economist Chapra dismisses all forms of modern futures contracts. He argues that futures contracts typically do not result in an exchange of title of the underlying commodity. However, a typical com-modity future does allow for exchange of title. His argument is based on the fact that users of futures may choose to close out their positions prior to maturity. The question then arises whether the fact that hedgers do not wish to take delivery of a commodity invalidates the use of futures. The clearest guidance we have is from the OIC Islamic Fiqh Academy which ruled that “trading in the futures market where the contract con-cludes on a converse contract sale resulting in a settlement based on the difference in price is not permissible.” An additional problem with regard to stock index futures is the ability of hedgers to shift price risks to speculators. In general term, this implies that futures depend on spec-ulation and may not be acceptable practice in Islam.

While hedging with futures is done to protect a position in the cash market, the ability to achieve this depends to some extent on the involvement of speculators. Speculators buy and sell futures to make a profit without necessarily having any involvement in the cash market. Speculators are regarded as essential in conventional futures markets because they assume the risk of price fluctuation that hedgers are try-ing to avoid. They also contribute to the liquidity of the futures mar-ket, and over time, their involvement reduces the volatility of the market. However, speculation alone does not rule out the use of futures. For example, trading in common stocks may be for speculative reasons, but that does not invalidate stocks as an Islamic financial instrument. What is necessary is to eliminate speculation. However, if we eliminate specu-lation from stock index futures in an Islamic stock market, the result is a

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 143

contract that hedgers would find difficult to use. In view of this, interac-tion of speculators and hedgers would be missing from the market.

Let us now consider whether hedging, as described above, is a legiti-mate form of activity in Islam. The problem has two dimensions. First is the observation that hedging is a form of insurance. Islam places severe restrictions on using modern forms of life and general insurance. The problem with Western conventional forms of insurance is that they con-tain elements of Riba and contractually the rights of the insured party are not as clearly defined as those of the insurer. Hedging in an Islamic stock market may be acceptable (Al-Suwailem 2006) provided both the buyer and seller of the stock index future are fully aware of the position they are in and are not attempting to speculate. The motive for hedging is the protection of an underlying investment. Hedging is just one of the risk minimization techniques used by investors. For example, investors hold diversified portfolios of stocks to eliminate a significant element of risk associated with holding single stocks or undiversified portfolios.

In summary, the argument for the use of stock index futures rests on their legitimate use as hedging techniques. The fact that the contract is capable of being used by speculators does not invalidate its use. The big-gest stumbling block is the technical nature of the settlement process. Commodity futures, where an exchange of title to a commodity can take place, would not present a problem in this respect. However, Western conventional stock index futures typically involve cash settlement and are therefore not acceptable by the Islamic scholar. Changing the settlement process to involve the delivery of the basket of stocks that comprise the index would conform to Shari’ah. While this creates a somewhat cum-bersome process, it is not impossible to create such a contract. An exam-ple of stock index futures such as the Dow Jones Islamic Index fund traded on the New York Stock Exchange involved physical delivery of stock.

Stock Options

Stock options (also known as equity options) are yet another area of complexity when considering in an Islamic stock exchange. In the devel-oped financial markets, a wide variety of exchange-traded and over-the-counter (OTC) options are available to investors. Exchange-traded options are standardized contracts traded on a derivatives exchange,

144 a. hassan and s. mollah

while OTC options are individual contracts negotiated with financial institutions.

In this section, we will deal only with exchange-traded stock options as the terms of OTC options are flexible. Exchange-traded options are relatively straightforward contracts and are sufficient to explore the issues from an Islamic perspective (Al-Amine 2005). A stock option provides the right to buy or sell the stock of a particular company at a specified price over a particular period of time. The holder of an option has the right, but not the obligation, to buy, or sell, the stock, whereas the seller of an option must sell, or buy, if the holder decides to exercise.

We will now explore why investors use stock options with the objec-tive of determining whether their use is justified in an Islamic stock mar-ket. A simple strategy is to buy a call option on a company’s shares. The investor in a call option can control a claim on the underlying stock for the life of the option. The cost will be the premium paid which is sub-stantially less than the cost of buying the stock. The buyer anticipates the stock will rise in price providing a profit on the option. However, if the stock price remains unchanged, or falls, the maximum loss is known in advance, i.e. the loss is the premium paid. It is clear from this example that a call buyer anticipates the stock price will rise while the seller of the call expects the price to remain unchanged or to fall. Such a simple call option strategy is extremely difficult to justify from an Islamic perspec-tive. If both the buyer and writer of the call do not hold the underly-ing stock, nor have any intention to hold it, their involvement is purely speculative. Their trading options are for the purposes of making returns from price movements. However, if the writer of the call option holds the underlying stock, a simple hedging strategy is being followed. The premium received provides some protection against a drop in price of the stock. The writer would of course have to be very confident that the price would not rise because unlimited losses could arise. There are, however, a variety of more complex hedging strategies that would pro-vide the hedger with better protection.

On the other hand, the buyer of a put is anticipating a fall in the stock price resulting in a profit on the transaction. The seller of a put option has an opposing view. Again the transaction appears as pure specula-tion, particularly if both parties have no involvement in the underlying stock. However, the purchaser of a put may be a hedger if the underly-ing stock is held in his or her portfolio. The investor buys the stock and

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 145

simultaneously buys a put written on the stock. The strategy provides a form of insurance against a drop in the price as the investor is able to sell the stock at a price higher than the market price.

When options are used as a hedging tool, it is difficult to justify their use in an Islamic context. The problem is essentially the same as with stock index futures where settlement is by exchange of cash. Stock options do provide for the delivery of shares at the exercise date, but in practice this is rarely done. The 7th Council of the OIC Islamic Fiqh Academy have considered traded options as part of the review of new financial instruments (JIBF 1994). Since options appear to have cre-ated many problems of interpretation therefore, it is not clear from the reports of the OIC Islamic Fiqh Academy whether they are regarded as permissible or not. The weakness of the case for stock options is that they are not issued as part of any underlying transaction, or even as part of a capital raising by the company concerned. Instead, they are issued by an options exchange to provide investors with the means by which they can speculate and hedge price movements in the underlying stock.

However, Elgari (1994) defends stock options as Islamically accept-able provided the seller of a call, and the buyer of a put, holds the under-lying stock. He also recommends standardized European-style options that can only be exercised at expiration, to reduce flexibility and hence the potential for speculation.

Warrants

Warrants are a particular type of call option issued by corporations giving holders the right to subscribe for new shares in the issuer. While war-rants are essentially call options, the characteristics are quite distinct from options on stocks. Warrants are typically much longer term than equity options. Underlying a warrant is the potential for the holder to become an equity investor in the issuing company at some future date. Warrants are not normally issued as a separate exercise, but are offered as part of a larger financing package. Investors, therefore, have the potential to par-ticipate in the growth of the company without actually being a share-holder. The attraction of warrants to issuing companies is that they are able to issue other forms of securities at a lower cost by attaching the warrants as part of the package. According to New Horizon Magazine published from, London, we give an example of the issue of warrants on

146 a. hassan and s. mollah

new shares in Petronas Dagangan Berhad as a part of an Islamic financ-ing package. The company concerned typically issues warrants as part of an underlying financing package. In the case of the Petronas warrants, the underlying transaction was an Islamic finance contract. This provides reassurance that the warrants are a permissible form of security.

11.5 conclUsIon

Very few Shari’ah-compliant derivative instruments have been developed to date; essentially none with universal acceptance. The task of develop-ing is assumed to be monumental, intellectually and financially, given the numerous applicable Shari’ah prohibitions and the widespread scepticism of Shari’ah scholars and investors. However, the International Swaps and Derivatives Association (ISDA) has established a committee for the development of Shari’ah-compliant derivatives, which should assist in the development of this aspect of the markets.

In this paper, we have discussed that the development of Shari’ah-compliant capital markets instruments which in its modern incarnation began in approximately 2002, and since then, it has been continuously expanded. Conventional financial institutions and its instruments such as shares, bonds, futures, options and swaps create problems when they are utilized in an Islamic economy. The reason stems from a lack of clear Shari’ah guidance on their acceptability. Therefore, IFIs need to adopt Shari’ah-compliant instruments as well appropriate techniques to manage risk of various kinds, particularly market and currency risk in order to compete with their conventional counterparts. We have reviewed stock index futures (financial futures), stock options and warrant to see where these instruments create obstacle in the way of finding Islamic alterna-tives within Islamic capital market activities.

Many difficulties are envisaged, particularly relating to speculation or contracts that have potential for speculative trading. There are also a number of technical problems relating to contracts that do not unequiv-ocally involve the purchase and sale of a stock at a clearly defined price. Some of the issues discussed and imply that an Islamic stock market as a part of Islamic capital market activity is likely to be a very different institution when compared with conventional stock markets. It is likely that any developments towards a separate market will involve a gradual introduction of Islamic contracts and practices. While we must accept

11 FINANCIAL FUTUrES, STOCK OPTIONS AND WArrANTS … 147

that speculation and related activity has to be contained, it is not incon-ceivable that stock index futures, stock options, warrants, contracts, etc., can be restructured to overcome the technical problems that at present inhibit their use.

references

Al-Amine, M. A. M. (2005). Commodity Derivaties: An Islamic Analysis. In M. Iqbal & T. Khan (Eds.), Financial Engineering and Islamic Contacts. Hampshire: Palgrave Macmillan.

Al-Suwailem, S. (2006). Hedging in Islamic Finance (Occasional Paper No. 10). Jeddah: IrTI-IDB.

Elgari, M. (1994). Towards an Islamic Stock Market. New Horizon, 32, 4–7.Hull, J. C. (1995). Introduction to Futures and Options Markets. Upper Saddle

river, NJ and Hertfordshire: Prentice Hall International.JIBF. (1994). Editorial: Latest Islamic Fiqh Academy rulings on Finance.

Journal of Islamic Banking and Finance, 11(2), 58–61.Jones, C. P. (1996). Investments: Analysis and Management (5th ed.). New York:

Wiley.Kamali, M. H. (2005). Fiqhi Issue in Commodity Futures. In M. Iqbal & T.

Khan (Eds.), Financial Engineering and Islamic Contacts. Hampshire: Palgrave Macmillan.

robertson, H. (1933). Aspects of the Rise of Economic Individualism. Cambridge: Cambridge University Press.

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Islamic microfinance programmes are used as an instrument to fighting poverty. Women are precisely targeted by Islamic microfinance under the rural development scheme of Islamic banks which provide interest-free loans to both men and women groups. The scheme has numerous ben-efits since women capitalize largely in their households. The main aim of this chapter is twofold: firstly, it needs to check or disprove a posi-tive relationship between Islamic microfinance and the socio-economic welfare of women and secondly, to explore the perspective in which Islamic microfinance packages function and the system of their perfor-mance can be enhanced. Based on a structured questionnaire survey, the study addressed two questions: (1) What should be anticipated from the programme of Islamic microfinance on the well-being of beneficiaries? (2) Under what circumstances would such a programme be more use-ful? The main result of this study shows that growth in women’s revenue and resources played an important role in improving women’s financial freedom and sense of self-possession. A significant policy endorsement in chapter is that it is essential to redirect Islamic microfinance to spread in the developmental activities which will drive to contribute towards the well-being of the recipients in the long run.

CHAPTEr 12

Small Solutions: Poverty Alleviation Through Islamic Microfinance

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_12

150 a. hassan and s. mollah

12.1 IntrodUctIon

Possibly the greatest benefit of economic progress of women in deprived society is possible through the self-employment with the creation of small and microentrepreneurship against the wage-based employment. The task here is thus to advance the entrepreneurship besides generat-ing enough productive employment generation and income prospects for the deprived people. The financing through banking system and entre-preneurship development are the two main agents in the route of eco-nomic development. Islami Bank Bangladesh Limited (IBBL) involves in promoting Islamic microfinance and women entrepreneurship through its rural development scheme (rDS) which was started in 1995 in Bangladesh. More than 30% of people in Bangladesh live with poverty. Presently, the scheme is being implemented in 60 districts of the coun-try and some 0.52 million group members are involved in this scheme (rahman and Ahmad 2004). So far, the performance of rDS has been remarkable compared over the long period and across other mainstream foremost microfinance institutions (MFIs) that have been operating in Bangladesh. The Islamic microfinance under rDS has used a very effec-tive model for eliminating poverty, the Grameen Bank model. But with Islamic social perspective of Muslim society of Bangladesh like Grameen Bank model, it has boarded on enablement of women with 80% of its clienteles being economically poor women. However, Islamic microfi-nance has endeavoured in the Shari’ah compliant manner that endorses family integration and cohesiveness. Also this scheme has endeavoured to encourage the healthy social practices by ensuring the participation of all members in the group activities.

Plan of operational adjustment guidelines of World Bank shows mixed impresses on the well-being of women. Also, socio-economic context during last 2–3 decades imposed huge number of restrictions on wom-en’s occupation and can occasionally reduce their socio-economic stand-ing, and compel them to intersect in the labour marketplace under severe conditions. Given the rise of awareness on Islam in Bangladeshi political discourse and social life, the role of women in the society in the light of Islamic principles is gradually recognized. Therefore, par-ticipation of women in economic activities is appeared as a dominant attention in the socio-economic development. In this situation, Islamic microfinance is used by Islami Bank Bangladesh and some other Islamic

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 151

non-government organizations to promote entrepreneurship as an instrument to eliminate poverty.

Here are some explanations that the women forces are explicitly tar-geted by several microfinance packages in Bangladesh. Some studies submit that involvement of women in microfinance programmes has a multiplier outcome since women devote mostly at their households (Akter 2001). The rDS of IBBL came out with a scientific Shari’ah-based programme with an objective of economic empowerment of women in particular and rural people in general, to alleviate poverty by providing credit for financing their investment in farm and non-farm activities and thereby raising level of income. This programme is charac-terized by different distinctive features, techniques and mechanism. This chapter will provide insights into well-being of women, achieved through Islamic microfinance programme for future policy and programmes to be undertaken for the betterment of rural development scheme (rDS) of Islami Bank Bangladesh Limited before it goes for further expansion.

Brief Introduction of Islamic Microfinance Programme: RDS

The rural development scheme (rDS)—a popular Islamic microfinance programme implemented under the umbrella of Islami Bank Bangladesh Limited (IBBL)—provides the investment requirements of the rural sec-tor, especially for agriculture to generate opportunity for employment opportunity and to raise income of village people in order to eliminate poverty. All branches of the Islami Bank Bangladesh Limited are directed by its authority to finance their deposits at their respective zones and spe-cifically for the economic uplifting of the people in the rural areas.

The main purposes of rDS as cited in the Annual report 2013 of the Islami Bank Bangladesh Limited are:

• To provide investment facilities to agrarian, rural farming and off-farming activities in the rural areas.

• To provide finance for self-employment and income-generating events of the village people, particularly for the unemployed of rural youths and the rural poor.

• To lighten rural poverty through integrated rural development approach.

152 a. hassan and s. mollah

• To spread investment facilities for hand tube wells and rural hous-ing, keeping in view the needs of safe drinking water and housing facilities of the rural dwellers.

• To deliver education and Medicare services to the people of down-trodden society.

The Islami Bank Bangladesh Limited (IBBL) is one of the biggest Islamic microfinance providers in Bangladesh. It provides Islamic microfinance facilities by its rural development scheme (Ahmad 2011). Through it rDS, Islami Bank Bangladesh Limited has designed a Shari’ah compliant model of poverty alleviation through rDS ensuing the group loan and participation management technique. In the target group or cluster comprises needy women and economically vulnera-ble poor people, a family with 0.50 acres of property either possessed or hired for farming or the families involved in a small off-farm activity within rural areas. Pattern of microcredit cluster creation and associated activities is identical as that of the Grameen model (a pioneer microfi-nance bank) in Bangladesh. Groups are homogenous and self-motivated. Members of a microfinance form homogenous group, and they elect 4–5 members in their management committee. The first and foremost con-dition is that the members essentially bear an excellent character with promising to the principle and wisdom of Islam.

Shari’ah Compliance Financial Plan of RDS and Growth

rDS is poverty alleviation scheme of Islami Bank Bangladesh Limited which has its own Shari’ah department and has a strong Shari’ah board comprising renowned Islamic scholars of Bangladesh. Also, there is a national Shari’ah supervisory board for all the Islamic banks operating in Bangladesh and this board monitors the investment and other activities of rDS (rahman and Ahmad 2004). Therefore, the official documents of Islami Bank Bangladesh Limited claim that all the products of the rDS comply with Shari’ah (Annual report of IBBL 2013). Under rDS, three types of funding are provided to the beneficiaries:

(a) Collateral-free microfinance up to Bangladesh Taka (BDTK) 50,000 to the poor in diverse income making activities;

(b) Microenterprise finance, i.e. collateralized finance up to BDTK 300,000 to the graduated and other microclients;

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 153

(c) Benevolent loan (Qard-hasan programme) up to BDTK 10,000 to the hardcore poor and distressed people for water, sanitation and rehabilitation.

Under the scheme of rDS, there is no collateral required for the flag-ship programme for the poor. A member can request for financing which may be considered within eight weeks after the date of her or his enrolment as a member of the group. A qualified member is entitled to obtain initial financing to the tune of BDTK 10,000.00 (US$145.00). The upper limit for financing under the scheme is BDTK 50,000.00 (US$725.00). The total debt (principal amount plus profit) is needed to be cleared by the client over a one-year period in forty-four equal weekly instalments.

Each and every member of Islamic microfinance groups under the rural development schemes (rDS) is required to save weekly at least Bangladesh Taka (BDTK) 20.00 (US$0.30) in their savings account at the Islami Bank Bangladesh Limited. The branches of Islami Bank Bangladesh Limited have the responsibility to implement the scheme. Investment in specified sectors is made in four modes, BaiMuajjal, BaiMurabahah, Bai Salam and Hire Purchase under SherakatulMelk, or Ijarah (Leasing). Parent organization Islami Bank Bangladesh Limited gives a profit of 12.50 (increased from 10.00%) on the investment. Well-timed refund is encouraged by offering 2.50% discount. Each group member needs to contribute BDTK 2.00 per week at the centre fund. Instalment is fixed on weekly basis as mentioned above. The Field Officers make collections of the instalments, personal savings and centre fund, etc., in the weekly centre gatherings. As on 2013, there are 2499 Field Officers who are trained by the Islami Bank Bangladesh Limited at their headquarters. These field officers are engaged in supervision of the Islamic microfinance programme. This rDS programme has been started to implement by the branches of Islami Bank Bangladesh Limited all over the country since 1995. Under this scheme, as on November 30, 2014, an investment of BDTK 98,259.07 million has been made to 569,426 people of which 80 per cent women and 20 per cent men through 242 branches in 17,488 villages in 64 districts of the country. recovery rate is 97.10% (outstanding was BDTK 16,462.20 million). This indicates that within a decade of time, Islamic microfinance pro-gramme under Islami Bank Bangladesh Limited covers 69% villages in Bangladesh (Table 12.1).

154 a. hassan and s. mollah

In this chapter, two main questions are addressed:

1. What is the expectation from the offer of Islamic microfinance pro-gramme on the welfare of beneficiaries?

2. Under what circumstances would such an offer be more useful?

rest of the paper is structured as follows. Section 12.2 presents a brief literature review. In Sect. 12.3, choices of variables of the study have been mentioned. Section 12.4 discusses methodology and data collec-tion of the study. Section 12.5 offers empirical results. Section 12.6 dis-cusses about the financial and social development of the beneficiaries. The ensuring Sect. 12.7 provides analysis of the microfinance experts’ opinion which is followed by conclusion and policy recommendations in Sect. 12.8.

12.2 lIteratUre revIeW

Emerging economies are rare possessors of significant economic means for women which mark them very destitute when facing financial cri-sis. In this regard, a few studies indicate that for the economically poor, the lack of fiscal resources is a vast limitation in undertaking eco-nomic events therefore is desired to apply the theory of “added worker effects” (Cerrutti 2000) by engaging women to produce extra income. On the other hand, the pressure put by economic conditions has led to the preponderance of the national “labour” policy over the traditional “gender” policy in the developing countries. Moreover, today majority of the Islamic scholars tend to say that women’s work does not contra-dict the traditional Islamic ethics as it is a prolongation of their role as mothers providing the basic needs of their families. In this situation, the

Table 12.1 Growing of Islamic microfinance programme: rDS

Source Annual report 2013, IBBL

Year 2008 2009 2010 2011 2012 2013

No. of villages 10,676 10,751 11,482 12,857 15,507 17,401No. of centres 21,193 22,261 20,833 22,206 24,623 27,800No. of beneficiaries 577,740 492,475 523,941 608,703 733,520 897,000No. of investment clients 321,848 312,036 319,859 382,319 474,766 584,000

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 155

application of microfinance is an instrument used in developing econo-mies to alleviate poverty on one side and to correct market disappoint-ments on another side (Khandker et al. 1995) which is a suitable scheme to engage women in income-generating activities.

Microfinance plays a significant role in improving the well-being of very poor families where savings are expensive because of their small income and high consumption (Ahmad 2007). Moreover, the idea of empowerment is vital in the foundation of the deal of microfinance to women. It inspires the capability of women to adopt new eco-nomic initiatives. In respect of “poverty combat,” this terminology is demarcated as the procedure of offering more economic power to the financially poor irrespective of age, sex, ethnicity in order to give them advantage from the benefit of development (Jahur and Quadir 2010).

In Bangladesh, microfinance programmes are reinforced by different non-governmental organizations and groups of specialists, each exe-cuting according to their own creed. Firstly, the proponents argue that microfinance places people in the sentiment of the route of development as well as policy expansion. Secondly, defenders of women rights believe that Islamic microfinance allows women since it endorses progress while focusing on eradicating gender discernment. Thirdly, the policy and approach of the poverty reduction encourage to adopt the microfinance programme because it allows the poor to make them financially inde-pendent and less susceptible when facing financial crises. Fourthly, the microfinance programme is supported by the economic experts since it encourages the growth of the less advanced area and less privileged clus-ter of folks within the society and encouraging economic development over the lengthy term.

The microfinance research activities have revealed that the useful-ness of Microfinance in alleviating poverty depends on the level pene-tration of Microfinance institutions in clients’ demands. The necessity to emphasis on demand-driven financial services persuades them to take optimum benefit from development-oriented suitable products and ser-vices with operation efficiency and more outreach enhancement. For example, the space of lending facilities presented to the poor people should address not only for production- and income-oriented activities but also for other needs such as education, health care, water and other social requirements. Subsequently improved financing products will pro-duce superior financial benefits for economically poor customers and

156 a. hassan and s. mollah

eventually greater effect to the society, predominantly the poor people (Seibel and Parhusip 1998; Zeller and Meyer 2002).

There is literature on microfinance which is focusing on develop-mental issues. The microfinance institutions (MFIs) are principally pre-pared to deliver social welfare objective with specific goal of poverty alleviation and to provide benefit to the beneficiaries. Studies in this area emphasis on the involvement of women and its emerging effect in terms of poverty eradication. Further some experimental studies, typi-cally from Bangladesh, offer suggestions on the welfare and endowing effects of microfinance on women (Kabeer 2001; Lakwo 2006; Osmani 2007; Pitt et al. 2006). Brau and Woller (2004) gave a lucid example on some important development matters such as the involvement of microf-inance institutions (MFIs) in women’s deliverance and the varied impact of women’s contribution on MFI’s productivity. regarding the growing impact of women’s involvement, Brau and Woller’s (2004) study speci-fied with mention to gender contribution and borrower’s solvency and poverty eradication.

Islam, as a faith and a system of living, is grounded on a customary of religious dogmas and economic standards that also emphasize on the inclusive welfare of humankind, particularly for the distressed and eco-nomically poorer classes of the society. In combination with the spiritual vision and objective of well-being, Islamic microfinance appeared as a novel financial instrument and as different from mainstream microfi-nance. researchers in Islamic finance frequently claim that the religious dogmas in Islamic countries contrast mainstream microfinance that is why Shari’ah-based or Islamic microfinance is needed and clarified why it is booming (Ahmad 2007; Obaidullah and Khan 2008). Ahmad (2007) reveals that the importance of Islamic microfinance as a tool is to boost economic development, to respond the effects of economic uncertainty and empowering women in the society. It is true, once women, who used to stay at home and devote their time to multiplicative tasks, new openings of opportunities, may arise to them by linking income-produc-ing activities. Microfinance programme based on Islamic value is specif-ically significant for women since they should get interest-free loan to start some legitimate income making activity. In fact, financially weaker class women frequently lack the essential guarantees and pre-condition to get loan from an official lending institution. On the other hand, Islamic microfinance packages are increasingly aiming women due to the follow-ing reasons:

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 157

First, a cost-efficiency rationale since women’s repayment rates are higher than men;

Second, an equity reason since women have less access to fruitful occupation in the emerging countries; and

Third, because women devote basically in their children and families, stimulating a multiplier outcome that expands the usefulness of the capitals.

It is generally understood that Islamic microfinancing is a word that specifies “the deal of financial facilities to clients with small income levels without charging interest or riba” (Ahmad 2011). Thus, Islamic micro-financing targets people with very low-income group people, having no entrance to the official lending system. Saad and Duasa (2010) have come out with the characteristics of Islamic microfinance as follows:

(i) microfinance products could serve as guidelines to microfinance institution in designing Islamic microfinance products,

(ii) reasonable service charges, (iii) easy and speedy evaluations, (iv) flexibility in payment of arrears.

In addition to that, there are several initiatives taken to strengthen the Islamic microfinance institutions (Obaidullah and Khan 2008): (i) participate in equity of Islamic Financial Institutions with a view to create a specialized microfinance divisions; (ii) create qard al-hasan (interest-free loan) specific funds to support various interest-free-based microfinance institutions across the globe; (iii) create refinance facil-ity to act as a whole-seller of Islamic microfinance products for a chain of Islamic microfinance retailers; (iv) participate in equity of takaful (Islamic insurance) and re-takaful (Islamic reinsurance) companies with a view to develop microtakaful products and services; (v) design a Credit Guarantee Scheme (CGS) for Islamic microfinance providers; and (vi) promote dialogue among Shari’ah scholars for collective resolution of fiqhi issues related to microfinance. The implementation of microfinance should be based on concepts of human well-being (falah) and good life (hayattayyibah) that emphasis on the utmost importance of brotherhood and socio-economic justice. This in turn would require a balanced satis-faction of both the material and the spiritual needs of all human beings (Chapra 2002).

158 a. hassan and s. mollah

Not much the existing literature on Islamic microfinance does pro-vide empirical evidence in respect of the well-being of women through Islamic microfinance. Only recently, Ashraf et al. (2014) analyse how common socio-economic factors such as income, assets and health care may explain the socio-economic well-being of women who enrolled in microfinance. Also a few studies (Jahur 2010; Alamgir et al. 2010; rahman and Ahmad 2004) show that family income, productivity of harvests and livestock, spending and employment had enlarged signifi-cantly due to the effect of invested money through Islamic microfinance scheme like rDS.

However, there is lack of study on well-being and socio-economic empowering effects of Islamic microfinance on women. In other words, so far no study focused on the socio-economic well-being of women through Islamic microfinance, rDS, since more than 80% members or beneficiaries under the scheme are women. Therefore, study on the role Islamic microfinance (rDS) in eradicating poverty and socio-economic well-being of women will be more appropriate in the current situation.

12.3 IslamIc mIcrofInance model stUdy

Two different methods exist in measuring the effect of the microfinanc-ing (Cerrutti 2000): first, the “welfarist” method which highlights on progresses gathered by microfinance on the receivers’ well-being and second, the “institutionalist” method on the other hand printouts the practical/formal aspects of the application, namely the financial sustaina-bility and outreach of microfinance schemes (Chaves and Gonzalez-Vega 1996; Buckley 1997). The first method is more appealing to donors and researchers, while the second method is used to economically validate the use of the capitals dedicated to the Islamic microfinance schemes. The “welfarist” method is the one that may conceptually escort our own investigation work. Actually, two diverse styles exist to associate between microfinance and women’s empowerment (Hashemi et al. 1996).

This research represents a summative evaluation of Islamic microfi-nance business model under rDS of Islami Bank Bangladesh Limited, more explicitly—a socio-economic outcome study on women welfare following the methodology employed by Nader (2008). A study con-ducted by Khandker (1998) displays that, in spite of the significance of the assessment of microfinance packages in matter of their economic sustainability and outreach, such norms do not essentially echo the real

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 159

effect on the society and the recipients. Consequently, this study as well as the selection of the variables falls within the “welfarist” method in evaluating the effect of Islamic microfinance business model of Islami Bank Bangladesh Limited. The variables have been selected to signify the socio-economic welfare of women. These variables are: possession of assets, income, schooling of children, awareness about health care and the awareness of the harmony in the family. reasons for choosing the following variables are.

Income

It is a general perception that obtaining Islamic microfinance loan would increase the income of the recipients while enabling them to widen their activity and to increase the quantity of the goods they sell. The income outcome is predominantly significant in Bangladesh in the perspective of the eradication of poverty. It may be stated that more than 27% of the fam-ilies depend on the woman as the main source of revenue (Ahmad 2011).

Assets

The ownership of assets has been kept provision as a second variable since this variable echoes the sustainability outcome of Islamic microfi-nance. The growth in the revenue would not have a sustainable effect on women if the assets they hold should rise at the upper level. After appre-hension of bigger profit, it appears that women would one day discon-tinue reliant on the Islamic microfinance when sufficient capital would be accumulated, the credit/investment being accordingly used for culmina-tion of not for consumption and nevertheless for production.

Health

Health care is chosen because health problem is an acute problem in Bangladesh and threaten people’s productivity. So, health care is an important variable as a development indicator of the third-world coun-tries. This sector needed further improvement. As a result, Islamic microfinance should make it promising to women who may get better treatments and more health care. This is very important in the situation of Bangladesh since insurance and social security systems in Bangladesh are not much efficient.

160 a. hassan and s. mollah

Schooling of Children

The education of children is another most significant variable to meas-ure human progress of a country (Sinha 1998). Certainly, this variable echoes the greatest outcome of Islamic microfinance, that of the mul-tiplier outcome, when the effects of a simple lending are provided over many generations. This is mostly stimulating since the struggle against illiteracy is one of the priority agendas of Bangladesh government for some years. Governmental movements and programmes are set up to inspire parents to send their children to the school. If the proposal to provide interest-free loan influences the schooling of the children of the beneficiaries, then the resources of the government and efforts might be transmitted towards other purposes. Furthermore, the education of girls is particularly significant in the circumstances of Bangladesh where boys frequently come first.

Family Harmony

The understanding of harmony in the family is selected as a fifth variable of the research. The harmony in the family means the degree to which all the members of a family are living tranquilly without facing any major problems and worrying events. While this variable has not been largely considered in the past research, it is revealed that the “harmony” is well considered by Islamic microfinance, if it could decline the household problems by enlightening the financial situation of the family.

12.4 methodoloGy of the stUdy

In this chapter, the research hypothesis we will test is that Islamic micro-finance (rDS) is confidently associated with the socio-economic welfare of women in Bangladesh with regard to: children’s schooling, income, health and harmony in the family and possession of assets. The meth-odology is used mostly by regression analysis and doing correlation of cross-sectional data. A few other inquiries are comprised in the inter-views to reflect the details regarding the happiness of the women vis a vis Islamic microfinance. Also, interviews are conducted with the Field Officers of Islamic microfinance programme managed by Islami Bank Bangladesh Limited and with Islamic microfinance specialists/experts in Bangladesh. Main purpose is to offer a qualitative dimension to the

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 161

investigation and to support the explanation of the outcome or results. This will provide the response to the second question relating to the operation of Islamic microfinance scheme and offer policy recommen-dations. It would, therefore, be of immense importance to examine the poverty and socio-economic welfare of women and their household by executing rDS—a prominent Islamic microfinance model in Bangladesh.

Sampling

This study aims at authenticating the relation between Islamic microfinance and the socio-economic welfare of recipients, and the unit of investigation—the women are benefitted from a Shari’ah compliant investment. In a domain of plentiful resources, a big-ger sample might have been selected. However, means and time for completion of conducting survey of this study were limited, and the sample totalled 700 women, customers of our sample Islamic microf-inance programme. This study is the effect of the programme or pol-icy and links the observed changes of the programme which may be called “treatment group” in terms of statistical analysis (Sinha 1998). In our case, we use the women who are benefitted from Islamic microfinance (i.e. rDS) as the treatment group and the women who are not benefitted from Islamic microfinance (i.e. rDS) as control group. Subsequently, finding women within the society with same class of likenesses is difficult; in this study, the sample was separated equally into two groups following the same method employed by Nader (2008):

Group 1 (treatment group or experimental): comprising 350 women benefited from Islamic microfinance programme for at least 3 years to ensure that it got minimum time to have effect on their lives.

Group II (comparison group): covering 350 women those who have recently joined the Islamic microfinance programme in order to make confirm that they have wished likenesses with the treatment group not being immediately profited by Islamic microfinance pro-gramme (rDS). The treatment and control group could ideally vary only by the point that one group received the credit and the other group did not or just get the credit. Any observed changes might then, for some reasons, be mostly attributed to Islamic microfinance programme.

162 a. hassan and s. mollah

The sample of participants was selected through the Field Officers of Islamic microfinance programme (rDS) by means of the Islamic micro-finance programme database of 7500 customers. The search and enrol-ment were operated by the Islami Bank Field Officers with concealment. Also, five key microfinance specialists were interviewed; out of them two were university professors and three microfinance officers who were from other microfinance organizations.

Data Collection

By following the same methodology as adopted by the study of Nader (2008), data have been collected by the ensuing process:

1. Verifying the programme documents and archives to collect infor-mation about membership rules, mechanisms and running.

2. One-to-one interviews carried out with members employing open-ended and closed-ended survey questionnaires. The sur-vey questionnaires were tested to confirm their transparency and understanding skills by the members who came from very poor background and have different literacy stages.

The researcher meets with key specialists of the microfinance area, spe-cifically with university professors who conducted academic study in the microfinance area and Microcredit Officers of Grameen Bank. Limitations of this study include the fact that some women were unwill-ing to response some of the queries regarding their education and income levels. Details and clarification of the purpose of this study moti-vated them more keen to cooperate. Also, if women believed that giv-ing constructive comments about the programme may increase their likelihoods of receiving more credits, the study would be prejudiced. To overcome this, a detailed demonstration about the nature or type of the study facilitated the target group of our sample helped to clear under-standing and reduced the mistake. Also the recklessness ratio of the Islamic microfinance programme would have signified a limitation of the investigation subsequently it would have caused in a variance between the profiles of the two groups and made them unhealthy for comparison. However, the fact is that this rate remained very small and made irrele-vant this risk.

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 163

Regression Equation and Statistical Test

Most of the previous studies aimed at examining the impact of conven-tional microfinance on the socio-economic welfare of the recipients have used simple quantitative methods in the form of regression analyses and correlation test where the indicators of welfare signified the dependent variables (El solh 1999; Doumato and Posusney 2003). In this study, firstly the correlation is made in order to investigate the existence of rela-tions between the Islamic microfinance and selected dependent variables and to show the possible size effect. Secondly, the regressions are done in order to exam the causality and importance of such relations. It may be pointed out that because the sample of this study is relatively small, simplification should be avoided. However, given that a few studies have previously measured the effect of Islamic microfinance packages on recip-ients, our expectation is to shed some focus on the following research questions:

• What is to be anticipated from the Islamic microfinance model in Bangladesh on the well-being of beneficiaries?

• Under what circumstances will such offer add extra benefit?

To reply these research questions, on the one hand, recipients of Islamic microfinance were questioned a varied kind of queries like: what is purpose of availing Islamic microfinance, what type of small activity or entrepreneurship is operated by them, how much they earn of that activity/entrepreneurship, do they have another source of earnings. The purpose of the questions was to distinguish it from the money they earn from Islamic microfinance-linked entrepreneurship. Also, the benefi-ciaries were questioned about the properties or asset they held and the method of use the money they earn, i.e. whether for buying or invest-ment of new assets or they use the earnings for consumption purposes.

On the other hand, the participants were asked to state about the number of their children going to the school and why other did not. The beneficiaries were also inquired about their health conditions and were asked to rank or level their healthiness status. In case, if they were receiving any treatments, then in what way they met expenditure in such treatments. The purpose of asking these questions was to ascertain their views—whether Islamic microfinance helped to make their health improved. Also queries related to balance in family affairs with husband

164 a. hassan and s. mollah

and sons have been addressed by requesting the beneficiaries to rank in the respect of “stability or lack of problems.” Further, the beneficiar-ies were requested to answer whether the income from Islamic microfi-nance helped them in making the relations within their families—added steady and harmonious. They were lastly asked to offer any comments or suggestions they desired to make in respect of the above-mentioned subjects or any supplementary Islamic microfinance/conventional micro-finance-related issue.

Further, microfinance specialists were requested to give their opinion or assessment about the efficiency of Islamic microfinance programmes in Bangladesh in terms of planning, outreach and operation; and effect on both microfinance recipients and in the economy.

The regression equations have been replicated from Nader (2008) as follows:

1. Income = A1 + B1 Islamic microfinance + C1 age + D1 educa-tion + F1 marital status + G1 number of children + e1.

2. Assets = A2 + B2 Islamic microfinance + C2 age + D2 educa-tion + F2 marital status + G2 number of children + e2.

3. Schooling of girls = A3 + B3 Islamic microfinance + C3 age + D3 education + F3 marital status + G3 number of children + e3.

4. Schooling of boys = A4 + B4 Islamic microfinance + C4 age + D4 education + F4 marital status + G4 number of children + e4.

5. Perception of health = A5 +B5 Islamic microfinance + C5 age + D5 education + F5 marital status + G5 number of children + e5.

6. Observation of the harmony in household = A6 + B6 Islamic microfinance + C6 age + D6 education + F6 marital status + G6 number of children + e6 where Islamic microfinance used the inde-pendent variable in recently since 3 years. The designated control variables were education, age, married status and children.

12.5 emPIrIcal resUlts

The results show (Tables 12.2a, b and 12.3) that Islamic microfinance has been positively linked to the income (r = 0.737), assets (r = 0.267), education of girls (r = 0.382) and the education of boys (r = 0.405). But the correlation is not statistically noteworthy between Islamic microfi-nance and the awareness of health, and the awareness of the harmony

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 165

Tab

le 1

2.2a

r

esul

ts o

f cor

rela

tion

*, *

* in

dica

tes

5%, a

nd 1

% le

vels

of s

igni

fican

ce r

espe

ctiv

ely

Age

Nos

. of c

hild

ren

Inco

me

of th

e m

embe

rsA

ssets

Hea

lth

Har

mon

y w

ithi

n th

e fa

mily

Age

10.

472*

*0.

014

−0.

011

−0.

395*

*−

0.14

6N

os. o

f chi

ldre

n0.

472*

*1

0.23

2*−

0.25

1*−

295*

*0.

028

Inco

me

of t

he

mem

bers

0.01

40.

232*

10.

454*

*−

0.05

60.

227*

Ass

ets

−0.

011

0.25

1*0.

454*

*1

0.06

80.

214*

Hea

lth−

0.39

3**

−0.

295*

*0.

066

10.

366*

*H

arm

ony

with

in

the

fam

ily−

0.14

60.

028

−0.

056

0214

*0.

366*

*1

Isla

mic

m

icro

finan

ce0.

000

0.17

20.

737*

*0.

267*

*−

0.03

30.

123

Gir

ls’ s

choo

ling

−0.

020

−0.

058

0.20

80.

232*

0.01

80.

014

Boy

s’ s

choo

ling

−0.

042

0.01

90.

371*

*0.

228*

−0.

.098

0.09

2E

duca

tion

−0.

306*

*−

0.23

8*0.

510.

111

0.21

0*0.

149

Mar

tial s

tatu

s−

0.36

7**

0.06

80.

088

0.19

20.

186

0.57

8**

Sam

ple

(Tab

le 1

A +

1B)

700

700

700

700

700

700

166 a. hassan and s. mollah

Tab

le 1

2.2b

r

esul

ts o

f cor

rela

tion

*, *

* in

dica

tes

5%, a

nd 1

% le

vels

of s

igni

fican

ce r

espe

ctiv

ely

Isla

mic

mic

rofin

ance

Scho

olin

g of

gir

lsSc

hool

ing

of b

oys

Edu

cati

on w

omen

Mar

ital

stat

us

Age

0.00

0−

0.02

1−

0.04

4−

0.30

8**

0.36

5**

Num

ber

of c

hild

ren

0.17

2−

0.05

90.

019

−0.

238*

−0.

066

Inco

me

0.73

6**

0.20

80.

373*

*0.

051

−0.

088

Ass

ets

0.26

7**

0.23

20.

228*

0.11

1−

0.19

2H

ealth

−0.

032

0.01

8−

0097

0.21

0*−

0.18

8H

arm

ony

in t

he

fam

ily0.

121

0.01

40.

094

0.14

7−

0.57

8**

Isla

mic

mic

rofin

ance

10.

382*

*0.

405*

*0.

023

0.00

0Sc

hool

ing

of g

irls

0.38

2**

10.

164

0.15

50.

097

Scho

olin

g of

boy

s0.

405*

*0.

164

10.

064

−0.

136

Edu

catio

n0.

023

0.15

50.

066

1−

0.15

4M

artia

l sta

tus

0.00

0−

0.09

90.

152

0.15

21

Sam

ple

(Tab

le 1

A +

1B)

700

292

298

700

700

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 167

Tab

le 1

2.3

reg

ress

ion

anal

ysis

Coe

ffici

ent

Inco

me

Asse

tsH

ealt

hFa

mily

har

mon

yG

irls’

scho

olin

g (e

duca

tion

)B

oys’

scho

olin

g (e

duct

ion)

Age

0.03

7 (0

.023

)−

2.80

2 (−

2.89

)−

0.02

9 (−

2.17

1)0.

021

(1.3

69)

0.00

3 (0

.601

)0.

002

(0.2

15)

Isla

mic

m

icro

finan

ce20

40.4

99

(9.2

22)

4850

.699

(2.

281)

−0.

017

(−0.

015)

0.37

6 (1

.633

)0.

295

(3.5

88)

0.31

1 (4

.688

)

Edu

catio

n19

.666

(0.

456)

255.

225

(1.3

25)

0.22

1 (0

.777

)0.

227

(0.8

37)

0.10

7 (1

.192

)0.

055

(0.6

48)

Mar

ital s

tatu

s30

.901

(0.

955)

272.

137

(1.3

11)

0.26

3 (0

.855

)2.

399

(6.7

12)

−0.

083

(−0.

844)

0.11

8 (1

.198

)

Num

ber

of c

hild

ren

9.58

6 (1

.376

)99

.021

(2.

188)

−0.

095

(−1.

399)

−0.

059

(−0.

875)

−0.

021

(−0.

967)

−0.

008

(−0.

374)

Con

stan

t25

2.09

8 (2

.611

)10

33.2

12 (

2.83

4)7.

729

(12.

988)

5.50

2 (1

0.10

2)0.

334

(1.7

28)

0.36

4 (2

.178

)A

djus

ted

R2

0.55

10.

129

0.14

10.

331

0.13

20.

142

Stan

dard

err

or12

0.27

138

779.

5881

210

.093

211.

1476

20.

3417

0.34

175

F-sc

ore

24.3

793.

599

4.20

910

.811

3.48

93.

913

F-pr

obab

ility

0.00

00.

003

0.00

20.

000

0.00

60.

001

168 a. hassan and s. mollah

in the household. Also, these results are established by the regression coefficients.

The results further show that the “income” equation in matter of income of the recipient inclines to rise on average by BDTK (Bangladesh Taka) 2040.00 per month when taking the Islamic microfinance loan. As per survey results, the average income of women who did not obtain/newly receive Islamic microfinance loan was BDTK 4010.00. An increase of BDTK 2040.00 represents about 49% increase which gives evidence that Islamic microfinance has a significant economic outcome on the women getting the loan. In the “assets” side equation, getting Islamic microfinance loan is linked with an normal growth of assets of BDTK 4850.00 as compared to members who do not get advantage from Islamic microfinance loan. The equation of the “schooling of girls” is linked with an average rise of 29% in the number of girls undergo-ing school from each family when getting Islamic microfinance loan. Similarly, in the equation of “schooling of boys,” their schooling is linked with an average rise of 31% in each family when getting an Islamic microfinance loan. regarding the equation of the “perception of health,” it is observed that Islamic microfinance coefficient is not at the signifi-cant level, suggesting the lack of a relation between the two variables.

As regards the equation of the “perception of the harmony in the family,” the Islamic microfinance coefficient is not at the statistically sig-nificant level. The results suggest that there is lack of a significant rela-tion between the harmony in the household and the fact of getting Islamic microfinance loan.

While examining the effect of Islamic microfinance investment/loan on women’s well-being, we see some interesting results. In order to comprehend it, first of all, it is imperative to see how much of the change may be able to make intervention of these women’s lives. In the study, if we employ the Cohen’s benchmark for the economics field to interpret r of size effect estimation, we observe that the consequence of Islamic microfinance on income is huge while its influence on the school-ing of boys, girls and ownership of assets is average. When we person-ify the power of this measure of the effect of size by the proportion of variance clarified by squaring the correlation coefficients in assessing the affiliation in the context of the total variance, we see that Islamic microf-inance accounts for almost 54% of the variance on income. In the follow-ing sections, details of economic and social implication of these results are given. The outcomes are in fact enormously important and decisive,

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 169

which may be clarified in the light of the socio-economic setting in which Islamic microfinance is presented too, from which the women get benefit from Islamic microfinance when they avail it.

The interpretation of the results and its implications is as follows:

1. Income: Positively associated with Islamic microfinance loan and hypothesis confirmed in the results (Table 12.4).

The income effect is extremely bad when women availed private loans. At that time, women did not join Islamic microfinance and they were enforced to receive their dealers’ terms and condition, among which are the substandard goods, since the women would interrupt the pay-ment till after retailing. These are the cases of exploitation to the poor women by private loan suppliers or money lenders. One female member exposed through the interviews that she confronted severe difficulties in her vegetable selling business before her joining in the Islamic microfi-nance programme: “The private dealer was very harsh as I did not pos-sess adequate money; so he provided me only faulty goods of last stock. I do not have right to select the goods or vegetables so was forced me to take the rotten vegetables. If I do not take it, then I would be given nothing. As a result, I always had losses because of substandard goods I had to take from the suppliers. By becoming a member of the Islamic microfinance group (rDS), I do not face anymore extortion. So I can select what I want!” After availing Islamic microfinance, they can now pay dealers immediately receiving goods and henceforth do not neces-sarily need to face severe circumstances. The malicious circle is thus cracked with their capacity to make their own choices that would abso-lutely increase their yield as well as trade. There were some cases that

Table 12.4 Validation hypothesis

Variables Correlation with islamic microfinance

Regression coefficient of islamic microcredit

Hypothesis validation

Income 0.737** 2040.499 (9.222) ConfirmedAssets 0.267** 4850.699 (2.281) ConfirmedSchooling of boys 0.405** 0.311 (4.688) ConfirmedSchooling of girls 0.382** 0.295 (3.588) ConfirmedHealth perception −0.033 −0.017 (−0.015) rejectedHarmony in the family 0.123 0.376 (1.633) rejected

** indicates 1% level of significance

170 a. hassan and s. mollah

earlier, the women borrowed cash from their friends or their family and neighbours to pay their acquisitions of goods. Sometimes, some women got humiliation and as a result it leads to the feeling of worsening of their societal standing. One woman spoke to us in the interviews that: “My parents-in-law termed me useless and forced me to do their house-work since they loaned me the cash which was required for the buying the goods. Certainly, I paid them back.” Now self-confidence and self-re-liance are boosted after women joining the group and obtained Islamic microfinance loans. With this loan, the women increased their income and feel economically liberated. Also, the increase in revenue permits them to achieve basic requirements of consumption as well as meeting daily expenses that could not afford in the past. In view of this, it seems that Islamic microfinance programme has increased well-being of the woman members and definitely empowered them.

Another significant fact to note when speaking about income, one question asked to the women contributing in this research was con-nected to the kind of the project or the activity they started after getting Islamic microfinance loan from the group. The responses were separated into five types of activities, and the outcomes display that practically 50% of our sample women work in the retail trade of household objects such as bed sheets and homemade handicraft articles in a narrow geographic zone. Some of the women earned fewer incomes as they faced severe price race. Also, questions associated with the other roots of income of women were comprised in the survey. Therefore, we used these responses to try to distinguish what their motivation to avail Islamic microfinance loan was. Answer received of this question found that nearly about 79% of the women were monetarily unstable. They did not have other roots of income and therefore, suffer consequently, because of the husband’s unstable income from unstable occupation. Hence, the result displays that there was a shift of economic role. This was the role of supplementing the household income by a wife in the family.

2. Assets: Positively associated with Islamic microfinance and hypothe-sis confirmed in the results (Table 12.4).

The result of this hypothesis testing echoes a long-term improvement in the recipients’ welfare. This betterment is sustainable since the growth in their revenue is financed in the assets which they own. Nevertheless, one must notice that occasionally the growth arisen in households and

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 171

individual assets (like TV, computer and others) and did not increase in production. Also, some of the recipients spent all their revenue and proceed for consumption purposes. Some even did not understand how to capitalize their additional income in a project since they required the suitable talents. Indeed, one woman admitted during the survey inter-view that: “I categorically avail Islamic microfinance loan as children’s wants are limitless. A good sum of money is wanted for their day-to-day subsistence and wants; such as private tuition, schooling of children and girl’s marriage preparation when they reach the teen ager stage. I used to borrow money from family and friends in the past. But now I meet these expenditures from the income I earn from my micro- business which is adequate.” Another one woman believed: “No practical difference in the magnitude of my venture occurred after getting Islamic microfinance loan. But it simply facilitated me to have an extra liquidity for sufficient spending at home and on my children.”

3. Schooling of Children: Positively associated with Islamic microfi-nance and confirmed hypothesis in the result (Table 12.4).

The result of this test is the most interesting one of our study. The improvement in the schooling of children signifies a multiplier outcome of providing Islamic microfinance loan to women. During the interview, most of the women announced that the education of their children is the greatest significant investment which they make. This is their prec-edence since in their own life they did not get such an opportunity to get education during their young age. Therefore, they want to provide opportunity to their children to become educated. The participants also believe that their children can have a better future with better education. One woman whom I met, recently joined Islamic microfinance pro-gramme, has five sons and a girl. She stated during the interview: “My kids were not receiving any education because earlier my modest reve-nue did not permit to meet the expenditure. I felt very bad. After avail-ing Islamic microfinance loan, I would invest this money in education of my children.” Another one woman just replied when I requested her to say the cause which she was asking loan from Islamic microfinance. She immediately replied: “I will provide education for my children!” It may be noted here that the very vital result exposed by this study is correlated to the link between getting an Islamic microfinance loan and progress in schooling of the beneficiaries’ children, both boys and girls.

172 a. hassan and s. mollah

Furthermore, it shows that no major variance occurs between the rise in the improvement in schooling of girls and boys. This result is certainly encouraging in respect of education in general and human resources development in particular.

In this regard, also some women stated that an advanced level of edu-cation of the children is redirected by an advanced volume of private coaching needed in Bangladesh since private coaching became essential for good success at the school test. As stated earlier, the key stimulating result of this research was that there was no key difference among the coefficients of schooling for girls and boys, which have echoed a deep transformation in the community. In Bangladesh, conventionally a head of the household preferred the education of boys since girls would be married and take care of their husband and households, whereas the boys are engaged as only bread earner of their future family. However, trend is changing. Currently, guardians ponder that the education of both boys and girls is equally vital since learning will benefit girls to marry a “bet-ter” groom, henceforth a decent life, while boys want “job oriented” education and extra “practical” skill to secure a superior job. Also, this reflects the social and cultural dimension of the choices they make.

In summary above, results are mainly motivating in the circumstance of Bangladesh as the combat against illiteracy has been urgency on the government programme for some years now. In this respect, the govern-mental actions and packages are set up to inspire families to direct their children to the school. Consequently, the governmental resources and determinations could be transmitted towards some other purposes.

4. Health Awareness: No significant link with Islamic microfinance and hypothesis not confirmed in the result (Table 12.4).

This result shows that women take less care about their health. They give preference of education of the children, proving food to the fam-ily members and certain extravagance stuffs such as purchasing superior clothes, etc. Most of the women are brought up with a faith that they are in lower standard than men and ought to sacrifice themselves and attend their household fellows. The women contemplate that the expenses asso-ciated with their individual medical or health service run by government which is free but is normally not very competent due to secondary qual-ity of facilities offered.

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 173

5. Opinion About Harmony in the Family: Positively non-significant associated with Islamic microfinance and hypothesis rejected in the result (Table 12.4).

Actually to test this hypothesis needs a bigger sample to see that the hypothesis gets established or rejected, since minor effects need bigger samples to confirm. However, the objective of selection of this variable in the research was due to the greater situation in Bangladesh where it is in the latest preceding considered that women’s labour outdoor of the house was offensive and regarded that women’s key role is for caring their family members. In this regard, we desired to test in what way a variation in this role would upset the harmony of the family. This out-come could be one or the other reflected by growing encounters because of the disapproval of husband in the matter of the woman’s new role, or by increasing the family solidity as a consequence of the family income rise. responses were considerably expanded concerning this issue amid the women of our sample of study. Some of the women stated that Islamic microfinance programme endangered their family solidity since the husband disliked the activity of his wife, she was doing. Certainly, others believed that stiffness in the family diminished because of the enhanced economic situations they enjoyed. In this regard, another woman stated: “I desired to accept an income making activity to evade the difficulties and family disparities caused by for want of money,” while certain women thought that they possibly would not report any note-worthy change in that part.

12.6 fInancIal and socIal develoPment (harmony) amonG benefIcIarIes

The performance of Islamic microfinance has been quite promising. In our study, our results reveal that the performance of rural development scheme (rDS) of IBBL was better in terms of growth (12.50%), drop-out rate (5.00%) and operational efficiency as compared to three con-ventional leaders in microfinance; Grameen Bank, Association for Social Advancement (ASA) and Bangladesh rural Advancement Committee (BrAC). Having lower rate of return charged (10.00% with 2.50% rebate for on-time payment) than other microfinance (16.00–22.50% of interest), this offers advantage for the poor (Obaidullah 2008a).

174 a. hassan and s. mollah

The Islamic microfinance also offers active spiritual development pro-gramme with the purpose to improve members’ awareness of social right and responsibility in order to improve better relationship with others (Obaidullah 2008a), the programme which has not been provided by conventional microfinance.

Concerning the impacts of Islamic microfinance, based on the empiri-cal evidence of this study, it can be discussed in two areas: economic and social aspect. In general, it is expected that provision of financial access to poor people will enable them to increase their income and economic well-being, develop assets, decrease weaknesses and get involved in devel-opment. Also, the latest economic impact presented by empirical study of IBBL’s (Islami Bank Bangladesh Limited) impact on rural poverty finds that loans affected considerably in improving household earnings, output of harvest and cattle, disbursement and employment (Obaidullah 2008b; rahman and Ahmad 2004). In particular, based on the field survey of 1024 respondents, rahman and Ahmad (2004) found that the family income increased by more than 33%, the expenditure for health increases 50%, family employment increased from 1.91 to 2.1 working members, and all types of assets have also increased. Moreover, the impressive eco-nomic impact is based on the study of three Islamic microfinance institu-tions in Bangladesh explored by Ahmed (2002), as he finds the economic impacts in increasing: time spent on productive activities by beneficiar-ies and other family members output of economic activity, particularly in improving amount of goods/services, innovation of new product, increasing assets and other properties. In the line of our study, it reveals that these economic aspects might imply that Islamic microfinance has an advantage to offer, although it still has weaknesses to be overcome.

Social development or impacts might include improvement in Islamic knowledge and relationship with others, health. Our study found that the health awareness of the respondents increases in terms of increas-ing the number of people who consume quality drinking water and use quality latrine for sanitation. Besides, the clients also have positive opinions towards improvement in their skills and social and economic well-being. These findings are similar to the study of rahman and Ahmad (2004). Ahmed (2002) also reveals that beneficiaries of Islamic microfinance not only get financial advantages, but also improvement in other aspects through social development programmes: improvement in Islamic knowledge, improving relationship with spouses and other

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 175

group members. These two studies support our results, and it can be implied that Islamic microfinance has considered social aspects includ-ing family harmony, although more attention should be emphasized. In overall, on the basis of our results, it can be inferred that Islamic micro-finance has considerable social aspects, although it requires more atten-tion. Hence, in order to have a wider impact, Dusuki (2008) argues that microfinance should provide market-based services, creativity to innovate new programmes and product differentiation, efficient operation and broader outreach, offering not only productive loans but also loans for consumption purposes to cover the cost of health, education and social responsibility.

12.7 dIversIfIcatIon of the scheme: exPerts’ oPInIon

There are two Islamic microfinance strategies exist to answer the needs of two different targeted groups. Firstly, the “protectionist” or “survival” strategy aims the very poor recipients to whom survival is the main con-cern. In this case, low amounts of loan are offered, allowing them to address the very urgent and basic needs of consumption through very modest economic activities. Secondly, the “promotional” approach is when the amount of loan is higher and targets less poor recipients per-mitting substantial investment in income-generating activities. This differentiation is very important in analysing the outcomes of Islamic microfinance programme, as we will see in the discussion of our results.

Most of the microcredit programmes in Bangladesh are working for the “survival” programmes of the poor since these programmes could only help women to survive by generating some extra income through the activity they undertake for meeting their daily expenses (Ahmad 2011). No substantive investment is made in most of the programmes and thus no real sustainable effect. Most of the microfinance pro-grammes only offer credit without any other accompanying services such as training or marketing. Coupled with the women’s lack of skills, rDS (Islamic microfinance) programme helps to increase the first effect (sur-vival not promotional). A former economic professor of a local university who is a devoted researcher in the area of interest-free microfinance pro-gramme in Bangladesh explained the reason why Islamic microfinance programme does not offer to “start-ups.” This programme requires that

176 a. hassan and s. mollah

the project applying for the loan must be running for at least 6 months. In fact, according to him and other experts in the field of Islamic microf-inance programme, it is mentioned that: “it is necessary to provide other non-financial services to women to help them better manage Islamic microfinance loan. This can significantly improve the product the Islamic microfinance offers and increases the chances of success of the project. If the programme is limited to the offer of Islamic microfinance, and if the only concern of the beneficiary is to have the loan and reimburse it, then one will face a simple vicious circle of loan.”

According to these experts, the objective should rather be the success of the projects via high-quality needs based on entrepreneurship training and services. Even if the programme does not directly offer the services, it could make available information about it and provide a network of useful services. Furthermore, there is a big competition between differ-ent programmes offering conventional microcredit and Islamic microf-inance programme in the same geographic zone. Therefore, there is a chance of the group members to switch from one programme to another for no specific reason and consequently limits the positive impact of such programmes. Sometimes, some regions have a surplus offer of credit and others have a lack of such an offer. There is therefore a need for a better planning of the existing Islamic microfinance programmes in Bangladesh so that these anomalies should not exist in future.

12.8 conclUsIon and PolIcy recommendatIons

Islamic microfinance run by Islami Bank Bangladesh has become a very important tool which has been used in Bangladesh, Egypt, Indonesia, Iran, Nigeria, Pakistan, Turkey and Yemen to combat poverty and enhance the social and economic well-being of its recipients. Women are specifically targeted because they are very vulnerable. They lack the necessary resources to adapt to changes their pathetic economic condi-tions. However, evidence shows that when women are involved in any income generation activities, they exhibit greater courage in ventur-ing into experiences and proved to be productive. Investing largely in beneficiaries’ families and increasing family member’s involvement with income-generating activities would reflect in borrowers’ well-being. In this regard, Islamic microfinance programme is an important input. The aim of this research was twofold: Firstly, it wanted to confirm or refute a positive link between Islamic microfinance business model rDS under Islami Bank Bangladesh Limited and the socio-economic well-being of

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 177

women in Bangladesh. Secondly, to explore the context in which Islamic microfinance programme (rDS) functions under Islami Bank Bangladesh Limited and the way their performance can be improved. The research also addresses the following two research questions:

1. What can be expected from the offer of Islamic microfinance busi-ness model of Islami Bank Bangladesh Limited on the welfare of recipients?

2. Under what conditions would such an offer be more beneficial?

The outcomes exposed some interesting facts and important policy implications. It was important to notice that the increase in women’s income and assets played a very important role in enhancing women’s economic independence and sense of self-confidence. It helped in break-ing the cycle of poverty they live in and allowed them to have more control over their lives and economic decisions. Moreover, both Islamic microfinance loan recipients’ answers and interviews with the experts were analysed. The results show that Islamic microfinance (rDS) has been found to exert a positive and significant influence on gross monthly income of the borrowing members. This means that Islamic microfi-nance programme can influence these socio-economic factors which we have mentioned in the study. The strategy followed by Islamic microfi-nance business model of Islami Bank Bangladesh resembles that the sub-sidies system to the targeting beneficiaries definitely helped in a limited way in transforming the women’s lives. Moreover, this was supplemented by the small amount of Islamic microfinance loan offered to the women of the groups. These women lacked the skills needed to engage in highly profit-making activities or entrepreneurship. Lack of opportunity to pur-sue diversified income-generating activities in the villages is one of the major causes of poverty. Therefore, there is need to establish small and cottage industries in the rural areas. Necessary technical support should also be given to the village entrepreneurs.

We trust that a very important policy recommendation is the neces-sity of reviewing the existing programmes in respect of the way Islamic microfinance is offered by Islami Bank Bangladesh Limited. Programme should shift from the simplistic ones to pluralistic ones that offer ser-vices besides Islamic microfinance (such as marketing, match-making and training). Also, it is necessary to redirect Islamic microfinance towards developmental activities that will contribute to the improvement, in the long run, in the well-being of the recipients. Furthermore, Islami Bank

178 a. hassan and s. mollah

Bangladesh Limited should increase the size of the investment in order to cope with the change in the value of currency because of inflation and other economic reasons. Also, the scheme should project their value of activities for future, and then, all parties should be involved by assign-ing in managing Islamic microfinance scheme and held responsible for job assigned at the beginning of the year. Further, the performance of the Islamic microfinance should be subject to balance scorecard system. The development would be possible when an Islamic microfinance loan allows real and substantial investments in the production/investment capital and assets, not only personal assets.

12.9 food for thoUGht

Is it appropriate to ask Islamic banks to take responsibility for poverty alleviation?

In principle, there is no question that very purpose of establishing an Islamic banking system is to bring justice and welfare for humanity in general, to rescue investors from the clutches of riba (usury) and to prevent investment in the unethical business activities which are pro-hibited by the Islamic value system. But before asking Islamic banks to take greater responsibility for alleviating poverty, we need to find clear answers to the following questions:

1. Are Islamic banks worldwide doing enough to help the poor?2. Should the Islamic Development Bank (IDB) play a larger role

in encouraging Islamic banks to implement microfinancing programmes?

3. Is it appropriate to pressure Islamic banks to do more microfinancing?4. Are microfinance and Islamic finance intrinsic to each other?

As we are aware, the Islamic banking phenomenon is not as old as the conventional banking system. Within very short span of time, it has attracted a large number of market players both in the West and in the East. It is understood that there is a latent demand from numerous cus-tomers for Islamic products that they can rely on without compromising their values and beliefs.

But on the other side, we should admit that Islamic banking has not reached the grass-roots level in the Islamic world. This is because many banks have tried to implement Western banking models in the Islamic

12 SMALL SOLUTIONS: POVErTY ALLEVIATION THrOUGH ISLAMIC … 179

world with little or no modification. Nonetheless, there is the need for a genuine Islamic Shari’ah-compliant banking system in order to cover the poor and weak in society.

While various policies have been tried in the last few decades to mit-igate the menace of poverty, it still continues to plague large segments of humanity in general and IDB member countries in particular. Poverty is a complex phenomenon and can be studied from both micro- and macroperspectives. While macroeconomic policies affect the overall growth and development of economies, distribution of income in the society determines overall poverty levels. The IDB has prepared pover-ty-reducing policies and an action plan, which includes an emphasis on microfinance.

12.10 role of zakah and aWqaf

Islamic banking should re-emphasize an understanding about the role and scope of zakah and awqaf in addressing the problem of poverty. Zakah is one of the fundamentals of Islam that has direct economic implications. It requires Muslims/Islamic banks to distribute a part of their wealth in order to alleviate poverty and achieve economic eman-cipation. Similarly, waqf is a voluntary charitable act that has wide eco-nomic implications. These institutions were able to solve the problems of poverty and extend social services in classical times.

Zakah and awqaf can play a role in redistribution of assets and oppor-tunities, capacity building, wealth creation and extending income sup-port. Zakah and awqaf money must be used for income support and poverty-alleviation schemes by introducing income-generating activities through Islamic microfinance programmes. It should also be used for the section of the population that is unable to earn a living due to physi-cal/mental inabilities. Islamic bankers should investigate and prepare an action plan on how these institutions can be used in contemporary times to cover more poor people in alleviating poverty within society.

Like conventional banks, Islamic banks are working within the cor-porate sector. They are not charitable organizations. At the same time, Islamic banks are not conventional banks; they have social commitments and corporate social responsibilities (CSr) within the Islamic value system. Poverty alleviation should be one of the priorities of Islamic banking.

180 a. hassan and s. mollah

12.11 fIttInG the PIeces toGether

The entire responsibility for poverty alleviation should not be placed on Islamic banks. Many developing countries have adopted poverty reduc-tion strategies/policies. Zakah and awqaf should be incorporated into such development strategies. If used effectively, they can play an impor-tant role in the redistribution of opportunities and assets, enabling the poor to become productive.

There is a need to formulate a viable scheme for zakah and awqaf institutions to involve them in the microfinance and microenterprise activities in collaboration with other organizations for all-around devel-opment for the poor. Islamic Financial Institutions should help to revital-ize the institutions of zakah and awqaf in order that they can better play their designated role.

references

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Ahmad, H. (2007). Waqf Based Microfinance: Realising the Social Role of Islamic Finance. Paper Presented at the International Seminar on ‘Integrating Awqaf in the Islamic Financial Sector,’ Singapore, March 6–7, 2007.

Ahmad, M. (2011). The role of rDS in the Development of Women Entrepreneurship Under Islamic Microfinance: A Case Study of Bangladesh. In M. Obidullah & H. Salma (Eds.), Islamic Microfinance for Micro and Medium Enterprises. Jeddah: IrTI and UBD.

Akter, S. (2001). rural Women in Micro Credit Programmes for Poverty Alleviation in Bangladesh-Participants and Constraints to their Activities. Parikarama, XXV, 7–19.

Alamgir, D. A. H., Hassan, M. K., & Dewan, H. H. (2010). A Comparative Review of Islamic Versus Conventional Microfinance in Bangladesh. Paper Presented at the 8th International Conference on Islamic Economics and Finance held in Doha, Qatar.

Ashraf, A., Hassan, M. K., & Hippler III, W. J. (2014). Performance of Microfinance Institutions in Muslim Countries. Humanomics, 30(2), 162–182.

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Cerrutti, M. (2000). Economic reform, Structural Adjustment, and Female Labor Force Participation in Buenos Aires, Argentina. World Development, 28, 879–891.

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Chaves, r., & Gonzalez-Vega, C. (1996). The Design of Successful rural Financial Intermediaries: Evidence from Indonesia. World Development, 24, 211–225.

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Dusuki, A. W. (2008). Banking for the Poor: The role of Islamic Banking in Microfinance Initiatives. Humanomics, 24(1), 9–66.

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183

There are currently 3 million Muslims living in the UK, and many of them find themselves trying to balance their Islamic principles with the realities of the mortgage system. Shari’ah-compliant mortgages provide them with an alternative to an interest-based mortgage.

However, Shari’ah-compliant mortgages are not just for Muslims, but for everyone. About 12% of Islamic finance customers in UK are non-Muslims who do not choose Islamic products for religious reasons, but for ethical ones.

13.1 sharI’ah-comPlIant mortGaGe models

The UK Treasury and Financial Services Authority (FSA), in consulta-tion with Shari’ah scholars, has developed Shari’ah-compliant mortgages (Islamic home financing products) under the Home Purchase Plans scheme. British Islamic home financing products generally adopt one of three basic forms of Islamic contract. These are Murabahah (lender resells house to borrower), Ijarah wa Iqtina (sometimes referred to as Ijarah Muntahia Bitamleek, which means lease to own) and Musharakah Mutanaqisah (diminishing partnership).

CHAPTEr 13

Home Sweet Home: Islamic Housing Financing

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_13

184 a. hassan and s. mollah

13.2 Ijarah mortGaGe

In this category of mortgage, the bank purchases the property and then rents, rather than selling to the homeowner. The amount of rent is agreed upon between the bank and the tenant at the outset. rates are fixed based on a London Interbank Offered rate (LIBOr) plus a spread formula (Fig. 13.1).

13.3 mUrabahah mortGaGe

The bank buys the property at a set price and immediately sells it to the client at a higher price. This is paid back in instalments and deemed to be a sale transaction, rather than one of lending. The following criteria are used to calculate the higher price that the homeowner has to pay:

• The balance owing on the property after the client’s original down payment (20%) has been paid.

• The length of the Murabahah mortgage term.• The size of the financial institution’s agreed profit.

Fig. 13.1 The Islamic mortgage structure/process in the UK

13 HOME SWEET HOME: ISLAMIC HOUSING FINANCING 185

Based on these criteria, the monthly repayment that the homeowner is required to make throughout the mortgage term is worked out.

13.4 mUsharakah mUtanaqIsah

Musharakah means partnership. Ijarah (lease) schemes usually incorpo-rate the diminishing Musharakah principle. This diminishing Musharakah operates in several ways. For example, in the case of the alburaq scheme in the UK, the bank purchases the property/home sought by the cus-tomer using its own funds plus a deposit (down payment) provided by the customer.

Initially, the property is registered in the name of alburaq at the land registry under the contract. The diminishing Musharakah (diminishing partnership) contract splits between the bank and the customer to reflect the relative size of their contributions to the purchase price. The cus-tomer may live in the property as a tenant and will pay rent to the bank. The amount of the rent is adjusted to reflect the fact that the customer owns part of the beneficial interest in the property.

Besides the rental payment, over time, the customer buys the bank’s beneficial interest in the property and at the end becomes the owner of the entire property. At this stage, the customer’s total rental payment is zero and the final formal step is taken of transferring ownership into the name of the customer at the land registry.

It should be noted that in some other diminishing partnership con-tracts, the property is held by the bank in trust for itself and the cus-tomer. In this arrangement, there is no effect on cash flows in the transaction.

13.5 tIered fInancInG ProdUct

In the Shari’ah-compliant mortgage market, there is also a tiered financ-ing programme. Under this programme, the customer (home buyer) enters into a tiered Istisna/diminishing Musharakah contract as a means of financing the construction of residential properties, as shown in Fig. 13.2.

The following processes take place under the Shari’ah-compliant tiered financing programme:

186 a. hassan and s. mollah

• The customer contributes a certain percentage of the construction cost of the building/property and the remainder is provided by the bank/building society.

• A bank or building society enters into a parallel Istisna arrangement with the customer and the building contractor.

• On completion of the construction, based on his/her capital contri-bution, the customer owns a portion of the constructed building or property.

• Both parties enter into a diminishing Musharakah contract in which the customer agrees to purchase the bank/building society’s share in the property in instalments. Ownership title to the build-ing/property is retained by the bank/building society during this period.

• At the end of the stipulated period, once the customer has pur-chased the bank/building society’s entire shares in the property/building, the bank/building society transfers the title to the cus-tomer and the tiered financing contract period comes to an end.

13.6 market Players In IslamIc mortGaGe

Islamic mortgages have been available in the UK’s Ahli United Bank (formerly called United Bank of Kuwait) since 1997, and HSBC Amanah launched a halal mortgage in 2003. Gradually, other financial institutions

Fig. 13.2 Tiered financing programme

13 HOME SWEET HOME: ISLAMIC HOUSING FINANCING 187

entered the UK market to provide Shari’ah-compliant mortgage loans. With considerable improvement, Shari’ah-compliant Islamic mortgages now have entered the mainstream. There are a number of financial insti-tutions/building societies that undertake Islamic mortgages in the UK market. Below are some examples:

• HSBC has been offering Shari’ah-compliant home finance in the last five years through its Islamic finance arm, HSBC Amanah.

• Bristol & West have teamed up with the Arab Banking Corporation to launch the alburaq Islamic home finance.

• The alburaq is also available through the UK high street bank Lloyds TSB (underwritten by Bristol & West).

• West Bromwich Building Society is acting for United National Bank, which provides a wide range of Islamic mortgage products.

• Ahli United Bank (formerly United Bank of Kuwait).• Al Ryan Bank (formerly Islamic Bank of Britain) is a full-fledged

British Islamic bank that has been offering Islamic mortgages.• Albait UK Real Estate Fund.

Ahli United Bank, London, offers products that are described as Murabahah and Ijarah. United National Bank, HSBC Amanah and albu-raq offer a diminishing Musharakah contract. Bristol & West, Lloyds TSB and IBB have also adopted the alburaq scheme. Until recently, HSBC offered an Islamic home financing contract in accordance with Ijarah wa Iqtina principles, but this has now been replaced by its dimin-ishing Musharakah product.

There are other overseas mortgage lenders who provide Shari’ah-compliant financing in the UK market, including TAB (Bahrain), Dominion Asset Management (HK), Qatar National Bank, HSBC Bank Middle East, Calyon, BNP Paribas and Masraf Al rayan.

13.7 sharI’ah mortGaGe Payment and fees

Since Shari’ah-compliant mortgage providers do not charge any interest in their transactions, customers may initially misunderstand their modus operandi. In general, a bank/building society first owns the property in full and later transfers it in the name of the customer at the end of term (as in an Ijarah plan). In the case of the diminishing Musharakah contract, a customer is a co-owner with the bank/building society from

188 a. hassan and s. mollah

the start. The fact that every month, a customer increases his/her share of the property while sharing all risks with the bank/building society is reassuring to customers.

All the Islamic finance providers in the UK use the LIBOr as the benchmark for rental payments. The rental rates are reviewed every six months. Both HSBC Amanah and IBB charge rent at 6.95% of the share that the customer does not own (not 6.95% in interest). Alburaq has a 6.76% rental charge on its standard residential products, 6.56% on its dis-counted plan and 6.49% on its Murabahah plan.

The rental charge percentage is the same regardless of the size, loca-tion or value of the property. In the case of Islamic mortgages, the administrative charges are lower than those on a conventional loan. However, HSBC Amanah charges a £275 application fee, while IBB and alburaq charge £299. Shari’ah-compliant mortgage providers assess whether the customers can afford the loan in the same way that they would for a conventional mortgage.

13.8 sector GroWth

The Islamic mortgage market has grown rapidly since 2003, following the abolition of double stamp duty on Islamic mortgages. According to the Treasury, since 2003, the Shari’ah-compliant mortgage market has grown to over £500 million and increased by around 50% in 2007. According to a survey conducted by Data-monitor, the value of the Islamic mortgage sector in the UK has increased from £40 million in 2002 to an anticipated £1.4 billion by 2009.

With around 3 million Muslims living in Britain, it is anticipated that the Islamic mortgage market will continue to grow. This is especially so in areas with large Muslim populations, such as London, with 725,000 Muslims out of a total population of 7.2 million, and Leicester, with 55,000 Muslims out of a total population of 280,000.

Some of the major Shari’ah-compliant mortgage projects in the UK are shown in Table 13.1.

13.9 reGUlatIon helP

The UK government had introduced regulations from time to time since 2003 which have helped to fuel the growth of the Islamic financial mar-ket (Table 13.2). These regulations and the positive strategy of the UK

13 HOME SWEET HOME: ISLAMIC HOUSING FINANCING 189

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13 HOME SWEET HOME: ISLAMIC HOUSING FINANCING 191

government are benchmarks for Western economies regarding Islamic finance.

With the Finance Act 2007, the law ensures that:

• Banks/building societies offering Shari’ah-compliant products are fit, proper and appropriately resourced with staff competent to undertake this business.

• Customers get clear, concise and consistent information about a bank/building society’s services and Islamic products on offer (including appropriate risk warnings) so that they can make informed choices.

• Customers get quality advice and are sold suitable products which take account of their circumstances and needs.

• If things go wrong, customers are able to obtain redress, if appropriate.

13.10 does beInG ethIcal Pay?Some customers may find their monthly payments are a little higher with a Shari’ah-compliant mortgage than an equivalent interest-based conven-tional mortgage. There are several reasons for this:

• The Islamic finance providers have to pay slightly higher rates for Islamic funding.

Table 13.2 UK legislation addressing Islamic finance

UK legislation Islamic products/matters addressed

Finance act 2003 removed the stamp duty and land tax (SDLT) for Murabahah- and Ijarah-based home financing

Finance act 2005 Clarified tax treatment of the payments made under Murabahah and Mudarabah contracts. removed the SLDT for diminishing Musharakah-based home financing

FSM 2000 (regulated activities) amendment no. 2, order 2006

Diminishing Musharakah- and Ijarah-based home financing now regulated by FSA

Finance act 2007 Islamic (Shari’ah-compliant) mortgages gained official protection from FSA. Mortgage conduct of business (MCOB) rules now covers home plus plans (Shari’ah-compliant mortgages)

192 a. hassan and s. mollah

• A relatively small number of banks/financial institutions in the UK have Shari’ah-compliant mortgage schemes, so competition is not as intense as for conventional mortgages.

• Shari’ah-compliant mortgage arrangements are slightly more com-plex and expose the bank/building society to greater risk than with an interest-based mortgage, especially with an Ijarah mortgage, where the bank owns the property for up to 25 years before trans-ferring ownership to the consumer.

Many customers feel that Shari’ah-compliant mortgages end up costing the same, if not more, than conventional ones, but Muslims prefer to have the choice. It seems that Shari’ah-compliant mortgage customers in UK will pay a small premium in order to avoid having to compromise on their religious beliefs.

13.11 leadInG eUroPe

Islam does not allow a Muslim to benefit from lending money. Islam bans interest and stipulates that financial deals must be based on tangible assets—that money cannot be made from money alone. These rules are applied to Islamic mortgages. Furthermore, Islamic financial products belong to the socially responsible investment category, backed by secure physical assets from which returns/profits are paid to investors rather than interest.

The popularity of Shari’ah-compliant mortgages is being reflected in the greater range of products, which will assist in building customer confidence in the Islamic mortgage market. It seems that the UK is now leading Europe in the development of Islamic finance products in gen-eral and Shari’ah-compliant mortgages in particular.

While conventional finance in Western Europe and North America is wracked with turmoil, in the world of Islamic finance, there is a refresh-ing burst of optimism. The Islamic financial system and related prod-ucts offer a stable alternate solution by not only prohibiting interest and interest-based products, but also emphasizing certain rules for trade, guidelines for governance and the promotion of ethical values. As the conventional financial institutions grapple with the credit crunch, there is an opportunity for Islamic Financial Institutions to expand.

193

Takaful and re-takaful are important components of the Islamic finan-cial market. As one of the risk mitigation tools, takaful complements its counterparts, explicitly the Islamic banking market, Islamic capital mar-ket and Islamic money market. Definitely, mitigation and prudent man-agement of risks are integral parts of Islam in order to achieve justice in the system which is in line with the objectives of maqasid al Shari’ah (objectives of Shari’ah). To date, the takaful market is considered one of the fastest growing Islamic Financial Service industries although it needs to work on further improvements. Due to its growing demand, the takaful industry seems to have a bright future awaiting it.

On the other hand, re-takaful is an agreement to contribute into large fund which assumes the task of covering part of the risks encountered by the participating takaful operators. In other words, re-takaful is a form of mutual assistance among participating takaful operations in which the operators pay a certain amount of contribution into the re-takaful funds in order to share a certain defined risk in a specified category if these exceed prudent underwriting limits.

This chapter covers the basic conceptual framework of takaful and re-takaful and their operational framework.

CHAPTEr 14

Operational Mechanism of Takaful and re-Takaful

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_14

194 a. hassan and s. mollah

14.1 concePt of takafUl

The principles of guarantee, derived from the word “Kafala,” are the basis of Islamic insurance, i.e. takaful. Takaful means that the majority guarantees the loss of the minority, i.e. the majority shares the burden of the unfortunate minority via the pooling of funds. This form of cooper-ative insurance is already in existence in several countries, permissible by Shari’ah. Moreover, this principle is further enhanced to incorporate the concept of Tabarru’ meaning donation, which explicitly mentions that the money collected is to be used for the purpose of assisting the fellow participants who require assistance according to the terms agreed as long as these terms are not in conflict with the Shari’ah (Fig. 14.1).

Taking into account these basic takaful concepts, practitioners have taken the step further to expand the model into a more commercially viable model of takaful. This model of Islamic insurance follows closely the concept of cooperative insurance, where a group of subscribers con-tribute to a pool of funds. Whenever one of the members makes a legit-imate claim, they draw money out of the pool. In the meantime, the funds in the pool are invested in an Islamic avenue and without exposing the policyholders to any extra significant risk. Unclaimed profit is then distributed among the policyholders. The concepts of takaful which are acceptable in Islam are as follows: (i) mutual cooperation, (ii) mutual indemnity, and (iii) brotherhood.

Fig. 14.1 Basic concept of takaful or Islamic insurance

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 195

This way of mutual cooperation and responsibility and the provision of financial benefits are indeed encouraged in Islam. Therefore, a sys-tem of mutual help being the basis of insurance and takaful is not a con-tradiction of Shari’ah rules. The evolution of takaful has a long history (Fig. 14.2).

The main identifiable stages are:

1979: The first taawuni (cooperative) model has been developed in Sudan

1984: The Mudarabah (profit loss sharing) model has been developed in Malaysia

1984: The Wakalah (agency) model has been developed in the Gulf countries

1996: The Waqf (endowment) model has been developed in South Africa.

It may be noted that the most takaful models are hybrids of the afore-mentioned models.

Fig. 14.2 Timeline of takaful development

196 a. hassan and s. mollah

14.2 takafUl oPeratIons

There are two types of takaful: (i) general takaful and (ii) family takaful. Both takafuls are analogous to life insurance.

14.3 General takafUl

The general takaful contact is normally a short-term policy where takaful participants pay contributions and operators undertake to manage the risk. The contributions paid by the participants are credited into the general takaful fund. The tabaru element is more apparent in general takaful as participants will normally under-take to regard their contributions as donations to follow partici-pant. All contributions go to a common pool of funds which will be used to compensate takaful participants in the event of a loss. There are no savings and investment elements, but the takaful operators will distribute any underwriting surplus to the participants in an annual basis.

Typically, general takaful is short term but renewable periodically. Takaful operators everywhere typically provide a full range of general takaful products in both retail and corporate segments. General takaful is categorized into two types: motor takaful and non-motor takaful. Motor takaful provides protection for private van, motorcycle and commercial vehicle. Non-motor takaful ranges from fire, personal accident, marine, health takaful and other areas.

14.4 famIly takafUl

Family takaful is a long-term policy for which most participants aim at saving for their long-term needs, for example for their children’s edu-cation, their pension and compensation for dependents in the event of death and disability, among others. This type of takaful has long-term horizon which ranges from 10 to 30 years. In family, takaful operators normally divide the contributions into two parts: firstly, the participant’s account and secondly, the participant’s tabaru account (special account) for meeting losses of fellow participants. In the event of a loss, the partic-ipants will compensate according to a pre-agreed formula. Accordingly, the clause of tabaru is incorporated in the contract. Both accounts are invested in Shari’ah-compliant securities. Depending on the type of

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 197

underlying contracts, the takaful operator may receive a fee or hare of investment profit.

As per contract of family takaful, if a participant dies prematurely, participant’s family gets the amount in the participant’s account plus dividends and amount in the participant’s special account as continued contributions until the maturity period. If the participant withdraws from the takaful programmer, he or she will get the amount in the par-ticipant’s account only. Among the most common and typical family takaful products offered include savings and educational plans, retire-ment annuities and ancillary benefits such as protection for critical illness, disability, accidental death or waiver contribution. It may be noted that family takaful does not mean insuring one’s life, but is a financial pro-tection for the heirs or beneficiaries of the deceased (or insured) against future unexpected financial risk. Family takaful is based on the principle of Mudarabah, which relies on the principles of mutual cooperation. In brief, the features of family takaful are:

– Long-term policy– Savings and investment elements– Two funds: participant’s account (savings) and participant’s special

account (PSA) which is called tabaru.

14.5 models of takafUl

There are several takaful models operating in the different countries of the world. These takaful models do apply several forms of contract governing the relationship between takaful operator and participants. However, most widely practiced models are Mudarabah and Wakalah. Further some takaful operators adopt a hybrid model either combining Mudarabah and Wakalah or Wakalah with waqf model. But most com-monly practiced contracts are Mudarabah (trust financial), Wakalah (agency) and waqf models.

The details of each takaful model are presented below:

Operation of Mudarabah Model

In this model, the takaful operator acts as mudarib (an entrepreneur) who will accept payment of the takaful contributions (ras la mal) or pre-mium from takaful participants (rabbul mal). In this model, contract

198 a. hassan and s. mollah

specifies that the share of the profit or surplus from the operations of takaful fund managed by the takaful operator is to be distributed between the participants as the providers of the capital and the takaful operator as entrepreneur as per norms of the Mudarabah contract. The sharing of such profits (out of the surplus) may be in a ratio of 50:50, 60:40 or 70:30 as pre-agreed conditions between the contracting parties. Further, the operator is entitled to a fixed percentage of any investment profit (Fig. 14.3).

In the Mudarabah-based model of takaful, the risk-sharing arrange-ments allow the takaful operator to share in the favourable investment performance of both the participant’s saving account and participant’s special account based on tabaru. In this model, in case of losses in the participant’s special account (tabaru), the takaful operator provides an interest-free loan that has to be repaid when the participant’s special account returns to profitability and before any future surplus is distrib-uted. Consequently, the takaful operator must be both prudent and active in investing the takaful funds to fain profits because their main income is generated from a certain ratio of such investment profits. In case

Fig. 14.3 Mudarabah-based takaful model (Source IFSB (2009). Guiding Principles on Governance for Takaful (Islamic Insurance) Undertakings (p. 30). Luaala Lumpur: IFSB)

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 199

of the cancellation of Mudarabah contract, all cumulative capital plus profit must be returned to the capital provider or particulars subject to deduction all the administrative or operational expenses.

Wakalah Model

Wakalah is a contract of agency. The Wakalah model of takaful is one that is becoming gradually popular. Based on the wakalah principle, the par-ticipants remain the actual owners of the takaful fund. The takaful opera-tor here acts as an agent on behalf of the participants. The operator as an agent manages the funds on commission basis and is entitled to agency fee (remuneration). The surplus of the participants’ investment funds goes to the participants. The agency fee rate is fixed annually in advance in consultation with Shari’ah supervisory board of the takaful company. Performance fee which is related to the level of performance is given as an incentive for good administration and governance of the participants’ fund.

As shown in Fig. 14.4, in a wakalah model of takaful, participants remain the owner of the takaful fund and appoint the takaful operator as agent. The agency fee which consists of agent’s remuneration and administration expenses will be channelled to the takaful operator. The group takaful fund is invested and any income or profit is returned to the group fund. The end of the year after deducting claims, re-takaful and reserve, the surplus is distributed to the participants.

Hybrid Wakalah–Mudarabah Model

This model fundamentally syndicates some features in both the wakalah and Mudarabah model. The wakalah principles are applied in underwrit-ing activities, while a Mudarabah contract is used in the investment of the takaful funds. Thus, the takaful operator is entitled to agency fee for managing the fund as a wakil or agent and share of profit for managing the investment of the fund as mudarib (entrepreneur) (Fig. 14.5).

In sum up, we can say that the contributions are divided into (i) agency fee and (ii) takaful fund. This division is made based on the agreed ratio between the takaful operator and participants in the con-tract. In a hybrid of the wakalah and Mudarabah model, the takaful operator is entitled to an agency fee for managing the fund as a wakeel (agent) and share of profit for managing the investment of the fund

200 a. hassan and s. mollah

as mudarib. It may be noted here that this model is well accepted and favourable than the other models and is widely adopted by many takaful operators worldwide.

Hybrid of Wakalah–Waqf Model

The wakalah–waqf takaful model is designed to enable any individual to save regularly with the aim of accumulation a fund that can be left as a donation under the waqf system. In this model, the shareholders of the takaful operator will initially make a donation to establish the waqf fund (Fig. 14.6).

Fig. 14.4 Wakalah model of takaful

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 201

This fund is invested in a Shari’ah-compliant investment, and the returns are used for the benefits of the participants. The tabaru fund from participants’ special account (PSA) too becomes part of the waqf fund.

In sum up, we can say that a waqf fund contains shareholders dona-tion and participants contribution in which the shareholders and partic-ipants lose ownership rights because the waqf fund can only be used for the benefits of all participants. At the end, monies or assets will become the property of the waqf fund which can only be used for the benefits of all the takaful participants of the company. The shareholders who act as the owners of the waqf fund delegate authority to the operator to come to the administrator of the fund, whose function among others includes paying claims from the fund. Also, the takaful operator under-takes the role of investment agent when it invests the waqf funds and they are entitled to a certain percentage of the investment profit as per-formance fee.

Fig. 14.5 Hybrid Wakalah–Mudarabah model of takaful

202 a. hassan and s. mollah

There is another model operated on the basis of the wadiah (safe keeping of the funds) contact. The wadiah model mainly aims to over-come some issues in the other models, such as ownership of the takaful fund, sharing of surplus, entitlement to the investment profits, etc. It may be noted that application of this model is very limited in the takaful industry worldwide.

Re-Takaful (Islamic Reinsurance)

Accounting and Auditing Organisations of the Islamic Financial Institutions (under 2/1 Shari’ah Standard No. 41, 2010) define re-takaful (Islamic reinsurance) as: “…the agreement among insurance

Fig. 14.6 Hybrid of Wakalah–Waqf takaful model

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 203

companies, on behalf of the insurance funds under their management, to devise a mechanism for avoidance of part of the risks which the insurance funds may encounter. On the basis of such agreement, a re-insurance funds which has a distinct legal personality and independent financial liability is formed through making contributions out of the insurance funds paid by the insurance clients on the basis of donation. The re-in-surance fund funs formed, assumes the task of covering part of their risks encountered by the insurance funds.” In view of this, re-takaful is a form of mutual assistance among participating takaful operators in which the operators pay a certain amount of contributions into the re-takaful fund in order to share a certain defined risk in a specified category if these exceed prudent underwriting limits.

Present re-takaful industry is mainly dominated by very large main-stream reinsurance companies. The process of sharing the insured risk between the takaful operator and other conventional insurance compa-nies is either due to lack of sufficient insurance capacity for such risk or because of regulatory requirements of risk sharing with regard to the management of the risk in questions.

14.6 methods

re-takaful currently adopts two main methods, namely facultative and treat. Facultative method is affected only in special cases and placed on an individual risk basis. The second method is treaty in which the takaful operator agrees to cede during a specified period, and the re-takaful operator agrees to accept all risks included within the terms of the re-takaful contact up to a specified amount.

According to the AAOIFI 2010 Shari’ah Saturday No. 41 (Item 4), facultative method is a type of re-takaful for individual policy or risk. This arrangement can be on a proportional basis which is the origi-nal form or non-proportion basis. It may be noted that the facultative underwriter of a re-takaful operator is free to accept or decline any offer from a takaful operator that wants to cede its risk to such re-takaful oper-ator (Table 14.1).

Following are the four ways of applying the treaty method:

1. Surplus: when the takaful operator in arrangement with the re-takaful operator allows only that portion of each and every risk when it does not like to retain.

204 a. hassan and s. mollah

2. In the own account: when the takaful operator in arrangement with the re-takaful operator shares each and every risk proportionately on the original terms and conditions.

3. Excess of loss: when a takaful operator bears all claims arising to a specified amount and only when this ultimate not loss exceeds the specified amount, they can recover from the re-insurer up to a specified maximum. In this matter, no proportional sharing of risk between the takaful operator and re-takaful operator.

4. Not responsible: the takaful operator will not be responsible for any loss, large or small, until the loss ratio for the year touches an agreed percentage of the premium.

It may be noted that the takaful operators must work towards the estab-lishment of a strong and bid re-takaful operator that would allow them to avoid dealing with conventional reinsurance companies.

Challenges before re-takaful industry:The re-takaful industry faces the following challenges, because of rela-

tively new presence in the market:

• Limited capacity• Strong competition with mainstream reinsurance companies• Lack of proper rating agency• Lack of expertise and training of the personnel• Lack of transparency in reporting standard

In order to accelerate the growth and successful operation of the takaful industry, the most important factors are the transparency of the opera-tions, the establishment of Shari’ah-compliant products and robust Shari’ah supervisory board that guide product design and ensure Shari’ah compliance. Furthermore, the development of actuaries focusing on

Table 14.1 Example of facultative re-takaful operation

risk 70% retained by takaful operator (TO)

30% placed facultatively to re-takaful operator (rTO)

Contributor 70% retained by TO 30% placed facultatively to re-takaful operator (rTO)

In Loss 70% retained by TO 30% placed facultatively to re-takaful operator (rTO)

14 OPErATIONAL MECHANISM OF TAKAFUL AND rE-TAKAFUL 205

takaful is important because they play a role in determining the pricing. The contribution should be invested in appropriate channels to meet both general and family takaful claims but the spectrum of financial instruments for investments is limited for takaful operators.

PArT II

regulation, risk Management, CSr of Islamic Financial Services, Accounting,

Governance, and Their International Islamic Infrastructure Institutions

209

Islamic finance involves financial transactions which are in accordance with the principles of Islamic law, known as Shari’ah. Although fre-quently referred to as Islamic law, Shari’ah is perhaps best characterized as moral guidance or a set of principles governing all aspects of the day-to-day activities of Muslims. The tradition of Shari’ah laws has a long history, but the implementation of Shari’ah law in modern commercial activities in general, and particularly in the contemporary financial sys-tem, is at the developing stage.

15.1 sharI’ah laWs In IslamIc bankInG

The Shari’ah is derived from the Qur’an (considered by Muslims to be the revealed word of God) and the Sunnah (the sayings and practices of the Prophet Muhammad, peace be upon him). However, sometimes the Qur’an and Sunnah principles are not sufficiently expounded to cater explicitly to every modern situation, including those pertaining to finance. Therefore, Islamic scholars apply human intellect to determine legal rules in the light of the Qur’an and Sunnah using analogical reason-ing and induction. This derived knowledge is referred to as fiqh. In this way, Islamic scholars come up with resolutions based on Shari’ah princi-ples and the fatwa (rulings) of preceding Islamic scholars to expand the body of Islamic law.

It may be pointed out that the introduction of fiqh led also to diver-sity of the legal opinions that crystallized into four major schools of

CHAPTEr 15

Courting Change: Development of Islamic Legal System Could Bring Growth

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_15

210 a. hassan and s. mollah

thought (Hanafi, Shafie, Maleki and Hanbali schools) within the Sunni Muslims’ tradition. All these four schools of thoughts organized many sets of rational principles (usul al aqliyyah), which laid down the rules of application of reason in developing laws. These principles latter evolved into the Islamic methodological discipline of Islamic legal theory, which is very important in Islamic banking and financial operations.

With the emergence of Islamic economic systems, Shari’ah laws were introduced into the banking system during the 1970s. With the spread of Islamic banking and finance, some countries enacted laws related to the operation of Islamic banking. At the same time, Shari’ah supervisory boards constituting groups of Islamic scholars were formed at various levels and they started pronouncing various fatwa related to economics and finance. Their rulings in the light of the Qur’an and Sunnah form the essence of Shari’ah laws related to banking operation in contempo-rary times.

15.2 creatInG neW contracts

The traditional Islamic contracts in their pure forms do not have features that can cater to the needs of the contemporary financial markets and institutions. Although some of these traditional contracts (like Salam, Istisna, Mudarabah and Musharakah) can be used for financing, they take place directly between the parties involved.

Thus, Shari’ah law had to create a new set of financial contracts that could cope with the transactions and dealings of the conventional finan-cial structure without violating any principles of Shari’ah.

The most common method by far of creating financial contracts has been the combination of traditional contracts to create Shari’ah-based new contracts. For example, Murabahah (sale or purchase contract) is a widely used instrument by Islamic Financial Institutions. Murabahah is used with several other concepts (promise, guarantee) to produce a financing tool. Similarly, ijara contracts are used with sale or gift con-tracts to form a financing instrument called ijara wa iqtina’ or ijara muntahia bittamleek. A diminishing musharaka associates a musharaka contract with that of a sale for financing purposes. Similarly, the contem-porary Sukuk is a composite of multiple transactions.

Another method of creating new contracts in the Islamic financial sec-tor is to adapt conventional products/contracts by removing the unde-sirable components to make them comply with Shari’ah principles.

15 COUrTING CHANGE: DEVELOPMENT OF ISLAMIC … 211

For example, equity-based funds such as unit trusts, mutual funds and common stock have been adopted by Islamic Financial Institutions by specifying the stocks that can be included in these funds. Investment in stocks is allowed if they fulfil certain business and finan-cial criteria derived from Shari’ah and usul al fiqh (Islamic legal theory). Accordingly, Islamic investment in companies that deal with forbidden goods/services like alcohol and tobacco, gambling, pornography and interest-based financing institutions is not allowed. Financial screening is used to weed out companies that have unwarranted dealings with forbid-den transactions.

15.3 adoPtIon of sharI’ah laWs for IslamIc fInance

The adaptability of the conventional legal system relates to the process of law making based on sources of present laws. While Islamic law is adapt-able, being based on Islam, it has different foundations and a different process of adaptability compared to Western legal traditions.

As most Muslim countries have adopted either common law or civil law frameworks, their legal systems do not have specific laws/statutes that support the unique features of Islamic financial products. Generally, Islamic banks and financial systems use Murabahah, Mudarabah, Musharakah and other Shari’ah-based instruments in their transac-tions, but current banking law and regulations in Muslim countries for-bid commercial banks to undertake such activities. This situation calls for specific laws and statutes that can support and promote the Islamic Financial Services industry.

While, in some countries, separate Islamic banking laws have been passed (e.g. in Brunei, Iran, Indonesia, Kuwait, Malaysia, Sudan), in oth-ers, Islamic banking is covered under a section of the existing banking law.

The implications of these Islamic banking laws on the operations and growth of the Islamic financial sector will depend on the type of legal system in place. However, the Islamic banking laws passed within civil laws in Muslim countries are worded in general terms and lack details on the different Islamic modes of financing. Some problems include the prohibition of trading and taking equity positions and double taxation in Islamic financial transactions (in the case of ijara).

Such uncertainty in the laws related to Islamic banking will place Islamic banks at a disadvantage compared to conventional banks. Thus,

212 a. hassan and s. mollah

there is a need for detailed codification of the law that would include Islamic principles for financial transactions and the administrative proce-dures for carrying out these activities.

On the other hand, common law which is based on English law is not a rigid as the civil law. Common law gives more room to manoeuvre in terms of evidence, witness, etc. In this system, the principal source of law is jurisprudence. Moreover, jurisprudence in terms of case law forms the core of the law which expresses through specific rules applicable to spe-cific facts. In fact, a case law is a source of law which is positively linked with stock market development and bank development. Therefore, its adaptability will have a significant effect on the obstacles that a company faces to get external finance. There are some evidences that the compa-nies in civil law system countries where statutory law is the source of law and judgements are based on statutory law rather than equity and face higher financing obstacles than common law countries where case law is the source of law, and judgements are based on equity rather than statu-tory law.

However, Islamic contracts and transactions under the common law regime may also face some problems of interpretation, as no precedents on these activities may exist. In a civil law regime too, the judges may deviate from the stature if the statue is incompatible results under legal documentation relative to the civil law system. Furthermore, in the civil law system, the courts will interpret the contracts on the basis of rea-sonableness and fairness, whereas the common law system will give the provisions in a legal document more weight, irrespective of other consid-erations such as materiality or fairness. As the sanctity of the contract is greater in the common law system, therefore, there may be a lower legal risk involved for Islamic banking instruments under this regime.

15.4 dIsPUte resolUtIon

In the absence of a Shari’ah arbitrator to provide enforcement, the legal risks for Islamic finance are increased. Thus, partners in transactions may avoid using Shari’ah law as they want to avoid the uncertainty of apply-ing it. In an environment with no Shari’ah courts, Islamic financial con-tracts include choice-of-law and dispute settlement clauses. In such cases, two approaches can be taken.

First, Shari’ah can be used as the governing law, as Islamic financial contracts’ legitimacy should be judged by the principles of Shari’ah. The

15 COUrTING CHANGE: DEVELOPMENT OF ISLAMIC … 213

contracts would include a clause indicating that Shari’ah law should be used for the settlement of disputes.

Second, the law of the country can be used to settle disputes.In the former approach, contracts should be shielded from the legal

environment and disputes settled through commercial arbitration. The implications of using the alternative to an existing legal system for dis-pute resolution for Islamic financial contracts depend on the type of the legal system in place. In a civil law country, laws related to Islamic bank-ing give the general features of Islamic banking and leave the interpre-tation of these to the courts. While Islamic banks have the freedom to define the financial instruments they use, lack of specifics in the law adds to uncertainty and increases the legal risks.

15.5 sharI’ah coUrts for dIsPUte settlement

In order to ensure the growth of the Islamic financial industry, there is a need to have Shari’ah courts for dispute settlement that understand the form of the contracts so that these can be interpreted and enforced accordingly. It is true that the whole court system of a country cannot be changed a day or two, but to address the problem, there is a need for a special Islamic bench to deal with, among others, financial transactions. In this regard, Brunei, Indonesia and some other countries have adopted several steps to build some legal infrastructure institutions for the Islamic financial industry to address litigation related to Islamic banking and finance.

In order to complement the Islamic court system, the Centre for Arbitration of Malaysia has been enhanced to deal with disputes on Islamic banking and finance for both domestic and international cases. To ensure the efficient functioning of the Islamic financial sector, the Bahrain Monetary Agency, Dubai International Financial Market, Brunei Darussalam Ministry of Finance and Bank Negara Malaysia have also constituted special committees to assess common law-based legislation and assimilate Shari’ah principles.

15.6 standardIzatIon of IslamIc ProdUcts

The lack of commonly accepted standards for products and prac-tices in any industry can be a barrier to development. This is because it is likely to increase costs, thereby reducing competitiveness relative

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to substitutes. This has been particularly true for Islamic finance, where the sector has had to address the standardization challenges that face all rapidly evolving industries, while also taking into account the dynamic nature of Shari’ah interpretation. Greater standardization in the Islamic finance industry would have many benefits, including:

• reducing transaction costs for firms, thereby enabling lowered prices for investors and consumers.

• reducing the time to market for new products.• reducing the burden on Shari’ah scholars, who are currently at a

progressing development stage.• Improving documentation standards and mitigating the risk of legal

challenges.• Improving confidence in the Islamic finance industry.

Standardized contracts are also advantageous at the individual level. The whole process of negotiating different aspects of a transaction becomes more simplified and streamlined. As a result, negotiation will become more specific to the issues and specific to the particular transaction rather than all the aspects of the contract. Furthermore, financial insti-tutions will be better protected against risks that they cannot anticipate. Standardized contracts will also imply that all transactions will be easier to administer and monitor after the contract is signed. Moreover, stand-ardization of Shari’ah principles will also help the interface of Islamic finance with conventional financial institutions and will prevent con-straint on the global growth of Islamic finance.

The standardization of Shari’ah rules needs to take place on two lev-els. First, at the national level, the rules governing economic transactions can be standardized by a national Shari’ah supervisory board. This body will be responsible not only for issuing rulings but also codifying them for application. Examples of national-level Shari’ah supervisory boards are those existing in Indonesia, Sudan and Malaysia.

Second, in order to harmonize Shari’ah rules with global Islamic financial transactions, there is a need for an international body that can issue standardized rulings on economic transactions.

It is also important that the standardized contracts should be flexible enough to adjust to changing businesses and environments. Flexibility is desirable at both the transaction and market levels. Each transaction has unique features which need to be taken care of in the documentation.

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Furthermore, the contracts and documentation should be flexible enough to evolve to match the changes in market conditions and envi-ronment. This is particularly essential in a world witnessing financial innovations and change.

15.7 valUe-added roles of sharI’ah scholars

Islamic scholars interpret the principles of Shari’ah in the light of com-munity consensus and analogical reasoning, issuing a fatwa in order to give the go-ahead to a product they deem to be permissible. It is the role of Shari’ah scholars to determine whether a financial product or service is compliant with Shari’ah principles. The Shari’ah principles can be sub-ject to varying interpretations. While there are many areas of consensus, scholars sometimes differ in their opinions depending on their method of reasoning. This means that for Islamic finance, there can be differences of opinion, either within or across national borders, on the permissibility of certain instruments.

Shari’ah scholars in Shari’ah supervisory boards should be specialized jurists in Islamic commercial jurisprudence and experts in the field of Islamic Financial Institutions and should fulfil the following roles:

First, the Shari’ah supervisory board of an Islamic Financial Institution should control and monitor the religious side of Islamic finance institu-tion transactions, services and products. The Shari’ah supervisory board has to review all the decisions of the board of directors and top manage-ment to ensure their compliance with Shari’ah. Furthermore, they should authorize all financial products and transactions and ensure their compli-ance with Shari’ah. The Shari’ah supervisory board should have the right to appoint a Shari’ah internal auditor to monitor day-to-day transactions and report directly to the Shari’ah supervisory board. If the Shari’ah supervisory board discovers that any transaction violated Shari’ah and that this transaction has generated revenue to the Islamic Financial Institution, they should separate this type of earnings and donate it to charitable organizations.

Second, the top management of the Islamic Financial Institution should provide all the information that might assist the Shari’ah super-visory board members in applying Shari’ah rules to transactions or products regardless of the outcome. By having access to all resources of information, the Shari’ah supervisory board can justify its decisions.

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Third, the Shari’ah supervisory board should be heavily involved in advising and counselling, starting from the external environment of stakeholders, regulators and central banks, and also going inside to enlighten the management and employees. The Shari’ah supervi-sory board should be responsible for finding religious proposals and suggestions for financial transactions that might contradict Shari’ah. Furthermore, the Shari’ah supervisory board should continuously guide and train top management to apply the Shari’ah rules in daily transac-tions and avoid any conflicts before going into any agreement with investors.

15.8 Global harmonIzatIon

The recent history of the growth of the Islamic financial sector based on new rulings of Shari’ah scholars is an indicator of the adaptability of Islamic law. While Shari’ah law can evolve, other elements of the legal infrastructure, such as laws and statutes and dispute settlement institu-tions, also need to be strengthened.

Market makers involved in the Islamic financial industry also view the standardization of Islamic banking and financial regulations as an impor-tant matter for increasing the marketability and acceptance of Islamic products globally. Therefore, some international institutions have been established to promote international consistency in Islamic finance. For instance, the Islamic Financial Services Board (IFSB) puts forth stand-ards for supervision and regulation and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) issues interna-tional standards on accounting, auditing and corporate governance. But more specialized international institutions need to be established for the effective functioning of Islamic Financial Institutions in the global market.

It is true that several leading Islamic financial centres around the world have adopted IFSB and AAOIFI standards, but much needs to be done to standardize Islamic financial products and regulation at the international level. No doubt, efforts by AAOIFI to issue a codified ver-sion of Shari’ah standards in this respect are noteworthy. But as AAOIFI is an institution dealing with mainly accounting and auditing standards, there is a need for a global Shari’ah body that can harmonize diverse bodies of knowledge to one standardized version that the Islamic finan-cial industries around the world can use.

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The Islamic financial industry is subject to prudential requirements which are similar to those of commercial banks. The regulatory regime governing Islamic banking and financial institutions varies across coun-tries. International organizations such as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have been established to set standards to strengthen and eventually harmonize prudential regulations as they apply to Islamic Financial Institutions (IFIs).

16.1 ratIonale behInd PrUdentIal reGUlatIon

Prudential regulation as an appropriate legal framework for finan-cial operations is a significant contributor to preventing or minimizing financial sector problems. Evidence shows that the absence of prudential regulations in some key areas can lead to bank failures and systemic insta-bility. In establishing sound, clear and easily monitored rules for financial activities, prudential regulation encourages management to run institu-tions better and facilitate the work of supervisors.

The fact is that the various IFIs and intermediaries operate completely outside prudential regulations. Some countries have one single general banking law covering all regulations, but in many countries, the opera-tional issues are left to statutory notes, circulars or even simply the rou-tine decisions of supervisory institutions. Various other laws can also

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Gaining Strength: Prudential regulations in Islamic Banking

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_16

218 a. hassan and s. mollah

have an impact on the operation of IFIs, such as company laws, securities laws, debt recovery laws and laws on liquidation and bankruptcy.

Many Islamic economists such as M. Umer Chapra, Tariqullah Khan and Zamir Iqbal have said that regulation is essential for IFIs. There are three main rationales for such regulation:

1. The public good.2. Protection of public resources.3. Enhancement of the integrity of fiduciary contracts.

Public Good View

It is understood that regulation is a public good that the market cannot supply on its own. The first part of this is the mitigation of risks taken by stakeholders unable to undertake the necessary due diligence to assess these risks on their own. However, some stakeholders have sufficient investment savvy to develop these assessments on their own and would not, in principle, need the support of public regulation to the same degree, except for transparency and disclosure requirements necessary to conduct due diligence. The second part is to mitigate the risk of disrup-tion of normal business performed by the financial system in terms of the provision of liquidity. Systemic risks could be the outcome of spillo-ver from a distressed institution, undermining confidence in the system. In this view, prudential regulation would address the quality and quan-tity of the public good to be delivered, as well as the nature of the risks involved.

Protection of Public Resources View

Prudential regulation maintains an orderly payments system and ensures the development of the economy. Maintaining orderly payments is clearly good for the public, whose supply stability needs to be protected. The existence of explicit or implicit safety in the form of takaful or deposit mutual insurance creates a government-contingent liability. The exist-ence of such a commitment of public resources entails not only the right, but also the duty of the public authority to regulate activities whose per-formance may endanger these resources.

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Integrity of Fiduciary Contracts View

Prudential regulation focuses on the fiduciary nature of the business of finance. The role of regulation is seen here as the provision of sufficient checks and balances to mitigate the risks of the intermediary failing the trust of its stakeholders. These are generally seen as the depositors, but also include small shareholders, raising the importance of sound corpo-rate governance. Prudential regulation should also integrate IFIs into the international financial system for financing the international trade and payments system. Counterparts of IFIs need to be satisfied with the ability and commitment of IFIs to fulfil the contracts they enter into. In this respect, national and international regulation can be grounded in the need to ensure orderly participation in international payments and the integrity of fiduciary contracts. Furthermore, in jurisdictions where the distinction between civil and religious law is less pronounced, one can see a public policy choice for assigning to a public regulator the role of ensuring that banking activity complies with Shari’ah.

The primary candidates for regulation are risk management, capital, transparency and licensing requirements. The method of prudential reg-ulation can rely to various degrees on a combination of direct “command and control” rules, market discipline and organization-specific home- developed risk assessments. The type and method of regulation chosen will depend naturally on the regulation rationale adopted, the extent to which IFIs follow core Shari’ah principles and assessment of their practices.

16.2 sUPervIsIon In IslamIc bankInG

Prudential regulation involves the imposition of rules or standards to govern the behaviour of regulated bank or financial institutions which are deposit-taking institutions. Prudential regulation is generally targeted to minimize the risk that institutions are unable to meet. regulation involves the development and enforcement of legislation and regulations, issuance of guidelines and approval of requests from regulated bank or financial institutions. Supervision, on the other hand, involves assessing the safety and soundness of individual regulated banks or financial insti-tutions and using supervisory powers to intervene to protect the rights and interests of depositors.

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Prudential supervision is necessary to ensure the soundness of the Islamic banking system and enhance banks’ developmental role. Luca Errico and Mitra Farabaksh present the following five reasons for the supervision of Islamic banks:

1. It may be worth keeping in mind that in an Islamic banking, investment risk is a critical operational risk that affects the bank because it is inherent in Islamic banks’ profit and loss sharing mode of financing. Therefore, assessment and management of investment risk become more difficult in Islamic law of contract. Main factor is that in Mudarabah contracts, the Islamic bank cannot exert con-trol on the management of the investment projects, and as a result, the administration of the profit and loss sharing modes of finance is more complex. Therefore, insolvency rules cannot be ruled out, notably in cases where Islamic banking operations are carried out to two-tier Mudarabah arrangements.

2. The risk of economic losses may be incurred in Islamic banks as a result of poor investment decision due to volatile operating envi-ronment, weak internal governance and limited market discipline.

3. Weak banks may detract from the achievement of fundamental macroeconomic objectives, such as the efficiency of the payments system and the effectiveness of monetary policy, particularly if implemented through the use of indirect instruments.

4. A weak banking system is likely to prevent the economy from ben-efiting from the ongoing globalization and liberalization of bank-ing and capital markets, particularly in countries where banks are the major players in domestic financial markets.

5. The possibility of economic losses or losses incurred as a result of poor investment decisions. Economic losses would be reflected in the depreciation of depositors’ wealth and in a decline in Islamic banks’ profitability. Such losses could jeopardize Islamic banks’ soundness if not corrected. Hence, compliance of regu-lation in Islamic banking principles should be ensured by proper supervision.

(Please see the paper titled “Islamic Banking: Issues in Prudential regulation and Supervision” by Luca Errico and Mitra Farabaksh, 1998; IMF Working Paper No. WP/98/30.)

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While, in principle, the central bank plays the same role in regulating banking and financial transactions when dealing with Islamic banks and other IFIs, in practice, problems have arisen where Islamic banks operate side by side with conventional banks. Elements that are very important in overcoming these problems and for the efficient functioning of Islamic banking include:

• Adoption of international standards for Islamic banks and IFIs.• Adoption of reserve requirement ratios for Islamic banks.• Appropriate monetary policy tools for Islamic banks.• The use of a lender of last resort facility by Islamic banks.

Therefore, there is a need for unified international best practices and prudential standards for supervision and regulation of Islamic banking to ensure:

• A legal framework for the functioning and supervision of Islamic banks. Banking laws or other laws pertaining to the banking sector should define the specific nature of Islamic banks and their relations with the central bank.

• Adequate risk management for Islamic banks and other IFIs.• Adequate disclosure of information by Islamic banks and other IFIs.• Adequate corporate governance in Islamic banks and financial

institutions.

The stress on these issues is likely to strengthen Islamic banking supervi-sion and therefore, the soundness of Islamic banks. Besides the AAOIFI and the IFSB, other institutions have recently been established which are involved in regulatory issues, such as the International Islamic Financial Market (IIFM) and the International Islamic rating Agency (IIrA). These organizations will also strengthen and harmonize prudential regu-lations as they apply to the Islamic banking and financial institutions.

16.3 lookInG to the fUtUre

Broad and deep financial markets, robust and effective regulatory and supervisory arrangements, sound corporate governance rules and a clear accounting and auditing framework would mitigate concerns of insta-bility and weak system integrity. Many of these conditions are not yet

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present for the Islamic finance industry, due to either the limited harmo-nization in its standards of operation or the poor institutional environ-ment in many of the jurisdictions where it operates. In such a context, Islamic banking and financial institutions are subject to prudential requirements which are similarly applied to commercial banks, including Basel II, limits on exposures to single counterparties, connected lending restrictions and corporate governance standards. A framework for the industry that can accommodate core principles of Shari’ah and address some of the deficiencies of the broader institutional infrastructure could result in IFIs structured as a group of fairly independent entities, each designed to optimize the functional demands of its clients.

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Islamic banking and finance is part of the broader concept of Islamic economics, which aims at the introduction of the value system and ethics of Islam into the economic sphere. Islamic banking and finance can be described as a system which provides just financing. It is free from factors unlawful to Islam and offers benefits not only to the shareholders of the bank but also to the stakeholders of the bank.

Islamic banking and finance not only faces the same risks as con-ventional banks, it is also confronted with new and unique risks as a result of their unique asset and liability structures. Islamic banking and finance needs different risk identification processes and risk management approaches and techniques. The unique risks arising from compliance with Shari’ah rules and principles need to be addressed by Islamic bank-ing and finance system and included in their assessment of risk manage-ment system.

17.1 rIsks In IslamIc fInancIal InstItUtIons

In order to realize the risks in Islamic finance, it is important to look into the balance sheet of the IFIs. Take for example, some Islamic econ-omists (like Iqbal et al. 1998; Hassan 2009) distinguish two models of Islamic banks based on the structure of their assets. Firstly, it is two-tier Mudarabah model that replaces interest by profit-sharing modes on both liability and asset sides of the bank. In particular, all assets in this model are financed by profit-sharing modes of financing, i.e. Mudarabah.

CHAPTEr 17

risk Management in Islamic Financial Institutions

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224 a. hassan and s. mollah

This model of Islamic banking will also act as an investment intermedi-ary. Second model of Islamic banking is the one-tier Mudarabah with multiple investment tools. This model has evolved due to the practical and operational problems faced by Islamic banks in using profit-sharing modes of financing on the assets side.

Further, Islamic banks use cost-plus mode of finance (Murabaha), long-term Murabahah, bai-mujjal (price differed sale), Iatisna, Salam (pre-paid sale), Ijarah (leasing) and Musharakah or Mudarabah on the assets side of the Islamic bank’s balance sheet. On the liabilities side, sav-ings and investment deposits take the form of profit-sharing investments accounts. The return on profit-sharing investments accounts is state con-tingent and neither the principal nor a return is guaranteed. The own-ers of the profit-sharing investments accounts participate in the risks and share in the Islamic bank’s profit and losses.

Bahrain and Kuala Lumpur based IIFSB (2005) has identified the var-ious risks face by institutions offering Islamic Financial Services has been discussed below. However, IFIs use a well-developed system for man-aging operational risk that lets risk managers conduct risk analysis and self-assessment exercises.

17.2 market rIsk

Market risk is defined as “the risk of losses” in “on- and off-balance-sheet” positions arising from movements in market prices. There are many market conditions which affect the banks and expose them to mar-ket risk. Changes in price of equity, interest rate, foreign exchange rates and prices of commodities are the main conditions. The balance sheets of the banks contain assets, liabilities and equities that are financed. Any price change in any one of the items will affect the banks’ financial stand-ing. For example, a bank with unmatched currency of assets and liabili-ties will be exposed to foreign exchange risk. A variable interest rate on assets and fixed interest rate on liabilities will expose banks to interest rate risk.

The Islamic laws (Shari’ah) forbid riba (interest); however, they do not prohibit lawful gains of capital. In Islamic banking, interest and the associated risks can be thought of as inclusive in the use of capital, which cannot be totally devoid of risk. Islamic banking is a system of exchange based on the premise of an equitable transfer between the two parties, in which there is equality in risk sharing and a clear title to the ownership

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and handling of assets. This risk sharing increases the need for assessing and evaluating the exposure that both parties are undertaking.

For instance, in Mudarabah contracts, the holder of the investment account shares the profit and also bears the market risk as well as the credit risk. The investor provides capital and therefore is eligible to share the profit, rather than receiving interest. The investor also shares the risk exposure and hence, the potential losses.

Market risk can be divided into two subcategories: systematic and unsystematic.

Unsystematic Risk

By utilizing Murabahah or Ijarah, Islamic banks are exposed to market risks of specific commodities. Since Islamic banks purchase commodities and take them into their possession, any change in price will affect their ability to sell them to third parties. Furthermore, the same risk applies to the value of the collateral. As Islamic banks collateralize Murabahah and Ijarah transactions, the commodity is also considered part of the col-lateral. Any change in price would not affect the amount of debt owed to the Islamic bank, but would change the value of the collateral. In Mudarabah and Musharakah partnerships, Islamic banks expose them-selves to risks that are specific to certain lines of business. For instance, if a Mudarabah partnership is established for a company that deals in tex-tiles and the prices of textiles decrease drastically, Islamic banks’ invest-ment would be affected negatively. Such risk is unique to Islamic banks and should be evaluated thoroughly.

In real operation, Islamic banks prefer trade-related instruments over equity-related instruments due to the business risk involved. Islamic banks also face unsystematic risk with Istisna and Salam contracts. Any single and independent event may affect the production/harvest of the subject goods. Therefore, an Islamic bank could receive the promised goods lately or may not receive them at all. Product-specific risk is also vital for Islamic banks to evaluate.

Systematic Risk

Investment account deposit holders are not promised a fixed return. Thus, Islamic banks are not exposed to any interest rate risk directly. However, Islamic banks face interest rate risk in two indirect ways.

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First, any profit margin added to a Murabahah transaction may use a benchmark rate. This rate should be high enough to meet the expecta-tions of the profit- and loss-sharing customer. Therefore, the benchmark rate will be close to a market interest rate. Any increase in the benchmark rate will expose Islamic bank to risk of withdrawals due to the fact that Murabahah deals have fixed payment schedules and the profit amounts cannot be changed.

Second, some of the credit customers of Islamic banks also work with conventional banks. In case of interest rate jumps, such companies would prefer to make payments to conventional banks due to the high cost of increased interest. They may even choose to divert the funds, which they plan to pay towards their Murabahah payments, to repay their debt with conventional banks. The fact that Islamic banks cannot impose a penalty on late Murabahah payments exposes Islamic banks to late payment risk and such risk increases with increased market rates.

Islamic banks may have different currency denominations for assets and liabilities, and any changes in currency prices expose Islamic banks to foreign exchange rate risk. While conventional banks may employ deriv-ative products to hedge such risk, no such financial product exists for Islamic banks.

Financial instruments of Islamic banks require involvement in real business sectors. Conventional banks, on the other hand, may choose to keep more government bonds than commercial credit. Therefore, Islamic banks would be exposed to macroeconomic changes more than conventional banks.

17.3 credIt rIsk

Banks are exposed to credit risk through default. Any counterparty of a credit transaction can expose the bank to credit risk. A customer with a loan agreement can expose the bank to credit risk due to the chance that he or she will not meet his/her obligation on time or at all. In such a cir-cumstance, the principal and earnings are at risk.

Due to increase in bankruptcies, the competitive spreads in loans and risk-adjusted credit policies have made credit risk an important type of risk for most banks. The main drivers for evaluating credit risk are the risk weights defined either by external bodies or internally by the bank. The Basel II proposals accommodate three approaches to estimate the risk associated with each and every asset of the banks: the standardized

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approach, the internal rating-based (IrB) approach and the advanced measurement approach. No matter which method is used, the total of credit risk-weighted assets will be used in the calculation of minimum capital that will be required by the supervisory authority.

The nature of Murabahah and Ijarah transactions of Islamic banks exposes them to similar credit risks as conventional banks. However, Mudarabah and Musharakah partnerships have unique credit risks. In a Mudarabah partnership, the operations depend on the managing part-ner. Islamic banks can be exposed to credit risk in Mudarabah through the managing partner’s fraud, misconduct, negligence or incompetence. There is also credit risk from the businesses involved. If the business cannot generate profits and starts realizing losses, the Islamic bank will have losses as well. This type of credit risk also applies to Musharakah partnerships.

Ijarah and Salam transactions also expose Islamic banks to credit risk. In both types of transactions, customers are expected to either produce or harvest goods. Their end product is purchased ahead of time to pro-vide funding. However, delayed or incomplete production/harvest will generate losses for the Islamic bank. Islamic banks cannot hold inter-est-bearing securities in any way.

While it is a normal procedure to ask for securities as collateral for credit, Islamic banks can only ask for non-interest-bearing instruments. It may not be easy to liquidate a non-interest-bearing instrument such as a mortgage. Thus, Islamic banks face market risk in collateralization of credit as well.

17.4 lIqUIdIty rIsk

Banks have daily liquidity requirements arising from activities including withdrawals, paying cheques, regulatory payments and credit payments. It is the responsibility of banks to undertake these payment obligations in a timely manner. risk of failure to do so is the liquidity risk. Banks have the option of borrowing in the money market for short-term liquid-ity needs, but such borrowing will be costly.

Islamic banks cannot borrow from money markets that operate with interest. Central banks also lend money with interest. The fact that there is no lender of the last resort exposes Islamic banks to liquidity risk in a vital way. In fact, illiquidity is the most important risk that an Islamic bank faces.

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Murabahah and Ijarah transactions have fixed scheduled payments. They cannot be called, as credits of conventional banks can be. Mudarabah and Musharakah transactions only make payments in case of profits, and the principal amounts are collected in case of liquidation. Istisna and Salam transactions have very long maturity structures, and any collection of prin-cipal is not possible before the completion of the project or harvest of the goods.

Conventional banks keep fixed-income securities in liquid assets; the liquidity of conventional banks is usually higher than that of Islamic banks. Since Islamic banks cannot get any return on liquid assets, the trade-off between safety and profitability is considerably higher for Islamic banks.

In principle, Islamic banks should be more liquid than conventional banks. In practice, it is the opposite. The cost of liquidity reflects directly upon the profitability of Islamic banks and their preference is to have lower liquidity levels. The fact that conventional banks keep short-term securities as liquidity and earn interest on them provides a safety cushion that is not available for Islamic banks.

17.5 oPeratIonal rIsk

Operational risk, as defined by Basel II, is the risk of losses resulting from inadequate or failed internal processes, people or systems or from exter-nal events.

In Islamic banking, the losses initiated from operational risk are fully covered by the institutions if fraud or breach of contract is fully proven. Nevertheless, when these losses have a significant value, they will directly or indirectly affect both financial institutions and their clients. Moreover, external catastrophic events cause an enormous number of losses and they need to be considered.

Furthermore, the operations of Islamic banks are not standardized. Even the application of Islamic banking products may differ from one bank to another. Many products of Islamic banks require adaptation to regulations that are designed for conventional interest-bearing sys-tems. These adaptations may bring complications with them and expose Islamic banks to operational risk.

The International Accounting Standards Board (IASB) does not include any standard to be used for Islamic banks. The Accounting and Auditing Organization for IFIs (AAOIFI) works towards providing

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standards for IFIs. However, the standardized accounting principles of AAOIFI are not adopted by most of the regulatory agencies for Islamic banks in their jurisdictions.

17.6 leGal rIsk

risk arising from laws and regulations is called legal risk. Islamic banks operate in interest-bearing financial environments, and such economies expose many risks for Islamic banks. In particular, if regulations designed for conventional banks do not include specific procedures for Islamic banks, complications may arise.

Operating within interest-bearing environments and competing against conventional banks expose Islamic banks to legal risk in terms of Shari’ah. In these environments, it can become cumbersome to facil-itate Murabahah transactions and equity participation of banks may be limited. Such situations would make it also impossible to undertake Mudarabah or Musharakah. Islamic banks may find sideways to over-come legal obstacles, but such procedures could also expose Islamic banks to legal risks.

17.7 rePUtatIon rIsk

The success of an Islamic bank or financial institution depends on stake-holders’ belief that the business of their Islamic institution is complying with Shari’ah principles. This is one of the main factors that intensify the role of good governance to ensure that the trust of stakeholders is not compromised and that business grows according to expectations. reputation risk arises out of any uncertainty of Shari’ah compliance. reputation risk can also arise from the perception of a link of an Islamic bank with unlawful financing. In the aftermath of September 11, 2001, Islamic banks made a lot of investment in their know-your-customer sys-tems and anti-money-laundering procedures in order to curb this risk.

17.8 rIsk related to hUman resoUrces

The shortage of skilled human resources is becoming a bigger concern for the Islamic banking industry. The strong growth in Islamic finance over the past decade and the creation of new Islamic banks mean that having and maintaining qualified human resources are becoming very

230 a. hassan and s. mollah

challenging. This risk could result in management discontinuity and ulti-mately damage the creditworthiness of an Islamic bank.

17.9 room for adaPtatIon

With the growing globalization of the financial markets, the risks associ-ated with conventional banking are likely to affect the markets of Islamic banking. Hence, Islamic banking cannot be seen in isolation. Although major differences exist between Islamic and conventional banks, Islamic banks must cope with international banking standards and provide via-ble and safe banking grounds. Although there are many shortcomings for Islamic banking, Bank of International Settlement (Basel) II & III permits enough room for adaptation of Islamic products.

Central banks and regulatory agencies must be responsible for impos-ing Basel II & III in their jurisdictions. Their understanding of Islamic banking and its potential for their economies will bring the coopera-tion that Islamic banks need to establish a well-structured and stabilized banking system which is very different from conventional banks.

references

Hassan, H. H. (2009). Basic Shariah Principles Governing Risk Management. Paper presented at the Harvard LSE Workshop on risk Management, London School of Economics, February 26, 2009.

IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB.

Iqbal, M., Ahmad, A., & Khan, T. (1998). Challenges Facing Islamic Banking (Occasional Paper No. 1). Jeddah: Islamic research and Training Institute.

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The Islamic Financial Service Board (IFSB) capital adequacy framework serves to complement the Basel Committee on Banking Supervision (BCBS)’s guidelines in order to cater to the specificities of Islamic banks/Islamic Financial Institutions (IFIs). A key issue related to the implementation of Basel II was to capture different types of risks faced by conventional banks and that do not cater to the risk specificities of Islamic banks. In 2010 BCBS issued two documents (Basel III) introduced buff-ers and deals with liquidity risk not accounted for in previous frameworks. New Accord does not represent a third vision of capital requirement for banks but a reinforcement of the Basel II framework. While the Auditing and Accounting Organisation of IFIs (AAOIFI) focuses on the sources of funds of an Islamic bank the IFSB however goes a step further consider-ing the uses of funds and assigning appropriate risk weights to each asset items that meet internationally acceptable prudential standards. Based on the secondary information this study provides an empirical fieldwork by analysing the implications of the Basel II Accord to Islamic banks in the light of IFSB guidelines. Since BCBS has not taken into account specifi-cities of Islamic banks in the elaboration of Basel III therefore this paper also made an attempt to confront the new requirements to these specif-icities. Balance sheet of Al-rajhi bank has been studied under the new framework and the results show that the move of Basel III frameworks from debt-based to equity-based instruments is fully in line with the busi-ness model of Islamic banks. Furthermore excess liquidity detained by Al-rajhi bank is actually an advantage under Basel III.

CHAPTEr 18

The Basel Accords in relation to Islamic Finance

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_18

232 a. hassan and s. mollah

18.1 IntrodUctIon

What is Basel Accord? Answer of the question cannot be given in one word. We know that the banks are a vital part of a nation’s economy. In their traditional role as financial intermediaries, banks serve to meet the demand of those who need funding. As such, banks make it pos-sible for people to buy homes and for businesses to expand. Banks therefore facilitate spending and investment, which fuel growth in the economy. However, despite their important role in the economy, banks are nevertheless susceptible to failure. Banks, like any other business, can go bankrupt. However, unlike most other businesses, the failure of banks, especially very large ones, can have far-reaching implications. As we know that during the Great Depression and most recent global financial crisis during the year 2007–2008 and the ensuing recession, the health of the bank system could trigger economic calamities affect-ing millions of people. Consequently, it is imperative that banks oper-ate in a safe and sound manner to avoid failure. One way to ensure this is for governments to provide diligent regulation of banks. Yet, with the advent of globalization, banking activities are no longer confined to the borders of any individual country. With cross-border banking activities rapidly increasing, the need for international cooperation in bank regulation has likewise increased. ready to meet this need is the BCBS.

In its role as the international advisory authority on bank regula-tion, the BCBS has promulgated guidance on issues critical to ensur-ing health in the banking systems across the world. One such issue, and one that played an important role in the recent global financial crisis, is the regulation of bank capital. Addressing this issue has been an ongoing process for the BCBS over the past twenty years and has resulted in the promulgation of capital adequacy standards that national regulators can implement. These standards are known collec-tively as the Basel Accords, named after the city in Switzerland where the BCBS resides. The Basel Accords have caused disagreement at times, but they are nevertheless important to the formulation of reg-ulatory policy relating to bank capital. In all, the BCBS has produced three such Accords.

Basel I was finalized and approved by the BCBS in 1988. Again, because the BCBS has no binding legal authority, countries had the option to adopt Basel I’s standards. Many BCBS member countries, as

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well as many non-member countries, did adopt Basel I, however, and thereby incorporated its features in their own domestic regulatory law. Since the BCBS’ work focused on banking at the international level, it intended that Basel I would be applied only to internationally active banks. However, many countries ultimately applied Basel I’s require-ments to all banks.

However, the BCBS organized Basel II around which it is called the “Three Pillar” approach. For the purpose of our discussion, however, attention will primarily be given to Pillar I, which is the Pillar that most directly addresses the issue of calculating capital adequacy and is also the Pillar that specifically attempts to correct the deficiencies identified in Basel I. Pillars II and III (of the Basel II) deal with supervisory review standards and market discipline issues, respectively, while important aspects of capital regulation do not have a direct bearing on the calcula-tion of bank capital adequacy.

The BCBS promulgated Basel III in September 2010. Formally titled, “A Global regulatory Framework for More resilient Banks and Banking Systems,” Basel III reflects the BCBS’s attempts to apply lessons learned from the financial crisis and apply them to the existing framework of banking regulation. Thus, Basel III does not replace Basel II, but rather augments it. The primary goal of Basel III is to improve the ability of banks to absorb asset losses without affecting the rest of the economy. Therefore, the Basel III package was proposed to ensure that the finan-cial system cannot suffer the type of collapse and resultant economic slowdown that occurred between 2007 and 2009. It encompasses:

– an un-weighted leverage ratio (Lr);– two new capital buffers—a conservation buffer and a countercyclical

buffer;– new and substantial capital charges for non-cleared derivative and

other financial market transactions; and– significant revisions to the rules on the types of instrument that

count as bank capital.

In sum up, it may be mentioned here that Basel Accords I, II and III have purported to improve upon the previous one, but some indications suggest that Basel III is not flawless and so it will likely not be the last Accord.

234 a. hassan and s. mollah

18.2 base accord aPPlIcatIon In IslamIc banks

Islamic banks are among the best capitalized banks in the world and his-torically comply with inflexible standards of capitalization; Islamic banks for capital requirements mean that local banks already exceed norms set by the Bank for International Settlements (BIS) as part of the Basel I, II and III Accords. Most Islamic banks already have stricter capital require-ments than what is proposed in Basel III. Therefore, Islamic banks being among the best capitalized on a global scale, they are on the safe side compared to their European or US counterparts. Their Tier 1 and total capital requirements currently stand at 8 and 12%, respectively, which are already higher than the target 2019 ratios set by Basel III.

Although the balance sheet underlying the rules of the Basel Capital Accords belongs to the conventional banking system whose structure essentially differ from that of Islamic banking system in terms of both liability and assets, but Islamic banks were required to abide by this international standard as well because capital adequacy has become the keystone for safety that reflects supervisory concerns. Definitely, the adoption of Basel Accords by Islamic banks has helped to enhance their credibility and fuelled their growth worldwide, even though no specific requirements addressing the particularity of Islamic banks’ balance sheet structure were introduced under these Accords.

The emergence of Islamic banking system onto the global state, the Basel II Capital Accord and its successor, Basel III, makes no distinction between conventional and Islamic banks. Despite the shortcomings of the Basel standards when applied to Islamic banks, the IFSB has worked hard to develop standards or guidelines that address risk issues specific to Islamic financing, as well as adapting elements from the Basel stand-ards to make them more relevant to Islamic banks/Islamic Financial Institutions (IFIs). The IFSB’s Capital Adequacy Standard, issued in 2005, forms the basis of the capital adequacy framework for Islamic banks and later it issued a revised framework in 2007 on the basis of Basel II revised Accord. Further, in the light of the Basel III guidelines, in December 2011, the IFSB published a risk management and capital adequacy guidance note for commodity Murabahah (trade-related cost-plus mode of finance) transactions. This guidance complements previous work by the IFSB in those areas (IFSB 2011).

The capital adequacy framework for Islamic banks, issued in 2007, addresses credit, market, operational and liquidity risks inherent to

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Islamic banks, as well as risks peculiar to Islamic banking transactions, such as Shari’ah non-compliance risk, rate-of-return risk, displaced com-mercial risk (DCr), and inventory and equity investment risks. Yet, the question remains as to whether individual regulators grant exemptions to IFIs within their jurisdiction to follow the IFSB standards or treat them on a par with other institutions following the Basel II standard. Most of the Muslim countries have adopted the Basel II standards, with most adhering to the standardized approach to risk measurement. But there is some debate over how the new set of international capital adequacy standards in the Basel III proposals would be adapted to fit the market dynamics of those countries where Islamic finance is prevalent.

As a result of particular nature of their activities, the risks born by IFIs differ to a greater or lesser extent from those outlined in Basel II. Serious attempt has been made by Islamic Financial Services Board (IFSB) to develop a better capital adequacy framework that addressed the risk pro-file of IFIs. Much of the IFSB efforts to develop a regulatory framework for the Islamic bank rest on already existing guidelines for conventional banks. As regards, Basel III does not represent the third version of cap-ital requirement for banks but reinforcement of Basel II framework. In fact, the Basel III is largely a response to the systemic failures that occurred in the conventional banking system, and as such, it is trying to resolve a problem that Islamic financing should never find itself in.

There are many issues still need to be clarified and addressed, given the specific nature of financing techniques developed by Islamic banks. The main focus of this chapter is:

1. To provide an empirical fieldwork by studying the implications of the Basel II Accord to Islamic banks in the light of IFSB guidelines and

2. To find out how the Basel III framework can be adjusted for Islamic banks taking into account at the particularity of their bal-ance sheets.

18.3 caPItal adeqUacy frameWork Under basel accord

Capital adequacy ratios are a measure of the amount of capital that a bank must hold expressed as a percentage of the bank’s total risk-weighted assets. Under Basel I and Basel II agreements, in order to be

236 a. hassan and s. mollah

classified the banks as “adequate capitalized,” they are required to hold a minimum 8% (Tier 1 representing at least 4% in Basel I) capital to assets ratios. The capital adequacy ratios can be computed by dividing total capital by total risk-weighted assets. Based on credit and counter-party risk, Basel I classified assets into five risk groups: 0, 10, 20, 50 and 100%. It was found that the Basel Accord, 1998, has many deficiencies that appealed for further review. For example, short-term funding was considered less risky than long-term financing and thus received a weight of 20%, while anything with a maturity greater than one year was risk-weighted 100%. Such a risk-weighting system might have contributed to financial instability by encouraging short-term lending at the expenses of longer-term stable credit.

New Basel II

BCBS has released consultative document confirming its proposal for Basel Capital Accord in 2001. It covers three mutually reinforcing areas, the so-called pillars comprising: (i) minimum capital requirements; (ii) the supervisory review process; and (iii) market discipline.

The first pillar reviews the calculation of minimum capital require-ments and technical issues leading to the capital adequacy requirements. The second pillar establishes key principles designed to ensure an effi-cient supervisory process. The third pillar reviews minimum disclosure requirements necessary to enhance market discipline (Basel Committee 2001; Muljawan et al. 2004). Without changing the definition of capi-tal, in the new Basel II Capital Accord, the computation of risk-weighted assets (rWA) has been modified with the inclusion of two additional types of risk: market risk and operational risk. Market risk results from the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. Of the innovations under Basel II, bank activities are classified into either banking or trading books for the pur-pose of calculating capital adequacy ratio. While the banking book consists of all banking activities such as the transformation of deposi-tors’ funds, the trading book clusters the activities that involve buying and selling of securities. Bank’s exposure to market risk is reflected in their portfolio of securities and is therefore estimated based on its trad-ing book. On the other hand, operational risk refers to the risk of less resulting from inadequate internal processes. For conventional banks, the

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capital adequacy ratio, as stipulated in Pillar 1 of Basel II as express as: Capital Adequacy ratio1

The methodology for calculating risk-weighting assets is highly impor-tant as riskier assets imply that a bank will need to increase its capital base in order to stay adequately capitalized. Pillar 1 of Basel II set a detailed framework for calculating rWA to cater to the different levels of risks that conventional banks are exposed to in their daily activities.

Basel III: Higher Capital Requirements and Liquidity Rules

In December 2010, the BCBS issued two documents constituting a reform to the minimum capital requirement for Banks. In fact, this new framework, known as Basel III, is committee’s response to the last finan-cial crisis. It may be noted that the Basel III does not represent the third version of capital requirement for banks, but a reinforcement of the Basel II framework. The new calibrated Basel III rules (BCBS 2011) and the transitional arrangements are summarized below:

New Capital Requirements

A. Capital ratios and deductions (Core Tier 1/common equity)

The Basel II rules require that a bank hold 2% of Core Tier 1 capital to risk-weighted assets. Core Tier 1 consists of ordinary shares, retained earnings and profits. The Basel III rules replace the concept with a tougher categorization: “common equity.” This basically consists of common shares plus retained income. The rules require banks to hold 4.5% of common equity.

(18.1)(CAR) =Tier 1 Capital+ Tier 2 Capital

RiskWeightedAssets.

1 Tier 1 capital consists of current accounts, saving accounts, time deposits, certificate of deposits and share capital plus reserves. Tier 2 capital consists of cumulative preferred shares plus subordinated debt.

238 a. hassan and s. mollah

B. Total Tier 1

The total Tier 1 requirement increases from 4 to 6% under Basel III, which means that other types of Tier 1 instrument, known as additional going concern capital, can account for up to 1.5% of Tier 1 capital.

C. Total Capital

The total minimum capital requirement remains at 8%, subject to a new capital buffer. However, 6% of capital must be Tier 1, which means that Tier 2 (which will no longer be divided into upper and lower tiers) can account for no more than 2% of capital. Tier 3, which is used solely for market risk purposes, will be removed completely.

D. Deductions from Capital

Under Basel III, deductions from capital must generally be made from common equity Tier 1. This requirement is stricter than the current rule, whereby a number of deductions are made from total capital. However, the July 2010 Basel III amendments relaxed some of the proposed deductions, allowing partial inclusion of minority interests and cer-tain deferred tax assets and mortgage-servicing rights (rather than their deduction, which had been proposed in December 2009).

New Capital Buffer

A. Capital Conservation Buffer

All banks will be required to hold sufficient capital to meet the mini-mum capital ratios, as well as having a capital conservation buffer above the minimum 8% total capital. This buffer is set at 2.5% and must con-sist solely of common equity, after deductions. In effect, common equity capital must be equal to 7% of risk-weighted assets, other than in times of stress, when the buffer can be drawn down. This, therefore, represents more than a threefold increase in the existing 2% Core Tier 1 requirement. The purpose of this buffer is to ensure that banks can maintain capital levels throughout a significant downturn and that they have less discretion to deplete their capital buffers through dividend pay-ments. Banks that do not meet this buffer will be restricted from pay-ing dividends, buying back shares and paying discretionary employee bonuses.

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B. Countercyclical Buffer

In addition to the conservation buffer, banks may at certain times be required to hold a countercyclical buffer of up to 2.5% of capital in the form of common equity or other fully loss-absorbing capital. This buffer is a macroprudential tool to protect banks from periods of excessive credit growth and is at the national regulators’ discretion. It will there-fore apply only when a national regulator considers that there is exces-sive credit growth in the national economy, and will be introduced as an extension of the capital conservation buffer.

Leverage RatioWhile banks in the USA have been subject to a Lr for some time, this tool has never previously been part of the Basel regulatory framework. The committee has agreed to test an un-weighted ratio of 3% over a transition period. It has made a number of changes to features of the ratio as they were set out in its July 2010 revisions; among other things, it allows netting based on the Basel II rules.

Systemically Important BanksThe committee has stated that systemically important banks should be subject to higher capital requirements than those in the Basel III pack-age. Work continues on the proposals. Options include capital sur-charges, contingent capital and bail-in-debt.

Liquidity RulesThe new liquidity coverage ratio (LCr) and net stable funding ratio will be introduced in accordance with the timing detailed below.

(i) Common Equity, Tier 1, Total Capital and National Implementation

The new capital ratios will be phased in. National implementation must begin on January 1, 2013, by which date banks should have 3.5% common equity, 4.5% Tier 1 capital and 8% total capital. In 2014, this increases to 4% common equity and 5.5% Tier 1 capital. The full ratios (i.e. 4.5% common equity and 6% Tier 1 capital) apply from January 2015.

(ii) Grandfathering of Existing Capital Instruments

Capital instruments which do not meet the criteria for inclusion in the common equity element of Tier 1 cannot count as common equity from

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January 1, 2013. However, certain instruments issued by non-joint stock companies which are Core Tier 1 at present will be grandfathered on a declining basis over a longer period. Certain conditions apply, including the provision that such instruments be treated as equity under prevail-ing accounting standards. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10-year period starting on January 1, 2013. Their recognition will be capped at 90%, to be reduced by 10% each year. Instruments with an incentive to redeem will be phased out at their effective maturity date. Only instruments issued before September 12, 2010 qualify for the tran-sitional arrangements. Existing public-sector capital injections are grand-fathered until January 1, 2018.

(iii) regulatory Deductions

Deductions will be phased in. Initially, 20% of the required deductions from common equity will apply by January 1, 2014, to be increased by 20% a year thereafter until 100% of the deductions are made from com-mon equity by January 1, 2018.

(iv) Capital Buffers

The capital conservation buffer will be phased in at 0.625% on January 1, 2016 and will reach 2.5% by January 1, 2019. The committee also states that banks which meet their general ratios, but remain below the 7% common equity target during the transition period should “main-tain prudent earnings” so as to meet the buffer as soon as possible. It is unclear exactly what this means and whether the requirement catches banks that comply with the transitional capital buffer phase in require-ments over the period until January 1, 2019, but do not meet the 7% requirement until that date—it appears to do so.

(v) Leverage ratio

The 3% ratio requirement will run parallel from January 1, 2013 to 2017. The committee will track the ratio, its component factors, and impact over this period and will require bank-level disclosure of the ratio and its factors from January 1, 2015. Based on the results of the parallel run, final adjustments to the ratio will be made in the first half of 2017 and it will be fully effective from January 1, 2018.

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(vi) Liquidity ratios

The LCr will be introduced on January 1, 2015. The net stable funding ratio will be applied as a minimum standard from January 1, 2018.

18.4 basel methodoloGy to IslamIc bankInG and fInance

Basel II standards, however, do not account for the specific risks related to the nature of Islamic banks’ activities. The fundamental tenet of Islamic finance is that of fairness, and IFIs at a most basic level are often structured towards fee-based revenues for services rendered and profit- and loss-sharing structures. Thus, in essence, IFIs are closer in spirit to asset management companies than to conventional banking institu-tions, and the impact of their operations on the balance sheet is unique. Further, Islamic banks differ from conventional banks in that their activ-ities are not confined to financial intermediation. An Islamic bank acts as an investor, a trader, a financial advisor, a consultant and a financing house. As a result, there exist a variety of Islamic modes of financing, each one having its own risk characteristics affecting both sides of the bank’s balance sheet. These particularities highlight the unique charac-teristics of Islamic banks and raise serious concerns regarding the applica-bility of the Basel methodology to Islamic banks.

The risks that arise from Islamic banks’ operations differ from the conventional risks backed by their peers and are not accounted for in Basel II. In order to apply the Basel Capital Accord guide-lines within Islamic banking system, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) put forward capital adequacy framework proposals before Islamic banks for consideration.

AAOIFI Capital Adequacy Framework

In the year 1999, a serious attempt was made by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) to develop a better capital adequacy framework that would address the risk profile of Islamic banks. The AAOIFI framework proposed a method for calculating capital adequacy ratio for Islamic banks. Much of the sug-gested methodology is based on Basel II standards, with the key differ-ence relating to liabilities side of Islamic banks’ balance sheet.

242 a. hassan and s. mollah

In fact, sources of funds of Islamic banks differ from those of conven-tional banks. While evaluating the capital adequate ratio of Islamic banks according to Eq. (1), the calculation of capital is not really problematic as there are neither preferred shares nor subordinated debt, meaning that Islamic banks’ capital sources are: current account, savings accounts in addition to shareholders’ equity capital and reserves. Actually, invest-ment accounts are of two types: restricted and unrestricted. Firstly, funds collected under restricted investment accounts (rIA) represent fiduci-ary services because depositors make all investment decisions, and the Islamic bank simply collects a fee for playing the role of agent. As those funds are invested according to clients’ directives and are not at the dis-cretion of the banks, they cannot be part of a bank’s source of funds. In this context, the AAOIFI recommends that rIA be included as off-bal-ance-sheet items. The implication is that such investment funds will not be included in the calculation of capital adequacy ratio.

Secondly, unrestricted investment accounts should be included in the balance sheet of Islamic banks and have to be considered in the capital adequacy ratio. It may be mentioned here that the foremost particularity of Islamic banks’ liability is that unrestricted investment account (UIAH) holders agree to share in the profit and loss with the bank. This implies that such funds cannot be guaranteed by assigning them 100% weight in calculating the capital adequacy ratio, or else this will be contrary to the Shari’ah principle of participation. The purpose of the AAOIFI document on capital adequacy is to address this issue and to determine appropriate risk weights to unrestricted investments. In the proposed risk-sharing scheme of AAOIFI, investment account holders share part of the risk with shareholders, and the capital adequacy ratio (CAr) for an Islamic bank is calculated as:

Here RWAKδCA represents the average rWA financed by the bank’s capi-tal and depositors’ current accounts, and rWAUIA represents the average rWA financed by the unrestricted depositor’s investment accounts.

No doubt AAOIFI proposal is an important contribution to the unex-plored topic of how to account for the risk exposure of Islamic banks and develop a reliable capital adequacy framework. However, AAOIFI pro-posals do not deal with the specific nature of Islamic banks assets and their related particular risks, probably due to the lack of implementation of industry-wide accepted standards for Islamic banking practices.

(18.2)CAR =Total Capital

RWAKδCA + 50%(RWAUIA)

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The IFSB Capital Adequacy Framework

The IFSB serves as an international standard-setting body of regulatory and supervisory agencies that have an interest in ensuring the reliability and stability of the Islamic Financial Services industry. The general objec-tive of the IFSB is “promoting, spreading and harmonizing best prac-tices in the regulation and supervision of the Islamic Financial Services industry.” It is specifically concerned with the standardization of Shari’ah committee rulings on Islamic banking practices. The IFSB also aims at standardizing the approach in identifying risks in Shari‘ah-compliant products and services and in assigning risk weights that meet internation-ally acceptable prudential standards.

The IFSB ProposalLike the AAOIFI proposal, the IFSB capital adequacy framework serves to complement the BCBS’s guidelines in order to cater to the specifi-cities of IFIs. While the AAOIFI focuses on the sources of funds of an Islamic bank, the IFSB, however, goes a step further by considering the uses of funds and assigning appropriate risk weights to each asset item. The major contribution of the IFSB is to acknowledge that the uses of funds for Islamic banks, which are by nature Shari’ah compliant differ from the typical asset side of the balance sheet for a conventional bank.

The aims of the IFSB framework are:

– Identifying the specific structure and contents of the Shari‘ah-compliant products and services offered by Islamic banks not con-sidered under Basel II or by the AAOIFI.

– Standardizing Shari‘ah-compliant products and services by assigning risk weights to those that meet internationally acceptable prudential standards.

– Setting a common structure for the assessment of IFIs’ capital ade-quacy requirements.

– Including market risk not only in the trading book but also in the banking book of Islamic banks due to the nature of the banks’ assets such as Murabahah, Ijara, Salam, Musharakah and Mudarabah.

In December 2005, the IFSB issued the “Capital Adequacy Standard for Institutions (other than Insurance Institutions) Offering Only Islamic Financial Services” (IFSB 2005a). The recent standard takes into

244 a. hassan and s. mollah

consideration the specificity of investment account holders who share part of the risk with shareholders as follows:

Here, rWA (Credit risk + Market risk + Operational risk) include those financed by both restricted profit-sharing investment accounts (PSIA). The capital amount of PSIA is not guaranteed by the Islamic Financial Institution, and any losses arising from investments or assets financed by PSIA are to be borne by the investment account holders and thus do not command a regulatory capital requirement. This implies that assets funded by either unrestricted or restricted PSIA should be excluded from the calculation of the denominator of the capital ratio.

Higher Capital Requirements and Liquidity Under Basel III and IFSB’s Revised Proposal (Capital Conservation Buffer)As per Basel III, compulsorily all banks are required to hold sufficient capital to meet the minimum capital ratios (at least 6% of rWA), as well as having a capital conservation buffer (Ccb) above the minimum 8% total capital. This buffer is set at 2.5% and must be in common equity, after deductions. In effect, common equity capital must be equal to 7% of rWA, other than in times of financial distress, when the buffer can be brought down. This, therefore, represents more than a threefold increase in the existing 2% common equity Tier 1 (CET1) requirement.

In case of Islamic banks, the definition of rWA is slightly different. In a typical Islamic bank, there are three fund resources: Islamic bank’s own capital, demand deposits and PSIA. This PSIA is subdivided into two categories: unrestricted investment accounts (UIA), on which the bank has full discretion in the way it invests them; and rIA, where hold-ers of these accounts define contractually, to the bank, the way it invests their funds (IFSB 2011). An Islamic bank acts as a mudarib for these two types of accounts. This means that it does neither guarantees profits, nor the capital, which are contingent to the success of the investment. As per revised notes, it can, also, manage them on a Wakalah basis (agency contract). In that case, it earns only a fee instead of sharing in profits (IFSB 2011). But apparently the first relationship (Mudarabah) is the

(18.3)

CAR

=Tier 1+ Tier 2

RWA(Credit risk+Market risk+Operational risk)

+RWA funded by Profit Sharing Account (PSIA)(credit risk market risk)

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most frequent, between PSIA holders and an Islamic bank. It may be noted that there are some market forces that prevent the mechanism of management of investment accounts, i.e. sharing of profit and not guar-anteeing the capital, to work freely. Profits distributed to (UIAH) are not tied anymore to the underlying assets’ performance on a yearly basis.

However, some Islamic banks both in dual and in full-fledged Islamic banking system, in a number of markets, implement many practices in order to give to UIAH a rate of return equivalent to a market bench-mark (IFSB 2010). In these techniques, an Islamic bank constitutes two reserves: profit equalization reserve (PEr) and investment risk reserve (Irr). In case of PEr, it is constituted before allocation of profit which is available for distribution between shareholders and UIAH. In the case of Irr, it is constituted after the bank has taken its part of profit as mudarib. Here PEr is used to reduce the effect of the volatility of rate of return of the underlying assets in the distributed profit. The Irr is used to compensate loss of capital for UIAH (IFSB 2010). In this practice, shareholders bear part of commercial risk (credit and market risk) initially supported by UIAH. This transfer of risk from UIAH to shareholders is called “Displaced Commercial risk” (DCr). To be accurate, DCr is present only in the two former practices of “smoothing” of profit. If the bank can manage the volatility of assets’ rate of return by the use of PEr and Irr, DCr in that case will be Nil (Sundararajan 2008). As per IFSB (2011) revised notes, it is compulsory on Islamic banks to manage UIA in the way stated above for two reasons: the underlying assets do not meet a targeted rate of return (temporarily or at all) and/or the super-visory authority required from banks to give to UIAH a rate of return according to a benchmark, to prevent these banks from withdrawal risk which can lead to systemic risk.

In view of the above, IFSB has taken into account the effect of DCr on capital requirement and modified the denominator of the CAr, for that purpose. The denominator of CAr, when there is DCr, is calcu-lated as follows:

RWADCR =

Total RiskWeightedAssets

less

RiskWeightedAssets byRestricted PSIA

less

(1−α)× (RiskWeightedAssets Funded byUnrestricted PSIA)

α (RiskWeightedAssets Funded by PER and IRR ofUnrestricted PSIA)

246 a. hassan and s. mollah

where α represents the part of profit added to the actual profit gener-ated by assets funded by UIAH’ funds. In case where there is smooth-ing of profit to UIAHs, profit distributed to them will be the sum of: first, actual profit generated during a year; second, profit transferred (mudarib’s share and/or profit given as Hibah from shareholders); and third, part of profit taken from PEr and Irr. Then, conceptually, α corresponds to the part of assets funded by UIA and generating the sum of profits in second and third cases. DCr is only present when profit in the second case is distributed to UIAH. If there is no DCr practiced by a given Islamic bank, α = 0 and the value of the denomina-tor will become:

In its capital adequacy standard, IFSB (2005b) gave discretion to super-visory authorities to define the value of α on a case-by-case basis or to their jurisdiction as a whole. Obviously, the amount of α was arbitrary because smoothing mechanisms vary widely between Islamic financial entities, even if they are in the same jurisdiction. Fortunately, in 2011 IFSB’s guiding note contained a methodology to calculate α or each Islamic bank. The methodology, utilized for the calculation, is quite easy and treats Islamic banks/Islamic Financial Institutions in equal footing.

It may be noted here that, in addition to the minimum required reg-ulatory capital, a minimum of 2.5% of rWA constituted from CET1 only must be retained by an Islamic bank as a Ccb. As CET1 available to draw near the minimum of 4.5% (75% of Tier 1), an Islamic bank may have two alternatives: it may retain its earnings (limit the distribution of dividends, share buybacks and staff bonuses, etc.) and raise new capital from the private sector, until the threshold of 7% of CET1 (4.5% + 2.5%) is attained. In an Islamic bank, the part of profits belonging to PSIA should not be concerned by this restriction (retention of earnings). The argument behind this is that assets financed by these accounts have been deducted from the calculation of rWA (RWADCR). However, if there is DCr, part of profits smoothed should be retained in the building of the

RWADCR =

Total RiskWeightedAssets

less

RiskWeightedAssets Funded byRestricted PSIA

less

RiskWeightedAssets Funded byUnrestricted PSIA

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buffer. For example, if PUIAH represents the profit distributed to UIAH and α is calculated for the given Islamic bank, then we will get:

where Pr = Actual profit generated by the assets funded by UIA during a year.

Pper/irr = Profit taken from PEr and IrrPsmooth = Profit transferred from shareholders shareIn order to constitute the buffer, profit available for distribution to

UIAH can be retained and will be:

Then, Ccb will be calculated as follows:

Leverage RatioDue to excessive on- and off-balance-sheet leverage, built-up in the con-ventional banking system, it has been a major factor in the amplification and spread of the subprime crisis. The BCBS introduced this additional requirement because it has the quality to be a simple, transparent and non-risk-based “backstop” measure. It is also calibrated to act as a cred-ible supplementary measure to other risk-based capital measures (BCBS 2010a). Two components are used in the measure of the Lr: capital measure and exposure measure.

The minimum value of 3% is still under test and can vary. The Lr accounted for is the average of the monthly Lr over the quarter. As defined by Basel III framework, capital measure is the amount of Tier 1 capital (Common Equity Tier 1 plus Additional Tier 1). It may be noted that PSIAs cannot be included in additional Tier 1 capital because they do not meet some criteria, among them: they must be held in the bank at least for five years and repayment of principal needs supervisory approval. Obviously, this is not the case for PSIAs which can be withdrawn before five years without notification to the supervi-sory authority.

PUIAH + PR + Pper/irr + Psmooth

Psmooth = αPUIAH − Pper/irr

Ccb = 2.5%× RWADCR

LR =CapitalMeasure

ExposureMeasure≥ 3%

248 a. hassan and s. mollah

Also, in Basel III, exposure measure represents the accounting value of on-balance-sheet items net of specific provisions and valuation adjust-ments. Physical or financial collateral, guarantees and other credit risk mitigation are not taken into account to reduce the value of on-bal-ance-sheet items. Netting of items in the assets and deposits is not allowed. Assets financed by PSIAs are normally excluded from the expo-sure measure because PSIAs are not included in Tier 1 capital. However, if there is DCr, a proportion α of these assets should be included in the exposure measure; since it is considered that they have been financed by shareholders’ own capital. Like derivatives, repurchase agreements and securities finance are not relevant for Islamic banks because they do not perform many Shari’ah requirements. Off-balance-sheet items are con-verted into credit exposure equivalents and included in the exposure measure, using a Credit Conversion Factor (CCF) of 100% subject to the condition that a commitment is unconditionally cancellable at any time by an Islamic bank, without prior notice; however, a CCF of 10% will be applied.

18.5 rIsk sPecIfIcatIon of IslamIc banks/IfIs

Since Islamic banks’ activities differ in substance and in form from con-ventional banks’ operations, they thus face a different risk profile. Basel II identified three types of risk exposures for conventional banks: credit risk, market risk and operational risk. Table 18.1 draws a comparative risk profile for conventional and Islamic banks. Credit risk is the default pay-ment risk, and risk weights are assigned based on the counterparty risk.

Table 18.1 Difference of risk implications between conventional and Islamic banks

Conventional bank Islamic bank

Credit risk Credit riskMarket risk

• Equity risk• Commodity risk• Interest rate risk• Foreign exchange risk

Market risk• Equity risk• Commodity risk• rate-of-return risk• Foreign exchange risk

Operational risk Operational risk• Price risk• Fiduciary risk• Displace commercial risk

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 249

Market risk results from the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. It applies to the port-folio of financial instruments held by the bank and is composed of four elements: interest rate risk (further divided into specific and general mar-ket risk), equity position risk, foreign exchange risk and commodity risk. Finally, operational risk represents the risk of loss resulting from inade-quate internal processes.

Early attempts by Shari’ah scholars to cater to the specificities and char-acteristics of Shari’ah-compliant products and services identified at least four different types of risks that are not accounted for under Basel II. This section introduces the risk implication on the trading and banking book of Islamic banks. While it can be argued that credit and operational risks can be accounted for in a similar way for both Islamic and conventional banks, special attention has to be paid to market risk. Although Islamic banks’ operations are free of interest, interest rate risk is present to a cer-tain extent because the London Interbank Offering rate (LIBOr) is gen-erally used as a benchmark in pricing. Thus, a change in the reference rate is likely to affect the rate of return that the bank expects to collect on its uses of funds and pay to its depositors. This is referred to as rate-of-return risk. Three additional risks identified for Islamic banks include price, fidu-ciary and DCr. Price risk refers to the risk that the price of the underlying asset might change over the course of the transaction.

If a conventional bank acquires a commodity for trading purposes, it is exposed to a form of price risk or market risk. In order to become compliant with the Shari’ah rule that “one cannot sell what one does not own,” Islamic banks, in contrast, have to own different assets before they can sell them to clients in need of financing. This exposes the majority of Islamic banks’ transactions to price risk resulting from the acquisition of various assets, which, in turn, introduces a new risk dimension to the banking book of Islamic banks.

Risk Specification in IFSB Guidelines

Basel II recommends that banks should keep track of their activities on the basis of either the banking book or the trading book of the institu-tion. Tables 18.2 and 18.3 illustrate the implications of the different risk exposure of conventional and Islamic banks on their banking book and trading book.

250 a. hassan and s. mollah

Tables 18.2 and 18.3 illustrate that, for conventional and Islamic banks, market risk exposure is calculated in a similar manner (except for interest rate risk) on the basis of their trading book, and that credit risk is computed using their banking book. Table 18.3, however, further shows that commodity price risk exposure of Islamic banks resulting from the acquisition of various physical assets is also reflected in the banking book of the Islamic bank. This introduces a new specificity that is not addressed by Basel II, namely that market risk exposure has to be calcu-lated not only on the basis of the trading book of the financial institu-tion, but also on the basis of the banking book as well.

On the other hand, Islamic banks are also confronted with unique risks resulting from the management of investment accounts. Fiduciary risk refers to the probability of the bank being guilty of negligence or misconduct in implementing the deposit (Mudarabah) contract. The depositors may, as a result, lose confidence in the bank and withdraw their deposits. Finally, DCr arises from the probability of the bank not being able to compete with other Islamic or conventional banks. To counter such risk, it is proposed that Islamic banks should hold a PEr account. A provision is deducted from the investment account holder’s earnings and is set apart for later distribution. Thus, Islamic banks can still pay a competitive return on these accounts even if they yield a lower rate of profits than market interest rates. The question that arises is to which extent this practice might be Shari’ah compliant. In this regard,

Table 18.2 Difference of trading book between conventional and Islamic bank

Conventional bank Islamic bank

Market risk• Interest rate risk• Commodity risk• Equity risk• Currency risk

Market risk• Commodity risk• Equity risk• Currency risk

Table 18.3 Difference of banking book between conventional and Islamic bank

Conventional bank Islamic bank

Credit risk• Portfolio risk• Transaction risk

Credit risk• Portfolio risk• Transaction risk

Market risk• Commodity price risk

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 251

the IFSB’s 2005 guidelines represent an important milestone in harmo-nizing and standardizing the risk exposure of IFIs by identifying the six risk categories: credit risk, equity investment risk, market risk, liquidity risk, rate-of-return risk and operational risk. Still, more effort is required in order to provide guidelines that account for some of these risk expo-sures, especially liquidity risk and operational risk.

Liquidity Risk in Basel III Framework

The most original contribution of Basel III reform is the introduction of liquidity risk in the field of international harmonization and regulation. One of the two documents, constituting Basel III framework, is exclu-sively devoted to liquidity risk. It introduces standards and monitoring tools to manage this risk. Monitoring tools are proposed to supervisory authorities. Banks have to comply with two ratios: LCr and net stable funding ratio.

The purpose of this standard is to ensure that a bank can survive to a stress scenario for at least 30 days until other dispositions are taken. The two components of the ratio are calculated under a stress scenario, described in the document of BCBS, which represents a typical scenario of the subprime crisis (BCBS 2010b). That scenario is only a minimum level of stress; banks have discretion to construct their own scenario and hold high-quality liquid assets.

Stock of High-Quality Liquid AssetsHere, stock of high-quality liquid assets represents the assets which can be, easily, converted into cash at little or no loss of value. They must not be pledged explicitly or implicitly to secure, collateralize or credit-en-hance in any transaction. The BCBS defines two categories of high-qual-ity liquid assets: Level 1 and Level 2. The maximum amount of adjusted Level 2 assets in the stock of high-quality liquid assets is equal to two-thirds of the adjusted amount of Level 1 assets after haircuts have been applied (2010b). In this regards, Level 1 assets include cash, central bank reserves, marketable securities (including Sukuk) issued by entities assigned a 0% risk weighted under the Basel II standardized approach.

LCR =StockOfHighQuality LiquidAssets

Total Net CashOutflowsOver theNext 30 Calender days≥ 100%

252 a. hassan and s. mollah

The financial institutions, and their affiliated entities, are excluded from this category. However, no 0% risk-weighted sovereigns and cen-tral banks are included if the securities are issued in the currency where the bank incurs liquidity risk. Marketable securities must meet criteria of high-quality liquid assets, as exposed in BCBS’ document (2010b). Under these criteria, Sukuk or other Islamic securities have to be listed on a developed and recognized exchange market.

Within the Level 2, assets are included in the high-quality liquid assets up to 2/3 of the total amount stocks (securities). In addition, at least 15% of these assets are applied to the current market value of the securities included in this category which may be incorporated in the marketable securities issued by an entity which has assigned a 20% risk weighted under Basel II. Condition is that the price of these securities must not have declined more than 10% over 30 days during a liquidity stress period. Additional marketable securities can be included if they are issued by an entity rated at least AA; not issued by a financial institution (including the bank itself) or one of its affiliates; and the price remains stable during liquidity stress.

Total Net Cash FlowTotal net cash flow is equal to total cash outflows during subsequent thirty days under the stress scenario, as above, minus total cash inflows or 75% of cash outflows, whichever value is smaller.

Total Net Cash Outflows over the next 30 calendar days = Outflows − Minimum {inflows; 75% of outflows}.

It may be noted that items included in the stock of high-quality liq-uid assets cannot be taken into account to calculate the amount of cash inflows because of double counting.

• Cash Outflows

In the case of retail deposits, for Islamic banks, as per IFSB (2001) notes, the demand deposits can be treated as stable deposits and a run-off rate of 5% is applied to their value. In case the PSIAs scheme is of any time withdrawal account, then they can enter in the category of less stable deposits and a 10% run-off rate which may be applied to their value. However, if they are not under any time withdrawal scheme (until a future date, beyond the 30 days), they are excluded from the LCr.

In the one hand, Islamic banks also can hold an account for a wholesale financial institutional customer with whom it has

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 253

operational relationship (clearing, custody or cash management). In that case, this account receives a 25% run-off rate. In order to man-age their liquidity risk, a given Islamic bank has recourse, with other Islamic banks, to a technique called Compensating Mutual Balances (CMB). It is only type exchange of interest-free deposit with an arrangement to ensure that net balances average to zero in a defined period (IFSB 2008). There is another liquidity risk management tool called Commodity Murabahah, where an Islamic bank can appoint another bank as its agent to perform some tasks. In this case, inter-bank funds are used to execute a Murabahah transaction in a com-modity, with the proceeds (net of commissions) passed on to the bank providing the fund.

On the other hand, deposits from other non-financial corporate entities, sovereigns, central bank, public-sector entities and multilat-eral development banks receive a run-off factor equal to 75%. Deposits from other legal entities (including other banks and Takaful compa-nies) will receive a run-off factor equal to 100%. It means that in the case of “Compensating Mutual Balances” (CMB), the run-off factor is 100%. As per Basel Accord, the conventional bonds issued by the bank are included in the latter category. In the case of Islamic banking system, it is usually assumed that Sukuk is their equivalent conventional bonds. However, there is a major difference between the two. Sukuk gives direct ownership of the underlying asset to Sukuk holders. In consequence, unlike bonds, Sukuk receives a 0% run-off factor.

Furthermore, Islamic banks may use another liquidity management tool which is called Interbank Mudarabah Investment (IMI). It is an investment process where interbank placement of funds for a period ranging from overnight to 12 months produces returns based on an agreed profit ratio. In this case, the formula for profit computation uses for Mudarabah investments of one year, or Mudarabah investments of comparable maturity on the basis of receiving the interbank funds (IFSB 2008). It can be considered as a secured funding under Basel III. In this case, the run-off factor of 100% is applied unless the investing entity is the domestic sovereign, central bank or a domestic public-sector entities (risk weighted 20% or lower under Basel II). Here, the run-off factor will be 25%.

run-off rate related to “other contingent funding obligations” is left to national supervisor’s discretion. In this category, relevant to Islamic banks includes: guarantees, letters of credit and commitments that are “unconditionally cancellable at any time without prior notice”

254 a. hassan and s. mollah

(IFSB 2005a). All other contractual cash outflows have a run-off rate of 100% (dividends and distributable profits to IAH, for example). Outflows generated by operating costs are not included in the standard.

• Cash Inflows

In order to prevent banks from relying solely on future anticipated cash inflows, it is limited to 75% of cash outflows. It means that banks have to hold stock of liquid assets representing at least 25% of cash outflows. Inflows are categorized by counterparties in the Basel III framework. Here, inflows from retail and business customers are recognized at a rate of 50%. On the other hand, inflows from wholesale customers are recognized at 100% for financial institution counterparties and 50% for the others (non-financial corporate, sovereigns, central bank and pub-lic-sector entities). In case an Islamic bank holds Sukuk, when it arrives at maturity within the 30-day time horizon and if there are cash inflows from the realization of the underlying asset, these inflows will be treated in the same category as those from financial institutions. In case of CMB and IMI, inflows should be recognized at 100%. Here, non-financial revenues are not taken into account in the calculation of net cash out-flows. However, for Islamic banks, there is a particularity which should be taken into account in the calculation of cash inflows. While the profit generated from Ijarah, Istisna’, Murabahah and Salam can be known in advance, this may not be the case for Musharakah and Mudarabah, unless operations of these two investment instruments are finished before the calculation of the liquidity coverage ratio, and the time of profits’ trans-fer is within the 30-day time horizon. Otherwise, there is no possibility to identify cash inflows in advance for these two instruments. Thus, for Islamic banks, inflows should be categorized by financial instruments too.

Despite the shortcomings of the Basel standards when applied to Islamic banks, the IFSB has worked hard to develop standards or guide-lines that address risk issues specific to Islamic financing, as well as adapt-ing elements from the Basel standards to make them more relevant to Islamic banks. In 2011, the IFSB published a risk management and cap-ital adequacy guidance note for commodity Murabahah transactions. This guidance complements previous work by the IFSB in those areas (IFSB 2011).

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 255

18.6 case stUdy: caPItal adeqUacy analysIs of al-rajhI bank Under basel frameWork

In this section, we investigated the implication of applying IFSB’s frame-work based on the Basel II and III. The contribution of the paper lies in considering separately some assets on the financial statements of Al-rajhi Bank in Saudi Arabia and assigning a proper risk weighted to it in order to calculate the CAr following the Basel II and Basel III. Al-rajhi Bank is operated in conformity with Shari‘ah. Its total assets amounted to: Sr 184,848.64 ($US49,291) million for the year 2010; liquid assets: Sr 59,139.86 ($US15,770) million and “cash and due from banks”: Sr 19,474.53 ($US5193 million). Its country rank is 3 and world rank is 403, by assets (Annual report 2010). Al-rajhi Bank has subsidiaries that are located in Malaysia, Jordan and Kuwait (in the form of bank) having 100% ownership and fully consolidated.

The Al-rajhi carried out Mudarabah transactions on behalf of its customers that are treated by the bank as being restricted investments. These are included as off-balance-sheet items. There is no indication in the Annual report 2010 that the bank is smoothing profit distributed to rIA, nor it holds PEr and investment Irr. However, Customer time investments represent only 6.7% of total customer deposit. Even if there is smoothing of profit, this does not influence results.

Capital and Buffer

Al-rajhi offers non-interest-based products including Mutajara, instal-ment sales, Murabahah and Istisna’ to its customers in compliance with Shari’ah rules. Mutajara and instalment sales are variants of Murabahah. Istisna’ represents, only, 0.4% of total financing. It can be seen from Table 18.4 that the level of CET1 held by the bank is largely above the requirements of Basel III. An amount of Sr 11,804,682 is availa-ble above regulatory capital and buffers. This situation is due, at least, to two factors: excess liquidity held by Islamic bank and turning from disadvantage to advantage in this case. The second factor is the exclu-sion of debt-based instruments from the regulatory capital-constrained Islamic bank to build their capital using equity-based instruments, due to Shari’ah considerations. Consequently, Islamic banks do not have to fur-nish an effort to go along with the move of Basel standards from a mix

256 a. hassan and s. mollah

Tab

le 1

8.4

Min

imum

cap

ital r

equi

rem

ent

and

buff

ers

(am

ount

in S

audi

riy

al)

Sour

ce A

nnua

l rep

ort

2010

Des

crip

tion

Und

er B

asel

II

Bas

el I

II c

rite

ria

Und

er B

asel

III

. A

s of J

anua

ry 1

, 201

9

ris

k-w

eigh

ted

asse

ts (

rW

A)

154,

636,

076

Cre

dit

risk

-wei

ghte

d as

sets

127,

166,

653

Mar

ket

risk

-wei

ghte

d as

sets

8,26

2,40

0O

pera

tiona

l ris

k-w

eigh

ted

asse

ts19

,207

,023

Com

mon

sto

ck (

shar

es)

15,0

00,0

0015

,000

,000

ret

aine

d ea

rnin

gs3,

205,

905

3,20

5,90

5St

atut

ory

rese

rve

12,1

11,8

8412

,111

,884

Gen

eral

pro

visi

ons

1,58

9,58

3<1

.25%

cre

dit

risk

-wei

ghte

d ri

sky

asse

ts1,

589,

583

Com

mon

equ

ity c

apita

l Tie

r 1

(CE

T1)

23,5

46,9

60≥

4.5%

rW

A6,

958,

623

Tie

r 1

capi

tal

23,5

46,9

60≥

6%r

WA

9,27

8,16

5T

ier

2 ca

pita

l8,

360,

412

≥2%

rW

A3,

092,

722

Cap

ital (

Tie

r 1

+ T

ier

2)31

,907

,372

≥8%

rW

A12

,370

,886

Unu

sed

Tie

r 1

(CE

T1)

14,2

68,7

95U

nuse

d T

ier

25,

267,

690

Cap

ital c

onse

rvat

ion

buff

er (

Ccb

)2.

5% r

WA

(fr

om C

ET

1)3,

865,

902

rem

aini

ng C

ET

16,

536,

922

rem

aini

ng T

ier

1 +

Tie

r 2

capi

tal

11,8

04,6

28

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 257

of debt-based and equity-based instruments to pure equity-based instru-ments, to comply with regulatory capital requirements.

Leverage Ratio

Table 18.5 shows the excess over the regulatory capital which reflected in the leverage ratio. It is at 15.57% largely higher than the minimum requirement of Basel III framework (3%). As shown in Table 18.5, the assets financed by restricted investments accounts are included as off- balance-sheet items; they are not included in the exposure measure.

Liquidity Coverage Ratio

One of the requirements in Basel III is the introduction of the LCr, which tracks the amount of liquidity that a bank makes available to meet its funding needs in a 30-day period. This requirement is met with highly rated assets. Under the liquidity coverage ratio, standard banks must maintain liquid assets to offset loss of funding for 30 days under a stress scenario. Each dollar of assumed run-off requires an offsetting dollar of liquid asset buffer. Basel III introduces this new quantitative global liquidity standard that includes a stressed LCr and a longer-term structural liquidity ratio (net stable funding ratio). In the matter of qualitative liquidity risk management standards, there is a require-ment that the banks need to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. As per BCBS

Table 18.5 Leverage ratio (amount in Saudi riyal)

Description Value Credit conversion factor

With factor Applied

Capital measure 23,546,960Exposure measure

(i) On-balance-sheet items 133,083,409(ii) Off-balance-sheet items 4,633,730 100% 6,633,730

– Letter of credit & acceptance– Letter of guarantee 6,363,594 100% 6,363,593– Irrevocable commitments to

extend credit7,167,869 100% 7,167,868

Total on and off-balance-sheet exposure

151,248,602

Leverage ratio (Minimum 3%) 15.56%

258 a. hassan and s. mollah

criteria, this observation period began in 2011, with implementation of the quantitative standards to occur in 2019 (LCr) and 2018 (net sta-ble funding ratio). This framework constitutes a global framework to be used by national regulatory authorities in developing specific implemen-tation standards for covered banks. The standard applies to big Islamic banks, but national regulatory authorities will determine which bank must adhere to the new standards. The IFSB participated in the develop-ment of standard for Islamic banks in the light of Basel III to endorse its implementation in Islamic countries.

Tables 18.6, 18.7, 18.8, and 18.9 shows the calculation of the liquid-ity coverage of Al-rajhi Bank under of Basel III framework.

Aforementioned Tables 18.6, 18.7, 18.8 and 18.9 show that Al-rajhi bank’s excess of regulatory capital over LCr which is higher than the minimum requirement of Basel II and III. Excess liquidity held by the Al-rajhi Bank is immunizing it from any shortage of stock of high-qual-ity liquid assets in a period of 30 days.

RWA of Al-Rajhi Bank and Minimum Capital Requirement & Buffers Risk-Weighted Assets

This section calculates rWA of Al-rajhi Bank (Table 18.4) using the IFSB guidelines for capital adequacy and following Eq. (3). Table 18.4 also shows minimum capital requirement and buffers risk. Data are taken from Al-rajhi Annual report for the year 2010. The methodology applied for calculating risk-weighted assets, and consequently the CAr of Al-rajhi Bank, consists of each asset item on the balance sheet assigning an appropriate credit and/or market risk weighted to it. Given the above assumption, Table 18.4 further presents the calculation of minimum cap-ital requirement and buffers risk rWADCr for Al-rajhi Bank following Basel II and III capital adequacy standard. In obtaining the CAr as per Eq. (3), the regulatory capital (the numerator) is computed in relation to the total rWA (the denominator). The total of rWA is determined by multiplying the capital requirements for market risk and operational risk to convert into risk-weighted equivalent assets and adding the result to the sum of rWA calculated for credit risk. As the bank’s funds are commingled, the rWA funded by PSIA are calculated based on their pro rata share of the relevant assets. The results of the lengthy calculations above show that Al-rajhi Bank is very well capitalized according to inter-national guidelines as its current capital ratio following ISFB guidelines is

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 259

Tab

le 1

8.6

Cas

e st

udy

liqui

dity

cov

erag

e ra

tio-s

tock

of h

igh-

qual

ity li

quid

ass

ets

(Sau

di r

iyal

’000

)

Des

crip

tion

Fact

ors (

to b

e m

ulti

plie

d ag

ains

t tot

al a

mou

nt)

Tota

l am

ount

Wit

h fa

ctor

ap

plie

d

Stoc

k of

hig

h-qu

ality

liqu

id a

sset

s1.

Lev

el 1

ass

ets

Cas

h10

0%20

,224

,680

20,2

24,6

80Q

ualif

ying

cen

tral

ban

k re

serv

e10

0%12

,111

,884

12,1

11,8

84

Dom

estic

sov

erei

gn/

cent

ral b

ank

debt

in

dom

estic

cur

renc

y10

0%25

,598

,479

25,5

98,4

79

2. L

evel

2 a

sset

s

– Q

ualif

ying

cor

pora

te b

onds

or

Suku

k (r

ated

AA

)85

%1,

007,

539

856,

408

Cal

cula

tion

of 4

0% c

ap o

f liq

uid

asse

tsM

axim

um o

f 2/

3 of

adj

uste

d L

evel

1 a

sset

s th

at

wou

ld e

xist

aft

er a

n un

win

d of

all

secu

red

fund

ing

tran

sact

ions

856,

408

856,

408

Tot

al v

alue

of s

tock

of h

ighl

y liq

uid

asse

ts58

,791

,451

260 a. hassan and s. mollah

Tab

le 1

8.7

Cas

e st

udy

liqui

dity

cov

erag

e ra

tio-c

ash

outfl

ows

(Sau

di r

iyal

’000

)

Des

crip

tion

Fact

ors (

to b

e m

ulti

plie

d ag

ains

t tot

al a

mou

nt)

Tota

l am

ount

Wit

h fa

ctor

ap

plie

d

Cas

h ou

tflow

s1.

Cus

tom

er d

epos

itsD

eman

d de

posi

t an

d qu

alify

ing

term

dep

osits

with

res

idua

l mat

urity

or

not

ice

peri

od w

ithin

30

days

– St

able

dep

osits

5%13

0,90

2,99

46,

545,

150

– L

ess

stab

le r

etai

l dep

osits

10%

419,

242

41,9

24T

erm

dep

osit

with

res

idua

l mat

urity

mor

e th

an 3

0 da

ys0%

11,7

41,8

01

2. U

nsec

ured

who

lesa

le fu

ndin

g–

Leg

al e

ntiti

es w

ith o

pera

tiona

l rel

atio

nshi

ps25

%2,

140,

575

535,

144

– O

ther

lega

l ent

ity c

usto

mer

s10

0%8,

836,

285

8,83

6,28

5

3. A

dditi

onal

req

uire

men

ts–

Cur

rent

ly u

ndra

wn

port

ion

of c

omm

itted

cre

dit

and

liqui

dity

fa

cilit

ies

to:

– r

etai

l and

sm

all b

usin

ess

clie

nts

5%7,

167,

869

358,

393

– O

ther

con

tinge

nt fu

ndin

g lia

bilit

ies

(suc

h as

gua

rant

ees,

lett

ers

of c

redi

t, r

evoc

able

cre

dit

& li

quid

ity fa

cilit

ies)

Tre

atm

ent

dete

rmin

ed b

y su

perv

isor

s (1

0%)

10.9

97,3

2410

.997

,324

Tot

al c

ash

outfl

ows

17,4

16,6

29

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 261

12.78% and that exceeds the recommended minimum of 8%. It appears that Al-rajhi Bank is carrying enough adequate capital to cover market, credit and operational risk.

On the other hand, Al-rajhi Bank does not hold tier 3 capital. As shown in Table 18.5, the level of common equity tier 1(CET1) held by the bank is largely above the requirements of Basel II and III. An amount of Sr 11,804,682 is available above regulatory capital and buff-ers. This situation is due, at least, to two factors: firstly, excess liquid-ity held by Al-rajhi bank, turning from disadvantage to advantage in this case, and secondly, exclusion of debt-based instruments from the regulatory capital to build its capital using equity-based instruments. Consequently, Al-rajhi Bank does not have to make further effort to go along with the move of Basel standards from a mix of debt-based and equity-based instruments to pure equity-based instruments, to comply with regulatory capital requirements.

Table 18.8 Case study liquidity coverage ratio-cash inflows (Saudi riyal’000)

Description Factors (to be multiplied against total amount) (%)

Total amount

With factor applied

Inflows by counterparty– Amount receivable from

non-financial counterpart50 21,868,835 10,934,418

– Other amounts receivable from financial Institutions

100 9,677,421 9,677,421

Total Inflows 20,611,838

Table 18.9 Case study coverage ratio (Saudi riyal’000)

Description Factors (to be multiplied against total amount)

Total amount

With factor applied

Total Inflows 20,611,838

Total cash outflows 17,416,628

Total net cash outflows = Total cash outflows minus minimum (total cash inflows, 75% of gross outflows)

4,354,157

Liquidity coverage ratio = Total value of high-quality liquid assets/net cash outflows

13.50 (1350%)

262 a. hassan and s. mollah

18.7 conclUsIons

The primary role of any supervisory monetary body is to protect depos-itors. The Basel II Accord set capital adequacy recommendations for internationally active banks. The proposed guidelines disregard the sources of funds of a conventional bank and assess the risk of its activities arising from the uses of funds. The objective is to ensure the safeguard of deposits that are at the disposition of the bank and that should be guar-anteed of full payment. Thus, when a conventional bank invests deposi-tors’ funds into yielding assets, it must bear all risks associated with such activities. The BCBS seems making vigorous efforts to prove that Basel II and Basel III will not let the interest-based banking system collapse further. The arguments reaching in the pick position about depositors interest need to be protected. In this matter, already available evidence shows that Islamic banking system is an established alternative banking system and has more potential to grow.

Under Islamic banking, depositors are not neutral providers of funds and the majority of deposits fall under UIA. Such depositors instead sup-ply investment accounts and participate in the bank investment activities through risk-sharing schemes. As such, Islamic bank depositors require less protection than conventional bank depositors.

The IFSB published a capital adequacy standard based on Basel II guidelines. The standard addresses the different risks faced by Islamic banks arising from the nature of their activities and assigns adequate risk weights to different Islamic financing modes.

The new framework considers credit, market and operational risks of the Islamic bank’s assets and, most importantly, does not require regula-tory capital for rWA that are funded by PSIA.

This chapter focuses on the implication of Basel Accord capital ade-quacy recommendation to an Islamic bank (Al-rajhi Bank) in Saudi Arabia. The analysis rests on a set of conservative assumptions in order to calculate credit, market risks and to find out how the new framework of Basel III can be adjusted for Islamic banks based on the information provided by the Al-rajhi Bank’s Annual report 2010. The results show that Al-rajhi Bank is very well capitalized and will confidently meet the recommended level of 8% set by international regulatory bodies. In this regard, in its response to the last financial crisis, in the year 2010, BCBS has introduced deep reforms to the regulatory requirements on capital adequacy for banks which is known as Basel III. Within Basel III, buffers

18 THE BASEL ACCOrDS IN rELATION TO ISLAMIC FINANCE 263

and a leverage ratio have been introduced to cater those banks with suf-ficient high-quality capital during a stress period. But the most original contribution of Basel III is the introduction of liquidity risk in the field of international harmonization and requirement; banks are required to comply with two ratios.

In our analysis of the financial statements of Al-rajhi Bank, the study shows that the move of Basel III frameworks from debt-based to equi-ty-based instruments is fully in line with the business model of Islamic banks. Furthermore, excess liquidity detained by these banks is, actually, an advantage under Basel III.

Empirical evidence shows that Al-rajhi bank is among the best capi-talized banks in the world, and historically comply with inflexible stand-ards of capitalization. It seems most of Islamic banks in the world already have stricter capital requirements than what is proposed in Basel III. With the Islamic banks being among the best capitalized on a global scale, they are on the safer side compared to their European or US coun-terparts; Tier 1 and total capital requirements currently stand at 8 and 12%, respectively, which are already higher than the target 2019 ratios set by Basel III.

references

Basel Committee. (2001). Basel Committee on Banking Supervision.Basel Committee on Banking Supervision. (2010a, December). Basel III: A

Global Regulatory Framework for More Resilient Banks and Banking Systems. http://www.bis.org/publ/bcbs189.pdf. Accessed July 21, 2012.

Basel Committee on Banking Supervision. (2010b, December). Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring. http://www.bis.org/publ/bcbs188.pdf. Accessed July 21, 2012.

Basel Committee on Bank Supervision. (2011). Basel III (Revised Version of Capital Framework June 2011) Published by the BCBS.

Islamic Financial Services Board. (2001). Kuala Lumpur: Malaysia.Islamic Financial Services Board. (2005a, December). Capital Adequacy

Standard for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services. http://www.ifsb.org/standard/ifsb2.pdf. Accessed June 10, 2012.

Islamic Financial Services Board. (2005b, December). Guiding Principles of Risk Management for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services. http://www.ifsb.org/standard/ifsb1.pdf. Accessed June 10, 2012.

264 a. hassan and s. mollah

Islamic Financial Services Board. (2008, March). Technical Note on Issues in Strengthening Liquidity Management of Institutions Offering Islamic Financial Services: The Development of ISLAMIC Money Markets. http://www.ifsb.org/docs/mar2008_liquidity.pdf.

Islamic Financial Services Board. (2010, December). Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders. http://www.ifsb.org/standard/eng_GN-_Guidance_Note_on_the_Practice_of_Smoothing.pdf. Accessed June 10, 2012.

Islamic Financial Services Board. (2011, March). Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services. http://www.ifsb.org/standard/eng%20GN-4_IFSB%20CASAlpha%20in%20Capital%20Adequacy%20ratio%20(Mar_2011).pdf. Accessed June 10, 2012.

Muljawan, M., Dar, H., & Hall, M. (2004). A Capital Adequacy Framework for Islamic Banks: The Need to reconcile Depositor’s risk Aversion with Managers’ risk Taking. Applied Financial Economics, 14, 429–441.

Sundararajan, V. (2008). Issues in Managing Profit Equalization reserves and Investment risk reserves in Islamic Banks. Journal of Islamic Economics, Banking and Finance, 4(1), 1–11.

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Corporate social responsibility (CSr) is an area of intense and increas-ing interest both on the practice and on academic fronts. The interest of investors in businesses that engage in CSr activities has grown dramati-cally because it has demonstrated that it adds substantial economic and social returns to businesses. However, CSr is still in the “being under-stood” stage in developing countries.

CSr defines the company’s commitment to its stakeholders and estab-lishes a method by which the stakeholder can hold the company account-able for its actions. Disclosure of corporate social responsibility practice plays an important role in demonstrating a company’s ethical accounta-bility to its stakeholders to aid them in their decision-making.

In Islamic Financial Institutions (IFIs), the concepts of justice (adl), trust (amanah) and benevolence (ihsan) are emphasized by Shari’ah. The Shari’ah guidelines also provide a guarantee of transparency, ethical behaviour, respect for stakeholder groups and an attempt to maximize social, environmental and economic goods that are, in fact, the core drivers of CSr. recognizing this fact, the governments of many Muslim countries are considering changes to company law so that environmental and social performance will be reported alongside financial performance. By giving importance to this matter, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is developing a standard of CSr disclosure which will give guidance to IFIs.

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266 a. hassan and s. mollah

19.1 stakeholder enGaGement

Stakeholder engagement is about building and maintaining construc-tive relationships over time. It is an ongoing process between a business entity and its stakeholders that extends throughout life and encompasses a range of activities and approaches, from information sharing to partici-pation, negotiation and partnerships. Key principles of effective engage-ment include:

• Providing meaningful information in a format and language that is readily understandable and tailored to the needs of the target stakeholders.

• Providing information on activities and decision-making.• Disseminating information in ways and locations that make it easy

for stakeholders to access it.• respect for local traditions, languages, time frames and deci-

sion-making processes.• Processes free of intimidation or coercion.• Clear mechanisms for responding to people’s concerns, suggestions

and grievances.• Incorporating feedback into project or program design, and report-

ing back to stakeholders.

In the case of Islamic Financial Institution, CSr disclosure can be viewed as an effective mechanism for the protection of the rights of stakeholders, including investors. Better transparency and disclosure practices can help shareholders gain a better understanding of IFIs’ management practices.

The economic, social and environmental aspects that are part of CSr are also elements of Shari’ah compliance. Moreover, Shari’ah mandates that businesses give back to the community and operate under the high-est moral standards.

19.2 dIsclosUre and accoUntabIlIty

The Islamic ethical principles upon which IFIs claim to operate should give an important consideration to social issues, and many IFIs have emphasized social activities in their articles of association, objectives and functions. IFIs should play an important role in economic regeneration and social justice in society.

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In an Islamic ethical context, the main objective of CSr is that IFIs should show their compliance with Shari’ah. A similar view is adopted by AAOIFI in its statement of objectives for financial reporting for IFIs. The idea is that IFIs should disclose all information necessary to advise stakeholders about their operations. In other words, stakeholders have the right to know how their IFI is acting for their well-being as well as for the community.

In order to implement accountability, IFIs should formulate a policy of disclosure that will include information on human resources, products and services, involvement in community activities, environmental report-ing, etc. At the same time, as institutional investors, IFIs should play a catalytic role in influencing the corporate governance and social and environmental behaviour of other companies.

19.3 the need for standards

The Islamic financial system is still highly nascent when compared with the conventional financial system. Islamic Financial Institutions also do not have uniform financial reporting and disclosure standards. Some of them follow the international accounting standard (IAS), while oth-ers follow standards issued by the AAOIFI, and a few countries have adopted accounting standards suitable to their local markets.

At this stage, IFIs are facing a crucial challenge to set up a uniform CSr disclosure standard to enhance their image and reputation globally, as well as to remain competitive. IFIs should incorporate some conven-tional CSr features such as transparency, accountability and partnership with stakeholders into their disclosure and reporting system, especially since they are already engaged in similar practices by adhering to Shari’ah principles.

In order to implement CSr disclosure traits within the Islamic finan-cial system, the most important step is to create awareness on the con-cept of CSr begin with. There is a need for Islamic Financial Institutions to understand that CSr disclosure involves the concepts of accountabil-ity, social justice and ownership that are central to social relations. CSr disclosure is a method by which management of IFIs can interact with stakeholders to influence external perceptions about their organization. This understanding will allow us to develop a list of CSr disclosures with which businesses should comply in the light of Shari’ah.

268 a. hassan and s. mollah

19.4 ProPosed model

This model standard of CSr disclosure is based on understanding of CSr literature and the Islamic perspective on a social responsibility framework. It may be noted that the majority of the tenets that define an effective CSr strategy are in line with those of a Shari’ah-compliant structure. The AAOIFI accounting standards disclosure requirements stress social aspects in many areas, so an overlap between our CSr disclosure bench-mark and the AAOIFI disclosure requirements is to be expected.

One of the purposes of the proposed CSr disclosure standard is to contribute to the growing debate on CSr in the Islamic financial sys-tem and key underlying issues associated with the emergence of new dis-closure practices for IFIs. New possibilities and challenges may also be explored.

We have identified six broad features to form the basis of CSr disclo-sure for IFIs. These features also differentiate IFIs from their conven-tional counterparts.

1. Adherence to Shari’ah principles, stakeholder engagement and governance policy.

2. Provision of riba-free, lawful transactions, building long-lasting relationships with customers and dealing fairly with those in the supply chain.

3. Giving due importance to Shari’ah supervisory boards’ opinions, treatment of Zakah and charity funds.

4. Focus on developmental, social and community goals.5. Maintaining good relations with employees.6. Keeping balanced corporate goals and supporting environmental

protection.

These six features of our proposed CSr disclosures are classified accord-ing to the following eight dimensions:

Ethical Behaviour, Stakeholder Engagement, Customer Relations and Good Governance

Islamic banks mobilize savings and invest them into the deficit savings units of the economy. They have been entrusted with the safekeeping of depositors’ savings and shareholders’ capital and invest the money for

19 CSr DISCLOSUrE FOr ISLAMIC FINANCIAL INSTITUTIONS 269

productive purposes as per Shari’ah guidelines. Therefore, they are not only financially accountable but also morally accountable for their busi-ness behaviour. As such, it is expected that IFIs should disclose such information.

Furthermore, those who manage and govern Islamic banks are expected to be committed persons imbued with piety and righteous-ness. They should have knowledge and competence in banking as well as knowledge of Shari’ah. It is expected that Islamic banks should disclose the following aspects of management to their stakeholders:

• Corporate objectives.• The state of customer relations.• Names, positions and profiles of board members and top

management.• Top managers’ knowledge of and competence in Islamic banking,

risk management practices, etc.

Interest-Free, Lawful Products and Services

Various financial instruments developed by IFIs have been based on two principles: the profit-/loss-sharing principle and the markup principle. Financial instruments based on the former principle include Mudarabah (venture capital) and Musharakah (partnership contract), while instru-ments based on the latter include Murabahah (resale with pre-agreed profit), bay’al-salam (forward sale contract), Ijarah (leasing) and ija-rahwaiqtina (operating and financial lease). In order to remain com-petitive in the market, IFIs have been innovative in their offering of products, but they must not violate Shari’ah principles. Furthermore, when there is fierce competition within sophisticated markets, stakehold-ers will demand more transparency. IFIs should disclose the following information:

• Details of investment activities, and if new products have been introduced, the basis of the Shari’ah concepts legitimizing the new products.

• Islamic acceptability of deals.• Manner of dealing with those in the supply chain, depositors and

investors.

270 a. hassan and s. mollah

Opinion of Shari’ah Supervisory BoardEach IFI has a Shari’ah supervisory board whose role is to ensure that any new formulations and modalities are in line with Shari’ah principles and Islamic norms. Hence, the Shari’ah supervisory board acts as an internal control mechanism and its primary objective is to give credibility to IFI operations. The Shari’ah supervisory board’s duties include set-ting the Shari’ah rules for the conduct of the IFI’s business; examining all or part of transactions to ascertain whether there have been breaches of Shari’ah rules; and issuing a statement in the annual report of the IFI as to its Shari’ah compliance.

It is expected that IFIs should disclose the Shari’ah supervisory board’s opinions and reports as follow:

• Name, background and Shari’ah expertise of the Shari’ah supervi-sory board members; their remuneration and number of meetings held during the accounting year.

• Whether there are defects in the products offered and if so, their recommendations to rectify the defects and the actions taken by management, as well as the basis of examination of the documents.

• Certification of Shari’ah compliance of the distribution of profit/loss and calculation of Zakah.

• Confirmation that all IFI operations, revenues and profits are law-fully gained.

Development and Social Goals

Islam emphasizes social justice. Therefore, IFIs are expected to be more socially responsible than their conventional counterparts. Under CSr disclosure, IFIs should disclose the following items:

Zakah (Religious Tax)One of the indicators of Islamic banks’ social goals is their contribu-tion to and management of Zakah. Zakah is one of the five pillars of the Islamic faith and the spending of the proceeds and the beneficiaries are specified in the Quran. However, there have been mixed opinions as to which party is liable for Zakah, banks or individuals. regardless, what is more important is for Islamic banks to disclose the following details:

19 CSr DISCLOSUrE FOr ISLAMIC FINANCIAL INSTITUTIONS 271

• The bank or depositor: which party is liable for Zakah.• Whether Zakah has been paid, sources of Zakah funds and the uses

of the Zakah fund.• Confirmation from the Shari’ah supervisory board that Zakah has

been properly computed and that the sources and uses of the funds are legitimate based on OIC Fiqa Academy rulings.

Qardh-Hassan (Benevolent Loan)Providing qardh-hassan for socially beneficial causes is an important social contribution that IFIs may make, especially to the local community in which they operate. IFIs should disclose the following information:

• The IFI’s policies in providing qardh-hassan funds and how non-re-payment of such funds will be dealt with.

• The amount of qardh-hassan, sources and uses of such funds.

Charity and Other Activities

Unlike Zakah, which is obligatory, charity (saddaqa) is voluntary in nature and can be used for purposes allowed by Shari’ah for the benefit of society. Furthermore, debtors receive special attention in Islam. Lenders are asked to be lenient with their debtors, and in certain circumstances, debtors are entitled to receive some funds (such as Zakah) and debts can be written off as charity. Some monies can also be spent for doing well. IFIs should disclose the following information:

• Amount, source and uses of charity funds that are separate from Zakah funds.

• Debt or default nonperforming loan policy.• Type of debt and amount of debts written off.

Commitment to Community Development

Public duties in Islam are believed to be rewarded hereafter. Under CSr policies, the needs of the community within which the IFI oper-ates should be addressed first. IFIs should disclose the following commit-ments to society:

272 a. hassan and s. mollah

• Supporting organizations that benefit society and participating in social activities and community welfare activities sponsored by the government.

• Sponsoring Islamic educational and social events.• Creating job opportunities.• Supporting poverty alleviation programmes.• Sports, Islamic art and culture.• Social solidarity and promoting employee volunteer work.

Research, Training and Development

Promotion of research, training and development should be an impor-tant agenda for IFIs. They should disclose the following information in their annual reports or in offer documents:

• Policy formulation.• Strategic decision-making support.• Standardized training curriculum.• Market survey and feasibility report.• Database management.• Supporting the research, development and training conducted by

universities and academics.

Employees

According to Islamic business ethics, employees are the greatest assets of the business and their welfare should be given due attention. It is the responsibility of employers to ensure that employees are paid fair wages, not overworked and have the opportunity to fulfil their spiritual obliga-tions. Equal opportunity is also stressed in Islam. For Islamic banks to be successful in a highly competitive services sector, there must be consistency between the brand values and staff behaviour. An adequate supply of capa-ble, trained staff with knowledge and understanding of Islamic banking and finance is one of the ingredients for success of an IFI. IFIs should disclose:

• Training and development opportunities, amount and proportion spent on training, provision of special training on Shari’ah aspects.

• recruitment and fair service conditions complying with the norms of international labour standards.

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• Equal opportunities.• Promotion and reward to employees.• Supporting employees in fulfilling their Shari’ah obligation, e.g. pil-

grimage to Mecca.

Environment

It is prohibited in Islam to destroy or damage the physical environment, which is considered harmful to an individual or community. IFIs are expected not to invest in activities which lead to harming the environ-ment. Furthermore, IFIs should provide funding to support environ-ment-related projects. IFI stakeholders want assurance that their IFI’s activities work towards the well-being of society. It is expected that IFIs should disclose the following information:

• Efforts in recycling and using environmentally friendly suppliers.• Activities in promoting energy-saving projects.• The nature and amount of any donation or activities undertaken to

protect the environment.• Whether IFIs have financed any projects that may lead to environ-

mental destruction.

19.5 joInInG Global standards

CSr is defined as a framework in which businesses align their core values with the expectations and needs of their stakeholders. CSr disclosure realizes the concepts of accountability, social justice and ownership that are central to social relations. The Islamic Financial Service Board, AAOIFI and other major players have been working to develop uniform regulations, accounting standards and CSr dis-closure standards to improve the credibility and transparency of the Islamic Financial Services industry. These developments should drive the Islamic Financial Services industry towards greater finan-cial and Shari’ah discipline, sophistication and integration with the international financial market. The proposed CSr disclosure standard will provide an avenue for IFIs to join in global standards while defin-ing CSr from an Islamic perspective.

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In an Islamic context, the Muslim community in general and stakehold-ers of Islamic Financial Institutions (IFIs) have the right to know about the effects of their financial institution’s operations on its well-being and to be advised within the requirements of Shari’ah as to how this has been achieved. Hence, accounting information for IFIs is an important aspect in serving the public interest. In this regard, the concept of “accountabil-ity” plays an important role. In Islamic ethics, it is interpreted as being, first and foremost, accountability to God through making information freely available.

Islamic accounting for Islamic finance ensures compliance of Islamic objectivity which fulfils the Maqasid al Shari’ah (goal of Islamic law). By setting clear objectives for financial accounting of Islamic financial system and institutions, as opposed to their conventional counterparts, it helps to make sensible judgements for choice among alternative accounting treatments.

20.1 sharI’ah laWs In the oPeratIon of IfIs

Compliance with Shari’ah laws in the operation of IFIs is an obligation. Shari’ah provides freedom of contract as long as the terms do not con-flict with the Shari’ah. In particular, it permits any arrangement based on the consent of the parties involved, so long as the shares of each are contingent upon uncertain gain and are a function of productive trans-formation of resources. These provisions are crucial, since the Shari’ah

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Just and Balanced: The Importance of Accounting in Islamic Finance

© The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0_20

276 a. hassan and s. mollah

does not enforce even a guarantee by the working partner to restore the value of invested capital, not only because it removes the element of uncertainty needed to legitimize the agreed distribution of the possible profits, but also because the lenders would not be remunerated to the extent of the productivity of their financial capital in the resulting loss. Main reason behind this, unlike conventional banking, an Islamic bank, is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for the lack of collateral would be financed by Islamic banks on a profit-sharing basis. Therefore, an Islamic bank plays a catalytic role in stimulating economic development.

The basic principles of the Shari’ah are laid down in the four main transactions of:

• Sales (bay): Transfer of the ownership or corpus of property for a consideration.

• Hire (Ijara): Transfer of the usufruct (right to use) of property for a consideration.

• Gift (hiba): Gratuitous transfer of the corpus of property.• Loan (ariyah): Gratuitous transfer of the usufruct of property.

These basic principles are then applied to the various specific transactions of, for example, pledge, deposit, guarantee, agency, assignment, land ten-ancy, waqf foundations (religious or charitable bodies) and partnerships, one of the main modes of investment of IFIs.

It may be mentioned here that partnerships play an important role in Islamic financing and there are a number of different forms of partner-ship recognized by Shari’ah which are: shirkah al-’inan (limited partner-ship), Musharakah (partnership) and Mudarabah (passive partnership).

The above-mentioned principles and freedom of contract based on Shari’ah provide an alternative framework for a just and balanced accounting system.

20.2 valUe-based accoUntabIlIty

The Islamic economic system allows people and IFIs to earn their liv-ing in a fair and profitable way without exploitation of others, so that the whole society may benefit. In this regard, Shari’ah requires both IFIs and Muslims to be fair, honest and equitable towards others. Therefore,

20 JUST AND BALANCED: THE IMPOrTANCE OF ACCOUNTING … 277

in an Islamic economic system, Islamic accounting theory is concerned with accountability. All types of trade and commerce, production and distribution mechanisms must be based on Islamic concepts and val-ues which provide a framework for a just business and commercial sys-tem. Furthermore, social responsibilities such as paying Zakah require accounting disclosure of the worth of assets and liabilities in terms of the Shari’ah obligation to succour the poor.

There are also positive values which are regulated by the various codes of Islamic investment ethics, adhering to the notion of adl (justice), amanah (honesty), iqtisad (moderation), ihsan (kindness) infaq (spending to meet social obligations), istislah (public interest), sabr (patience), etc.

Similarly, there are a number of values which are negative and thus to be avoided: hirs (greed), iktinaz (hoarding of wealth), israf (extrava-gance) and zulm (tyranny). Banking and investment activities within the positive parameters are halal (lawful) and within the negative parameters are haram (unlawful).

Therefore, IFIs have some special responsibilities and accountability to serve stakeholders’ interests. Islamic accounting monitors the compli-ance with Islamic values in IFIs.

20.3 IslamIc fInance Works dIfferently

Why does Islamic finance need a different accounting system than the conventional financial system? To answer this question, one needs to understand how Islamic finance works. At the outset, rejection of inter-est (Riba) in Islamic financial transactions poses the question of what replaces the interest-rate mechanism in an Islamic financial system. If the paying and receiving of interest are prohibited, how do IFIs operate?

In order to address this question, the concept of partnership financing arrangements comes in, substituting profit and loss sharing for interest (Riba) as a method of resource allocation. Although a large number of different contracts feature in Islamic financing, certain types of transac-tions are central: Mudarabah (trust financing); Musharakah (equity par-ticipation); and Murabahah (markup) methods.

Mudarabah is a profit- and risk-sharing contract where one party entrusts funds to an investor in return for a predetermined share in the profit/loss outcome of the project concerned. This principle lies at the heart of the Islamic financial system, since most funds are provided to an Islamic Financial Institution under such investment arrangements.

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On the other hand, under the Musharakah mode of financing, there is usually more than one single contributor of funds; all of the parties invest in varying proportions and the profits or losses are shared accord-ing to their contributions in the project. Musharakah involves a more active partnership between entities who pool their capital and man-age and control the enterprise together, with profits and losses divided among them according to prearranged ratio.

Markup is added when assets and other items are acquired for later resale or lease with a markup on the purchase price.

Furthermore, Islam has formulated a comprehensive Shari’ah-based governance system in respect of how financial institutions should be run, how accounting ought to be undertaken, and how finance is to be arranged. In view of this, there is need for a separate accounting method for IFIs in order to sustain a unique and comprehensive form of Islamic investments which has no counterpart in the conventional financing system. Moreover, IFIs are different in principle from their conven-tional counterparts, which creates special problems for Islamic account-ing. In other words, IFIs are followed by Shari’ah compliance corporate governance.

20.4 PrIncIPles of IslamIc accoUntInG

Two essential principles of Islamic accounting are the concept of full dis-closure and the precept of social accountability. The first is at variance with ideas of window dressing, creative accounting and legal form over substance. The second makes clear that the Islamic accountant’s prime obligation is to the ummah (community). A special responsibility is placed on those engaged in finance, which necessitates:

• The absence of interest-based (riba) financial transactions.• The introduction of Zakah (almsgiving).• The prohibition of the production of goods and services which con-

tradict the values of Islam.• Avoidance of economic activities involving maysir (gambling) and

gharar (uncertainty).

Islamic finance revolves around the substitution of profit- and loss-shar-ing principles for interest-based borrowing and lending activities.

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Instead of charging or paying riba (interest), IFIs invest predominantly by engaging in trade and industry, directly or in partnership with oth-ers, and sharing the profits. These financing methods give rise to many ambiguities in accounting theory and practice which have no counter-part in a conventional financial system. Therefore, there is a need for the IFIs to maintain a system of accounting and auditing controls based on Shari’ah which will satisfy both the Shari’ah-compliant auditors and external ones.

20.5 challenGes for IslamIc accoUntInG

In the process of developing an alternative accounting system for IFIs, there are a number of challenges to be overcome.

1. Investment Accounts

In IFIs, the balance sheet status of investment accounts provides the first challenge to Islamic accounting. Depositors’ funds can be placed either on an al-wadia (custody, safekeeping) basis or under the mode of Mudarabah (trust financing) principles in an investment account from which the IFI invests funds on behalf of depositors and shares the profits according to a pre-agreed profit-sharing ratio. Most funds are deposited into investment accounts. Some IFIs include such funds on their balance sheet, while others show them off the balance sheet as funds under man-agement, much as an investment bank would do. According to current regulatory requirements, the choice is governed by whether funds are the client’s risk or co-mingled with those of the IFI, and whether invest-ment is restricted or unrestricted.

Under the Musharakah arrangement for investment accounts, depos-itors act as financiers by providing funds, and the IFI acts as an entre-preneur by accepting them. Neither the nominal capital value nor a predetermined rate of return on deposits is guaranteed. Depositors effectively become shareholders. If the IFI makes profits, then the share-holder-depositor would be entitled to receive a certain proportion of these profits. On the other hand, if the IFI incurs losses, the depositor is expected to bear the loss as well. Accordingly, from a depositor’s per-spective, dealing with an Islamic Financial Institution is in many respects similar to investing in a mutual fund or investment trust.

280 a. hassan and s. mollah

2. relationship With Shareholders

There are some differences between Islamic banking or an Islamic mutual fund and an investment company. In the case of an investment company, the shareholders own a proportionate part of the company’s equity capital and are entitled to a number of rights, including receiving a regular flow of information on developments of the company’s business and voting rights. If they are dissatisfied with the performance, they can simply exit by selling their shares in the stock market.

Islamic banks, by contrast, mainly accept deposits from the public rather than issuing and selling shares. Depositors are entitled to share the bank’s net profit (or loss) according to the profit-sharing ratio stipulated in their contracts, but have no voting rights because they do not own any portion of the bank’s equity capital. The Mudarabah contract cannot influence the bank’s investment policy.

In fact, Islamic banking is essentially an equity-based system in which depositors are treated as if they were shareholders of the bank. However, they are a very special type of shareholders. In effect, they are nonvoting shareholders. Normally, people with ownership rights in a company can express their disappointment with the company’s performance by either getting rid of their shares or in some way expressing their concern. This may be called the dichotomy between “exit” and “voice.” Expressed in these terms, the Islamic depositor/nonvoting shareholder has little “exit” and no “voice.”

There is no provision such as “deposit insurance” in the Islamic bank-ing system. In fact, IFIs depositors have more incentives to monitor bank performance than conventional depositors. Information disclosure should be more important in an Islamic banking and finance environ-ment as a result of the “agency” problem. This, in turn, places a special responsibility on the adequacy of Islamic accounting procedures.

3. Distribution of Profit

Islamic methods of income recognition and expense allocation have obvious implications for the allocation of profits between investors and shareholders. Some IFIs deduct only direct investment-related expenses from profits paid to customers along with a mudarib (management) fee, while others also apportion indirect overheads, such as depreciation and directors’ salaries, to the returns accruing on investment accounts.

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Considerable discretion exists for the recognition of income arising from investment in Islamic financing instruments. In this case, the profit can be recognized immediately at the inception of the transaction or when realized over the life of the instrument.

In Murabahah transactions which involve an asset purchase by the IFI and a resale on a deferred payment basis to the customer, after the trans-action is made, the profit can be recognized in five different ways:

• In full when the customer takes delivery of the asset.• On a pro rata basis on the due dates of the monthly payments.• On the receipt of monthly instalments.• Once all the payments have been received.• Once the capital has been recovered.

These five methods of recognizing income all have different impacts upon the profit returns credited to holders of investment accounts. Conventional accounting procedures will not be a perfect answer in this case.

4. Financial Statements

Islamic financial statements must show the financial impact of financial and other transactions of IFIs. Accurate changes in the financial posi-tion must be determinable from the balance sheet, along with how those changes arose from the income statement. In accounting for Islamic finance, the elements of financial position would include all items which are subject to financial evaluation, assets (including various aspects of property), liabilities and residual benefits.

But a number of accounting concepts such as “conservatism” (the lowest values of assets and the highest values of expenses) and “match-ing” (recognizing expenses in the same period as associated revenues) would seem to imply an accrual rather than a cash basis of accounting. Use of an accrual basis for recognizing revenues and expenses in terms of amounts expected to be received in the future would seem to pose some difficulties for IFIs. Assigning revenue to the fiscal year in which it is earned rather than to that in which it is received would have two implications.

Firstly, in terms of the payment of Zakah, the institution may pay Zakah for wealth not yet received. Secondly, the Mudarabah principle

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underlying investment accounts involves the distribution of a cash profit, and profit distribution has to be treated like a refund of capital.

5. Shari’ah Checks and Balances

The Shari’ah supervisory board (SSB) of the IFI is responsible for ensur-ing the Shari’ah compliance of the IFI’s activities and products and for overseeing the collection and distribution of Zakah. Shari’ah auditors of the IFI look for breaches of Shari’ah and seek Shari’ah clearance on transactions before finalization of the financial accounts.

One of the main matters of concern is the subjectivity of interpreta-tion of the Shari’ah; there have been many conflicting opinions given by SSBs of different IFIs. While broadly similar supervisory procedures operate among the IFIs, this does not mean that they will reach identical solutions.

In order to resolve some Islamic accounting issues, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was established in Bahrain in 1991. In 1999, a 15-member Central Shari’ah Board was set up by AAOIFI with the aim of harmonizing and converging concepts and their application among the supervisory boards of IFIs. The objective is to avoid inconsistencies between the individual boards in adopting an Islamic accounting system and to assist with devel-oping new products.

Furthermore, almost every IFI has a board of Shari’ah scholars, com-monly known as its SSB, to review the juristic correctness of the IFI’s transactions. The SSB is one of the main monitoring systems developed by IFIs to assure the stakeholders of the IFI’s adherence to Shari’ah precepts. The standards promulgated by the AAOIFI have a provi-sion that in order to self-regulate their financial reporting and auditing, IFIs require both the SSB and the financial auditors of Islamic banks to report on these banks’ compliance with Shari’ah doctrines.

20.6 ethIcs for all

Islamic ethical principles define what is true, fair and just concerning the nature of corporate responsibilities along with Islamic accounting standards. In addition to providing a set of Islamic business ethics, cer-tain Islamic financial principles have a direct impact upon accounting practices and policies. These principles include, most importantly, the

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institution of Zakah (alms giving), the prohibition of Riba (usury), pro-hibition of the production of goods and services which contradict with Shari’ah, and avoidance of economic activities involving maysir (gam-bling) and gharar (uncertainty). Therefore, the accounting systems of IFIs require full disclosure for predicting future obligations and assessing investment risk in Islamic partnership arrangements. Accountants, like any other adherent, should perform their duties in accordance with the Shari’ah rules.

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The Qur’an and Sunnah (sayings of the Prophet Muhammad, peace be upon him), from which Islamic ethical principles are derived, have defined clearly what is true, fair and just. They have also outlined cor-porate roles and responsibilities and spelled out specific accounting standards for accounting practices. The principles were derived from the recognition that economic transactions create the potential for abuse towards others, and thus require ethical accounting standards and prac-tices that can be applied to the details of any given set of financial deal-ings. These accounting standards should be grounded in principles of fairness, justice and equity between parties—as well as a fundamental sharing of risk and profit of investment.

Scrutinizing the distribution of wealth among stakeholders is a prime objective of Islamic accounting. Similarly, in the corporate sector, one of the main aims of Islamic accounting should be to provide information about those who involved in the corporations regarding their account-ability to the Ummah (community). In a business enterprise, both man-agement and the providers of capital are accountable for their actions, both within and outside their firm.

The demand for Islamic accounting is a response to the significant growth in Islamic banks and financial institutions that has occurred in recent years. Despite the fact that Islamic banks have made considerable

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inroads in the world, with a growing popularity among investors and financial practitioners in the major financial centres of Europe, the USA and Asia, Islamic accounting is still in the developing stage. However, two approaches are currently followed:

1. To establish objectives based on the spirit of Islam and its teaching and then consider these established objectives in relation to con-temporary accounting thought.

2. To start with established objectivities in contemporary accounting thought and test them against Islamic Shari’ah, accept those that are consistent with Shari’ah and reject those that are not.

Whether Islamic banking should develop its own standards and practices or attempt to find the closest equivalent practices in conventional bank-ing and finance that do not contradict Shar‘iah is an important question. Many Islamic economists say the choice has nearly always been oriented towards finding a compromise with conventional standards and practices to survive in the competitive market.

However, the development of Islamic accounting has been based on the provisions of Islamic law along with other necessary principles and postulates codified in international accounting standards which are not in conflict with Islamic law. Along these lines, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) opted to exam-ine the existing international standards and their applicability to Islamic Financial Institutions. With active support from Bank Negara Malaysia (Central Bank of Malaysia), the International Association of Islamic Banks and AAOIFI agreed to work to establish an agency that would address the prudential regulations that were necessary for a healthy mar-ket, and as a result, the Islamic Financial Services Board (IFSB) was established in 2002. That was a major milestone, and since that time, the IFSB has been active in issuing measures and standards to promote capi-tal adequacy management, disclosure and transparency.

In order to develop Islamic accounting standards for business firms in general and Islamic banking in particular, Islamic scholars have identified six core elements. They are:

1. Prohibition of riba (usury).2. Prohibition of gharar (uncertainty).

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3. Adoption of an acceptable accounting valuation technique.4. Valuation for Zakah (Islamic religious tax).5. Avoidance of investment in unlawful business activities.6. Environmental awareness.

These six elements may be regarded as core components with respect to Islamic accounting standards.

21.1 ProhIbItIon of rIba

The literal translation of riba is “excess” or increase, which covers inter-est on both lending money and usury transactions. The condemnation of giving and accepting usury was common to both Islamic jurisprudence and medieval canon law. There is consensus that the reason for this is that charging interest on money lending clearly involved an exploita-tion of the poor by the rich. Interest-based lending is seen as failing to promote the wider objectives of Islamic economics, which include pro-ductive activity, growth and employment for the benefit of the entire community.

In lieu of interest-based contracts, Islamic business laws follow profit and loss sharing (PLS) contracts. PLS contracts are perceived to have a number of advantages over interest-bearing loans. First, interest is avoided to avoid exploitation. Second, the sharing of risk is perceived as better conforming to the spirit of Islam. And third, because the lend-ing institutions share the burden of risk, they have a greater incentive to improve risk assessment, thereby decreasing the rate of business failure and increasing overall economic well-being.

However, PLS contracts are considerably more complex than their antecedents. During the Islamic period in seventh-century Arabia, a PLS agreement would typically be formed between a single borrower and lender. But a modern Islamic Financial Institution uses the deposits of many lenders to fund a range of productive projects. Ideally, accounting principles and practices should reflect the positive side of these contracts. But some drawbacks have been found in the ability of current accounting practices to fully capture the complexity of multi-layered contracts which may involve the funds of many depositors spread across a range of invest-ments. That is why a full-fledged Islamic accounting system needs to be developed, and the AAOIFI is striving to achieve this.

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21.2 ban on Gharar

Gharar is the sale of probable items whose existence or characteristics are not certain, which makes the transaction similar to gambling. The Qur’an explicitly forbids games of chance, and the sayings of the Prophet Muhammad (peace be upon him) acknowledge and extend this position to include a prohibition against uncertainty which explicitly incorporates business transactions.

21.3 adoPtIon of accePtable valUatIon technIqUes

A number of valuation methods have been used in conventional accounting which uses models where future values are discounted to net present value using an estimated interest rate as the discount rate. Such valuation tech-niques are not acceptable in Islamic accounting for a number of reasons.

First, there is the question of the extent to which the ban on riba constitutes a ban on interest. The current consequence of this debate is sensitivity to the use of interest which has extended the prohibition not only to actual contractual arrangements, but also to valuation tech-niques. This is despite the suggestion by some moderate Islamic schol-ars that interest-based valuation models could potentially be adapted in a manner that would ensure their compliance with the Shari’ah.

Second, the concept of the time value of money is simply not recog-nized as a basis for financial calculations in an Islamic context. This is a result of the ban in Islam against uncertainty. It is well known that the valuations of future income flows in most valuation models are highly subjective, so that small changes in estimated interest rates (and other variables) can result in large changes in estimated values. In order for the mathematics to be valid, the original investment, as well as estimated future income flows, must all be positive, which will not always be the case in reality.

Third, most of the valuation models also utilize a so-called risk-free interest rate, when in practice the notion of any return being risk free is debatable. For instance, a government bond may have a default risk approximately equal to zero, but a borrower may still face a risk of adverse currency movements, for example.

In view of this, the conventional valuations model cannot be consid-ered legitimate in Islam because of the risk inherent in the uncertainty associated with the calculations.

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21.4 valUatIon of zakah

Zakah (Islamic tax) is an obligatory annual payment levied on net real-izable wealth of all kinds. There is no doubt that the importance of accurate asset valuation techniques for Zakah purposes is a major aim of Islamic accounting standards.

21.5 forbIdden bUsIness actIvItIes

Shari’ah-compliant businesses are not involved in activities which are against the fundamentals of the Islamic faith. These include transac-tions involving alcohol, pornography, the slaughter or sale of pork or any uncertain contracts, such as those having reference to future uncertain-ties. Uncertain contracts are forbidden because they may lead to future conflict if circumstances should change between the times the contract is determined and when the transaction actually takes place. Forbidden business activities constitute an important issue in Islamic accounting standards.

21.6 envIronmental aWareness

The environment is highly important in Islam. The rapid deteriora-tion of the environment can closely be connected to a crisis of values. Safeguarding, protecting and caring for the environment are deeply rooted in all fields of Islamic teaching and culture. The need to care for the Earth and the environment and a related need to spread virtue and good deeds are repeatedly demanded in the Qur’an.

21.7 trUsteeshIP

The holism of Islam, evident in the principle of Tawhid (unity of God), and the concern to look after the Earth are suggestive of a macrolevel governance, incorporating planning and control, and associated account-ings. At the same time, the need for attention to detail and co-ordination would suggest derivative systems of governing and associated account-ings at the microlevel. Therefore, the concept of Islamic accounting is actually given a very key role—and one that reflects a more holistic notion of accounting than is conventional today—in relation to the Islamic principle of trusteeship.

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During the Islamic rule of the fifteenth and sixteenth centuries, the person described as an accountant, or muhtasib, was the one responsi-ble for making sure that business did not harm the community. It was the muhtasib’s task, for example, to ensure that business activities such as baking and tanning were situated in areas where they did not have a neg-ative impact on the community through the emissions and smells they produced. The accountant would be concerned, among other things, about trying to guarantee that individuals, organizations, and societies were held to account what was needed.

21.8 InformatIon and fInancIal statements

In Islamic accounting, a close relationship must exist between the finan-cial accounting information and the purpose for which this information is provided. Accounting information is relevant if it helps the main users of financial statements to evaluate the potential outcomes of maintaining or establishing relationships with the given firm or Islamic Financial Institution, rather than assisting investors in choosing from alternative options. To be relevant, accounting information must satisfy three main criteria:

1. Predictive value: This makes it possible for users to asses the potential outcome of a current or a new relationship with the organization.

2. Feedback value: This assists users in checking the accuracy of their prior predictions on income and loss.

3. Timeliness: This means information is only useful at the time when it is needed. Optimal frequency of reporting and minimal lag between successive reports are therefore important.

In addition to these, Islamic accounting information must fulfil the fol-lowing four criteria:

1. Reliability: This permits users to depend on the reported infor-mation with confidence, but reliability does not mean absolute accuracy. It means that based on all the specific circumstances sur-rounding a particular transaction or event, the method chosen to measure/disclose its effects produces information that reflects the substance of the event or transaction. The provision of esti-mates/judgements in accounting methods is not inconsistent with

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Shari’ah. Most particularly, reliability should satisfy properties such as representational faithfulness, objectivity and neutrality.

2. Comparability: The usefulness of accounting information is enhanced by comparability of the firm or Islamic bank’s perfor-mance over time. This requires the adoption of similar methods of measurement/disclosure in relation to similar events.

3. Consistency: Corporations or Islamic banks should stick as much as possible to the same measurement/disclosure methods from one period to another, unless there is genuine call for change (e.g. changing depreciation measurement). In this case, the new change and its effect should be appropriately disclosed.

4. Understandability: Islamic accounting information is targeted to common users, not to accountants. The nature of the information, the way it is presented and the technical background of external users are important factors in the preparation of understandable information. Use of simple classification tools, clear information headings and statement of net results which users want to know contribute to better understandability.

Financial Statements

A financial statement of a firm or Islamic bank can be one of the followings:

1. Financial statements reflecting the firm’s function as an investor and its rights and obligation. Such financial statements include:• Statement of financial position.• Statement of income.• Statement of cash flow.• Statement of retained earning or statement of changes in own-

ers’ equity.2. A financial statement reflecting changes in restricted investments

managed by the firm or Islamic bank for the benefit of others, whether based on a Mudarabah or agency contract.

3. Financial statements reflecting the firm’s role as a fiduciary of funds made available for social purposes when such services are provided through separate funds:• Statement of sources and uses of Zakah and charity funds.• Statement of sources and uses of funds in a Qard-al-Hasan Fund.

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21.9 assets and lIabIlItIes

Islamic accounting statements must show the financial impact of trans-actions and other consequences of Islamic economic activities. Accurate changes in the financial position must be determinable from the balance sheet and how those changes arose must be clear from the income state-ment. Under Islam, the elements of financial position would include all items which are subject to financial evaluation, assets, liabilities and the residual benefits, based on the Qur’an.

In one side, Shari’ah laws deal with various aspects of assets. An Islamic asset includes all valuable property resulting from previous events belonging to the owner. Such an asset should not be usurped and if obtained in a lawful (halal) way has economic benefits for its owners. Lawful acquisition is a critical aspect of “asset” in this context; rights to interest income are never recognized.

On the other hand, liability is defined in Islam either as a faithful obli-gation or as any debt to other persons or business entities. In case of liability too, the payment of interest is prohibited, and therefore, only principal amount of debt needs to be repaid to meet the liability. It means that debt is tied to real exchange in the Islamic accounting system.

Finally, in Islamic accounting, equity in residual benefits is obtained directly from the financial evaluation and contrasting assets and liabilities.

21.10 sharI’ah-based accoUntabIlIty In accoUntInG

Islamic accounting system follows the principles of Shari’ah laws which give importance to certain notions. It has tended to focus on the fol-lowing: accounting issues in relation to the calculation of Islamic Zakah, implications for accounting related to the Islamic prohibition of inter-est or usury and Islamic concerns on social accountability. Furthermore, an alternate valuation system may have to be conceived giving scores to events and actions which have social and moral values according to Islam. If information users know that the entity has not followed Shari’ah actions, they can demand explanations and take actions resulting in the entity complying with the Shari’ah in the future, thus protecting the economic, social and spiritual future of the stakeholders.

While conventional accounting is based on a decision usefulness framework, Islamic accounting is based on accountability within Shari’ah framework. As the AAOIF defines, an Islamic accounting system seeks to

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“determine the rights and obligations of all interested parties, including those rights and obligations resulting from incomplete transactions and other events, in accordance with the principles of the Islamic Shari’ah and its concepts of fairness, charity and compliance with Islamic business val-ues.” While Islamic accounting does not neglect the objective of financial accounting to provide useful information to users of the reports, infor-mation is aimed at enabling them to make legitimate decisions in their dealing with Islamic banks or financial institutions, as opposed to just buy, sell or hold decisions to increase their wealth.

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Long before the age of complex legal documentation and financial revo-lution, Islamic business ethics made compulsory the writing of clear-cut contractual agreements for each financial transaction and insisted that no part of any agreed contract or exchange be exploited. Islamic modes of finance also implicitly bring a rich and superior architecture and tex-ture to the field of corporate governance. In fact, an Islamic Financial Institution is subject to additional layers of governance, since the suita-bility of its investment and financing must be in strict conformity with Islamic business ethics and the expectations of customers.

Islamic Financial Institutions encourage product innovation that moves from fixed interest loan transactions to profit and loss sharing contractual arrangements. In one way, an Islamic Financial Institution is a partner of its depositors; on the other hand, it enters a partnership with the firm or company, while employing the funds of depositors/share-holders in a productive investment.

Furthermore, Islam forbids the charging of interest, but encourages the earning of profits. Therefore, Islamic Financial Institutions (IFIs) are not permitted to charge for the mere use of money. Purely specula-tive transactions are not allowed in the Islamic financial system. IFIs are also not allowed to finance any enterprise involved in pork, pornography, conventional financial services, arms and munitions, tobacco, gambling, alcohol, polluting industries, etc. The inherent exposure of risk in the Islamic modes of finance is also very different from the risk associated with the loan business of the conventional financial system.

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Corporate Governance

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Therefore, IFIs have a distinct perspective on financial transactions. The special characteristics of the Islamic financial system operate under a slightly different structure of corporate governance than conventional financial institutions. We may call this Shari’ah corporate governance.

The uniqueness of Shari’ah corporate governance for Islamic bank-ing and financial institutions stems from two principles. Firstly, it is an approach that mandates the conduct of the business according to Shari’ah. This approach also takes into account a combination of both profit and service motives that recognize business and investment trans-actions in order to keep shareholders’ value intact.

22.1 ProvIdInG a foUndatIon for Good Governance

The main elements of Shari’ah compliance corporate governance are:

1. Board of Directors

The board of directors is the primary level of authority in an Islamic Financial Institution. They are the key decision-makers in implementing policies and bylaws within the institution. The board of directors makes up committees on risk management, credit and internal audit and shares responsibility with management.

2. Efficient Shari’ah Supervisory Board

A distinct feature of the Islamic financial system is the requirement to set up a Shari’ah supervisory board. From the perspective of Shari’ah com-pliance corporate governance, the establishment of a Shari’ah supervisory board is important to instil public confidence in the purity of IFI opera-tions. The Shari’ah board serves as a check and balance to ensure that the management and operations of financial or banking institutions do not deviate from Islamic ethical principles.

3. reputational risk Management

The very success of an Islamic bank/IFI will depend on stakeholders’ belief that the business of their bank/IFI is complying with Shari’ah principles. This is one of the main factors that intensifies the role of good governance to ensure that the trust of stakeholders is not compromised

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and that business grows according to their expectations. reputational risk arises out of any uncertainty of Islamic business ethics compliance.

4. Shari’ah Compliance Accounting and Auditing Standard

In order to maintain the highest standard of accounting and auditing, IFIs should follow a proper audit and accounting standard based on the criteria of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

5. Standard Disclosure and Transparency

An Islamic financial system can function efficiently only if disclosure and transparency are observed. In view of this, Islamic Financial Institutions must maintain the highest international standards and practices for financial/non-financial reporting and disclosures. Furthermore, Islamic Financial Institutions must be transparent in the adoption and applica-tion of Islamic business ethics.

6. Inspection

Since the Islamic financial system operates on the basis of Shari’ah prin-ciples, Shari’ah compliance inspection is needed to ensure that accounts, specific terms of Islamic contracts and rulings of Islamic scholars on transactions are maintained according to AAOIFI standards. Therefore, the Shari’ah guided inspection process is an important element of the governance system of the Islamic banking/financial system.

22.2 role of the sharI’ah sUPervIsory board

In Islamic banking or financial institutions, the Shari’ah supervisory board is part and parcel of the Islamic financial system. The main objec-tive of the Shari’ah supervisory board is to guide the IFI in setting poli-cies and regulations according to Shari’ah, approve financial transactions from the legal side and prepare IFI contracts for future transactions according to the guidelines of Shari’ah.

The authority of the Shari’ah supervisory board comes from Islamic legal and fiqi (jurisprudence) resources. The Shari’ah board members rep-resent the IFI in the general meeting and clarify any Shari’ah questions

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that the stakeholders may have regarding any transaction. In addition, the Shari’ah supervisory board provides advice to the board of direc-tors as well as the top management on Shari’ah issues and verifies inter-nal auditing regularly on IFI documents to ensure their conformity with Shari’ah.

The roles of the Shari’ah supervisory board are as follows:

• The Shari’ah supervisory board controls and monitors the religious side of IFI transactions, service and products. The Shari’ah super-visory board must review all the decisions of the board of directors and top management to ensure their compliance with Shari’ah. Furthermore, the Shari’ah supervisory board authorizes all financial products and transactions to ensure their Shari’ah compliance. The Shari’ah supervisory board has the right to appoint Shari’ah internal auditors to monitor day-to-day transactions and report them.

• The top management and the managing director of the IFI must provide all the information that might assist the Shari’ah supervi-sory board members in applying the Shari’ah code to transactions and products.

• Shari’ah supervisory board members act as advisers and counsellors to the stakeholders, regulators and central banks. Shari’ah supervi-sory board members also address investors’ inquiries and clarify any ambiguity in transactions.

The role of the Shari’ah supervisory board is an essential part and parcel of IFIs and is radically different from that of their conventional counter-parts in major aspects such as foundation, management and products.

22.3 dIvIsIon of resPonsIbIlItIes

IFIs are obliged to appoint Islamic scholars to the Shari’ah supervisory board. Based on the recommendation of the board of directors, the members of the Shari’ah supervisory board are appointed by the general assembly of shareholders. In a true sense, the Shari’ah supervisory board is independent from the board of directors. According to AAOIFI guide-lines, the Shari’ah supervisory board is allowed to attend the board of directors’ meetings to discuss the religious aspects of their decisions. The traditional corporate governance assumes that there is only one board of

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directors, which is independent. However, each IFI has two independent boards: the board of directors and Shari’ah supervisory board.

The Shari’ah supervisory board members are specialized jurists in Islamic jurisprudence and experts in Islamic finance. This common back-ground among SSB members facilitates their communication and enables them to share and transform their knowledge in a faster and clearer way than the members of the board of directors. In principle, the SSB mem-bers have same roles as the board of directors except the planning and strategizing roles, as their task focuses on present and historical events rather than building up a future strategy.

The main values brought by the Shari’ah supervisory board to the IFI are: transparency, trust, ethical behaviour and credibility as well as the values and beliefs underlying Islamic business ethics. A large num-ber of customers join IFIs because they strongly believe these values. The Shari’ah supervisory board carries the Islamic wisdom that drives the operations and actions of IFIs.

22.4 conclUsIon

There is a growing concern emerged with a great profile regarding Shari’ah compliance corporate governance. Islamic economy has pro-gressed a great deal during these last two decades with impetus as an important concern in developing an Islamic corporate system. The devel-opment of the dimension of Shari’ah compliance corporate governance has broader horizon and cannot compartmentalize the roles and respon-sibilities in which all actions and obligations fall under the jurisdiction of the Shari’ah. While the virtues of Islam have always advocated good gov-ernance, the challenge to Islamic Financial Institutions lies in its mod-ern application. Therefore, corporate governance of Shari’ah compliance should aim to serve economic well-being, justice and equitable distribu-tion of income.

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The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), established in 1991, is an Islamic international body that prepares accounting, auditing, governance, ethics and Shari’ah standards for Islamic Financial Institutions (IFIs) and the Islamic Financial Services industry. The existing accounting standards such as the interna-tional accounting standards or national level accounting standards in the different countries have been developed for conventional or mainstream Institutions, and the conventional accounting practices are insufficient to provide for and report on Islamic financial transactions. AAOIFI, within the Islamic Shari’ah rules and principles, has the following objectives:

1. To develop accounting, auditing, governance and ethical thought relating to the activities of Islamic Financial Institutions taking into consideration the international standards and practices which com-ply with Islamic Shari’ah rules.

2. To disseminate the accounting, auditing, governance and ethical thought relating to the activities of Islamic Financial Institutions and its application through training seminars, publication of peri-odical newsletters, preparation of reports, research and through other means.

3. (i) To harmonize the accounting policies and procedures adopted by Islamic Financial Institutions through the preparation and issuance of accounting standards and the interpretations of the same to the said institutions.

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(ii) To improve the quality and uniformity of auditing and gov-ernance practices relating to Islamic Financial Institutions through the preparation and issuance of auditing and govern-ance standards and the interpretation of the same to the said institutions.

(iii) To promote good ethical practices relating to Islamic Financial Institutions through the preparation and issuance of codes of ethics to these institutions.

4. To achieve conformity or similarity—to the extent possible—in concepts and applications among the Shari’ah supervisory boards of Islamic Financial Institutions to avoid contradiction and inconsist-ency between the fatwas (Shari’ah scholar’s ruling) and the appli-cations by these institutions, with a view to activate the role of the Shari’ah supervisory boards of Islamic Financial Institutions and central banks through the preparation, issuance and interpretations of Shari’ah standards and Shari’ah rules for investment, financing and insurance.

5. To approach the concerned regulatory bodies, Islamic Financial Institutions, other financial institutions that offer Islamic Financial Services, and accounting and auditing firms in order to implement the standards, as well as the statements and guidelines that are published by AAOIFI.

6. To offer educational and training programs, including professional development programs on accounting, auditing, ethics, govern-ance, Shari’ah and other related areas, so as to promote knowledge on, and to encourage greater professionalism in, Islamic bank-ing and finance. Training, examination and certification shall be carried out by AAOIFI itself and/or in coordination with other institutions.

7. To carry out other activities, including certification of compliance of AAOIFI’s standards, so as to gain wider awareness and accept-ance of AAOIFI’s standards on accounting, auditing, ethics, gov-ernance and Shari’ah.

The AAOIFI is responsible for examining the specific requirements of Islamic financial transaction and recommending standards to resolve issues of Shari’ah compliance and identify gaps in applying conventional financial reporting to Islamic Financial Institutions. The AAOIFI is pri-marily responsible for the development and issuance of standards for the

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global Islamic finance industry and has so far issued 26 accounting stand-ards, 5 auditing standards, 7 governance standards, 2 codes of ethics and more than 100 Shari’ah standards.

The AAOIFI is supported by a number of institutional members, including central banks and regulatory authorities, financial institutions, accounting and auditing firms, and legal firms, from over 45 countries. Its standards are currently followed by all the leading Islamic Financial Institutions across the world and have introduced a progressive degree of harmonization of international Islamic finance practices. Besides standardization and harmonization of international Islamic finance prac-tices and financial reporting in accordance with Shari’ah, the AAOIFI conducts different professional qualification programmes to enhance the IFI’s humane resource base and governance structures. These pro-fessional qualification programmes are: Certified Islamic Professorial Accounting (CIPS), Certified Shari’ah Advisor Auditor (CSAA) and the corporate compliance programme.

The AAOIFI also published a number of standards both in Arabic and in English. It also publishes a high-quality half-yearly double-blind peer-reviewed refereed journal titled: Journal of Islamic Finance Accountancy (JOIFA) regularly. It plays an important role in the devel-opment of a framework of the Islamic accounting concepts; standardi-zation of practices across the globe in the line with the principles of Shari’ah; and catering to the needs of Shari’ah conscious users in general and of the Islamic Financial Institutions in particular.

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Islamic Financial Services Board (IFSB) has been officially started opera-tion on 10 March 2003.

It is based in Kuala Lumpur. Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act 2002, which gives the IFSB the immunities and privileges that are usu-ally granted to international organizations and diplomatic mission. The objectives of the IFSB are:

1. To promote the development of a prudent and transparent Islamic Financial Services industry through introducing new, or adapting existing, international standards consistent with Shari’ah principles and recommending these for adoption.

2. To provide guidance on the effective supervision and regulation of institutions offering Islamic financial products and to develop the Islamic Financial Services industry, the criteria for identifying, measuring, managing and disclosing risks, taking into account international standards for valuation, income and expense calcula-tion, and disclosure.

3. To liaise and cooperate with relevant organizations currently set-ting standards for the stability and the soundness of the interna-tional monetary and financial systems and those of the member countries.

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

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306 a. hassan and s. mollah

5. To encourage cooperation among member countries in developing the Islamic Financial Services industry.

6. To facilitate training and personal development in skills in areas rel-evant to the effective regulation of the Islamic Financial Services industry and related markets.

7. To undertake research into, and publish studies and surveys on, the Islamic Financial Services industry.

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

9. Any other objectives which the General Assembly of the IFSB may agree from time to time.

24.1 constItUent member

As on December 2017, the IFSB has a total of 185 members who com-prise 75 regulatory and supervisory authorities, eight international inter-governmental organizations and 102 market players (financial insti-tutions, professional firms, industry associations and stock exchanges) operating in 57 jurisdictions.

The IFSB serves as an international standard-setting body of regula-tory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic Financial Services industry, which is defined broadly to include banking, capital market and insurance. In advancing this mission, the IFSB promotes the development of a pru-dent and transparent Islamic Financial Services industry through intro-ducing new or adapting existing international standards consistent with Shari’ah principles and recommends them for adoption. To this end, the work of the IFSB complements that of the Basel Committee on Banking Supervision, International Organisation of Securities Commissions and the International Association of Insurance Supervisors.

24.2 adoPtIon of standard

Since its inception, the IFSB has issued twenty-seven Standards, Guiding Principles and Technical Note for the Islamic Financial Services industry. The published documents are on the areas of:

1. risk Management (IFSB-1) 2. Capital Adequacy (IFSB-2)

24 INTErNATIONAL ISLAMIC FINANCIAL INFrASTrUCTUrE … 307

3. Corporate Governance (IFSB-3) 4. Transparency and Market Discipline (IFSB-4) 5. Supervisory review Process (IFSB-5) 6. Governance for Collective Investment Schemes (IFSB-6) 7. Special Issues in Capital Adequacy (IFSB-7) 8. Guiding Principles on Governance for Islamic Insurance (Takāful)

Operations (IFSB-8) 9. Conduct of Business for Institutions offering Islamic Financial

Services (IIFS) (IFSB-9) 10. Guiding Principles on Shari’ah Governance System (IFSB-10) 11. Standard on Solvency requirements for Takāful (Islamic

Insurance) Undertakings (IFSB-11) 12. Guiding Principles on Liquidity riskManagement (IFSB-12) 13. Guiding Principles on Stress Testing (IFSB-13) 14. Standard on risk Management for Takāful (Islamic Insurance)

Undertakings (IFSB-14) 15. revised Capital Adequacy Standard (IFSB-15) 16. revised Guidance on Key Elements in the Supervisory review

Process (IFSB-16) 17. Core Principles for Islamic Finance regulations (IFSB-17) 18. Guiding Principles for re-takāful (Islamic reinsurance) (IFSB-18) 19. recognition of ratings on Shari’ah-Compliant Financial

Instruments (GN-1) 20. Guidance Note in Connection with the risk Management

and Capital Adequacy Standards: Commodity Murabahah Transactions (GN-2)

21. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders (GN-3)

22. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in the Capital Adequacy ratio (GN-4)

23. Guidance Note on the recognition of ratings by External Credit Assessment Institutions (ECAIS) on Takāful and re-Takāful Undertakings (GN-5)

24. Quantitative Measures for Liquidity risk Management (GN-6) 25. Development of Islamic Money Markets (TN-1) 26. Stress Testing (TN-2) 27. Guiding Principles on Disclosure requirements for Islamic

Capital Market Products (IFSB 19)

308 a. hassan and s. mollah

It may be noted from the above that the IFSB has issued a whole spec-trum of prudential and supervisory standards which constitute the equivalent of Bank of International Settlement (BASEL) I, II and III in Islamic banking and finance which covers risk management, capital ade-quacy, corporate governance, transparency and market discipline. These standards take into account international prudential standards across the banking, investment, securities and insurance markets and simultaneously cater effectively for the specificities of Islamic financial firms, their risks and Shari’ah compliance.

24.3 PsIeIs data and PUblIcatIons

The IFSB has established a Prudential and Structural Islamic Financial Indicators (PSIFIs) project to facilitate macroprudential analysis and to help assess the structure and state of development of the Islamic Financial Services. While macroprudential analysis deals with the macro-economic and institutional determinants of the soundness of the finan-cial system, the analysis of the structure and development of the Islamic Financial Indicators would help gauge its contribution to economic growth and the overall development of the financial sector.

Besides the publications of the twenty-seven Standards Guiding Principles and Technical Notes for the Islamic Financial Services indus-try, the IFSB published 3 books on Islamic regulatory aspect and a num-ber of public lecture series which are used by the researchers as reference materials.

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The Islamic International rating Agency (IIrA) is an international Islamic rating agency based in Bahrain, started operation in July 2005. Initially, it was established as an infrastructure institution for the sup-port of Islamic finance as conceived by the Islamic Development Bank (IDB). This puts IIrA in a league with system supporting entities like Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB). The IDB remains a prominent shareholder and maintains oversight through its nominee, as chairman to the board of directors. The IIrA is structured in a way to preserve its independence. It has a board of directors and a completely independent rating committee. It has Shari’ah supervisory board (SSB) that comprises experts in the field.

25.1 InternatIonal recoGnItIon

The IIrA is formally recognized in a number of international jurisdic-tions including as an approved External Credit Assessment Institution (ECAI) with the Central Bank of Bahrain (CBB), Central Bank of Jordan (CBJ) and the Banking regulatory and Supervisory Agency (BrSA) in Turkey. IIrA provides ratings to entities in a number of Islamic jurisdictions and has continuously expanded its area of influence over the last few years.

IIrA’s special focus is on the development of local capital markets, primarily in the region of the Organization of Islamic Cooperation

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(OIC) countries and to provide impetus through its ratings to ethical finance, across the globe. The IIrA has been facilitating in the develop-ment of the regional and national financial markets by delineating rela-tive investment or credit risk, providing an assessment of the risk profile of entities and infrastructure. It is the sole rating agency established to provide the capital markets and the banking sector in predominantly Islamic countries. While the traditional ratings agencies have a very important role to play in the analysis of conventional institutions and the instruments they issue, the IIrA services in carrying on the business of rating, evaluating and appraising both institutions and instruments within the Islamic finance planetary.

25.2 tyPe of ratInGs IIra offers

The IIrA offers sovereign ratings, credit ratings, Shari’ah quality ratings and corporate governance ratings. Sovereign and credit ratings assess the likelihood that an entity will repay its debt obligations in a timely man-ner. Shari’ah quality ratings evaluate the level of compliance with Shari’ah principles, while the corporate governance ratings consider the practices of an entity to assess the demarcation of stakeholders rights and responsi-bilities as well as compliance with the existing decision-making rules and procedures.

For an example, we discuss below the categories of IIrA sovereign Sukuk (Islamic bonds) ratings.

The six basic categories used by IIrA in analysing sovereign Sukuk and the likelihood of any default on debt obligations at maturity are:

• Politics and Policy Continuity• The Economy—Structure and Growth Prospects• Budgetary and Fiscal Policy• Monetary Policy and Flexibility• The External Accounts• Internal and External Debt.

25.3 sovereIGn ratInGs

• A reliable third party gives an opinion on the feasibility of the repayment of the issuer or an issue of its financial obligations within the record time.

25 INTErNATIONAL ISLAMIC FINANCIAL INFrASTrUCTUrE … 311

• The general rating of countries as sovereign entities is first carried out before the rating of particular issue or institution.

Methodology

• Involves both qualitative and quantitative factors• Assessing the likelihood of default on debt obligations for sovereign

Sukuk.

25.4 IssUer ratInGs

• rating Sukuk issuer with special emphasis on ability to fulfil its financial obligation

• Non-financial organs such as the corporate and Shari’ah governance of the entity from the Sukuk ratings.

Methodology of Issuer Ratings

In rating the issuer:

– Non-financial organs rated with particular regard to creditworthi-ness and continued ability to fulfil debt obligations to stakeholders

– Overall financial and institution creditworthiness of issuer deter-mines level of investors’ confidence potential (Fig. 25.1).

25.5 sUkUk ratInGs

• rating of Sukuk in financial markets is as important to investors as to the issuer

• Investors aspire to receive dividends in a timely manner after sub-scribing to Sukuk.

Methodology of Sukuk Ratings

• Documented terms and covenants of the issued Sukuk are evaluated and the risk/return is measured

• Viability of such Sukuk in the secondary market will proportionally increase the number of subscribers.

312 a. hassan and s. mollah

Fig. 25.1 IIrA sovereign ratings of Turkey (Source IIrA)

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25.6 InsUrer fInancIal strenGth ratInGs

• Financial strength of the insurer of the Sukuk will help in avoiding or mitigating risks

• Insurer of the Sukuk must have corporate ability and requisite financial strength to meet contractual obligations

• IIrA aims to be a source of reliable information and ratings, encouraging growth of a financially strong insurance industry

• IIrA believes it has a vital role encouraging prudent management of insurance companies and improving the industry’s strength for the benefit of all stakeholders.

25.7 PUblIcatIons and traInInG

The IIrA publishes professional analytical research for its multiple con-stituencies. The research is set a high standard for the market, enhancing the level of understanding of the value of fundamental analysis in assess-ing default of investment risk. The Islamic rating related publications by ISrA have helped significantly in enhancing investment decision.

IIrA also conducts training workshops in Islamic countries. These workshops are aimed at introducing concepts of Islamic finance in new markets and deepening the understanding of Islamic finance for the more established Islamic finance centres.

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In order to enhance the ability of the Islamic Financial Institutions (IFIs) to manage liquidity, the International Islamic Liquidity Management Corporation (IILM) has been established on October 25, 2010 with 14 founding shareholders—12 central banks from Indonesia, Iran, Kuwait, Luxemburg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and UAE; and two multinational institutions: Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector. Its head office is located in Kuala Lumpur. The pri-mary objectives of the IILM shall be to:

• Facilitate cross-border liquidity management among the IIFS by making available a variety of Shari’ah-compliant instruments, on commercial terms, to suit the varying liquidity needs of the IIFS;

• Foster regional and international cooperation to build robust liquidity management infrastructure at national, regional and inter-national levels; and

• Any other objectives as the Governing Board may propose.

The IILM is an international organization recognized by central banks, monetary authorities and multilateral organizations to create and issue Shari’ah-compliant financial instruments to facilitate effective cross-bor-der Islamic liquidity management. In other words, the IILM aims to enhance cross-border investment flows, international linkages and finan-cial stability by creating more liquid Shari’ah-compliant financial markets

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for institutions offering Islamic Financial Services. Its membership opens to central banks, monetary authorities, financial regulatory authorities, government ministries and agencies which will hold shares of the IILM.

The landmark of inaugural issuance further represents the first mon-ey-market instrument backed by sovereign assets in the form of Sukuk. The IILM Sukuk is expected to complement the intermediate and long-term Sukuk currently available in the market. Further, on August 26, 2013, the IILM achieved a significant milestone by issuing the first US dollar-denominated, highly rated, short-term, tradable Sukuk. The IILM inaugural Sukuk of USD490 million, rated A-1 by Standard & Poor’s rating Services, were issued at a tenor of 3 months and were fully subscribed.

recently, on October 20, 2017 the IILM has conducted an auction for a 3-month US$550 million Sukuk priced at a 1.67742% profit rate by increasing its total Sukuk issuance to US$3 billion from USD2.45 billion.

Also in October 2017, the Islamic Financial Services Board (IFSB) and International Islamic Liquidity Management Corporation (IILM) signed a Memorandum of Understanding (MoU), to strengthen coop-eration and collaboration in enhancing the ability of each institution to achieve its respective objectives and mandates. With these activities, the IILM has been developing a robust Islamic liquidity management as a catalyst for cross-border financial linkages.

317© The Editor(s) (if applicable) and The Author(s) 2018 A. Hassan and S. Mollah, Islamic Finance, https://doi.org/10.1007/978-3-319-91295-0

Index

AAccountability, 12, 265–267, 273,

275–278, 285, 292Asset securitization, 97–109Auditing, 97, 107, 132, 202, 216,

217, 221, 228, 231, 241, 265, 279, 282, 286, 297, 298, 301–303, 309

BBalance, 6, 8, 31–34, 42, 55, 65, 67,

70, 73, 75, 94, 125, 163, 178, 183, 184, 223, 224, 231, 234–236, 241–243, 247–249, 255, 257, 258, 279, 281, 292, 296

Basel Accord II, 233Benevolence, 31, 32, 34, 265Board of directors, 134, 215, 296,

298, 299, 309Bond (Sukuk), 27, 97, 104, 253Boom and bust, 56, 60, 81

CCapital, 7, 21, 24, 33, 37, 54, 56–58,

68, 72, 74, 80, 81, 83, 84, 87, 89, 92, 94, 97–101, 107, 108, 112–114, 117–121, 126, 132, 145, 146, 157–159, 178, 198, 199, 219, 220, 224, 225, 227, 232, 233, 235–240, 242, 244–248, 255–258, 261, 263, 268, 276, 278–282, 285

Capital adequacy, 231–237, 241–243, 245, 246, 254, 255, 258, 262, 286, 306–308

Capital buffer, 238, 240Capitalism, 8, 53, 55, 56, 59, 60, 62,

68, 72, 75, 79, 83, 117Capital market, 97, 98, 111, 115,

131, 133, 139, 146, 193, 306, 307

Cash flow, 38, 67, 252, 291Checks and balances, 79, 219, 282Codification, 212

318 INDEX

Corporate governance, 29, 37, 216, 219, 221, 222, 267, 278, 295, 296, 298, 299, 307, 308, 310

Credit, 23, 24, 37, 47, 53–57, 60, 64, 70, 84, 151, 159, 161, 162, 175, 176, 226, 227, 234, 236, 239, 249, 253, 257, 258, 260–262, 296

Credit rating, 54, 69, 310

DDebt, 22, 24, 36, 56, 57, 60–63, 65–

67, 69, 74, 80, 90, 92, 93, 98, 104, 108, 114, 115, 117–119, 123, 124, 128, 129, 153, 218, 225, 226, 231, 237, 239, 242, 255, 257, 259, 261, 263, 271, 292, 310, 311

Disclosure, 23, 37, 116, 218, 221, 236, 240, 265–268, 270, 273, 277, 278, 280, 283, 286, 291, 297, 305, 307

Dispute resolution, 212, 213

EEntertainment, 21, 114, 123Entrepreneurship, 127, 150, 151, 163,

176, 177Environmental awareness, 287, 289Ethics, 3–8, 10, 14–17, 23, 31,

32, 34, 35, 37–39, 45–52, 65, 69, 116, 133, 154, 223, 272, 275, 277, 282, 295, 297, 299, 301–303

FFamily, 150, 152, 158–160, 163,

165–176, 196, 197, 205Fatwa, 22, 209, 210, 215

Fiduciary contracts, 218, 219Financial crisis, 14, 30, 53–55, 60,

64, 67, 70, 71, 81–84, 118, 130, 154, 232, 233, 237, 262

Financial dealings, 35, 80, 285Financial economics, 83Financial futures, 29, 131, 141, 146Futures, 131, 133, 134, 138–143,

145–147

GGambling, 9, 21–23, 25, 36, 42, 59,

75, 80, 89, 113, 114, 120, 123, 139, 211, 278, 283, 288, 295

Gharar, 21–23, 26, 80, 88, 120, 139, 140, 278, 283, 286, 288

Grameen Bank, 150, 162, 173

HHarmonization, 109, 216, 222, 251,

263, 303Health care, 155, 158, 159Humanistic, 8

IInspection, 297Institutions, 13, 15, 20, 26, 27, 30,

46, 54, 55, 63–68, 70, 71, 80, 81, 83, 84, 90, 93, 106, 111–114, 132, 141, 144, 146, 150, 156, 157, 174, 179, 180, 186, 187, 192, 210, 211, 213, 214, 216, 217, 219, 221, 222, 224, 228, 235, 241, 243, 252, 254, 261, 275, 278, 285, 287, 293, 296, 297, 301–303, 305–307, 310, 315, 316

Instruments, 9, 10, 23, 24, 36, 87, 90, 94, 98, 113, 131–134, 139, 141,

INDEX 319

145, 146, 205, 211–213, 215, 220, 225–227, 231, 239, 240, 249, 254, 255, 257, 261, 263, 269, 281, 305, 307, 310, 315

Interest-free banking, 25, 149, 156, 157, 160, 198

Investment, 7, 9, 21, 23–25, 30, 32, 33, 36, 37, 39, 40, 43, 51, 57, 58, 60, 63, 65–67, 69, 70, 74, 78–81, 87–92, 94, 99, 106, 111–118, 120–129, 131–133, 140, 143, 151, 152, 161, 171, 175, 178, 196–198, 201, 205, 211, 218, 220, 224, 225, 229, 232, 242, 244, 255, 257, 262, 278–282, 287, 288, 291, 295, 296, 302, 308, 310, 315

Investment account, 225, 242, 244, 245, 250, 279, 307

Investment principles, 112, 113Investment profits, 198, 202Islamic accounting, 275, 277–280,

282, 285–293, 303Islamic bankers, 45, 179Islamic banking, 11, 13, 20, 21, 23,

25, 27, 31, 46, 53, 55, 80–82, 84, 90, 92, 178, 179, 193, 209–213, 216, 217, 219–224, 228–230, 234, 235, 241–243, 245, 253, 262, 269, 272, 280, 286, 296, 297, 302, 308

Islamic business ethics, 23, 34, 45, 48, 50, 52, 133, 272, 282, 295, 297, 299

Islamic capital market, 97, 111, 115, 131, 133, 139, 146, 193, 307

Islamic economics, 3, 6–16, 19–21, 55, 71, 72, 75, 79, 83, 223, 287

Islamic equity, 40, 87, 94, 95Islamic finance, 3, 7, 9, 16, 17, 19,

21, 24, 26, 27, 29, 30, 35–37, 53, 84, 104, 116, 120, 127, 128,

131–133, 146, 156, 178, 183, 187, 188, 191, 192, 209, 211, 212, 214–216, 222, 223, 229, 235, 241, 275, 277, 278, 281, 299, 303, 307, 309, 310, 313

Islamic Financial Institutions (IFIs), 9, 16, 19, 21, 22, 25–27, 30, 45–48, 50–52, 90, 97, 107, 132, 133, 146, 157, 180, 192, 202, 210, 211, 215–218, 223, 228, 229, 231, 234, 235, 241, 243, 246, 251, 265, 267, 275, 277–279, 282, 286, 295, 297, 299, 301–303, 309, 315

Islamic financial products, 19, 27, 192, 211, 216, 305

Islamic insurance, 22, 47, 157, 194, 307

Islamic investment, 20, 22, 41, 47, 90, 113, 127, 211, 277

Islamic marketing, 45–47, 51Islamic microfinance, 149–179Islamic scholars, 19, 22, 36, 83, 91,

92, 94, 95, 98, 152, 154, 209, 210, 215, 286, 288, 297, 298

Issuer, 98–100, 102, 104, 108, 109, 134, 138, 145, 310, 311

JJoint venture, 33, 99, 101, 102, 189Justice, 5, 6, 8, 9, 11–13, 16, 25, 31,

32, 34, 35, 45, 51, 55, 73, 74, 157, 178, 193, 265–267, 270, 273, 277, 285, 299

LLeverage ratio, 233, 239, 247, 257,

263Liquidity, 36, 70, 71, 92–94, 98, 104–

106, 115, 117, 128, 139, 218,

320 INDEX

227, 228, 234, 239, 252–255, 257, 258, 260, 261, 315

Liquidity risk, 227, 231, 234, 251–253, 257, 263, 307

MManagers, 7, 32, 37, 39, 40, 42, 43,

52, 116–119, 124, 129, 138, 224, 269

Market, 7, 15, 16, 19, 25, 26, 29, 37, 45, 54, 57–61, 63–67, 69, 71, 72, 75, 76, 83, 84, 87, 88, 94, 95, 98, 99, 104, 105, 107, 109, 112, 115, 117, 118, 120, 123, 125, 127–133, 136, 138–146, 155, 185, 187, 188, 192, 193, 212, 214, 216, 218, 220, 226, 234, 245, 250, 252, 261, 262, 269, 273, 286, 308, 311, 313

Market players, 40, 178, 186, 306Mezzanine, 118, 125Microfinance, 150–152, 154–158,

162–164, 173–175, 178–180Mobilization, 26, 111Morality, 4, 6Mudabarah, 24Murabahah, 24, 99, 102, 107, 125,

183, 184, 187–191, 210, 211, 224–229, 234, 243, 253–255, 269, 277, 281

Musharakah, 24, 33, 34, 94, 97, 100, 101, 107, 111, 120, 121, 183, 185–187, 191, 210, 211, 224, 225, 227–229, 243, 254, 269, 276–279

Mutual funds, 90, 111, 112, 115, 116, 211Mutual responsibility, 195

NNet Asset Value (NAV), 90, 112

PPortfolio performance, 37, 40, 41Poverty, 5, 25, 149–152, 155, 156,

158, 159, 161, 174, 176–180, 272

Premium, 109, 134, 136, 138, 139, 144, 192, 197, 204

Private equity funds, 117, 120, 122, 125, 127

Profit-loss sharing (PLS), 22, 24, 88, 90, 94, 105, 132, 226, 241, 269, 278

Prohibition of Riba, 21, 283, 286, 287

Public goods, 218Put, 7, 87, 88, 135, 137, 144, 145,

154, 241

QQuran, 22, 113, 131, 270

Rregulation, 25, 27, 29, 39, 40, 54,

69, 72, 74, 83, 188, 216–221, 232, 233, 243, 251, 305, 306

re-insurance, 203reporting, 204, 266, 267, 282, 290,

297, 302, 303resources, 10, 14, 25, 32, 40, 62, 68,

74, 75, 126, 128, 149, 154, 160, 161, 172, 176, 215, 218, 229, 244, 267, 275, 297

riba, 10, 21–23, 36, 55, 72, 73, 77, 78, 80–84, 88, 95, 113, 114, 120, 123, 125, 143, 157, 178, 224, 268, 277–279, 288

risk, 21–24, 26, 33, 35, 37, 38, 42, 58, 63, 65, 66, 69, 72–75, 80, 81, 98, 99, 111, 113, 127, 132, 133, 138–143, 146, 162,

INDEX 321

191–194, 196–198, 203, 204, 212, 214, 218–221, 223–231, 234–238, 241–256, 258, 261, 262, 269, 277, 279, 283, 285, 287, 288, 295–297, 305–308, 310, 311, 313

SScreening, 36, 37, 41–43, 113, 114,

122–124, 211Shareholders, 25, 31–33, 38, 69, 93,

117, 200, 201, 219, 223, 242, 244–248, 266, 268, 279, 280, 295, 296, 298, 315

Shari’ah compliance, 111, 152, 282Shari’ah-compliant commerce, 88Shari’ah-compliant mortgage, 183,

185, 187, 188, 191, 192Shari’ah law, 21, 36, 91, 95, 120, 121,

133, 139, 209, 210, 212, 213, 216, 275, 292

Shari’ah principles, 9, 29, 40, 94, 98, 107, 115, 116, 120, 127, 209, 210, 213–215, 219, 229, 242, 267–270, 296, 297, 301, 305, 306, 310

Shari’ah quality ratings, 310Shari’ah supervisory board (SSB), 9,

40, 125, 128, 282Socially responsible investment (SrI),

30, 35–37, 192Speculation, 9, 21, 22, 25, 26, 54, 60,

61, 74, 83, 115, 138–140, 142, 144–147

Stakeholder’s engagement, 266, 268Stakeholders’ perspective, 31Standardization, 213, 214, 216, 243, 303Standards, 10, 16, 35, 156, 213, 214,

216, 217, 219, 221, 222, 228–235, 240–243, 251, 254, 255,

257, 258, 261, 263, 266–268, 272, 273, 282, 285–287, 289, 297, 301–303, 305–308

Stock index, 131, 133, 139, 141–143, 145–147

Stock options, 29, 133–136, 139, 141, 143–147

Sukuk (Bond), 27, 97, 104, 253, 310Supervision, 25, 33, 153, 216,

219–221, 231, 232, 236, 237, 243, 247, 262, 305, 306

Systematic, 4, 14, 56, 88, 225

TTabaru, 196–198, 201Tawhid (Unity of God), 289Trade, 19, 20, 23, 26, 36, 56, 67, 72,

73, 78–80, 88, 92, 99, 114, 115, 139–141, 169, 170, 192, 219, 225, 228, 234, 277, 279

Transactions, 10, 19, 33, 35, 37, 80, 89, 93, 121, 127, 140, 187, 209–216, 221, 225, 227–229, 233–235, 249, 254, 255, 259, 268, 270, 276–278, 281, 282, 285, 287–289, 292, 293, 295–298, 301, 307

Trust, 5, 16, 31, 33, 34, 47, 48, 50, 52, 99, 111, 177, 185, 211, 219, 229, 265, 279, 299

UUncertainty (Gharar), 21, 120, 140,

278, 283, 286

VValuation for Zakah, 287Value-base accountability, 276–277

322 INDEX

WWakalah, 107, 121, 195, 197, 199, 244Warrants, 29, 133, 134, 138, 141,

145–147

ZZakah, 10, 15, 25, 78, 179, 180, 268,

270, 271, 277, 278, 281–283, 289, 291, 292