The Financial Management syllabus contains a section on Islamic finance (Section E3). All components of this section will be examined at intellectual level 1, knowledge and comprehension
Although the concept of Islamic finance can be traced back about 1,400 years, its recent history can be dated to the 1970s when Islamic banks in Saudi Arabia and the United Arab Emirates were launched. Bahrain and Malaysia emerged as centres of excellence in the 1990s. It is now estimated that worldwide around US $1 trillion of assets are managed under the rules of Islamic finance.
Islamic finance rests on the application of Islamic law, or Shariah, whose primary sources are the Qur'an and the sayings and practice of the Prophet Muhammad. Shariah, and very much in the context of Islamic finance, emphasises justice and partnership.
The main principles of Islamic finance are that:
The following activities are prohibited:
As mentioned above, the receipt of interest is not allowed under Shariah. Therefore, when Islamic banks provide finance they must earn their profits by other means. This can be through a profit-share relating to the assets in which the finance is invested, or can be via a fee earned by the bank for services provided. The essential feature of Shariah is that when commercial loans are made, the lender must share in the risk. If this is not so then any amount received over the principal of the loan will be regarded as interest.
There are a number of Islamic financial instruments mentioned in the Financial Management syllabus and which can provide Shariah-compliant finance:
Emirates Airlines regularly uses Ijara to finance its expansion. Another example of the Ijara structure is seen in Islamic mortgages. In 2003, HSBC was the first UK clearing bank to offer mortgages in the UK designed to comply with Shariah. Under HSBC’s Islamic mortgage, the bank purchases a house then leases or rents it back to the customer. The customer makes regular payments to cover the rental for occupying or otherwise using the property, insurance premiums to safeguard the property, and also amounts to pay back the sum borrowed. At the end of the mortgage, title to the property can be transferred to the customer. The demand for Islamic mortgages in the UK has shown considerable growth.
There are a number of ways of structuring sukuk, the most common of which are partnership (Musharaka) or lease (Ijara) structures. Typically, an issuer of the sukuk would acquire property and the property will generally be leased to tenants to generate income. The sukuk, or certificates, are issued by the issuer to the sukuk holders, who thereby acquire a proprietary interest in the assets of the issuer. The issuer collects the income and distributes it to the sukuk holders. This entitlement to a share of the income generated by the assets can make the arrangement Shariah compliant.
The cash flows under some of the approaches described above might be the same as they would have been for the standard western practice paying of interest on loan finance. However, the key difference is that the rate of return is based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not necessarily on the financial impact. In Islamic finance the intention is to avoid injustice, asymmetric risk and moral hazard (where the party who causes a problem does not suffer its consequences), and unfair enrichment at the expense of another party.
Advocates of Islamic finance claim that it avoided much of the recent financial turmoil because of its prohibitions on speculation and uncertainty, and its emphasis on risk sharing and justice. That does not mean, of course, that the system is free from all risk (nothing is), but if you are more exposed to a risk you are likely to behave more prudently.
The Shariah board is a key part of an Islamic financial institution. It has the responsibility for ensuring that all products and services offered by that institution are compliant with the principles of Shariah law. Boards are made up of a committee of Islamic scholars and different institutions can have different boards.
An institution’s Shariah board will review and oversee all new product offerings before they are launched. It can also be asked to deliver judgments on individual cases referred to it, such as whether a specific customer’s business proposals are Shariah-compliant.
The demand for Shariah-compliant financial services is growing rapidly and the Shariah board can also play an important role in helping to develop new financial instruments and products to help the institution to adapt to new developments, industry trends, and customers’ requirements. The ability of scholars to make pronouncements using their own expertise and based on Shariah, highlights the fact that Islamic finance remains innovative and able to evolve, while crucially remaining within the bounds of core principles.
Perhaps the main current problem is the absence of a single, worldwide body to set standards for Shariah compliance, meaning that there is no ultimate authority for Shariah compliance. Each Islamic bank’s adherence to the principles of Shariah law is governed by its own Shariah board. Some financial aspects of Shariah law, and, therefore, the legitimacy of the financial instruments used can be open to interpretation, with the result that some Islamic banks may agree transactions that would be rejected by other banks. Therefore, a contract might unexpectedly be declared incompatible with Shariah law and thus be invalid.
In Malaysia, the world’s biggest market for sukuk, the Shariah advisory council ensures consistency in order to help in creating certainty across the market. Some industry bodies, notably the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain, have also been working towards common standards. To quote the AAOFI website: ‘AAOIFI is supported by institutional members (200 members from 45 countries, so far) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide. AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements.’
However, despite these movements towards consistency, some differences between national jurisdictions are likely to remain.
Ken Garrett is a freelance author and lecturer