Thursday, September 13, 2007

Challenges Facing Sector's Growth; Global Islamic Finance

The link to the article online at Arab Times newspaper-Kuwait website:-
17th Apr 2007 : Web Edition No:12855

Challenges facing sector’s growth; Global Islamic finance
By: El Waleed M. Ahmed, Legal Consultant, Foreign Affair Department, Kuwaiti Lawyer Law Firm, Al-Jabria –Kuwait. LL.M Degree "Master of Laws" From Temple University School of Law-Philadelphia-PA USA.

In the 1970s, Islamic financial institutions really took off, due at least in part to the new oil wealth in the Gulf. Since then, Islamic banking in the Middle East is growing and becoming important in mobilizing local and regional saving, as well as providing an important source of capital. Thus, the Islamic finance industry is a phenomenon that has generated considerable interest in the financial world in recent years. Specifically the GCC region has been the hotbed of activity as far as the Islamic banking & investment industry is concerned.Part of the reason why Islamic finance has boomed so much in recent years is the increase in the oil price & repatriation of Arab money in the wake of the aftermath of terrorist attacks on US on Sept 11, 2001. Many Arab investors withdrew their money for US and the West in general and reinvest their fortune in the region and they favor Islamic investment. Moreover, the vast liquidity in the oil exporting countries is attracting a lot of bankers and borrowers who are prepared to adhere to the Islamic restrictions on the use of capital. Although, contributing to the growth of Islamic banking in the Middle East was the establishment of the Islamic Development Bank by the “Islamic Organization Conference” in the early 1970s. The Islamic Development Bank serves as a “World Bank” for Muslim countries, with the aim to facilitate the expansion of the Islamic banking and financial institutions in the Muslim countries and worldwide. As a result, the annual growth of the Islamic financial institutions has been an estimated almost 15 percent worldwide over the last decades.Islamic banking and investment systems bases on risk sharing. Therefore, risk-free investments are generally not found in the Islamic business environment. There is no room for profit without exposure to some degree of risk in Islamic investment. Thus, the principles of Islamic transaction are: the prohibition of interest-based transactions “Riba”, adhering to Halal “lawful activities “Haram” Sinful Activities” and carrying some degree of risk.For Islamic banking and investment to grow and gain global acceptance as genuine alternative to the convention banking system. It must overcome a lot of difficulties and obstacles. This article will highlight how Islamic banking functions, the major difficulties facing Islamic finance growth & global acceptance and how it can be overcome. Because, in the age of globalization, there will be no universal acceptance for system that serves only the interests of a particular country or group of countries. Thus, Islamic financial institutions will not only be assessed by their Sharia aspects, but also by other factors including their effectiveness and efficiency, their resilience and their ability to evolve and reinvent to meet the challenges of the continuously changing demands as we advance forward. Operation: On the surface, Islamic banking systems differ greatly from all Western banking systems. Imagine being able to borrow money without paying interest and having the financial institutions assume half the risk; this is a common transaction in the rapidly growing world of Islamic banking.All Islamic banks or financial institutions have a religious supervisory board (RSB), consisting of an Islamic scholar, who acts as advisory council to the official of the Islamic institutions. The “RSB” is set up as permanent institutions located and financed by the Islamic financial institution “IFI”. The “RSB” oversees the Islamic financial institution activities according to Islamic law and publishes its opinion in the Islamic financial institutions annual reports. Thus, the business section of the Islamic banks works in connection with the religious supervisory board of “RSB” to review financial transactions’ proposal with regard to its conformity to Islamic principle.The fundamental principle underlying the Sharia approach to finance is that no one wishing to earn a return on money has any rights to retain the initial sum intact; in order to earn profit in Islamic finance, it is necessary to take risk. Moreover, the foundation of the Islamic banking is asset management. Although, Islamic finance rests on two main principles: (1): the main financed asset must exist. (2): the financier must bear the risk associated with this asset for some period of time, and that what will justify a rate of return on the basis of this risk exposure.Investment agencies in the Islamic financial systems work according to a contract, in which an agent invests funds on behalf of the principal in exchange for a fixed wage or share in profit. The principal owns the invested fund, therefore is entitled to the profit of the investment and liable for its losses, while the agent is entitled to a fixed wage if the agency stipulates that. Furthermore, Islamic-banking systems are based on sales agreements; Islamic bank sells you the money, making a profit on that sale. On the other hand, the depositors in the Islamic banking systems do not earn any return on their deposit while those holding ‘investment accounts’ earn a shared of the profit and exposed to potential losses.” In project finance, Islamic banks will lend against the title of a key parts of given project. Technically it is not a loan, but a purchase and sale agreement. Moreover, the Islamic bank can pursue sale by order such as “Salam and Istisna” financing, and then can buy the non- existent goods at a discount such as “the salam and Istisan price” and sell the goods later on delivery at retail price. Comparison: Conventional finance bows to one master, ‘profit’. Islamic finance however, has two masters, ‘profit’ as well as ‘Shari’ah principles’. Obedience to two masters is no easy task. There are some basic differences between the Islamic banking system and the conventional banking system. First Islamic banking systems do not charge or pay interest and they will not invest in enterprises they believe to be immoral, where the banks share in the management of the borrowed fund during the life of the loan. Moreover, Islamic banks, unlike their counterpart “conventional banks” have to share in the risk of their transaction. Thus, in conventional banks the client is obligated to repay the bank, the principle amount of the loan, plus a set rate of interest over a term of monthly installments.Thus, the conventional banks are based on borrowing and lending and Islamic bank is based on selling. Furthermore, Islamic finance is asset-based, or based on “money for asset,” opposite to “money for money” in the conventional banks. Also, Islamic financial intuitions relied more heavily on their equity than conventional banks. Furthermore; Islamic financial institutions faced more difficulties in attracting deposits than interest-based banks. And had higher cash/deposit ratios than conventional banks. Moreover, Islamic financial institutions tended to channel their funds into direct investment (using musharakah and mudarabah products), rather than personal-loans. Accordingly, there are different structures of the Islamic and conventional securitization such as under Islamic type the security issued by the SPV “ Special Purpose Vehicle” are claims assets help by the issuer SPV and are such that the claim are closely attached to the ownership of such assets. Also, In the Islamic type there is no guarantee of predetermined rate of return, but a variable one according to the rate of return. And the transfer of the asset from the originator to the SPV should be in true-sale basis. Challenges faced: -The Need for Global Standardizations and Harmonization Of Sharia’s Board Decision: Sharia board at individual banks actually defines what is and is not Islamic banking. In the absence of a universally accepted central religious authority because of the lack of uniformity in religious principle applied in Islamic countries that will lead to identical financial transaction will be interpreted differently from one Shria board to another and that will lead to uncertainty about what is the acceptable way to do business in Islamic banking and finance systems, which in turn will complicate the assessment of risk for both the financial institution and its customer. Therefore, the way Sharia advisory boards of Islamic financial institutions function remains a source of confusion. Even though, sharia is certainly dynamic and like all jurisprudence, open to level of interpretation but lack the center level of standardization of Sharia board’s ruling and that is one of the challenges facing the global acceptance & growth of the Islamic finance. Because the difference of interpretations of Sharia laws, which lead to the inability of one Islamic bank to copy another Islamic bank’s products. Furthermore, there is a need for conformity or similarity to extend possible in concept and application among the Sharia supervisory boards of Islamic financial institutions to avoid contradiction and inconsistency between Fatwa “Sharia Board’s Ruling” and the application by these institutions with the a view to activate the role of sharia supervisory boards of Islamic financial institutions and central bank through preparation, issuance and interpretation of Sharia standard and Sharia rules for investment, financing and insurance.Therefore, there is a necessity of the existence of unified Sharia board in the national and international levels by forming a uniform council representing different Islamic schools of thought so as to decide what types of financial services are conforming to the Islamic law, to define cohesive rule and to expedite the process of introducing new product.On the other hand, some Sharai scholars argue in favor of the acceptance of the different opinion between Sharia boards, because they bring more innovation and give room for variation in products that is essential in dynamic markets like the financial markets. Moreover, Islamic finance is traditionally flexible. Why go against that? Flexibility is one of its major strengths. It means there can be a broad variety of products tailored to suit the client’s needs. Other Sharia scholars argue that there should be Sharia counseling: independent companies offering consultation on Sharia matters instead of having Sharia board in each financial institution.Accordingly, there is a necessity for the Islamic financial institutions to handle the complex issues and problems pertaining to standardizations and harmonization. At the same time there is a need to provide Islamic remedies without compromising Sharia principles. The need for Transparency, Disclosure And Standardization of Accounting Procedure: Necessity of the unified accounting and regulatory standard body to govern the Islamic banking and finance nationally and globally:For an Islamic financial institution to succeed it needs to establish universally accepted accounting, auditing and regulatory standard in order to achieve global acceptability and continue its rapid expansion. Therefore, there is a need to develop uniform accounting and reporting structures among Islamic financial institutions. Because the absence of accounting (and auditing) standards pertinent to Islamic banks and the uncertainty in accounting principles involves revenue realization, disclosures of accounting information, accounting bases, valuation, revenue and expense matching, among others lead to the results of Islamic banking schemes may not be adequately defined, particularly profit and loss shares attributed to depositors.Although, disclosure requirements need to be comprehensive and more frequent to inform investors of investment techniques so as they can make decisions based on their risk preferences. Therefore maintaining clear transparency and insuring adequate disclosure of financing mechanisms are important steps toward building the necessary foundation for Islamic finance. Therefore, there is need for all Islamic financial institutions to unite their effort so as to standardize financial statement and disclosure requirement across the whole Islamic industries.Furthermore, the Islamic financial institution needs to recognize the responsibilities of regulators to apply national supervisory principle to all Islamic financial institutions especially the effective liquidity management, the definition of a deposit and the standardization of accounting and disclosure.” The lack of a thorough comprehensive and consistent a counting standard and the lack of the effective regulation are vital for Islamic banking to continue grow is to overcome those problems.Therefore, there is a need for unified Islamic accounting standard covering areas such as the presentation of financial statement and disclosure in the Islamic financial institutions. Thus, the Islamic accounting standard must seek to comply with international accounting standard.The Need for Secondary Market For Islamic Financial Institution to Handle Their Liquidity: One of the major challenges to Islamic financial institutions remains how to handle their liquidity, because those banks have been more successful in attracting deposit than in identifying funding opportunities. Thus, liquidity has always been the most critical issue for Islamic financial institutions, because there are only small secondary markets that exist to enable the Islamic financial institutions to manage their liquidity, because the Islamic banks asset generally not saleable in any secondary market. Therefore, the establishment of genuine inter-bank markets would be a significant step towards providing Islamic financial institutions with the ability to maintain an adequate liquidity without holding excessive amount of very short-term asset. There is a need to establish international Islamic financial market “IIFM” to facilitate the development of the international Islamic money market and to harmonize the standard regulation and the practices in the Islamic financial industry. Islamic Financial Institutions Need To Enhance Their Risk Management Techniques: Financial institutions that are providing Islamic products are facing the challenge of understanding the associated risks and design as well as developing a strong risk management framework. Thus, Islamic financial institutions need also to identify where and when their risks are arising for each of their financial instrumentsTherefore, Islamic bank will be require employing the most modern risk management techniques, improving audit systems and enhance international standards of transparency regulation and supervision. Islamic Financial Institution Should Avoid Short-Term Management Transaction: Potential risk facing Islamic finance is that it may drift into services that are designed for the rich only, such as Tawarruq and other short-term management. These tools practically serve only the rich; they don’t look into the developmental aspect. In most cases, these instruments are used for liquidity management, rather than project finance and consumer financing, which are essentially developmental. Also, traditionally Islamic investment opportunities have been low-risk and short-term ventures and a lack of tradable financial instruments have restricted investment opportunity. Therefore, there is need for Islamic financial institution to focus more on project financial transaction and consumer transaction. ConclusionSince the Cold-War era, there has been a massive Islamic movement within the Islamic countries and the minorities Muslims communities around the globe. This movement has demanded that the Islamic law governs all aspects of their life from political, economic and daily life according to the Islamic principle.Therefore, the need to expand the Islamic financial institutions services to accommodate the Islamic communities’ needs will continue to grow rapidly in the near future. There is a need for collective efforts from the bankers, economists and the Islamic legal scholars to develop financial solution that meets the religious requirement to the Muslim communities. Moreover, the Islamic financial community must accept that their institutions have to be regulated and supervised to meet the international standard. Ultimately their ability to grow and compete will depend on international acceptance of the regulatory regime.There is need for universally accepted principal governing Islamic financial dealing, before the system can be accepted internationally, because the weakness of the Islamic financial market has also resulted from the lack of the common Islamic accounting and legal framework governing the Islamic financial market. Since the Islamic law does not require the banks to be Islamic banks or all its resources to be Halal “permitted” then the conventional institution could have subsidiaries offer Islamic finance to Muslim and non-Muslim alike as an alternative to the interest-finance. This might be used mainly to offer the most needed financial services such as mortgages and car financing to the minorities’ Muslim community in the non-Islamic countries. Such efforts are needed to meet the needs of an ever-growing Muslims communities trying to live their lives according to their beliefs. By El Waleed M. Ahmed
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Challenges facing sector’s growth; Global Islamic finance