ISLAMIC FINANCE

Overview

Islamic finance stems from the principles of the Sharia Islamic law which provides guidelines for Muslims in terms of their relationship with money. It applies ethical and extra-financial criteria that represent potential crossover with SRI. We must first examine the foundations of Islamic finance and how it works, without succumbing to the stereotypes and prejudices that often prevail in non-Islamic countries. In terms of the extra-financial aspects of Islamic finance, it bears similarity to SRI in its socially responsible purpose and the exclusion of businesses deemed unethical. Islamic finance is, however, an entire financial system in its own right. The very recent emergence of a special offer from Swiss SRI specialists brings some insight as to how these two approaches can be combined. However, it is much too early to determine whetherEnvironment, Social and Governance (ESG) criteria can be extended to Islamic investors.

.I FROM CHRISTIAN FINANCE TO SRI

.II ISLAMIC FINANCE IN PRACTICE

II.Markets

Ranking

According to IFSL, Iran is the largest market, holding over one-third of the global assets under management. This is due to the fact that Iran aligned its entire banking system with the Sharia in the 1980s. Some of the Gulf states follow suit, as well as Malaysia, aprecursor in Islamic finance in Southeast Asia. Interestingly, the United Kingdom ranks

II. ISLAMIC FINANCE IN PRACTICE

.

These figures do not include sukuk (the Islamic equivalent of bonds), for which Malaysia, thanks to its regulatory system described below, is the undisputed leader, with more than half of the bond issues in 2007. This does not, however, change the ranking by country.

Since the end of 2007, new initiatives have emerged in other markets such as, including Sudan, Egypt and Bangladesh. Despite having established a dedicated department at its central bank, Pakistans assets under management are lagging behind, but this could simply be a question of time, given the current coordination with Golf states and efforts to follow the example of Malaysian progress with the set-up of a single Sharia council for all the Islamic banks in the country. Singapore is also seeking to catch up with Malaysias leading position in the region.

In Europe, London quickly seized the opportunity to make inroads into the Islamic finance market, demonstrated by the number of Sharia-compliant assets under management and the number of institutions (more than twenty, of which at least seven are completely Islamic). Paris has also recently shown a firm interest in competing with the City on this market. The Jouini-Pastr report to Paris Europlace estimates the potential influx of investments into France at EUR 100 billion, mostly from the Middle East and Southeast Asia. There are also six million Muslims living in France, the largest Muslim community in Europe, who could contribute investments. This report also notes two types of products to be developed, namely property loans and remunerated bank deposits. Socit Gnrale AM already offers its Reunion Island customers twoinvestment funds in line with Islamic principles.

II. ISLAMIC FINANCE IN PRACTICE

Regulatory evolutions

Necessary adjustments

Due to its special and sometimes complex financial mechanisms (see appendix), Islamic finance is less tax-friendly than traditional finance for similar types of investment strategies under existing tax legislation. We will look at the example of purchasing a residence: traditionally, the buyer takes out a loan at the bank, buys a residence from the seller and then repays the loan. There is only one transaction, which is taxed only once. However, to avoid the interest generated by the loan, an Islamic bank offers the murabaha system, whereby the bank buys the residence and sells it piece by piece to the buyer. This involves several transactions which are therefore taxed several times. Another example is the tax benefits on interest earned on investments, which do not apply to Islamic financial products since they do not generate fixed interest.

The expansion of Islamic finance has undergone and is undergoing regulatory adjustments to allow for fair competition between traditional and Islamic financial products and services.

often made with some degree of opportunism

In 2003, the United Kingdom launched a series of legislative amendments introduced by Gordon Brown, then Chancellor of the Exchequer. His current office at 10 Downing Street offers reassurance to advocates of Islamic finance in London. However, France boasts a number of strong arguments to challenge London as European leader in Islamic finance, notably access to the Euro zone. This point was made in the Jouini-Pastr report published in December 2008 by Paris-Europlace, which offers ten proposals for collecting EUR 100 billion. Some of these proposals are of a legal nature, in particular concerning double taxation on the non-speculative buy-sell transactions as mentioned above. On 18December 2008, tax laws were adopted on the initiative of Europlace and Christine Lagarde, Minister of Economic Affairs who clearly announced her intention to lighten the regulatory and tax frameworks of Islamic finance, as is the case in London and other markets.

Malaysia went a step further, positioning itself as the Islamic finance hub in Southeast Asia. In 2006, tax incentives were put in place, such as tax exemptions through to 2016 for Islamic banks and funds. The result is clear: nearly 20% of bank assets are Sharia- compliant, and the country is by far the largest issuer of sukuk.

Other initiatives

Due to the development of Islamic finance in Muslim countries as well as in the United Kingdom and the United States Islamic banks have been created as independent entities or as subsidiaries of major bank groups. Namely, HSBC Amanah, holding 87% of Sharia- compliant bank assets in the United Kingdom, in addition to Deutsche Bank, UBS and Citigroup. Regional and international institutions, such as the Islamic Development Bank, established to act as a world bank for Muslim countries, and organisations such as the International Association of Islamic Banks, attest to the globalisation of this approach. In France, the financial authorities have expressed their decision to embrace Islamic finance, resulting in a number of new Islamic banking prospects: Qatar Islamic Bank hasalready announced its plans to open a French branch by 2010. BNP Paribas is already

II. ISLAMIC FINANCE IN PRACTICE

experimenting with a Sharia-compliant ETF, and Socit Gnrale AM with Islamic investment services on Reunion Island.

This development has given rise to a number of educational programmes on the subject. A number of Masters degrees are now available in France, notably at the EM Strasbourg Business School. The United Kingdom has excelled in this area, even well ahead of countries such as Malaysia or the United Arab Emirates, with programmes in 55 schools out of a total of 205 in the world, according to the Research Intelligence Unit. Furthermore, Islamic finance conferences and seminars are springing up throughout France, due to the high media coverage of the subject and the current regulatorychanges.

.III PRINCIPLES OF ISLAMIC FINANCE

III.Principles of Islamic finance

Motivations behind Islamic finance

The Sharia, or Islamic law, is based on the writings of the Quran and sayings of the Prophet, and acts as a framework for different aspects of day-to-day life for Muslims. In particular, it lays down five major principles for dealing with money:

Prohibition of usury (riba)

Profit and loss sharing between the lender and the borrower

Prohibition of hazard or uncertainty (gharar), notably speculation

The existence of an underlying asset, i.e. the obligation to back all investments with real assets

Prohibition of forbidden assets (haraam), determined as such by business sector and the companys financial position.

Another principle is one of the five pillars of Islam, almsgiving (zakat), which consists in giving one-fortieth (2.5%) of ones yearly income to charity.

The prohibition of usury, the fundamental and most widely known principle of Islamic finance, is not specific to Islam as it is also commended in Christianity and Judaism. However, the traditional financial system clearly contradicts this as well as several other principles.

This is why a system consistent with the teachings of Islam is necessary to provide access to everyday financial services. To do so, rather complex banking mechanisms have been set up (see appendix), but with some differences in interpretation about what is acceptable (halal) and what is forbidden in investments (haraam).

As such, each Islamic financial institution has a Sharia Board comprised of independent experts (academics, jurists, specialised economists) that issues opinions on products available on the market. Moreover, internal and external audits are performed on a regular basis to confirm compliance with Islamic principles. Lastly, if the generation of interest is suspected, purification systems have been put in place, mainly as donations to the poor.

Islamic finance: ethical...

One of the Sharia-compliant investment principles relates to the prohibition of certain assets. One of the criteria used to define these forbidden assets is the business involved, which may be considered reprehensible from an ethical or religious standpoint. The list of forbidden businesses varies but may include:

Alcohol

Tobacco (less systematic)

Weapons (less systematic)

III. PRINCIPLES OF ISLAMIC FINANCE

Gambling

Pornography

Leisure industries (music, cinema, etc.)

Finance industry

Pork products

There is some leeway, however. For example, to allow the financing of a major luxury hotel, the construction of a casino was forbidden, but the sale of alcohol within the establishment was tolerated, as it was deemed necessary for its economic viability. However, the transaction then required purification by contributing to the fight against alcoholism. The purification process thus applies when the forbidden activity is unavoidable or considered difficult to ascertain due to the complexity of the businesses and structures financed.

moral

Islamic finance is a system intended to be fair, with the aim of improving quality of life. The prohibition of usury is based on two moral principles:

The application of a fixed interest rate is considered unfair and discriminatory.First, it prevents the lowest-income groups from having access to credit. For investments, it leads to an uneven distribution of risk and profits: the investor receives fixed income without any correlation to the success or failure of the business, while the entrepreneur bears all the risk. Conversely, in the event of significant profits, the investor receives an insignificant share of the profits while the entrepreneur takes the lions share. In other words, the profit attributed to the capital is fixed, while that attributed to the labour is variable and tinged with uncertainty.

Earning interest is by definition not correlated with the business itself. This transgresses the principle that the creation of wealth is based on a real asset and that the money itself cannot be a source of added value.

Another moral principle linking finance to the real economy is that of not selling what one does not own. This particularly applies to speculation and partly explains why Islamic banks have not been severely impacted by the crisis: they were not exposed to subprime mortgages.

Lastly, the principle of zakat also upholds the idea of social equality. By recommending that believers give a portion of their income (2.5%) to the poor, zakat allows for the redistribution of wealth and helps correct inequality.

and financial!

Islamic finance has developed a number of often complex mechanisms (explained in the appendix to this document) to remain in line with the five principles listed above, among which the prohibition of usury. This system has not only set moral rules and extra- financial principles but has actually designed the tools necessary to apply them. Investing only in real underlying assets and setting specific financial guidelines on Sharia-compliantinvestments therefore require a particular type of financial analysis. The following ratios

III. PRINCIPLES OF ISLAMIC FINANCE

are those used by the Dow Jones Islamic Market indices, even if the thresholds may vary from one institution to the next:

Total debt divided by trailing 12-month average market capitalization must not exceed 33%.

The sum of a company's cash and interest-bearing securities divided by trailing12-month average market capitalization must not exceed 33%

Accounts receivables divided by trailing 12-month average market capitalization must not exceed 33%.

These ratios are in line with the principle that income is in relation to an existing underlying activity and in line with the prohibition of usury: although it is, in practice, inevitable that a company will be in debt, will earn interest and cash, most of its added-value must be based on a genuine activity.

.IV CROSSOVER WITH SRI

Appendix:Main financial mechanisms

Mudaraba

This practice is a form of business relation in which an investor brings capital (financial or other) and an entrepreneur provides expertise. The entrepreneur is responsible for managing the business, and the profits (excluding capital employed and the entrepreneurs management costs) are shared between the two parties based on pre- agreed terms. In the event of losses, they are borne by the investor, and the entrepreneur is not compensated for his labour.

Figure 1 Mudaraba mechanism

FINANCIAL CAPITAL

REMUNERATION (1)

Investor(Rab el Mal)

Project (investment, company)

Entrepreneur(Moudarib)

RETURN (2)

HUMAN CAPITAL (know-how, expertise)

APPENDIX MAIN FINANCIAL MECHANISMS

(1) Part of the profits in case they exist. Otherwise, nothing.(2) Part of the profits in case they exist. Otherwise, investor bears the entire loss.

A variation of this kind of deal is the mudaraba double-deposit scheme, in which the bank acts as an intermediary. The bank plays the role of entrepreneur with clients who deposit the funds, and the role of investor with entrepreneurs of the projects it finances with these deposits.

Musharaka

This system is close to mudaraba, except that the parties combine their capital and share profits and losses in the proportion to the capital contributed.

APPENDIX: MAIN FINANCIAL MECHANISMS

Figure 2 Musharaka mechanism

FINANCIAL CAPITAL

PART OF PROFITS AND LOSSES

Investor Project Entrepreneur

PART OF PROFITS AND LOSSES

HUMAN / IN KIND / FINANCIAL CAPITAL

Murabaha

This system replaces a traditional bank loan: the bank buys a given asset then resells it to the customer in exchange for one or more pre-defined payments. It differs from a loan in that the bank becomes the owner of the asset before selling it and is not paid interest but a flat fee. Although the end result is the same, the transaction is considered Sharia- compliant as it involves a real asset and payment is provided for a service provided bythe bank, rather than for the money itself.

Figure 3 Murabaha mechanism

ASSET PROPERTY TRANSFER

TERM PAYMENT (100+x, margin)

Seller Intermediate broker

Buyer

OUTRIGHT PAYMENT (100)

ASSET PROPERTY TRANSFER

Ijara

This mechanism is similar to the murabaha, except that the buyer actually leases the asset with an option to buy at the end of the lease period. Ijara therefore mirrors lease financing, except that the buyer is not charged penalties for late payments, and the lessor bears the risk associated with the asset as it is the owner (unless the lessee is guilty of malice or negligence).The murabaha and ijara mechanisms can be used as a substitute for a property loan, but the transfer of ownership is gradual in the case of murabaha, and occurs at the end of the contract in the case of ijara.

APPENDIX: MAIN FINANCIAL MECHANISMS

Figure 4 Ijara mechanism

ASSET PROPERTY TRANSFER

PAYMENT OF RENT WITH CALL (BUY OPTION)

Seller Intermediate broker

Buyer

OUTRIGHT PAYMENT

ASSET RENTING

Takaful

This term refers to a group of people who insure each other. Takaful companies operate similarly to mutual insurance companies as risk is pooled and any losses shared by all the insured parties. The members of a takaful insurance company are both insurers and insured. They own the funds, while the company acts as manager and receives compensation in the form of fees. The investments made with these funds must of course be Sharia-compliant.

Sukuk

This instrument is a Sharia-compliant investment certificate equivalent to a private or public bond. Sukuk must have an underlying tangible asset or usufruct on a tangible asset and generally correspond to a specific project. The compensation paid varies according to the performance of the underlying asset rather than the time elapsed.

Fears are currently emerging that the development of new mechanisms will result in complex products, such as speculative instruments, that will be Sharia-compliant in theirform but not in their spirit.