GLOBAL PERSPECTIVE ON ISLAMIC BANKING & INSURANCE

ISSUE NO. 184JULY–SEPTEMBER 2012

SHA’BAAN – SHAWWAL 1433

PUBLISHED SINCE 1991NEWHORIZON

PROGRESS REVIEW:LIQUIDITY AND ISLAMICBANKS

FOOD FOR THOUGHT:THE ROLE OF THE SHARI’AHAUDITOR

COUNTRY FOCUS:INDONESIA – IS THESLEEPING GIANT STIRRING?

POINT OF VIEW:THE CHIMERA OF ECONOMICJUSTICE

ACADEMIC ARTICLE:DEFINING ETHICS IN ISLAMICFINANCE: LOOKING BEYONDLEGALITY

ANALYSIS:ISLAMIC FINANCIALINSTITUTIONS AND THEIMPLICATIONS OFACCOUNTING UNDER IFRS

IN THE SPOTLIGHT:AN INTERVIEW WITH RICHARDTHOMAS OBE, GATEHOUSEBANK

NewHorizon 184_NewHorizon 23/07/2012 12:28 Page 1

NEWHORIZON Sha’baan Shawwal 1433

CONTENTS

11 Liquidity and IslamicBanks

This brief review takes a look at theliquidity issues faced by Islamic banks andprovides an update on some of the latestthinking and developments designed toimprove the situation.

13 The Role of theShari’ah Auditor

Mufti Aziz Ur Rehman is a Shari’ah auditorand advisor. In this article he reflects onaspects of the role where changes andimprovements could bring better outcomesto the Islamic finance industry.

15 Indonesia – Is theSleeping Giant Stirring?

Indonesia, with the largest economy inSouth East Asia and the biggest Muslimpopulation in the world, has the potential to

be a significant centre of Islamic finance.This article looks at the reasons why it isnot and the prospects for the future.

19 The Chimera ofEconomic Justice

If Islamic banks are merely imitatingconventional banks, can they really deliverthe economic justice that people like theOccupy Wall Street protestors aredemanding? Usman Hayat reviews thethinking on the subject.

20 Defining Ethics inIslamic Finance: LookingBeyond Legality

Dr Habib Ahmed argues that by focusingtoo closely on the legality of transactions,Islamic financial institutions run the risk ofbehaving in an unethical manner. Hesuggests that regulators overseeing theIslamic finance industry should be

responsible for promoting ethicalbehaviour and not just ensuring practicesadhere to the letter of the law.

27 Islamic FinancialInstitutions and theImplications of Accountingunder IFRS

Mohammed Amin discusses whether thereare any disadvantages for Islamic financeunder IFRS accounting rules.

30 An Interview withRichard Thomas,Gatehouse Bank

Gatehouse Bank is the largest UK Islamicbank licensed by the Financial ServicesAuthority. In this interview RichardThomas talks about Gatehouse Bank andshares his thoughts on the role and futureof Islamic banking.

05 NEWS A round-up of the important storiesfrom the last quarter around theglobe.

10 SUKUK UPDATEHighlighting some of the keydevelopments in the sukuk marketduring the last quarter.

32 IIBI NEWSRecent news from the IIBI.

33 IIBI LECTURESReports of the April 2012 lecture byHabib Motani on recentdevelopments in the standardisationof Islamic hedging documents, theMay lecture by Dawood Taylor onmodern day takaful and the Junelecture by Asim Khan on the role ofconventional financial institutions inIslamic finance.

38 AWARDSList of IIBI post graduate diplomasand certificate qualifications.

39 DIARY OF EVENTSENDORSED BY THE IIBI

40 BOOK REVIEWSThe two books reviewed are ‘FirstPrinciples of Islamic Economics’ and‘The Financial Crisis; Who is to Blame?’

NEWHORIZON July–September 2012

Four years after the collapse of Lehman Brothers, the inability ofWestern governments and regulators to stem the continued growthof real unemployment and increasing poverty confirms that thecurrent global economic crisis has brought about a systemicbreakdown of the world financial system. The comment by anunnamed senior G20 aide, reported by Reuters, at the recentMexico G20 summit that ‘We will somehow get through it’ doesnot encourage any optimism that the world economic powers areapproaching a realistic solution.

No amount of talks, recriminations or austerity measures can helpwhen these actions are dictated by corporate/financial elites withspecial interests often to the detriment of society in general.Certainly governments and institutions would claim that they aremaking every effort to regulate the excesses in the financial sector,yet there does not any appear to be any collective will to addressthe moral implications of financial practices.

Usman Hayat comments in this issue of NewHorizon that economicjustice is an enticing but elusive prospect, but that is no reason toslacken our efforts to be a force for good and it may just be that theworld is more ready now to hear the message. Also, Dr HabibAhmed highlights in this issue’s academic article on Ethics inIslamic Finance: Looking Beyond Legality that, within theparadigm of a moral economy, the nature of responsibilities forfirms in general and Islamic banks in particular must conform notonly to national laws and statutes, but also to the moral substancethat underpins faith-based traditions and Islamic financial contractsat the transactional level. Transactions that merely adhere to theoutward form of the law will not suffice.

I hope that Western governments and regulators will consider thebenefits of addressing the morality of certain conventional practicesand also understand that it is more desirable to provide financingfor productive activities that enable the real economy to grow andto make profits without harming society. What is needed most of allis a recognition that the behaviour that has brought the globaleconomy to its knees is not only reckless; it is also increasinglyimmoral and unethical. So long as the Islamic finance industry canavoid practices that cater only for the elites, it can be a driver forchange and communal prosperity that will also benefit the widersociety.

EDITORIAL

Mohammad Ali Qayyum,Director General, IIBI

Andrea Wharton

Rahim Ali

IIBI

Mohammad ShafiqueMohammed AminM Iqbal AsariaRichard T de BelderAjmal BhattyStella CoxMuhammad NasirIqbal KhanDr Imran Ashraf Usmani

Institute Of Islamic Banking andInsurance7 Hampstead Gate1A FrognalLondon NW3 6ALTel: +44 (0) 207 2450 404Fax: +44 (0) 207 2459 769Email: IIBI@islamic-banking.com

Institute Of Islamic Banking andInsurance7 Hampstead Gate1A FrognalLondon NW3 6ALTel: +44 (0) 207 2450 404Fax: +44 (0) 207 2459 769Email: IIBI@islamic-banking.com

Farhan Rafiq QuadriInstitute of Islamic Banking andInsurance7 Hampstead Gate1A Frognal London NW3 6ALUnited Kingdom Tel: + 44 (0) 207 2450 404Fax: + 44 (0) 207 2459 769Email: IIBI@islamic-banking.com

©Institute of Islamic Banking andInsuranceISSN 0955-095X

Surat Al Baqara, Holy Quran

NEWHORIZON Sha’baan Shawwal 1433 NEWS

No Rush to Islamic Banks in Qatar

BLME US Dollar Fund Delivers Top Percentile Performance

One year on from Qatar’sdecision to instruct conventionalbanks to close Islamic windowoperations the expected inflowof funds to fully-fledged Islamicbanks seems not to havematerialised. In fact assetgrowth at Islamic banks inQatar slowed from 39% in2010 to 35% in 2011, whileassets at conventional banksgrew from 16% to 23% overthe same period. The picturemay be somewhat blurred bythe fact that conventional banks

were allowed to retain Islamicinvestments until they reachedterm, provided they did not takeon any new ones, but if theauthorities in Qatar had beenhoping to give Islamic banks aquick boost, they will have beendisappointed.

There have been suggestionsthat other factors such asquality of service may be moreimportant than religion whenindividuals and organisationschoose a banking partner, but

the situation isprobably a lotmore complexthan that. Inertiaalmost certainlyplays a part in thereluctance tochange bankingarrangements, asdoes the personalrelationshipbetween banks and theircustomers. It will take longer than just 12 months tojudge whether Qatar’s central

bank has achieved its objective of levelling the playing field betweenconventional and Islamic banks.

Doha Skyline, Qatar

The investment grade BLME(Bank of London and theMiddle East) US Dollar IncomeFund, has delivered toppercentile performance and isranked six out of 763 fundsover three years in the US $Global Money Markets sector,according to Reuters fundranking service, LipperHindsight.

Managed by former F&C fundmanager, Jason Kabel, the Fundhas delivered consistent positivereturns of 3.28% since itslaunch in March 2009. Thefund currently has assets undermanagement of more than$50,000,000 and is open toinstitutional and professionalinvestors in the UK, Europe andMiddle East. The fund is ratedinvestment grade by Moody’s.

Jason Kabel, manager of theBLME US Dollar Income Fund,commented:

‘We launchedthis fundthree yearsago anddespite threeyears ofmajor marketturmoil wehave delivereda consistentincomestream forinvestors,outstrippingthe vastmajority ofourconventionalpeers. We arenow in aposition tocapitalise onour strong performance trackrecord and to inform investors about thebenefits of an investmentapproach with transparency,fairness and integrity at its core.’

The BLMEUS DollarIncome Fundis structuredas aLuxembourgdomiciledSICAV-SIFand aims toprovide acompetitivelevel of incometogether with a highdegree ofcapitalsecurity, whileat the sametimemaintaininggood levels

of liquidity for investors. The fund seeks to achieve this by investing in a diversifiedportfolio of high quality Islamic money marketinstruments.

The BLME US Dollar IncomeFund was the first fundlaunched by BLME, the largestIslamic bank in Europe.Subsequently, BLME haslaunched a number of productsincluding its Light IndustrialBuilding Fund and its Shari’ahHigh Yield Fund.

Nigel Denison, Head of AssetManagement at BLME added:

‘We have striven to bringbalance and choice to theindustry with our fixed incomeoffering and the positiveperformance across our fundrange is testament to thestrength of our approach toinvestment management. In theyears to come, we believe thatproduct innovation, increasedfund flows and a buoyant sukukmarket will be central to thecontinued evolution andlong-term success of the Islamicasset management industry.’

Jason Kabel

NEWHORIZON July–September 2012NEWS

AAOIFI Announce Review of Standards

In one sense Dr Khaled AlFakih is certainly not letting thegrass grow under his feet. Justthree months after taking uphis post as Secretary General ofAAOFI, the Bahrain-basedstandards setting body for theIslamic finance industry, heannounced at AAOFI’s annualmeeting in early May that theorganisation would beundertaking a review of certainaspects of the industry, inparticular the way Shari’ah

boards operate; the structures ofcertain instruments – murabahah,mudarabah and ijara; takafuland investment products and thedisclosure of information byIslamic financial institutions. Theproblem is some of these reviewsare fairly long dated, with thereport on Shari’ah boards notexpected until the end of 2013.

While it is understandable thatAAOIFI want to consultproperly on any new guidelines

The Debate on Islamic Banking in India Rumbles On

The latest organisation to enterthe debate on interest-freebanking in India is the NationalCommission for Minorities(NCM). They have asked India’scentral bank, the RBI (ReserveBank of India) to review thesituation. (The stronglydefended secular nature of theIndian constitution means thatanything called Islamic bankingwould be almost bound to failto receive official support, hence

the call for interest-freebanking.)

It is clear, however, that therequest is informed by a desire,among other things, to allowIndia to benefit from inwardinvestment from wealthyMuslim countries. WajahatHabibullah, chair of the NCMis reported to have said, ‘Thiswill help the country tochannelise more funds from the

Muslim business communityabroad.’

At times the issue of interest-freebanking in India almost descendsinto farce. In May, AlternativeInvestments and Credits, aKerala-based NBFC (Non BankingFinancial Corporation), whichoperates in accordance withShari’ah principles, applied to theHigh Court in India against anRBI order rescinding its license,

because it had failed to publish therates of interest at which it lendsto borrowers, a requirement forNBFCs under the code of fairpractice. It is rather difficult to seehow they could comply and theRBI surely must have known thatwhen the license was granted. It isall rather silly and does nothing toenhance the reputation of the RBI.(See New Horizon, Issue 170 for afull background on Islamicfinance in India.)

(this in itself is a change fromthe ‘behind closed doors’ type ofdebate that has been the normat AAOFI) and to avoid anyaccusation of a knee-jerkreaction to the fairly loud andpersistent debate about Shari’ahscholars, two years couldperhaps best be described asstately progress, rather than atimely response. The timelinemay be a tacit acceptance of thefact that negotiations may provedifficult; there is a lot of vested

interest at stake. There is adanger, however, that AAOFImay find itself playing secondfiddle to the Kuala Lumpurbased IFSB, which has alreadybegun the process of issuingguidelines on the compositionand qualifications of Shari’ahboards. The ideal, of course, isfor AAOFI and IFSB to act inconcert to create de factostandards that IFIs (IslamicFinancial Institutions) wouldfind hard to ignore.

Federal High Court Justice,Gabriel Kolawole has declaredthat Islamic banks in Nigeriaare illegal, although he fellshort of nullifying the licencegranted to Jaiz Bank byNigeria’s central bank (CBN),because the person bringingthe action, Godwin SundayOgboji, a Nigerian lawyer, had

no legal standing (locus standi)to bring the action. He said thatbut for the issue of locus standihe would have nullified thelicense.

He is reported to have said,‘There are no provisions in theCBN Act and the Banksprovided for in the Banks and

Other Financial Institutions Act(BOFIA) that empowers theCBN Governor Sanusi LamidoSanusi to issue a license for non-interest financial institutions tooperate under the principles ofIslamic jurisprudence withoutthe approval of the head of statethrough the minister of finance.Unlike the other specialised

banks, the Jaiz InternationalBank PLC can only beestablished in the country withthe intervention of theNational Assembly byamending the BOFIA Act.’

Mr Ogboji had brought thecase claiming the action hadadversely affected him and

Nigerian Judge Declares Islamic Banks Illegal

NEWHORIZON Sha’baan Shawwal 1433 NEWS

The Shari’ah Advisory Council(SAC) of the SecuritiesCommission Malaysia (SC) hasannounced the adoption of arevised screening methodologyto determine theShari’ah-compliant status oflisted companies. This actionhas been taken in view of thedevelopments and growingsophistication of the Islamicfinance industry since theintroduction of the currentscreening methodology in 1995.The SAC has revised themethodology by adopting atwo-tier quantitative approach,which applies the businessactivity benchmarks and thenewly-introduced financial ratiobenchmarks.

The outcome of the revisedmethodology will be reflected inthe List of Shari’ah-compliantSecurities by the SC’s SACeffective from November 2013.In addition to the two-tierquantitative assessment, theexisting qualitative assessment

will continue to be applicablewhile the release of the list ofShari’ah-compliant securitieswill remain twice a year.

‘The revision to the screeningmethodology will furtherfacilitate the orderlydevelopment of the Islamicequity market and fundmanagement industry at bothdomestic and internationallevels, in line with the growthstrategies outlined under theCapital Market Masterplan 2,’said Zainal Izlan Zainal Abidin,Executive Director, IslamicCapital Market of the SC.

It is believed that thisdevelopment is driven at least inpart by Malaysia’s desire toattract more investment fromGCC countries. Malaysia’ssomewhat more relaxedapproach to Shari’ah screeninghas to some extent been adeterrent to investors incountries such as Saudi Arabia,where stricter rules have applied.

citing Section 10 of theconstitution, which states thatthe government should notadopt any religion. The CBNhad asked for the case to bedismissed on the grounds thatMr Ogboji had not offered anyexplanation as to how he hadbeen adversely affected.

He added, ‘This case is herebystruck out for lack of locusstandi, but the AGF (AttorneyGeneral of the Federation)should take steps to remedy

the situation, and further ensurethat the CBN carries out itsduties within the provisions ofthe law establishing it.’

Perhaps more instructive is thereaders’ blog of Nigeria’s DailyPress. There are, of course, theusual conspiracy theorists, whosee Islamic banking as a backdoor to the Islamisation of thewhole county and those whobelieve the CBN Governor,Sanusi Lamido Sanusi, isbehaving arrogantly and as

though he is above the law.What is most disappointing,however, are themisunderstandings aboutIslamic banking, e.g.interest-free banking equates tofree banking. If those wishing toestablish Islamic banking inNigeria really want to makeprogress, they need to do farmore to educate people aboutexactly what Islamic bankingreally is. Fear is usually closelyassociated with ignorance andto quote the 18th century

English statesman, EdmundBurke, ‘No passion soeffectually robs the mind of allits powers of acting andreasoning as fear.’

On a more positive note forIslamic finance in Nigeria, theNigerian Stock Exchange hassigned an MOU (Memorandumof Understanding) with LotusCapital to develop an index ofShari’ah-compliant shares. Itwill be known as the NSELotus Islamic Index.

According to Reuters, theIslamic Bank of Britain haveconfirmed that they havereceived an approach fromQatar International IslamicBank (QIIB) for the just lessthan 12% of the share capitalof the Bank that they do notalready own. Their intentionapparently is to sell the Bankin its entirety with Qatar’sMashraf Al Rayan beingmentioned as the likelypurchaser of 70% of IBB’sshares with the balance of30% going to the governmentof Qatar.

By mid 2010 the Britishexperiment in Islamic retailbanking was being describedas a flop. Foundingshareholder QIIB rode to therescue with a further capitalinjection taking their stake tomore than 80%, laterincreased to more than 88%.Losses have, however,continued, £9.5 million in

2009 and £8.1 million in2011.

Given that retail banking is avery small part of Mashraf AlRayan’s business and thatcorporate banking is the biggestcontributor to its income andprofitability, it is tempting towonder whether such a changeof ownership, if it goesthrough, could herald a changeof direction for IBB. On theface it of it, the putative deallooks like a mismatch.

Meanwhile, IBB are trying toraise their profile in the UK. InApril they hosted an event,entitled ‘Islamic FinanceQuestion Time’ – an open,public Q&A session with theBank’s Shari’ah Scholars. IBBsay that this is the first event ofits kind and the only time a UKIslamic bank has given publicaccess to its Shari’ah scholars.The aim of the event was todemystify Islamic finance and

Malaysia’s Securities CommissionTightens Shari’ah Screening Rules

QIIB to Sell Their Stake inIslamic Bank of Britain

Auditing Organisation forIslamic Financial Institutions)Shari’ah Supervisory Board andSheikh Dr. Akram Laldin,executive director of theInternational Shari’ah ResearchAcademy both join the IIBRShari’ah Committee, withJustice Taqi Usmani taking therole of Chairman to continuethe work of Sheikh Yusuf TalalDeLorenzo who remains acommittee member.

In addition, both Dr. AbbasMirakhor, first chair of IslamicFinance at INCEIF (InternationalCentre of Education in IslamicFinance) and Ismail E Dadabhoy,an independent Islamic bankerand former executive directorand head of Islamic Finance atUBS, join the IIBR IslamicBenchmark Committee.

Established in co-operation withthe Islamic Development Bank(IDB), AAOIFI, the BahrainAssociation of Banks (BAB),Hawkamah Institute forCorporate Governance and anumber of major Islamic banks,the IIBR uses the contributedrates of 16 Islamic banks tocalculate the IIBR rate daily.

Thomson Reuters announcednew appointments to thesupervisory bodies of the IslamicInterbank Benchmark Rate(IIBR) at the 8th Annual WorldIslamic Funds and FinancialMarkets Conference held inBahrain in May. Theappointments expand both thegeographic and communityrepresentation on both the IIBRShari’ah Committee and IslamicBenchmark Committee.

Launched in November 2011 asthe world’s first Islamic financebenchmark rate, IIBR isdesigned to provide an objectiveand dedicated indicator for theaverage expected return onShari’ah-compliant short-terminterbank funding and analternative to the conventionalinterest-based benchmarks usedfor mainstream finance. Boththe Shari’ah Committee and theIslamic Benchmark Committeejointly oversee the ongoingimplementation and integrity ofIIBR.

Retired Justice Muhammad TaqiUsmani, a well-known Shari’ahscholar and chairman of theAAOIFI (Accounting and

NEWHORIZON July–September 2012NEWS

Malaysia’s central bank, BankNegara Malaysia, hasannounced a new Islamicmonetary instrument, thecollateralised murabahah. This is a Shari’ah-compliantfinancing instrument backed by assets in which the financier has the right to sell the asset should the client fail to repay the financing. Itcombines the widely acceptedmurabahah financingtransaction with sukuk as thepledged asset to back thetransaction.

Bank Negara describescollateralised murabahah as anew low credit risk financialinstrument that enablescollateralised interbanktransactions in the Islamic moneymarket in Malaysia. It is intendedto increase the diversity ofexisting liquidity managementtools and further promote greaterliquidity in the Islamic financialmarket. Collateralisedmurabahah can be used byIslamic financial institutions toobtain liquidity from the Bankunder the standing facility and itwill also be expanded to facilitatedaily Islamic money market

operations in the interbankmarket.

Initially this will be an overnightfacility, but it is expected to beextended to long tenors in thenear future. Funding is ringgitonly, but collateral can bedenominated in other currencies.

Shortly after this announcementAl Rajhi Bank Malaysiaintroduced CollateralisedCommodity Murabahah-i (CCM-i) as a new instrument forits treasury use, claiming to bethe first Islamic financialinstitution to adopt such aninstrument in managing its dailymoney market transactions. TheBank’s CEO commented, ‘Theintroduction of CCM-i is anotherimportant milestone for Al RajhiBank as it has met therequirements of the Shari’ahstandards of both Malaysian andSaudi Arabian scholars.’ This hasapparently been achieved byprecluding the principles of Bai’Al Inah (sale and buyback), Bai’Dayn (trading of debt), Wa’ad(undertaking) and TawarruqMunazzam (pre-arrangedtransaction between multipleparties).

Bank Negara AnnouncesNew Liquidity Instrument

Thomson Reuters StrengthenIIBR Supervisory Committees

IBB’s Shari’ah Scholars Question Time provide an insight into how itoffers a faith-based alternative toconventional finance andbanking.

Commenting on the event,Chairman of the IBB Shari’ahScholars Committee (SCC),Sheikh Dr Abdul Sattar AbuGhuddah said, ‘Islamic financeis as old as the religion of Islamitself. However, there is still a

lot of misunderstandingaround how it works and theneed for Muslims to managetheir finances in aShari’ah-compliant manner.The IBB SSC hopes the IslamicFinance Question Time eventhas shed some light on thematter and gone some way toencourage the further take-upof Shari’ah finance amongstthe Muslim community.’

An agreement betweenQInvest, a Qatari, Shari’ah-compliant investment bankand Egypt’s EFG Hermes inwhich QInvest will buy a 60%share in EFG Hermes inreturn for a capital investmentof $250 million with theoption to acquire fullownership 12 to 36 monthsfrom the date of theagreement being signed, is notyet a done deal. A consortiumof Arab investors has emergedto challenge the deal, whichwould see the break-up of oneof the largest investmentbanks in the Middle East.Shareholders voted at anExtraordinary GeneralMeeting to accept the QInvestoffer, but the rival bidders arebelieved to be planning anappeal to the EgyptianFinancial SupervisoryAuthority

HSBC is to merge its businessin Oman with OmanInternational Bank (OIB).HSBC will be the majorityshareholder with 51% of thenewly formed HSBC BankOman SOAG. The merger isexpected to complete in thesecond quarter of 2012,following an injection of$94.7 million in capital intoHSBC Oman.

The ratings agency Standardand Poors (S&P) have warnedthat they may downgrade thesovereign ratings of fiveMiddle Eastern countries inthe next one or two years.They have indicated that theoutlooks for Egypt, Bahrain,Jordan, Oman and Tunisia arenegative.

By the time it closed on 22 May2012, the RO 60 million IPOfor Bank Nizwa, Oman’s firstIslamic bank, was more than 11times oversubscribed. Theshares will be listed on theMuscat Securities Exchangefrom mid June. The bank isexpected to open its first threebranches very shortly.

Abu Dhabi Islamic Bank (ADIB)opened for business in Londonat the end of May in theprestigious surroundings of OneHyde Park. ADIB is the firstUAE-based Islamic bank to belicensed by the FinancialServices Authority and is mainlytargeting wealthy individualsfrom the UAE who havebusiness and personal interestsin the UK.

The latest rumours in thelong-running saga of therestructuring of Gulf FinanceHouse (GFH) suggests that itwould like to sell its 4% stake inQInvest, which it holds throughKhaleeji Commercial Bank andwhich it apparently views as alegacy asset. GFH’s debts wereestimated at around$300 million at the end ofMarch 2012.

Judgement in the case BankAlkair has brought against itsformer CEO, Majid Al- Refaiand Canadian lawyer, RobertLittle for forging the banksarticles of association allowingAl-Refai to override anyshareholder decisions to amendhis powers and authority waspostponed until late June.Al-Refai has also been chargedwith a range of other offences

including misappropriatingbank funds, money launderingand destroying critical bankdocuments. Al-Refai has so farfailed to make any courtappearances and the moneylaundering case has beenpostponed until early July. Inthe meantime the court hasissued an instruction freezingAl-Refai’s assets and placinghim under a travel ban inBahrain.

Qatar International IslamicBank has announced it isresigning its seat on the board ofthe Syria International IslamicBank (SIIB) following thedecision of the US Treasury toimpose sanctions on SIIB. Twoother Qatar-based directorshave also resigned their seats onthe board. Dr. Yousef Ahmed AlNaama, who had served asQIIB’s representative on theBoard of SIIB, commented, ‘Inlight of the decision taken toimpose sanctions on SyriaInternational Islamic Bank, Iand my fellow Qatar-based,non-executive directors nolonger felt we were in a positionto continue our roles asdirectors. Qatar InternationalIslamic Bank takes the issue ofsanctions imposed by theinternational communityseriously. We were unaware ofthe actions taken by SIIB thatled to the decision to imposesanctions and we cannotcondone any such activity bycontinuing in our roles asdirectors.’

The merger between threeBahrain-based banks, Capivest,Elaf Bank and Capital

NEWS

Management House, firstproposed in September 2011is reaching a conclusion withshareholders expected to voteon the proposals by the end ofJune. If the deal goes throughit will create an organisationwith $350 million inshareholder equity and$400 million in assets. Thefinal hurdle will be obtainingregulatory approval.

Egypt’s Muslim Brotherhood,the largest single party inEgypt’s parliament, has tabledamendments to the country’sbanking law designed to boostIslamic finance from itscurrent 5% share of thebanking market to 35% by2017. No date has yet beenset for the amendment to bediscussed.

National Bank of Kuwait’s(NBK) proposed takeover ofBoubyan Bank was approvedby the latter’s board in lateJune. The two remainingobstacles now are the 19.2%share of Boubyan, which isheld by the Commercial Bankof Kuwait (CBK) andregulatory approval. Themore problematic issue isprobably the shares owned byCBK. These were bought fromInvestment Dar in 2008, withthe right to buy them backbuilt into the deal. In 2009CBK said that Investment Darhad forfeited their right ofbuyback and tried to sell themin the open market. Thisaction was blocked by thecourt, following anapplication from InvestmentDar.

In Brief

NEWHORIZON Sha’baan Shawwal 1433

NEWHORIZON July–September 2012SUKUK UPDATE

Qatar Set to Issue First Sovereign Sukuk in10 Years

It is rumoured that Qatar has asked fivebanks – HSBC, Barwa Bank, QInvest,Deutsche Bank and Standard Chartered tocome forward with a proposal for asovereign sukuk to be issued later this year.The last time Qatar issued a sovereignsukuk was in 2003.

Dubai Government Sukuk – Another Stepon the Road to Recovery

Dubai has raised $1.25 billion with a sukukissued at the end of April. The issue was morethan 3.5 times oversubscribed, attractingsome 260 investors including fund managers,banks and insurance companies. The issuecomprises two elements - $600 million are ona five-year basis at 4.9% and $650 million ona 10-year basis at 6.45%. The success of theissue will no doubt be particularly welcometo the government of Dubai, which cameclose to default in 2009. A spokesman fromDubai’s Department of Finance is reported tohave said that the sum raised will help Dubaito manage its budget deficit and refinancingplans proactively. It is to be hoped thatdeteriorating global financial conditions donot derail Dubai’s recovery. Unlikeneighbouring countries it has very limited oilreserves and is more reliant on its financeindustry, international trade and tourism, allof which could be affected if the presentproblems in the Eurozone trigger a furtherfinancial crisis.

Also in Dubai, Jebel Ali Free Zone (JAFZA),a state-backed industrial free zone, hasissued a $650 million sukuk, which wasmore than 3 times oversubscribed. Part ofthe proceeds will contribute to the earlyredemption of an approximately $2 billionsukuk due in November, which is sixmonths earlier than the original due date.

Kazakhstan to Issue Sukuk in Malaysia

There have long been rumours thatKazakhstan would issue a sovereign sukuk.

It now seems that they are reaching the finalplanning stages with news that officialsfrom the Development Bank of Kazakhstan(100% owned by the government ofKazakhstan) have been meeting withpotential investors in Malaysia with a viewto issuing the sukuk in the Malaysianmarket. The ringgit-denominated issue isunderstood to be worth up to $300 millionand will be based on an ijarah contract. It isunderstood it will be listed on both theMalaysia and Kazakhstan stock exchanges.

Afghanistan Eyes Sukuk to Fill the ForeignAid Gap

It is understood that draft laws will shortlybe presented to the Afghan parliament toenable the issuance of sukuk, with theprobable timescale for the first issue beingtowards the end of 2013. It is believed thatthe decision to opt for a sukuk rather thanconventional government bonds is driven bya desire to kick start the domestic investormarket, which may be averse to non-Islamicissues. At the end of the day the success ofany Afghan government issues, whetherconventional bonds or sukuk and the yieldthey have to pay, will depend on theinvestors’ views about the government’sability to repay its debts once US, UK andNATO troops have been withdrawn fromthe country in 2014.

A Second Saudi Project Finance Sukuk

Aramco and Dow Chemicals are expectedto issue a sukuk in early 2013 as part of thepackage of financial instruments to fund theconstruction of the Sadara facility in SaudiArabia. The sukuk is likely to contribute$2 billion of the total $12.4 billion neededand will probably be denominated in Saudiriyals.

This will be only the second project financesukuk to be issued in Saudi Arabia and islikely to have a somewhat easier birth thanthe sukuk issued in the late summer of 2011to finance the Aramco/Total joint venture tobuild the Jubal oil refinery. This gestation

period for this sukuk was somewhatprotracted due to the concerns of Shari’ahscholars about the validity of using anunbuilt asset as security, but the agreementsreached then are expected to provide thetemplate for the Aramco/Dow joint venture.

Gulf International Bank Establish SukukProgramme in Malaysia

Gulf International Bank (GIB) hasestablished a 3.5 billion ringgit sukukal-wakala medium term note programme inMalaysia. GIB is 97% indirectly owned bythe government of Saudi Arabia and this hasno doubt been instrumental in the grantingof an indicative rating of AA1 byMalaysia-based RAM Ratings. Commentingon the programme, HE Jammaz binAbdullah Al-Suhaimi, chairman of GIB,said, ‘The sukuk programme represents astrategic move to tap into the ringgit marketin an effort to diversify funding avenues andcurrencies for the Bank’.

GIB recently ran a two-day road show inMalaysia to introduce the programme toMalaysian investors. GIB’s CEO, Dr YahyaA Alyahya said, ‘The road show was verysuccessful and included intensive investorpresentations. We are very pleased with theinterest shown by these investors and expectan issuance of sukuk in the near futurewhen the market conditions are convenient.GIB will continue to monitor the market inthe future to assess funding opportunitiesand this sukuk programme will allow theBank to further diversify its funding baseand improve the maturity profile of itsliabilities.’

IDB Launch Five-Year Sukuk

The Islamic Development Bank haslaunched its first sukuk since May 2011.The five-year sukuk was slightly larger thanexpected at $800 million and carries a profitof 1.357%. (The previous issue had been£750 million with a profit of 2.35%.) IDBissues are AAA rated.

Sukuk Update

NEWHORIZON Sha’baan Shawwal 1433 PROGRESS REVIEW

In the light of discussions at AAOIFI’srecent annual conference, this brief reviewof the issue of liquidity and Islamic bankstakes a look at some of the issues facingIslamic banks and provides an update onsome of the more recent developmentsand suggestions on the issue.

Background

Liquidity is about banks being able to meetdebt obligations as and when they fall due.Problems arise when the inflow of depositsdo not match the demands for repayment. Afinancial institution may have more thanadequate assets to cover this mismatch, butif it cannot realise those assets or borrowagainst them, when it is called upon to meeta debt obligation, it could trigger a run onthe bank, even though the bank may befundamentally sound. If that situation arisesthe lender of last resort is the central bank ofthe particular jurisdiction in which the bankis domiciled, e.g. the Bank of England in theUK or the Federal Reserve in the USA.

Why do such liquidity problems arise? In alecture to the IIBI in July 2011 MohammadAmin, an Islamic finance consultant andformer UK Head of Islamic Finance atPricewaterhouseCoopers, observed thatshort-term money can be borrowed or lentat a low rate of interest, while a five or10-year loan would earn a substantiallyhigher rate of interest. It is thereforeprofitable for banks to borrow short andlend long, a practice they have followed forcenturies. They choose to take the risk inthe interests of optimising earnings.

Regulators have been busy in recent yearstrying to curb banks’ risk-taking behaviour;to contain it within reasonable bounds.Most recently Basel III has promulgatednew regulations to ensure that banksbalance their transactions in such a way asto avoid maturity mismatches; that in any30-day period cash inflow exceeds cashoutflow and that they hold sufficient assets

that can fairly readily be converted to cash.

Even if Basel III has the effect thatregulators intend, there are still likely to beoccasions when a bank will need short-termfunds to cover the repayment of a debt. Forexample, during any 30-day period theirinflow of funds may exceed the outflow, butthe flows may be lumpy and so there maybe one or two days, when they need toborrow money to cover a debt repayment.That is when banks will need to turn to oneor more of the instruments designed to helpthem over their temporary problem.

Shari’ah Banks and the Liquidity Challenge

In many respects Shari’ah banks are nodifferent from their conventionalcounterparts. They operate in accordancewith Shari’ah principles, but they face thesame liquidity management challenges asconventional banks. Unlike conventionalbanks, however, they face some additionalchallenges. Many of the mechanisms thatare used by conventional banks to manageliquidity – the interbank money market,secondary markets for financial instrumentsand a lender of last resort are notuniversally available to Islamic banks beingbased, as they are, on interest.

In some countries, even Muslim majoritycountries, there is no Islamic lender of lastresort operating in the way the Bank ofEngland, for example, does for conventionalbanks in the UK. That is not to say thatcentral banks will not act to help banks indifficulty. For example, the UAE’s centralbank acted to inject funds into Islamic banksduring the Dubai debt crisis, but this was anad hoc arrangement. The problem with adhoc arrangements is that they are agreed ona case-by-case basis and the industry needsmore system, more certainty if it really is torealise its full growth potential.

In addition, there is not only a shortage ofshort-term assets suitable for liquidity

management purposes, many of the assetsheld by Islamic banks are not easy to sell.Sometimes the only way to realise the valueof assets is to sell them at bargain-basementprices. If a bank has to continue to do this,a liquidity issue is quite likely to become asolvency problem.

Curiously, the lack of standardised productsat an international level adds to theproblem. It effectively means that the muchvaunted $1 trillion of global, Shari’ahliquidity is something of a chimera, becausefunds cannot easily be moved aroundinternationally; they are locked intonational or at best regional pools, becauseproducts accepted as Shari’ah compliant inone country may be unacceptable inanother.

The Role of the IILM

Recognising the issues that need to beaddressed to turn Islamic banking into a trulyglobal industry, the IILM (InternationalIslamic Liquidity Management Corporation)was set up in late 2010 by 12 central banksor monetary authorities representingIndonesia, Iran, Kuwait, Qatar, Turkey,Malaysia, Mauritius, Saudi Arabia, Sudan,the United Arab Emirates and Luxembourgplus two international bodies, the IslamicDevelopment Bank and the IslamicCorporation for the Development of thePrivate Sector. Its mission is to develop andissue short-term, Shari’ah-compliant financialinstruments to facilitate effective, cross-borderinvestment flows and financial stability.

The IILM has yet to issue its first product,but it is widely believed that this will come inthe form of a short-term sukuk sometimearound mid 2012. Initially, it was suggestedthat this US dollar-denominated issue wouldbe worth $200–300 million, but in March2012 Bloomberg reported IILM’s chairman,Zeti Akhtar Aziz as saying that the issuecould be worth as much as $1 billion.

Liquidity and Islamic Banks

By: Andrea Wharton, Editor

NEWHORIZON July–September 2012PROGRESS REVIEW

The date of issuance will depend on theIILM receiving its credit rating. This is key,because a high credit rating would have adirect impact on the amount of capital abank would be required to hold, i.e. capitalrequirements would be lower.

Trade Transactions as Liquidity Instruments

In an interesting presentation in 2011,Brandon Davies, a director of GatehouseBank, an Islamic bank based in London,argued for trade transactions to be used asliquidity instruments for Islamic banks,particularly in view of their limited access tosuitable government bonds. He pointed outthat trade bills as liquidity instruments havea long history with their short-term naturemaking them well suited for the role.

While trade instruments would not beacceptable under Basel III, Mr Davies saw‘no reason why any Central Bank could notaccept, for the banks it supervises,short-term, trade-related instruments(including Shari’ah-compliant instruments)as eligible as stock liquid instrumentsagainst the security of which the centralbank could provide funding.’ Ultimately hefelt that Basel III could be adapted to makesuch trade finance transactions acceptable.

In support of his case, he argued thatgovernment bonds could no longer beroutinely accepted as risk-free credit,particularly in view of the Eurozone crisis.(Since Mr Davies made his presentation inApril 2011 the Eurozone situation hasfurther deteriorated with Italian andSpanish bonds under pressure and mostrecently even Germany feeling someknock-on effects.) Mr Davies noted, ‘Self-liquidating short-term transactions based ongood commercial credits backed by bankguarantees (acceptance) look moreattractive today as against many long termgovernment bonds.’

Islamic Repos

At the recent annual meeting of AAOIFI inBahrain there was much discussion aboutIslamic repos. (Repos or repurchaseagreements are short-term instruments,where institutions dealing in government

bonds sell to a lender and agree to buy themback on an agreed date for an agreed price.The short-term nature of the instrument andgovernment backing mean they are regardedas generally very low risk.)

Some within the Islamic finance industrywould like to see AAOIFI produceguidelines for the structure and use of suchproducts, but the meeting broke up withoutany firm recommendations being made. Theproblem is that repos are likely to be a boneof contention among Shari’ah scholars. Dorepos address a real economic need? Is thecalculation of margin calls interest by anyother name? Would it be permissible totrade the asset behind the repos with thirdparties? In addition the regulators in manyGCC countries do not recognise the practiceof netting. (Netting allows traders to cancelpositions in their trading books by settingthem off against each other.)

There have, however, been some examplesof Islamic repos. In late summer 2011 theNational Bank of Abu Dhabi and AbuDhabi Islamic Bank executed aShari’ah-compliant repo transaction – aone-week maturity deal worth $20 millionagainst both Malaysian and Abu Dhabisukuk. Somewhat earlier in the year thecentral bank of the UAE also launched arepo facility for sukuk.

Going Forward

The message is loud and clear. Islamic banksneed a more diverse range of liquidityinstruments and they need them now. Weare mindful that standards bodies such asAAOIFI and IFSB should not indulge inknee-jerk reactions, rushing to produceguidelines that may later prove to beinadequate or unduly contentious, but itwould be good to see greater evidence of asense of urgency.

The simple fact is that, in the absence ofagreed international standards, the Islamicfinance industry will seek to help itself.Bank Negara Malaysia has recentlyannounced a collateralised murabahafacility to promote greater liquidity inIslamic financial institutions. (See the Newssection in this issue for further details.) The

problem is that the use of murabaha byfinancial institutions is not universallyaccepted as a Shari’ah-compliantinstrument.

It is always easier to set standards and tohave them implemented, if standards-settingbodies act before rather than after the event.Furthermore, the Islamic finance industry ismore likely to be able to influence standardsin general, e.g. Basel III, if they can presenta united front. Getting Islamic-finance-friendly regulations into both national andinternational regulations are important inlevelling the playing field betweenconventional and Islamic finance.

If they do not act in a timely fashion, theywill find the horse has bolted – centralbanks will have devised liquidityinstruments, which will meet therequirements of their own particularregulatory and Shari’ah bodies, but whichwill not necessarily have internationalacceptance. If that is allowed to happen, it isthe Islamic finance industry that will havelost; its desire to become a truly globalbanking system will have beencompromised, perhaps not forever, butcertainly in the short term.

‘Self-liquidating short-termtransactions based on goodcommercial credits backed bybank guarantees (acceptance)look more attractive today asagainst many long termgovernment bonds.’

NEWHORIZON Sha’baan Shawwal 1433 FOOD FOR THOUGHT

Internal and External Shari’ah Audit

The Shari’ah review and audit is anexamination of the extent of an Islamicfinancial institution’s (IFI) compliance in allits activities with the Shari’ah. This examina-tion includes agreements, contracts, policies,products, transactions, memorandum andarticles of association, financial statements,reports, circulars and any other legal docu-ment, which is pertinent to an IFI’s operation.

The internal Shari’ah review is an integralpart of the bodies of governance in Islamicfinancial institutions and operates under thepolicies established by the Islamic financialinstitution according to the memorandumand article of association. It should have astatement of purpose, authority andresponsibility, i.e. the charter. The chartershall be consistent with Islamic Shari’ah rulesand principles in both conventional banksopening Islamic windows as well fully-fledgedIslamic financial institutions. The chartershould be approved by the Fatwa andShari’ah Supervisory Board (F&SSB) andissued by the Board of Directors. The chartershall be regularly reviewed.

The external Shari’ah review and audit isconducted to review the internal proceduresand to act in support of the internal audit.In respect to the external auditors, who arenot employees of the institution can take amore independent approach. They can alsotake the advantage of their access to variousF&SSBs and IFIs, as well as benefiting fromtheir wide vision and experience innon-confidential issues. This gives theexternal auditors a pool of knowledge,experience and insight which can be usedwhen assisting IFIs to improve theirperformance in these areas. Anothersignificant opportunity is keeping up-to-datewith latest industry developments.

Objectives of the Shari’ah Review

The objectives of the Shari’ah review are toensure that the activities carried out by anIslamic financial institution do not contradictShari’ah rules and principles in general aswell as fatwas, guidelines and instructionsissued by the Fatwa and Shari’ah SupervisoryBoard of the institution.

The internal Shari’ah review should becarried out by an independent division.Conventional banks, offering Shari’ahproducts through Islamic windows have noindependent audit body. For example, in abank in the UAE with an Islamic windowproviding Islamic products, the reporting linefor the Shari’ah auditor is to a conventionalfinance service support manager andaccording to the job description the Shari’ahaudit report has to be submitted to the linemanager who, after getting satisfactoryreport from all departments, will submit thereport to management. Finally, it is only afteramendments have been made that the reportis submitted to the F&SSB.

On the other hand in most Islamic financialinstitutions all departments are consideredvery important (in their view) – sales,operations, risk management, IT, finance,accounts, etc. Sadly there is one exception,the Shari’ah department. The Shari’ahdepartment is always under resourced andunfortunately the management of IFIs onlysee this side of their business as an expense.In fact the Shari’ah department is the mostimportant and fundamental section for allfinancial institutions.

Distribution of ResponsibilitiesThe auditor’s responsibilities:

The auditor is responsible for forming andexpressing an opinion on the financial state-ment after the completion of Shari’ah review.

The management’s responsibilities:

The management is responsible for ensuringthat the financial statement and the IFI’sactivities comply with Islamic Shari’ah rulesand principles as determined by the F&SSB.To ensure an IFI is performing as it should isbased on the auditor’s confirmation, so themost important job resides with the Shari’ahauditors. The annual management report,shareholders report and F&SSB reportdepend on the Shari’ah auditor’s report.

AAOIFI Standards

According to AAOIFI standards thelegislative wording in the Annual F&SSBreport to the AGM is:

‘We conducted our review, which includedexamining, on a test basis, each type oftransaction, the relevant documentation andprocedures adopted by the Example IslamicFinancial Institution.

We planned and performed our review so asto obtain all the information andexplanations, which we considerednecessary in order to provide us withsufficient evidence to give reasonableassurance that the Example IslamicFinancial Institution has not violatedIslamic Shari’ah Rules and Principles.’

The Shari’ah Supervisory Board, however,does not physically come to the audit, butthey trust the Shari’ah auditors and Shari’ahdepartment within the Islamic financialinstitution. Shari’ah auditors and/or theheads of Shari’ah departments, therefore,have two sets of responsibilities – to themanagement of the IFI and to the F&SSB.They have to provide facts to the F&SSBs,because without evidence no one can submitan audit report to the Shari’ah Board andsubsequently the F&SSB report prepared forthe shareholders. In the AGM the F&SSB

The Role of the Shari’ah Auditor

By: Mufti Aziz Ur RehmanIn this article Mufti Aziz Ur Rehman discusses the Shari’ah compliance andsupervision process. He starts from his own position as a Shari’ah Auditor.

NEWHORIZON July–September 2012FOOD FOR THOUGHT

representative reads this report, taking theresponsibility that the IFI fulfilled theShari’ah requirements and the whole profitearned is purely halal, i.e. the IFI achievedthe goal. My question is did the IFI achievetheir goal? What is the aim of the Islamicfinance industry? What was the purposebehind the creation of Islamic banking? Is itprofit maximisation? Is it market strategyand the opportunity to win clients? Is itsimply about displaying an Islamic bankingsign board? What is it really about?

I would like to see an opinion survey of thegeneral public take place; we need to knowthe public’s opinion on IFIs. God forbid thatwhen we get the results more than 80% ofthe people are not satisfied and the reason isbecause of people like me, people employedby the IFIs, who, due to lack of knowledgeand education, are unable to satisfy clientsand explain the products. It is insufficient tosay ‘our Shari’ah Board approved.’ Myresponsibility is to convince the client andprove the superiority of Islamic financialproducts in contrast to the conventional.

It is all very well to fulfil our responsibilitiesto carry out the Shari’ah audit; report to theshareholders and satisfy the F&SSB, i.e. theearnings are halal, but what about thegeneral public and the clients of the IFI. Is itnot our responsibility to satisfy them aswell? There are more clients thanshareholders. In addition the level of publicawareness is poor.

AAOIFI Auditing Standards

AAOIFI did valuable work in the structuringof auditing and governance standards. Theyalso started a certification programme inShari’ah and accounting, CSAA and CIPA.No doubt it is a positive step and excellentwork, but what are the eligibility criteriarequired for the CSAA? I studied the wholestandard and I found only this one paragraphin AAOIFI auditing standards number four. Itstates ‘The auditor shall be knowledgeableabout Islamic Shari’ah rules and principles.However, he would not possess the same levelof knowledge as that of F&SSB members andthus the auditor shall not be expected toprovide interpretation of these rules andprinciples.’

My question is how can the auditor ensurecompliance with Shari’ah, if the Shari’ahauditor is unable to convey what the F&SSBrequires in this fatwa? If he doesn’tunderstand the essence of a fatwa, then howcan he possibly implement it in the correctway? How can we make sure that themanagement implementation fulfils theShari’ah rules and regulations? On whatwill his observations be based? The wholeissue raises a lot of questions.

Are the CSAA and CIPA adequatequalification? This question always remainsin my mind. There are no conditions foreligibility and entitlement, no experienceand pre-education are required and they donot cover the full AAOIFI standards. Thereis also a question mark over trainers; howqualified are the trainers to deliver the bestpossible training. What about those trainers,who have no or little Shari’ah knowledge,misrepresenting the rules and thus creatingmore doubt and misunderstanding about100% Shari’ah transactions? How manyauditors in the industry are truly qualified?Are Shari’ah auditors really in a position toperform their jobs perfectly and truly? Icannot avoid the conclusions that there area lot of shortcomings in the industry.

I would like to point out here that I am notcriticising AAOIFI. AAOIFI has done morethan any other body in this industry to pushfor some level of standards andimprovement based on a measurable scale.It is sadly third parties who do not maintainthese standards and thus paint a bad pictureof the body. I am a proud member ofAAOIFI and continue to work closely withthem. Indeed the issues raised here are notjust for the sake of criticism, but a genuineattempt to highlight shortcomings and toeffect improvements. This is an on-goingand very tough task and I pray Allah guidesus all to do the best we can.

I would recommend the following: 1. Proper, official Shari’ah audit training2. A review of the AAOIFI certification

process3. The establishment of some criteria, some

pre-qualification to be accepted on anAAOIFI CSAA study course to enhancethe value and standing of the certificate

4. More detailed standards for Shari’ahaudit and governance

5. Limiting certification to professionalauditors

6. Proper control and support by theShari’ah Supervisory Board inappointment procedures with the F&SSBreviewing and interviewing applicants

7. The F&SSB should select a person withthe ability to function as a Shari’ahauditor.

8. Standardisation of Shari’ah auditprocedures

9. The industry, in cooperation with globalaudit firms, needs to establish aprofessional, dedicated audit body withclose links to AAOIFI and otherstandard bodies

10. The industry needs to find ways toimprove its standards on thepreparation of audits, governance andhuman resources

The Islamic finance industry is like a treeplanted by our respected Shari’ah scholars.It is our religious and ethical responsibilityto tend that tree, to water it and take care ofit, so that it grows strongly and healthily.

Mufti Aziz Ur Rehman is qualified in bothcontemporary finance and Islamicjurisprudence, with a specialism in Fiqh UlMu’amalaat. He is currently the Shari’ahmanager at Dubai-based Mawarid Financeas well as a member of several Shari’ahboards. He is also a lecturer, trainer andauthor. He has a degree in Islamic finance;is a Chartered Shari’ah Auditor andAdvisor formally certified by AAOIFI and aCertified Islamic Finance Arbitrator.

NEWHORIZON Sha’baan Shawwal 1433 COUNTRY FOCUS

Modern Indonesia emerged from 450years of colonial rule by the Dutch andthe Portuguese in the middle of the 20thcentury. It is the world’s fourth mostpopulous nation with around 238 millionpeople, more than 88% of whom areMuslim, making it the largest Islamicnation in the world. It is also the largesteconomy in South East Asia and amember of the G20.

Post Independence Indonesia

It is important to understand whathappened in Indonesia during the yearsfollowing independence to have anyappreciation of where the country standstoday and the way that itspost-independence history has shapedindustry and commerce. For 50 yearsIndonesia’s government was dominated bytwo men, President Soekarno and PresidentSuharto. By the mid 1950s PresidentSoekarno’s regime had become increasinglydictatorial; parliamentary democracy wasseriously compromised in favour ofsomething that Soekarno described as‘Guided Democracy’ and there wasincreasing public ownership of the country’sindustry and commerce under the title‘Guided Economy’. He was eventuallyreplaced by General Suharto in 1968.

President Suharto brought in Western aid tohelp rebuild Indonesia’s shattered economyand although he was careful to observe theconstitution, his regime was basicallyauthoritarian and dissent was not tolerated.Opposition political parties, both left andright were carefully controlled and thatincluded Islamic parties. The problem wasthat Indonesia’s increasing wealth wasunevenly distributed with the Suharto familyand inner circle benefiting disproportionatelyfrom Indonesia’s economic success. Hisnemesis was the Asian financial crisis of thelate 1990s. With the currency plummetingand inflation again running out of control, hewas forced from office by the sort ofanti-government demonstrations that were

characteristic of the more recent Arab Spring.Since that time Indonesia has enjoyedsustained economic growth.

Banking in Indonesia

Although President Soekarno’s regime cameto an end in the mid 1960s, his legacy livedon for many years with banks remaining instate control. It was not until the late 1980sthat the country saw measures enacted toderegulate banking. Suharto’s move to allowthe establishment of Islamic banking in1992 is viewed by many as an attempt tobring Muslim elements on side in anincreasingly fractious political environment.

By the late 1990s Indonesia was alsoremoving the barriers to foreign bankseither setting up subsidiaries or buying intolocal banking operations. Recently, however,there have been rumours of changes tobanking regulation, which will affect foreignbanks looking to invest in Indonesia.Although no official announcement hasbeen made, it looks as though Indonesia’s

central bank will go ahead with a cap on thesize of individual shareholdings inIndonesian banks. It seems likely that thecap will be set at 30% for individuals and40% for financial institutions. At presentshareholdings by an individual or financialinstitution can be up to 99%. According tosources, it appears the cap will not beretrospective, so it will not impact bankssuch as Malaysia’s CIMB Group andMaybank, which own 97.0% of CIMBNiaga and 97% of Bank InternasionalIndonesia respectively. It may, however,prove a deterrent to other banks, whichhave been expressing interest in theIndonesian market. The most immediateeffect of the new ruling could be onSingapore’s DBS Group Holdings bid forIndonesia’s Danamon Bank.

Islamic Banking in Indonesia

Indonesia has the largest Muslim populationin the world and yet it came relatively lateto Islamic banking in 1992, 10 years behindneighbouring Malaysia and 20 years behind

Indonesia – Is the Sleeping Giant Stirring?

Bank Muamalat is Indonesia’s longest-established Islamic bank, founded in 1991 just afew months after the law enabling the foundation of Islamic banks was enacted. Todayit is Indonesia’s second largest Islamic bank with assets of around 3.5 billion US dollars.

In the late 1990s the bank was badly affected by the Asian financial crisis and with itsequity standing at less than one third of its original capital, it sought furtherinvestment. The Saudi-based Islamic Development Bank stepped up to the plate andbecame a major shareholder in the bank. By 2002 the bank had turned the corner andtoday it serves more than 2.5 million customers through 275 outlets across 33Indonesian provinces. Interestingly it has also opened a branch in Kuala Lumpur,Malaysia’s capital.

Currently the Islamic Development Bank owns 32.82% of the bank’s shares, BoubyanBank Kuwait has 24.94% and Atwill Holdings Limited holds 17.95%. It has beenrumoured for about 12 months that some of these existing shareholders are keen toreduce their stakes in the bank and possible suitors have included Qatar Islamic Bank,which ruled itself out in mid 2011 and more recently Malaysia’s Bank Islam.

At the end of May 2012 the bank announced a 10-year subordinated sukuk wortharound160 million US dollars to be issued in tranches over the next two years. Themoney will be used to fund further expansion at the bank.

NEWHORIZON July–September 2012COUNTRY FOCUS

Dubai. Banking legislation in 1992 pavedthe way for the establishment of Indonesia’sfirst Islamic bank, Bank Muamalat in thesame year. In 1999 further legislationallowed Indonesia’s central bank to makeuse of Islamic instruments as part of itsmonetary policy.

Progress has been slow, but since about2007 the number of fully-fledged Islamicbanks has grown from three to 11, with 23conventional banks having Islamicwindows. In terms of presence on theground, however, the fully-fledged Islamicbanks outnumber window operations bynearly 5:1 with the former having 1,365offices and the latter just 303. More than80% of the financing at the fully-fledgedIslamic banks is based on three contracttypes – murabaha (54%), musharakah(18%) and mudarabah (10%), adheringmore closely to the classical Islamic modelof economics than possibly any othercountry.

Islamic banks, however, still represent just4.27% of Indonesia’s total banking assets.They are mainly retail banks and theirapproach to financing is investment ratherthan trade based. Nevertheless, statisticsfrom Indonesia’s central bank do indicate

that growth averaged around 34% perannum between 2005 and 2009 and recentcomments from the head of Islamic bankingat Indonesia’s central bank suggest that inthe last two years that growth rate hasstrengthened, despite the global financialcrisis.

It has been suggested that Indonesia’s failureto match the growth of Islamic banking inneighbouring Malaysia is in part due to thenarrower range of Islamic banking productsin Indonesia. Indonesia has taken a muchstricter approach to Shari’ah complianceand products such as bay al dayn, bay alinnah, tawarruq, bay al arbun and bay alwafa, which are offered in Malaysia, are notconsidered to be Shari’ah compliant inIndonesia. Indonesian products rely largelyon murabaha, musharakah, salam andistisna.

There are pros and cons in such aconservative approach. On the one hand the limited range of products makes it more difficult for Indonesia’sIslamic banks to compete against theirconventional counterparts. On the otherhand, such a stance may be more attractive to investors from other moreconservative Muslim countries looking for

investment opportunities in South East Asia.

Related to the previous point is the fact thatthe approvals process for Shari’ah productsis currently somewhat cumbersome. Bankshave to submit new products to both theNational Shari’ah Board and the Bank ofIndonesia, the country’s central bank, forapproval. Early in 2011 a working partycomprising representatives from BankIndonesia, the National Shari’ah Counciland the Indonesian Institute of Accountantswas established to review the approvalsprocess, but to date no recommendationshave been issued.

Another factor in the slower than predictedgrowth is the time the Indonesiangovernment have taken to amendlegislation, particularly tax rules, to level theplaying field for Islamic banks. Changesthat effectively remove the double taxationon murabaha financing are very recent,dating to 2010. Earlier, the Islamic BankingAct No.21 of 2008 was passed by theIndonesian parliament to strengthen lawenforcement in relation to Islamic bankswith the expectation that it wouldencourage more players to support theindustry. Indonesia, however, has a longway to go to match the Islamic financefriendly environment that has been createdin neighbouring Malaysia. Foreign investorsinterested in the region may very well findthe Malaysian market more appealing at thepresent time, all the more so if rumours ofchanges to the rules on bank ownershipprobe to be true.

Finally, Indonesia suffers perhaps more thanother countries from a shortage of skilledmanpower – individuals who understandboth Shari’ah and the working of thebroader financial market. This is for themost part due to the rapid growth of thesector and the fact that training in Islamicfinance is a relatively recent phenomenon.The number of educational institutionsoffering courses in Islamic finance has beensteadily growing since 1999 and nowincludes the Tazkia Institute, Karim BusinessConsulting and the Indonesian BankingSchool/LPPI. In 2009 the University ofIndonesia began to offer a Master’s degree

NEWHORIZON Sha’baan Shawwal 1433 COUNTRY FOCUS

in Islamic finance and apparently plans tooffer undergraduate and doctoralprogrammes, but this is a drop in the ocean.There is need to expand educationalopportunities at every level – professionalqualifications such as those offered by theIIBI among others, undergraduate and postgraduate degrees.

Islamic Microfinance

One area in which Indonesia is at theforefront, however, is Islamic microfinance.This is not surprising given that Indonesia’seconomy is dominated by small andmedium-sized enterprises (SMEs), with 40%of the population employed in theagricultural sector, followed by trade witharound 23% and industry with 14.5%. TheAsian financial crisis of the late 1990s ifanything boosted the number of SMEs, asworkers laid off by big employers turned toself employment.

The history of rural banks in Indonesia datesback to the colonial period, but in theirmodern incarnation they are enshrined in the1992 Banking Act and then in 1992Indonesia’s central bank published adocument called a ‘Blueprint of IslamicBanking Development in Indonesia’. Thisnine-year plan included specific support forthe Islamic rural banks, of which there arenow 154 with 362 offices. Business isoverwhelmingly on the basis of murabahacontracts at 79% of total business.(Interestingly the single biggest businesscategory of customer among rural banks istrade, restaurants and hotels (food andrelated services) by a significant margin.)These banks, along with conventional ruralbanks and financial cooperatives are theoutlets that deliver microfinance in Indonesia.They can only be owned by citizens ofIndonesia and offer loans, which are mostlyfairly short term and savings accounts, butnot payment services. One of the biggestproblems faced by rural banks, just as withthe mainstream Islamic banks, is the lack oftrained management and staff to run them.

Islamic microfinance is still a tiny part ofthe banking industry in Indonesia,accounting for just 2% of all outstandingmicrofinance loans, but according to a

World Bank Survey carried out in 2007, itwas the largest Islamic microfinance sectorin the world with a more than 60% share oftotal Islamic microfinance loans. (OnlyBangladesh’s Islamic microfinance sectorhad more clients, although with a loweraverage loan size it had just 17% of theworld’s microfinance loans.) Interestingly inboth these countries the majority ofcustomers were female – 90% in Bangladeshand 60% in Indonesia.

Bank Rakyat Indonesia Syariah (BRISyariah) is an important player inIndonesian Islamic microfinance. It is asubsidiary of Indonesia’s largestmicrofinance institution Bank RakyatIndonesia (BRI). Until 2003 BRI was a100% government owned bank, but inNovember that year they sold a 30% stakein the organisation through an IPO (InitialPublic Offering). BRI Syariah wasestablished in 2009. Some of themainstream Islamic banks such as BankMuamalat also have microfinance divisions,but the largest providers of Islamicmicrofinance are 150 Islamic rural banks(BPRS) and more than 3,000 BMTs (BaitulMaal wat Tamwils), which are a network ofIslamic financial cooperatives. These aregrassroots developments funded bymembers of the Muslim community and arelargely unregulated and their success tendsto be strongly linked to the skill andcommitment of their founders.

One of the major issues for BMTs was theirpreference for qard hasan; they had tended tobe very purist in their approach and weregenerally uncomfortable with instrumentssuch as murabaha, still too close to riba intheir view. Many borrowers, however,apparently perceived loans based on qardhasan as free, charity, even though Shari’ahmakes a clear distinction between qard hasanand sadaqah (charity). Even when theobligation to repay the loan was accepted,borrowers frequently believed it was theirright to decide when they would repay. In factthe situation is now changing and BMTs areusing more murabaha and mudarabah.

The Bank of Indonesia is believed to be keento persuade these BMTs to convert intobanks. This would probably result in

mergers as the capital requirements for theseorganisations would increase; as would therequirement for management to have somefinancial qualifications.

Sukuk in Indonesia

Although changes in the law in 1999 pavedthe way for the Indonesian government touse Islamic financing instruments as part oftheir overall monetary policy, it was notuntil 2008 and further enabling legislationthat Indonesia issued its first sovereignsukuk. Since then it has raised nearly13 billion US dollars via sukuk with thelatest issue in April 2012 being heavilyoversubscribed. While Indonesia was thesecond biggest issuer of sukuk in Asia in2011, it lagged a long way behindneighbouring Malaysia, accounting for just6% of that country’s total issuance. Thatgap could close as Indonesia seeks funds fora large number of infrastructure projectsplanned in the coming years.

To date the Indonesian sukuk market hasbeen dominated by sovereign issues andduring 2011 there was an almost totalabsence of corporate sukuk, but it looks asthough 2012 will see a change. BankMuamalat and Mayora Indah, a biscuitmanufacturer, have already announced theirintentions to issue sukuk worthapproximately 85 million US dollars and27 million US dollars respectively in 2012.Another three corporate sukuk are believedto be in the pipeline.

Changes in tax and sukuk laws are nowmaking it easier for Indonesianorganisations to issue US dollardenominated sukuk and along withIndonesia’s elevation to investment gradestatus by ratings agencies should makeIndonesian issues more attractive toinvestors from the GCC looking to diversifytheir investments.

Is the Sleeping Giant Stirring?

Indonesia has the largest Muslim populationin the world, a robust economy and itsgovernment appear to be increasinglysupportive of Islamic finance, even iffrustratingly slow at times. Having bumped

NEWHORIZON July–September 2012COUNTRY FOCUS

along the bottom of the classic growth curvefor the past few years, it has now probablyreached the stage where it could suddenlytake flight. It does, however, have to addresssome issues for that dramatic growth tohappen, in particular the shortage ofexperienced personnel at all levels andproduct innovation.

On the issue of skilled manpower, there aretwo possible approaches. One is to extendthe range of courses, both vocationalcourses and university-level courses and theother is to somehow import expertise, notjust to kick start the sort of growth that theIndonesian government say they want to seein Islamic finance, but also to provide thesort of ongoing, on-the-job training thattrainees and graduates will need followingformal education. The answer, of course, isthat Indonesia probably needs to pursueboth approaches, not least because growingyour own Islamic financial expertise takestime and Indonesia needs to boost thatresource now. It is important to note,however, that to date only a few topexecutives have been imported intoMalaysian-owned banks and Indonesia haspreferred to grow its own expertise byrecruiting conventional bankers andretraining them. This is admirable, but mayprove to be a growth-limiting factor.

While the provision of formal education islargely in the Indonesian government’s ownhands, an injection of expertise depends onIndonesia’s ability to attract inwardinvestment into their nascent industry. In thepast 12–24 months there have been signs ofinterest from both Malaysia and the GCC;indeed the Indonesian government seem tohave been actively courting Gulf banks, but sofar there have been no positive results fromthis courtship. In some respects partnershipswith more conservative Gulf banks may suitIndonesia’s purist approach to Islamic financebetter than those with neighbouring Malaysia.On the other hand there is probably greatercultural synchronicity with Malaysia.Currently, however, the rumoured changes toownership rules limiting the stake a singleshareholder may hold, is likely to be puttingany investments on hold. Indonesia needs toclarify this situation as soon as possibleotherwise they may just find potential

investors have moved on and found otheropportunities.

There are two issues in relation to productinnovation. One is the rather cumbersomeapprovals process, which apparently theIndonesian central bank is addressing,although progress again seems slow. Theother is more complex, because it relates toboth the shortage of experienced personneland to the very purist approach to Islamicfinancial products in Indonesia. Solutions tothe problem of a shortage of experiencedpersonnel are not particularly contentious,but, if the development of innovativeproducts requires Indonesia to take a freshlook at its approach to what is acceptable ornot in Shari’ah, that is likely to be muchmore difficult. Without a very in-depthunderstanding of the influences at work inIndonesia, it is impossible to say whetherany such changes are likely to happen. Thecurrent purist approach is likely to appeal tosome of the more conservative investors, butare there enough of these to help theindustry to grow in the way that theIndonesian government is hoping it will.

Finally there is the issue of stability andfairness. The conspiracy theorists are havinga field day with the proposed new ruling onbank ownership suggesting that it has beendesigned to scupper the DBS bid for Bank

Danamon, but that seems somewhatexcessive. Bank Indonesia could surely havefound some other reason not to approvethat particular deal without changing thewhole ownership structure for banks,Islamic and conventional alike. Othersources have suggested it is a sign ofgrowing nervousness in Indonesia about theextent of foreign investment and follows onfrom proposals to limit foreign investmentin mining companies to 49%. BankIndonesia itself has said the bankingownership measure is designed to preventmajority shareholders abusing bankoperations for their own financial gain.

Whatever the reasons behind the proposalone thing is clear; if Indonesia wants tofoster growth in its financial sector andparticularly in the Islamic sector, they needto reassure potential investors that thesystem is stable, fair and transparent.Without a degree of certainty that business will be carried on in an orderlyfashion and will not be subject toapparently capricious governmentbehaviour, Islamic banking will find itdifficult to break out from its verypromising base and achieve the levels ofgrowth that seem to be within its grasp. Thevalue of the additional funds and expertisethat foreign investors can bring to the partyshould not be underestimated.

Jakarta

NEWHORIZON Sha’baan Shawwal 1433 POINT OF VIEW

Economic justice has been a central themeof the Occupy Wall Street (OWS)movement, but what exactly does economicjustice mean? Academic writings show thecomplexity of the topic. In his book Justice:What’s the Right Thing to Do?, MichaelSandel of Harvard University explains thatan individual’s definition of economic justicedepends on his beliefs. For instance, somemay believe that any distribution of incomeand wealth produced by a free market is just.

But there is no such thing as a free market,according to Ha-Joon Chang of CambridgeUniversity. Chang argues that regulationsrestrict the freedom to contract in allmarkets. If there is no free market, how canthe distribution of income and wealthproduced by it be just?

Nobel laureate Amartya Sen in his bookThe Idea of Justice explained that we do notneed a theory of the ideal state of justice inorder to pursue justice. In addition, publicreasoning and discussion can help reduceinjustice.

‘When people across the world agitate to getmore global justice … they are notclamouring for some kind of minimalhumanitarianism,’ Sen wrote. ‘Nor are theyclamouring for a perfectly just world societybut merely for the elimination of someoutrageously unjust arrangement to enhanceglobal justice.’

Post 2008, many commentators havepointed out the negative externalitiesimposed on society by the financial sector.They have expressed deep concerns aboutthe privatisation of profits and thesocialisation of losses by the financial sector.

The frequent references to economic justiceby the OWS movement should strike afamiliar chord in the small but growing fieldof Islamic finance. Mohammad NejatullahSiddiqi, who has been writing in the fieldsince the 1950s, has even called Islamic

finance a ‘quest for justice.’ Similarly, TaqiUsmani, a prominent Muslim jurist,repeatedly talks about ‘distributive justice’in his writings on Islamic finance.

Clearly, it is too much to burden the Islamicfinancial sector with delivering economicjustice all by itself. That necessarily involveswider economic policy and the Islamicfinancial sector is but a small niche withinglobal finance. But why is Islamic financeexpected to facilitate economic justice?

One explanation is that the Islamicprohibitions of riba and excessive ghararinclude in their scope the lending of moneyon interest and the trading of risk. Whilethey restrict the freedom to contract, theyalso keep finance tied to the real economyand promote enterprise and risk sharing.This is in sharp contrast to many establishedelements of conventional finance. In theory,because of these prohibitions and othermoral checks and balances, Islamic financeshould facilitate the distribution of wealthand opportunity, thereby facilitatingeconomic justice.

The initial experiments in Islamic finance inthe late 1960s are often seen as broadlyconsistent with the spirit of economic justice.Since the establishment of the first Islamiccommercial bank in 1975, however, Islamicfinance has largely consisted of commercialbanking within conventional fractionalreserve banking. According to a researchreport published by TheCityUK, as much as72% of the assets in this nearly one-trillion-dollar sector are in commercial banking.

Observers have long held the view that,legal form and religious symbolism aside,the economic substance of Islamiccommercial banking is very similar to, if notthe same as, that of conventionalcommercial banking. In the concludingchapter of their book, Islamic Law andFinance: Religion, Risk, and Return,Harvard University professors Frank Vogel

and Samuel Hayes III wrote that it is a ‘legaland financial embarrassment’ that Islamicbanks ‘mimic conventional banks’ instead ofbeing the profit-and-loss investmentintermediaries that Islamic economic theorydemands. They went on to suggest thatgenuine profit sharing through pooled fundscould be the solution.

Such observations regarding Islamic financeare not confined to banking; one comesacross them in capital markets and insurancetoo. Observers may also find it puzzling thatone could switch from conventional financeto Islamic finance but still be dealing withsimilar debt-based financial services andsome of the same large financial institutions,which are seen as part of the problem by theOWS movement.

In response, Islamic finance practitionerstend to argue that the current legal, tax, andregulatory frameworks are meant forconventional finance but that Islamicfinance is forced to fit into them, creatingthe gap between its theory and its practice.Some also contend that their customers arenot looking for something different fromconventional financial services in their risk-return profile. Others may say that they aredoing what they can under the currentcircumstances and that it will take time anda different legal and economic framework tomove toward alternatives that are moreauthentically Islamic and just.

The arguments offered by Islamic financepractitioners are not without merit, but theOWS protestors might ask: If the economicsubstance of Islamic banking is the same asthat of supposedly unjust conventionalbanking, how would banking the Muslimway facilitate economic justice? Perhaps theanswer is that reducing economic injusticein practice can be even more difficult thandebating the complexities of its theory. Be itconventional or Islamic finance, economicjustice remains enticing but elusive.

The Chimera of Economic Justice

By: Usman Hayat, Director of Islamic Finance and ESG, CFA Institute

NEWHORIZON July–September 2012ACADEMIC ARTICLE

Introduction

The pioneers of Islamic economics assertedthat an economy based on Islamic valuesand principles would produce a moraleconomic system serving the needs of notonly Muslims but humanity at large. Theeconomy would strive to fulfil the goals ofShari’ah (maqasid al-Shari’ah) and result inachieving a just and vibrant economy. Thefinancial sector was expected to entailrisk-sharing features and serve all sectionsof the population thereby bringing aboutequity, stability and growth. Themanifestation of Islamic economics,however, ended up as sub-economies in thefinancial sector. While the growth of Islamicfinancial industry in its short history hasbeen impressive, there is a general feelingthat Islamic finance has failed to fulfil thesocial and ethical goals of Shari’ah.

Although the criticisms levelled at theindustry should be verified empirically, thereis a need to come up with a clearunderstanding of what is considered ethicalin Islamic finance. Addressing this issuewould require examining the nature andresponsibilities of a firm. Carroll (1979) andSchwartz and Carroll (2003) identify theresponsibilities of a firm as economic, legal,ethical and philanthropic/discretionary. Theeconomic responsibility is obvious giventhat firms supply goods and services to earnprofit. Firms have to comply with all thelaws and regulations of a country in thepursuit of profit. Other than the economicand legal responsibilities, society alsoexpects firms to follow certain ethicalnorms. Finally, it may be desirable for firmsto be philanthropic, though this is left totheir choice and discretion.

Being a part of the moral economy andfollowing the Shari’ah principles, the natureof responsibilities for Islamic firms in

general and Islamic banks in particularchanges. Islamic banks have to conform notonly to the national laws and statutes, butalso to the Islamic law of contracts at thetransactions level. Furthermore, beingethical is required of an Islamic firm, notjust expected. As ethics is considered a keyfor Islamic banking practice, there is a needto define its scope from an Islamicperspective. Note that ethics is difficult todefine even for conventional businesses. ForIslamic banks it becomes even more difficultas it will include the ethical standards thatapply to conventional banks and someadditional requirements.

As Islamic banks comply with the valuesand principles of Islam, there are additionalfactors that influence ethics. Specifically,two other norms of morals and laws willalso affect the ethics of Islamic banks.Whereas there is some discussion on therelationship between Islamic law on ethics,there is no research (to the best of myknowledge) linking the ethics of Islamicbanking practice to moral issues. This paperattempts to fill this gap by providing aframework of ethics for Islamic finance bylinking it to morality. I argue that to arriveat an appropriate Islamic stance on theethics for Islamic banking there is a need togo beyond the legalistic arguments andexamine the moral principles derived fromIslamic teachings.

To have the discussion in some perspective,the paper examines the ethical issues arisingfrom debt, a key instrument used by thebanking sector. Whereas the ideal model ofIslamic banking envisaged a two-tiermudaraba model, Islamic finance turned outto be one that is dominated by debt-basedinstruments. Although debt will be anintegral part of an Islamic financial system,its magnitude and impact on individuals andsociety may have certain moral implications.

However, the moral consequences of debthave been ignored in Islamic financepractice and discourse. This is apparentfrom the indifference shown by somepractitioners, Shari’ah scholars and Islamiceconomists towards a larger share of debt inthe economy, both at the individual andnational levels. The lack of concern aboutincreasing debt levels stems mainly fromadopting a legalistic approach that assertsthat as long as debt is created byShari’ah-compliant means, its level is notconsidered a problem. I argue that thislegalistic approach can lead to unethicalpractice as it ignores the broader issuesrelated to the moral teachings of Islam.

Morals, Ethics and Laws

Norms in any society can be distinguishedas morals, ethics and laws. To avoidconfusion about these concepts and todetermine how they are related to eachother, there is a need to clarify what theymean. Hazard (1994–1995: 451) definesmorals as ‘notions of right and wrong thatguide each of us individually andsubjectively in our daily existence’. Erhardet. al. (2009: 35-36) view morality as asocietal issue and defines it as ‘the generallyaccepted standards of what is desirable andundesirable; of right and wrong conduct,and what is considered by that society asgood behaviour and what is considered badbehaviour of a person, group, or entity’.They place morality in the realm of ‘socialvirtue’. Morals are embedded in culturesand determined by a variety of factors suchas upbringing, education, religion andenvironment. Morals tend to have anemotional orientation whereby its validity istaken as given (Ray 1996).

Hazard (1994–1995: 453) defines ethics as‘norms shared by a group on a basis ofmutual and usually reciprocal recognition’.

Defining Ethics in Islamic Finance: Looking Beyond Legality

By: Dr Habib Ahmed, School of Government and International Affairs, University ofDurham

NEWHORIZON Sha’baan Shawwal 1433 ACADEMIC ARTICLE

Erhard et.al. (2009: 36) provide a moreelaborate definition of ethics as ‘the agreedon standards of what is desirable andundesirable; of right and wrong conduct; ofwhat is considered by that group as goodand bad behaviour of a person, sub-group,or entity that is a member of the group, andmay include defined bases for discipline,including exclusion’. They identify ethics tobe in the realm of ‘group virtue’. One wayin which ethics can be understood is toexamine the ends or consequences of actionsor activities. Thus, an act will be ethical‘when it promotes the good of society ormore specifically, when the action isintended to produce the greatest net benefit(or lowest net cost) to society whencompared to all of the other alternatives’(Schwartz and Carroll 2003: 512).

Laws are ‘norms formally promulgated by apolitical authority that are enforceable andmore or less regularly enforced through alegal process based on adjudication’ (Hazard1994–1995: 448). Erhard et.al. (2009: 37)put law in the realm of ‘governmental virtue’and defines it as ‘the system of laws andregulations of right and wrong behaviour thatare enforceable by the state through theexercise of its policing powers and judicialprocess, with the threat and use of penalties,including its monopoly on the right to usephysical violence’. In general, law entails abody of rules which can be formed throughstatutes, decrees and edicts, decisions ofjudges or jurists, etc. While ethics entailsstandards that members of a group areencouraged to follow and realise, law setsclear rules and standards that are enforced byhigher body (such as government) by usingpunishment and sanctions (Ray 1996: 50).

The norms of a society residing at differentlevels as morals, ethics and laws haveunique features and are interrelated.Whereas morals relate to individuals andare subjective, ethics is more rational andcan change in the context of a group. Ethicsis considered as an aggregate concept whosecomponents are morality (Ray 1996).Unlike law, ethics and morals cannot beadjudicated or enforced by an authority. InWestern legal scholarship there is a debateamong the legal theorists on the role

morality plays in laws. While the positivisttheorists (such as Hart) view law as amoral,interpretive theorists (such as Dworkin) linklaws to morality (Donato 1988). Hazard(1994-1995) takes the interpretive view andmaintains that ethics and morals shared byindividuals and community can influencelaws. With concerted efforts, it is possiblefor individuals in a community to convert amoral norm into a law. Although the threenorms are expected to be complimentary,yet they can potentially contradict eachother. For instance, enacted laws can turnout to be either unethical or immoral.Examples of such laws include ones thatlegalise slavery and discrimination.

As mentioned, the relevant norms affectingfinancial institutions are laws and ethicsthat govern their operations and activities.While laws apply equally to all firms, ethicalnorms in the organisational setting are morespecific to tasks and situations, whichmembers in a firm face (Sinclair 1993).Davies (2001: 282) indentifies some of theethical norms for financial institutions asconduct operations with integrity and dueskill, care and diligence, organise the affairsresponsibly and effectively with adequaterisk management systems, observe properstandards of market conduct, ensure thatconflict of interest does not exist, payattention to the interests of its customersand treat them fairly.

Ethics, Morality and Legality from anIslamic Perspective

The essence of the Islamic worldview istawheed which means oneness andsovereignty of God (Allah). Thoughtawheed means unity of God and creation,it has implications related to all aspects oflife including economics and finance. Theconcept of tawheed also implies that God isthe only source of value and norms. Thus,all discussions on law and morality ensuefrom this concept (Kamali 2008, p. 17).Islam, being a complete code of life providesrules and norms for economic activities andtransactions. Islamic economics and financewill reflect the Islamic worldview and, assuch, is driven by Islamic laws and moralsrelated to economic transactions.

The underlying principle guiding Shari’ah isthat ‘God orders the good because it securesthe welfare of the community and forbidsevil because it is evil and because it isagainst the public good’ (Abdel-Wahab1962–63: 122). As Shari’ah entails all theteachings of Islam, it is understood toinclude both Islamic morals and laws. Theimplication is that Islamic law and moralityare expected to contribute positively to thewelfare and public good (maslahah). For thepurposes of this paper, however, we usethree domains of norms discussed above –morals related to individuals (and society),ethics belonging to groups includingorganisations and laws governed andimplemented by entities with legal andregulatory authority.

The distinction between laws and moralscan be made by examining the section ofIslamic jurisprudence known as hukmtaklifi. Accordingly, any human act will fallunder one of the following – obligatory(wajib or fard), recommended (mandub),reprehensible (makruh), permissible(mubah) and forbidden (haram) (Reinhart1983: 195). Kamali (2008: 47) contendsthat while the first and last types ofactivities (wajib and haram) have legalforce, the remaining three activities fall intothe domain of morals that cannot beadjudicated in courts. When Shari’ahproscribes usury or gambling, these becomelegal obligations. However, Islamicteachings encouraging people not to causeinjury to women and the elderly or animalsreflect ‘the moral underpinnings of Shari’ah’(Kamali 2008: 49).

The moral teachings in Islam will take theform of encouraging the recommended andavoiding the reprehensible. The moralsrelated to the recommended and thereprehensible are derived from Shari’ah.While there are some clear indications aboutmorality in the texts, others are implied andare extracted indirectly. An example of aclear recommendation is found in theProphetic sayings ‘Feed the hungry, relievethe distressed and visit the sick’ (Khan andHasan undated: 100). An example of anindirect implied norm can be observed in thesaying of the Prophet (PBUH) ‘Oh God, I

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NEWHORIZON July–September 2012ACADEMIC ARTICLE

seek refuge in You from niggardliness’ (Khanand Hasan undated: 84). The implication ofthe above hadith is that niggardliness is amorally reprehensible act and as such shouldbe avoided. Similar conclusions can bedrawn from the verses of the Quran. Uddin(2003) derives some norms for businessrelated practices from different verses of theQuran. For example, he concludes thatQuran (17:36) can mean ‘honesty andtruthfulness; investigation and verificationbefore action; right and ethical conduct; truewitness’. Quran (11:85) can be interpretedas ‘no deception in measure and weight,mischief and corruption is avoided’.

Note that while the legal issues wereadjudicated by independent courts inIslamic societies, the institution of hisbah (incharge of promotion of good andprevention of evil) historically functioned tosupport moral values (Kamali 2008). Thisnot only shows the difference of the legaland moral aspects in the light of Shari’ah,but is also indicative of the importance thatIslamic societies place on morality ingeneral. Given the above framework, theroles of law and morality on ethics at theorganisational level are discussed next.

Islamic Law and Ethics

The basic principle for commercialtransactions is ‘permissibility’ whichsignifies that all acts/contracts arepermissible unless there is a clear injunctionof prohibition (Kamali 2000: 66). The twobroad categories of prohibitions related toeconomic transactions recognised inShari’ah are riba and gharar. At the contractlevel, these prohibitions are intended tobring about fairness and good measure and,as such, these get more consideration overcomplete freedom of contracts (Saleh 1992:146). The legal maxim ‘in contracts,attention is given to the objects andmeaning, and not to the words and form’.(Majallah 2001, Article 3) provides theguiding principle of devising contracts infinancial transactions. While the form is thecontractual construct of the transaction, thesubstance relates to the outcome. Forexample, the outcome of a sales contract isthe transfer of ownership of an asset inexchange for a price. Fulfilling the form, but

not the substance will not be harmoniouswith the spirit of Islamic law.

Reinhart (1983: 186) maintains that Islamiclaw is not just a law; ethics are inherent asboth constitute ‘a call to righteous action inconformity with the guidance ofRevelation’. Thus, while the ethics related tocontracts will include virtues such ashonesty, trust and transparency, they willalso incorporate fulfilling the legalobligations and stipulations. As a result,ethics can be evaluated by examiningwhether the legal conditions andstipulations of a contract are fulfilled or not(Arabi 1997). For a transaction to beethical, the overall goals of Shari’ah(maqasid) should also be fulfilled at thecontract level. Other than avoiding riba andgharar, Kahf (2006) indicates that fulfillingmaqasid at the transaction level wouldinvolve satisfying the objectives, principlesand values underscored in the Islamic lawsof transactions. This would include, amongothers, linking returns to risks and bearingthe risks of ownership by the owner of theasset. An important related principleincludes fulfilling the conditions of a sale,which is realised by transferring the asset tonew owner. Similarly, conditions of trustand guarantee relationships in terms ofliability of loss have to be implemented.Given the divine nature of these conditions,a contract would be considered unethical ifsome of these stipulations are not fulfilled.

Another aspect related to ethics at thecontract level relates to intention (niyah)and outcomes. While niyah is an integralcomponent in worshiping rituals (ibadat), ineconomic affairs (muamalat) there isdifference in opinions about its statusamong different schools of thought. Notethat all schools agree that an illegitimatemotive will make a contract illegal evenwhen all the legal components of a contractare fulfilled. The disagreements arise inrelation to the status of intentions whenthey are not explicit in contracts (Arabi1997: 215). Thus, an intention of comingup with an illicit act using a valid contractwould not only be void, but also immoral.The legality of a transaction will not onlydepend on the validity of a contract, butalso on the end use of the contract, which

can be deduced ex-ante by the niyah andex-post by examining the outcome orconsequences.

Islamic Morals and Ethics

All Islamic banks will be expected to beethical in ways similar to their conventionalcounterparts. As mentioned above, theseethics include among others conductingoperations with integrity and with due skill,care and diligence, avoiding conflict ofinterest (Davies 2001). As ethics relates tothe notions of what is right and wrong inthe organisational context, for Islamicbanks it will also be influenced by theIslamic notions of legality and morality. Assuch, Islamic banks will have additionalethical dimensions arising from theiradherence to the laws and morals ofShari’ah. Although Islamic scholarship hasdiscussed issues related to the application oflaws to ethical practice, the relationshipbetween morality and ethics has not beenaddressed.

If the ethical and legal norms are presumedto coexist in a transaction, some may argue,as some Shari’ah scholars do, that as long asthe requirements and stipulations of thecontract are fulfilled, the contract will beboth legal and ethical. However, thisargument may lack credence as the outcomeof the transactions can lead to adverseeffects on morality and societal welfare.One way to link morals to ethics is toexamine the impact of the activities of firmson the society. As pointed out by Schwartzand Carroll (2003: 512), a business activitywill be ethical if it promotes good in society.We use the same logic to determine theethicality of transactions and activities ofIslamic banks. Specifically, the activity of anIslamic bank would be ethical when itenhances welfare (maslahah) and themorality of individuals in the society. On thecontrary, any banking practice thatproduces adverse effects on either welfare orIslamic morals would be consideredunethical.

Morality and Ethics: The Case of Debt

In an Islamic economy, debt can be eithercreated through interest-free loans or

NEWHORIZON Sha’baan Shawwal 1433 ACADEMIC ARTICLE

sale-based debt instruments. Debt can becreated through transactions involvingmurababah (cost plus or mark up sale)bai-muajjal (price-deferred sale),istisna/salam (object-deferred sale orpre-paid sale) and ijarah (leasing). Islamicbanks do the bulk of their financing byusing fixed-income debt-based products.While debt is permissible in Islam, somemoral issues related to its size can arise.

Morals Related to Debt

While Islam does not prohibit debt, severalsayings of the Prophet (PBUH) discourageMuslims from engaging in excessiveindebtedness. The following sayings (hadith)provide the moral implications related todebt:

Narrated ‘Aisha: Allah’s Apostle used toinvoke Allah in the prayer saying, ‘O Allah,I seek refuge with you from all sins, andfrom being in debt.’ Someone said, ‘OAllah’s Apostle! (I see you) very often youseek refuge with Allah from being in debt.’He replied, ‘If a person is in debt, he tellslies when he speaks, and breaks hispromises when he promises.’ (Bukhari,Volume 3, Book 41, Number 582)

Narrated Salama bin Al-Akwa: Once, whilewe were sitting in the company of theProphet, a dead man was brought. TheProphet was requested to lead the funeralprayer for the deceased. He said, ‘Is he indebt?’ The people replied in the negative.He said, ‘Has he left any wealth?’ They said,‘No.’ So, he led his funeral prayer. Anotherdead man was brought and the people said,‘O Allah’s Apostle! Lead his funeral prayer.’The Prophet said, ‘Is he in debt?’ They said,‘Yes.’ He said, ‘Has he left any wealth?’They said, ‘Three Dinars.’ So, he led theprayer. Then a third dead man was broughtand the people said (to the Prophet), ‘Pleaselead his funeral prayer.’ He said, ‘Has he leftany wealth?’ They said, ‘No.’ He asked, ‘Ishe in debt?’ They said, (‘Yes! He has to pay)three Dinars’. He (refused to pray and) said,‘Then pray for your (dead) companion.’Abu Qatada said, ‘O Allah’s Apostle! Leadhis funeral prayer, and I will pay his debt.’So, he led the prayer. (Bukahri, Book 37,Hadith 488)

The above two sayings of the Prophetclearly indicate that a Muslim should try tostay away from debt. In the first hadith, theProphet is seeking refuge from sins anddebt, thereby implying the negativeattributes of both. In the second hadith, theProphet refused to lead the funeral prayer ofsomeone who died indebted and did nothave the means to repay it. The incidentshows that even though the deceased was aMuslim, the consequence of not repayingthe debt was a serious enough factor forhim not to lead his funeral prayer. Theimplications that one can draw from thesesayings of the Prophet are the following –people should take on debt only if itnecessary; the debt should amount to thatwhich is within a person’s capacity to repayand once indebted people should strive torepay it.

The Welfare Implications of Debt onIndividuals and Society

The recent financial crisis exposed thedamaging features of excessive debt in theeconomy. It revealed that too much debtwas one of the key causes of thepredicament and harmed many indebtedindividuals and economies at large. Theaftermath of the crisis led to a renewedscrutiny of the harmful consequences ofdebt. The Economist published a specialreport on debt in its 24 June 2010 issue inwhich it examined various aspects ofindebtedness. The morals related to debtchanged from being something negative inthe past to acceptable in the present. Overthe past century taking on debt becamefashionable and was promoted in society,both at the individual and national levels.The change in attitude resulted in theincrease in levels of debt for individuals,corporations and nations. This is reflectedin the rise in household debt from aboutGBP 14,000 per head to GBP 24,000 perhead between 2001 and 2010 in UK andfrom USD 27,000 to USD 44,000 in the USduring the same period (Economist 2010b).The corresponding figures for public debtwere GBP 5,000 and GBP 18,000 and USD16,000 and USD 34,000 for UK and USrespectively. For ten industrialised countries,the average total debt (private and public)increased from 200% of GDP to 300%

between 1995 and 2008, with Icelandhaving a debt 1200% of its GDP(Economist 2010a).

High levels of debt have had variousdetrimental effects on both individuals andnational economies. A study revealed thathigher debt levels were associated withlower levels of growth (Economist 2010a).In a study, Campbell and Hercowitz (2009)find the higher growth in the level of debtreduces the welfare of households. TheEconomist likened debt to alcohol andnicotine stating ‘a debt boom tends toinduce euphoria’ (Economist 2010a).Analysing the problems related to the crisis,Taleb and Spitzagel (2009) identifies toomuch debt as the ‘real evil’.

Data shows that Muslim countries are notimmune to the culture of debt. Consumerdebt in the GCC peaked in 2008 at $151billion and then fell to $139 billion inAugust 2010 in the aftermath of the crisis.The growth rate of the level of outstandingdebt was 80% between 2002 and 2010(White 2010). A survey shows that 52% ofthe youth are indebted in Saudi Arabia, ofwhich two-thirds is due to credit cards(White 2010). A study on the UAE revealedthat 85% of UAE residents are in debt,many having difficulty in paying their dues(Walter 2010). Another survey reveals thatmore than 25% of UAE residents have adebt of Dh 250,000 each and 40% havepersonal loans between Dh 100,000 and Dh200,000. Interestingly, 20% did not haveany idea of the amount of debt they owed(Emirates 24/7 2011). A report by theLafferty Group in 2010 indicates that therewere 199.4 credit cards for every 100people in the UAE, which is one of thehighest in the world. After the crisis, theamount of bounced checks increased to25% in UAE (Sambidge 2010).

Part of the problem of high indebtedness iseasy access to credit and the willingness ofbanks to provide facilities with relatively laxstandards. Some specific cases in the UAEindicate banks were permissive with lack ofproper scrutiny of clients before providingcredit. Walter (2010) reports that a personwith a salary of Dh 15,000 ran up debts ofDh 250,000 and people with salaries of as

NEWHORIZON July–September 2012ACADEMIC ARTICLE

low as Dh 6,000 managed to get eight creditcards. While it is difficult to ascertain theextent to which the debt was fuelled byIslamic banks, given the significant share ofthe Islamic banking sector in the country itis safe to conclude it has played animportant role in the build up inindebtedness.

The Ethics of Debt for Islamic Finance

The above discussion indicates that theremay not be any ethical issues arising in usingdebt from a legal perspective as appropriateShari’ah-compliant instruments can be usedto create it. However, the morals derivedfrom the Prophetic traditions indicate thatMuslims should strive to keep the levels ofdebt to a minimum. If the objective ofIslamic banks is to expand business byfinancing goods and services that results inhigher indebtedness among individuals, thenthey contribute to the immorality of beinghighly indebted as perceived from an Islamicperspective. Consequently, if bankingpractices affect moral values negatively, thepractice of Islamic banks would beconsidered unethical.

Beyond the moral proposition from areligious point of view, limiting the level ofdebt also can be rationalised from theperspective of the welfare (maslahah)implications at the individual and societallevels. As discussed above, higher levels ofdebt can affect the welfare of individuals inthe economy adversely. The evidence of theadverse impact of debt on individuals andnational economies indicates that the levelsof debt must be kept reasonable andmanageable. If Islamic banks ignore theharmful effects of debt on individuals andhelp to fuel its increase to levels that start toaffect the welfare of people negatively, thenthese activities could be considered immoralfrom an Islamic perspective. The implicationis that if Islamic banks focus narrowly onthe legal technicalities and ignore the impactof debt on moral teachings and maslahah,they fail to operate ethically.

Conclusion and the Way Forward

This paper has discussed the role of lawsand morals in defining the ethical practices

of Islamic banks. While Islamic law andethics appears to be closely linked, casesmay arise when the practices of Islamicbanks can produce unethical results evenwhen the contracts are legitimate. To judgeif banking practices are ethical or not, it isimportant to examine the consequence oftransactions on morality and welfare.Situations can arise when the transactionsmay not have legal/ethical issues at thecontract level, but can be unethical as theyhave adverse impact on welfare or morality.This paper has examined the morality ofexcessive debt and concluded that thepractice of Islamic banks could be unethicalif they fuel the increase in indebtedness ofindividuals beyond certain levels.

The ethicality of Islamic banking practicearising from the effects on moral valuescannot be grasped by focusing on the legalaspects of contracts only. A question thenarises about whether morality and ethicalnorms can be realised by Islamic banks thatare engaged in expanding their businesses incompetitive markets. While there are certainaspects of ethical self regulation at theorganisational level that can be useful, it haslimitations. Davies (2001: 281) points outthat self-regulation may not be appropriatefor ‘raising standards in the market as awhole, or dealing with a problem wherethere was a need for the whole industry tochange’. Furthermore, when the conduct ofbanks has implications that go beyond theirrealm and that affect other members ofsociety, regulatory oversight may benecessary to govern these activities.

If Islamic banks narrowly focus on thelegality of transactions that can lead tounethical outcomes, there is a need to havea mechanism to ensure that Islamic bankingpractices are ethical by not contradicting themoral teachings of Islam. Kamali (2008)asserts that if public interest (maslahah)necessitates it, a lawful government isauthorised to change the reprehensible intoforbidden and the recommended intoobligatory. In the past, Islamic societies hadinstitutions that oversaw the moral issuesrelated to economic affairs. Kamali (2008)maintains that while the courts dealt withthe legal issues, the market controller

(muhtasib) was authorised to intervene andstop immoral practices. Duringcontemporary times, this role can be takenup by the regulators thereby ensuring ethicsat the organisational level is moved to thepublic domain. This paper suggests thatthere is an additional role for regulatorsoverseeing the Islamic finance industry – itis to promote morality-enhancing, ethicalbehaviour in Islamic banking practices.

Professor Dr Habib Ahmed is the SharjahChair in Islamic Law and Finance atDurham University. Prior to joiningDurham University in September 2008,Professor Ahmed worked at NationalCommercial Bank and Islamic Researchand Training Institute (IRTI) of the IslamicDevelopment Bank Group in SaudiArabia. His paper, ‘Defining Ethics in Islamic

Finance: Looking Beyond Legality’ waspresented at the 8th InternationalConference on Islamic Economics andFinance held in Doha in December 2011and is reproduced here by kindpermission of the author and by theorganisers of the conference, the QatarFoundation and the Islamic DevelopmentBank.

NEWHORIZON Sha’baan Shawwal 1433 ANALYSIS

At Islamic finance conferences, one is oftenasked whether Islamic financial institutions(IFIs) should account under InternationalFinancial Reporting Standards (IFRS) orunder the accounting standards publishedby the Accounting and AuditingOrganisation for Islamic FinancialInstitutions (AAOIFI). This article discussesthe following issues:

1. Do IFIs have a choice between IFRS andAAOIFI?

2. How do IFRS and AAOIFI accountingpractices differ?

3. Are there any disadvantages from IFRSaccounting?

4. How should accounting for IFI’s moveforward?

Given the breadth of the subject, the articleconcentrates on the high-level issues leavingreaders to explore the details independently.

Do IFIs have a choice between IFRS andAAOIFI?

In most cases, there is no choice. Instead theaccounting standards that an IFI must applywill be prescribed by the laws of the countryin which it is incorporated or where it listsits securities.

For example, European Union law requiresall EU companies with publicly-listedsecurities to prepare their consolidatedaccounts under IFRS. (More precisely, underIFRS subject to any modifications requiredby the EU.) Conversely the writerunderstands that all Bahraini and QatariIFIs are required to account under AAOIFI.

The writer has not attempted a globalsurvey; however a review of the accounts ofGulf Cooperation Council (GCC) IFIsshowed that all GCC countries use IFRSapart from Bahrain and Qatar. IFRS is also

the prevalent accounting standard almosteverywhere except the USA, which uses itsown standards, albeit with the aim ofconverging with IFRS in the next few years.There are a few other countries such asSudan which are understood to use AAOIFI.

How do IFRS and AAOIFI accountingpractices differ?

The fundamental differences between IFRSand AAOIFI accounting standards arisefrom the different objectives of accounting,as seen by the two standard setting bodies.

The objective of IFRS accounts

IFRS are published by the InternationalAccounting Standards Board (IASB). In2001 the IASB adopted its ‘Framework forthe Preparation and Presentation ofFinancial Statements.’ Paragraph 12 states:

‘The objective of financial statements is toprovide information about the financialposition, performance and changes infinancial position of an entity that is usefulto a wide range of users in makingeconomic decisions.’

In paragraphs 33 and 34 the frameworkemphasises the need to faithfully representthe transactions that have taken place:

‘To be reliable, information must representfaithfully the transactions and other eventsit either purports to represent or couldreasonably be expected to represent. Thus,for example, a balance sheet shouldrepresent faithfully the transactions andother events that result in assets, liabilitiesand equity of the entity at the reportingdate, which meet the recognition criteria.’

‘Most financial information is subject tosome risk of being less than a faithful

representation of that which it purports toportray. This is not due to bias, but ratherto inherent difficulties either in identifyingthe transactions and other events to bemeasured or in devising and applyingmeasurement and presentation techniquesthat can convey messages that correspondwith those transactions and events. Incertain cases, the measurement of thefinancial effects of items could be souncertain that entities generally would notrecognise them in the financial statements;for example, although most entities generate goodwill internally over time, it is usually difficult to identify or measurethat goodwill reliably. In other cases,however, it may be relevant to recogniseitems and to disclose the risk of errorsurrounding their recognition andmeasurement.’

Paragraph 35 emphasises the importance ofsubstance over form:

‘If information is to represent faithfully thetransactions and other events that itpurports to represent, it is necessary thatthey are accounted for and presented inaccordance with their substance andeconomic reality and not merely their legalform. The substance of transactions or otherevents is not always consistent with thatwhich is apparent from their legal orcontrived form. For example, an entity maydispose of an asset to another party in sucha way that the documentation purports topass legal ownership to that party;nevertheless, agreements may exist thatensure that the entity continues to enjoy thefuture economic benefits embodied in theasset. In such circumstances, the reportingof a sale would not represent faithfully thetransaction entered into (if indeed there wasa transaction).’

Islamic Financial Institutions and the Implications ofAccounting under IFRS

Mohammed Amin discusses whether there are any disadvantages to Islamic financefrom IFRS accounting

Here the bank has bought a machine for$1,000 and resold the machine to itscustomer for $1,250 payable in five years’time. It is clear that the $250 price upliftoccurs only because the customer is allowed five years credit before makingpayment.

Paragraph 8 of AAOIFI FinancialAccounting Standard No. 2 ‘Murabaha andMurabaha to the Purchase Orderer’ requiresthe bank to defer the $250 profit on thesale. It states that the preferred method ofaccounting is ‘Proportionate allocation ofprofits over the period of the credit wherebyeach financial period shall carry its portionof the profits irrespective of whether or notcash is received.’ In simple terms the bankwould recognise a profit of $50 in each ofthe five years, or perhaps it may be moresophisticated and spread the $250 over thefive years using compound interestprinciples in which case it would recogniseprofits of $45.64, $47.72, $49.90, $52.18and $54.56 in years 1–5 respectivelycomputed as follows using the internal rateof return of 4.564%.

Year B/f Profit C/f1 1,000.00 45.64 1,045.642 1,045.64 47.72 1,093.363 1,093.36 49.90 1,143.264 1,143.26 52.18 1,195.445 1,195.44 54.56 1,250.00

250.00

The legal and factual position is that thebank does everything needed to earn theprofit on the day of the original transaction.Afterwards, it has a credit risk exposure for

five years until the customerpays, but the bank needs todo nothing else other thanwait five years for the $1,250payment. The AAOIFIaccounting recognises theeconomic reality that thebank’s $250 profit arisesfrom giving the credit.

Are there any disadvantagesfrom IFRS accounting?

The principal drawback isthat, because IFRS

concentrates upon the economic substancerather than the legal form of thetransactions, users of the IFI’s accounts maynot receive sufficient information to form aninformed view on whether the IFI’stransactions are Shari’ah compliant.

For example, the boxed section on page 29illustrates IFRS accounting for a sale andleaseback transaction where the assetremains throughout on the balance sheet ofthe original owner. This can make it harderto assess whether the sale and leaseback wasconducted in a Shari’ah compliant manner.

This risk, however, can be mitigated byproviding good quality additionaldisclosures. IFRS prescribes the basicaccounting (for example requiring the saleand leaseback to be accounted for as afinancing transaction), but IFRS does notprohibit the IFI from making additionalinformative disclosures in the notes to thefinancial statements. Accordingly the IFIcan, and should, provide supplementarydisclosures so that its shareholders andcustomers can satisfy themselves about theShari’ah compliance of its transactions.

How should accounting for IFI’s moveforward?

The starting point is to recognise that theapparent dichotomy between IFRSaccounting and AAOIFI accounting is notreal. With the exception of a few countries,most IFIs in the world account under IFRS.

Accordingly all of the emphasis should beon identifying the additional voluntary

NEWHORIZON July–September 2012ANALYSIS

The objective of AAOIFI accounts

AAOIFI was established in 1991 andpublished its ‘Statement of FinancialAccounting No. 1: Objectives of FinancialAccounting for Islamic Banks and FinancialInstitutions’ in 1993. The introduction tothat statement says:

‘Financial accounting in Islam should befocused on the fair reporting of the entity’sfinancial position and results of itsoperations, in a manner that would revealwhat is halal (permissible) and haram(forbidden).’

Section 6/2 of the standard sets out theobjectives of financial reports in sixparagraphs of which the first is:

‘Information about the Islamic bank’scompliance with the Islamic Shari’ah and its objectives and to establish suchcompliance; and information establishing theseparation of prohibited earnings andexpenditures, if any, which occurred, and ofthe manner in which these were disposed of.’

Summary of the different objectives

The above objectives can be summarised asfollows:

IFRS focuses on reporting the economicsubstance of the transactions undertaken.

AAOIFI’s primary aim is that the IFI’saccounting should demonstrate itscompliance with Shari’ah.

Accordingly it should be no surprise if IFRS and AAOIFI standards give rise todifferent reporting when applied to the same transactions. Many examples can befound where IFRS and AAOIFI result indifferent accounting treatments for identical transactions, for example in the case of sale and leaseback illustrated in the accompanying boxed section.

Even AAOIFI accounts, however, oftendeviate from the legal form of thetransaction in order to report the economicsubstance. Consider the deferred paymentsale illustrated at the top of the page:

NEWHORIZON Sha’baan Shawwal 1433 ANALYSIS

disclosures that should be made by IFIsaccounting under IFRS. It would be verydesirable to standardise these additionalvoluntary disclosures so that shareholdersand customers of IFIs knew what additionaldisclosures to expect and what constitutedbest practice.

Since AAOIFI brings together within onebody both Shari’ah expertise and expertaccounting knowledge regarding IFIs, it iswell placed to devise the additionalvoluntary disclosures that IFIs accountingunder IFRS should make. That would be abetter use of AAOIFI’s resources thancontinuing to publish accounting standardsthat are applied in only a handful ofcountries.

Conclusion

The total profit the bank makes is $25,regardless of whether accounting underIFRS or AAOIFI. However the periods inwhich it is reported are different. Alsodifferent is the balance sheet presentation.

A sale and leaseback illustration

Assume the following transactions:

• On 1 January 2012 a customer sells its building to a bank for $100.• The bank leases the building back to the customer a rent of $5 per year payable

annually in arrears.• The bank and the customer enter into mutual sale and purchase undertakings

exercisable on 31 December 2014 at a price of $110. • The rent is paid as agreed and the sale back from the bank to the customer on 31

December 2014 takes place.

Accounting for the sale and leaseback under IFRS

IFRS is about reporting the economic substance of the transactions. From an economicperspective, the bank has provided $100 to the customer, in exchange for thecustomer’s obligation to pay it $5 on 31 December 2012 and 2013, and to pay it $115on 31 December 2014.

Accordingly the bank does not record the building on its balance sheet, as it has noeconomic exposure to its value. Its economics are identical to the following loantransaction.

Loan B/F Interest Repayment Loan C/F2012 100.00 8.08 –5.00 103.082013 103.08 8.33 –5.00 106.412014 106.41 8.59 –5.00 110.00

Accordingly the bank would account as follows:

2012 2013 2014Income statementFinancial income from leasing 8.08 8.33 8.59

Balance sheetInvestment in finance lease 103.80 106.41 0

(Zero at the end of 2014 as lease finishes)

Accounting for the sale and leaseback under AAOIFI

It appears appropriate under AAOIFI to account for the transaction that is actuallytaking place, which is a sale of the building and its eventual repurchase. The bank willshow the building it purchases on its balance sheet, and report the rental income andthe gain from selling the building in the periods when they arise. This leads to thefollowing accounting for the bank:

2012 2013 2014Income statementRental income from building 5.00 5.00 5.00Gain on sale of building 10.00

Balance sheetBuilding (cost) 100.00 100.00 0.00

(Zero at the end of 2014 as building sold back)

Mohammed Amin is an Islamic financespecialist, with a particular interest inaccounting issues and in how Islamicfinance is treated in Western tax andregulatory systems. He is a member of the Editorial Advisory Board of and was previously UK Head of Islamic finance atPricewaterhouseCoopers LLP.

NEWHORIZON July–September 2012IN THE SPOTLIGHT

Gatehouse Bank is the largest, fully-fledgedIslamic bank licensed by the FinancialServices Authority (FSA) in the UK. Canyou tell us something about the bank’sjourney so far?

Gatehouse enjoyed a great deal of supportfrom the government and regulatoryauthorities in establishing the bank. There isa clear enthusiasm among all politicalparties to level the playing field for all formsof finance; to enable social and economicequality. It has gained full banking statuswith the ability to do anything that anyother bank can do. The only difficulty hasbeen around the definition of the depositsthat we are allowed to take. I do, however,want to see more cooperation betweenIslamic banks in the UK to bring depth andsubstance to the market.

Banks have been criticised in recent yearsfor causing the financial crisis, however ithas been claimed that Islamic banks offer amore balanced and ethical basis forinvestment activities. How would yourespond to that comment?

I would agree that the Islamic economicmodel offers a more pragmatic solutionthan today’s conventional economic model.Whether Islamic banks apply the Islamiceconomic model consistently and effectivelyis a matter of practicality. The tools andopportunities exist for them to providesolutions that the conventional banks are nolonger able to offer.

Since the financial crisis we have seen manyproblems in the capital markets, has thisimpacted Gatehouse Bank at all?

We originally thought that Gatehouse Bankwould have a much larger capitalcomponent than it, in fact, has. For example,we envisaged developing the globalcorporate sukuk market, in particular theUK market, but the crisis blew away manyof those opportunities. We saw the sukuk

market retrench, not just due to the issueswith the conventional market, but alsobecause many sukuk failed to come up toAAOIFI standards. It really only recoveredthrough the issuance of sovereign sukuk,which were not in our original business plan.

The bank had to reinvent its position,becoming more of a merchant bank. We stillhave a plan to intermediate thequasi-governmental and corporate sectors intrue asset-backed sukuk, but that ambitionhas been set back many years. Luckily, like allIslamic banks, we did not have the terriblelegacy of failed US debt on our books, so ourability to ride out the crisis was much greaterand we have emerged at the other side withmore capital than when we started, a strongteam of people and real optimism about thefuture. Provided the conventional sector doesnot blow itself up completely and we do notend up with the Armageddon scenario thatthe press seem want to encourage us tobelieve is coming, then we will certainly be atthe forefront of Islamic banks takingadvantage of the Islamic system.

You have mentioned your focus on the UKcorporate sector, but what other strategiesdoes Gatehouse Bank have going forward?

Gatehouse Bank has become probably theforemost real estate investment bank in theUK, certainly as an Islamic bank. It does notmatter where the money is coming from, thedemand is for security, asset backing andlong-term, secure income plays.

The world made a decision that the UKproperty market is the most secureopportunity anywhere around the globe andwe have benefited enormously from being inthe right place at the right time. Real estatehas been at the heart of our profitability,because we have been meeting a customerneed. While real estate is our bestperforming area, portfolio management forequities and sukuk have been showing goodgrowth as well.

Gatehouse Banks is the only one of the fourfully-fledged Islamic investment banks in theUK to have full-time, in-house Shari’ahscholars. Why did you decide to take thisapproach?

I am actually surprised that we are the onlyone of the banks that does this. We needin-house scholars, because the business iscomplex and things change every day. If weapplied to our scholars offshore and wewaited a few days, a week or two weeks foran answer, the business would quite possiblyhave gone or changed.

You are one of the very few individuals thathas more than three decades of experience inIslamic investment banking, so what, in youropinion, are the major obstacles in designingand promoting Islamic investment products?

One of the major obstacles is unfaircompetition and that is a complex blend ofscale and the tax and regulatory aspects ofthe business in which we operate.Conventional organisations can avoidtaxation and characterise their instrumentsin particular ways not open to Islamicbanks. I believe that this competition is notonly unfair, it is in fact unhealthy.

While Islamic banks stuck to their principlesin most areas, conventional banks haveinvented and re-invented a whole range ofunhealthy products, which gives them unfaircompetitive advantage and notionalprofitability, which is hard to match. Islamicbanks have to compete with thoseconventional banks, who even stray into theIslamic space with sukuk products in thecapital markets, thereby bringing that unfairpractice into Islamic finance through the backdoor, so not only do Islamic banks have tocompete with the unhealthy conventionalproducts, they also have to compete with theconventional banks to develop healthyIslamic products. That has been one of themajor obstacles of the last 30 years.

An Interview with Richard Thomas, OBE,Chief Executive Officer, Gatehouse Bank

NEWHORIZON Sha’baan Shawwal 1433 IN THE SPOTLIGHT

We have struggled when that kind ofcompetition has been compounded byregulations and taxes, which have supportedthe development of these unhealthyproducts and penalised the compliantproducts on which Islamic finance relies.Despite all of those disadvantages, Islamicfinance has prevailed and it has not onlygrown, but grown at a faster rate.

What is the total size of the Islamicinvestment industry?

It is a very interesting question that oftenexercises me. Estimating the growth ofIslamic banking by the amount of money inbanks, it is moving towards a $4 trillionindustry, but that includes all of thesukuk-related activity and it double countsmoney in the same way that theconventional banking system does. Thatmeans Islamic banking has less than 2% ofthe world’s counted money in bankbusiness, but that ignores the amount ofnon-bank business done, for example in thetakaful industry. The Islamic economicsystem is much larger than that which ismonetised in the banking system.

How do you view the present legal andregulatory system in the UK and its impacton Islamic finance?

The government and its differentdepartments and bodies related to Islamicfinance, by which I mean particularly HMTreasury and Customs and Revenue, butalso the Bank of England, the FSA andParliament, have devoted adisproportionately large amount of time toenabling legislation to provide Islamicfinance with a level playing field. There is,therefore, no shortage of enablement in theUK for Islamic financial services to prosper;there are no inherent barriers to our businessmodel. The threats really are to actualapplication; we run ahead of the actualenthusiasm in Parliament. For example, wehave a regular debate about whether thereshould be a UK government sukuk; there is alot of demand for a government instrumentto be issued, which is something I feel we arenot in a position to support right now.Firstly, there is the controversy aboutgovernment-type borrowing, mostly puredebt instruments, which have createdproblems in the conventional market. Do we really want to bring moregovernment debt into the Islamic bankingmodel? At the same time the government islooking at the controversies that have arisenaround sukuk.

There is no standard model for agovernment to borrow money Islamically.

Sovereign sukuk structures are difficult forthe British government to understand andthat is an issue. On the other hand we dohave enabling legislation for corporatesukuk; alternative finance investment bondsdo exist. We have enthusiasm from Islamicbanks to get involved in corporate sukuk indeveloped markets such as the UK, but thereis no take up by corporates.

You have been at the forefront of promotingeducation and qualifications. How do yousee the UK’s position in this aspect of theindustry?

There would have been no career for me orfor many of my friends in Islamic financialservices without the Institute for IslamicBanking and Insurance (IIBI), whichprovided the only source of education inthis area not only in the City of London, but also across Europe. Without the IIBInone of the educational programmes thathave grown up since would have happenedand there would be no Islamic financeindustry in London or indeed in the westernworld.

What are your expectations for Islamicinvestment banking in the future?

The conventional market is at a crossroads,as too is the Islamic banking market. Wehave a choice – to become conversant withand fully embrace the compliant model orto continue finding ways to compete againstconventional banks and their unfairpractices. If the conventional bankscontinue with those practices, they will failand the economies based on them will alsofail. It is a very complex time.

I believe that, if the Islamic banks do focuson developing their natural advantages onthe basis of their economics and ifgovernments and conventional banks domanage to salvage the good practices thathave existed in Europe for hundreds ofyears before this recent crisis, then we canmove together, hand in hand, into a brightfuture. The highly leveraged and speculativebusiness lines with which conventionalbanks have become enamoured, however, isnot the future for Islamic investmentbanking.

Richard Thomas became CEO ofGatehouse Bank in August 2009 followingthe merger of the Bank with GlobalSecurities House UK Limited (a subsidiaryof The Securities House). Richard is aveteran in the field of Shari’ah-compliantfinance, with over 30 years’ experience inthe sector, he was Head of IslamicFinancial Services at the Arab BankingCorporation in London, as well as CEO ofABCIB Islamic Asset Management Limitedand Alburaq. He also held seniorpositions related to Islamic financialservices at United Bank of Kuwait andSaudi International Bank in London.Richard is also the UK Trade &Investment’s Special Representative forKuwait, assisting in the Government’spolicy on the promotion of bilateralbusiness and trade development betweenthese countries and a Fellow of theChartered Institute for Securities &Investment. In 2011, Her Majesty QueenElizabeth II bestowed Richard with thehonour of OBE, for civic excellence induties for the UK Islamic finance industry

The Institute of Islamic Bankingand Insurance (IIBI) haveentered into a Memorandum ofUnderstanding (MoU) withMetropolitan Consulting S.A.Eto help meet the need foreducation and professionaldevelopment within the Islamicfinance industry in Egypt.

Metropolitan Consulting S.A.Eprovide a variety of services inthe field of financial consultingand training including Islamicfinance consultancy and trainingwithin the SME (small andMedium Enterprise) sectors aswell as for corporate clients. Dr Shahinaz Rashad, GeneralDirector, MetropolitanConsulting S.A.E commentingon the collaboration said, ‘With the growth of Islamicfinance internationally, there is a pressing need for qualifiedShari’ah scholars and staff, andthis requires education andtraining. As a result, bankersand practitioners arehighlighting the need ofeducating staff and buildinghigh-calibre human resourceswho can take Islamic finance astep further. With this in mind,we hope that the partnershipbetween MetropolitanConsulting and IIBI will bringprosperity to the Egyptianeconomy in light of the growing need for Islamicfinance.”

Mr Qayyum, Director General,IIBI, also commented, ‘Egypt ishome to the fifth largest Muslimpopulation in the world and isconsidered by some as thenatural home of Islamic finance,because of the early innovationsthat took place there in the1960s. However, the industryhas since then grown extensivelybeyond Egypt and, therefore,education and training is vitalfor the healthy development ofthe Islamic finance industry. We are confident that thiscollaboration with Metropolitan Consulting willhelp. The industry, however, has grown extensively since thenand, therefore, education andtraining is vital for the healthydevelopment of the Islamicfinance industry. We areconfident that this collaboration with MetropolitanConsulting will help to addressthis need in the Egyptianmarket.’

Metropolitan Consulting S.A.Ewill be offering class-basedtraining in Islamic finance aswell as acting as an accreditedcentre for the delivery of IIBICertificate, Diploma and Post-Graduate Diplomaexaminations and qualifications in Egypt.Metropolitan Consulting S.A.E can be contacted atinfo@metro-egypt.com.

Dr Muhammad Syafii Antonio,Founder, Tazkia Group,Indonesia visited the IIBI officein May 2012 to meet with MrMohammad Qayyum, DirectorGeneral, IIBI. The purpose ofthe meeting was to learn aboutthe history and activities of IIBIand Tazkia Group respectively.

Dr Antonio presented the visionof Tazkia Group, which startedas a consultancy 13 years agoproviding advisory services tofinancial institutions withrespect to Islamic financialtransactions. Dr Antoniohimself is qualified as a Shari’ahscholar and is a Shari’ah advisorto several banking institutionsand takaful operators inIndonesia, Malaysia and Dubai.The Tazkia Group subsequentlyexpanded and now includesSekolah Tinggi Ekonomi IslamTazkia (Tazkia UniversityCollege of Islamic Economics).The university, which so far hasa total of 1,100 alumni andstudents, is located the southernpart of Jakarta amid beautifulsurroundings with buildingsreminiscent of Al-Andalus. Itprovides comprehensive

education in Islamic economicsand finance with the aim ofproducing graduates who arecompetent and skilled in Islamiceconomic theory and practice.The Tazkia Group expandedfurther to include microfinanceand micro takaful services thatalso combine educational andmedical services, among variousother social activities. To date,there are 14,500 micro takafulparticipants and 3,000 microfinance participantsadministrated by Tazkia.

Dr Antonio and Mr Qayyumalso discussed areas ofcooperation that may leadfurther advances in Islamicfinancial research and educationboth in Indonesia and theUnited Kingdom. Also inattendance was Mrs MurniatiMukhlisin, Senior Lecturer inAccounting and ManagementBoard Member, TazkiaUniversity College of IslamicEconomics; Mr MuhammadNasir, Researcher, IIBI and MrRahim Ali, Researcher, IIBI.Further information on Tazkiacan be found atwww.tazkia.ac.id.

NEWHORIZON July–September 2012IIBI NEWS

IIBI Collaboration BoostsIslamic Finance Education in

Egypt

IIBI Meets Dr MuhammadSyafii Antonio

Dr Antonio Meets with the IIBI

NEWHORIZON Sha’baan Shawwal 1433 IIBI LECTURES

There is ongoing work to producestandardised documents for use in thecontext of hedging. The ISDA(International Swaps and DerivativesAssociation) has developed standarddocumentation in the conventional marketand they were approached around 2006to help develop similar documentation forthe Islamic market. Mr Habib Motani,Partner, Clifford Chance, reviews theprogress of the initiative and describesthe standardised documents that haveemerged.

Background

In the mid 1980s the conventionalderivatives market faced the same sorts ofissues in relation to standardised documentsthat the Islamic market faced 20 years later.There were a relatively small number ofplayers, with others looking to participate.As a consequence people were working offtheir own bespoke documents, so a clientcould end up trying to compare three orfour different sets of documents and thiswas also a problem for providers. Theexperience for Islamic providers morerecently has been exactly the same.

This probably would not be too much of anissue without the strong growth of theIslamic finance markets over the last 10-20years. Individual institutions have grown to asize where they have a range of assets andliabilities and alongside this there is a greaterpotential for mismatches on their books. Thequestion is whether this is an issue that needsto be addressed; is it going to constrain

growth. If it is decided it does need to beaddressed, how can this be done best.

The other important aspect of this growth isthat Islamic banks are increasinglyinternational. Not only do they have branchesand clients in a number of countries; theirinvestments are also international. That bringscurrency risk with it.

The increasing demand for thestandardisation of documents is therefore areflection of the growth and increasingmaturity of the Islamic finance industry.Ultimately it contributes to efficiency,liquidity and to a degree certainty.Potentially it might also reduce costs,because transactions become easier and it,therefore, levels the playing field betweenthe conventional and Islamic industries.

The Starting Point

The features of standardised documentationare not particularly complicated and are verymuch the same for Islamic finance as they arefor any other market seeking to achievestandardisation, apart from the need to ensurethat documentation is Shari’ah compliant.

Obviously, if you are producingdocumentation for hedging purposes, it needsto provide the necessary hedge; it has to beenforceable and, perhaps debatably, it shouldalso contribute to risk management andmitigation. Risk management and mitigationtended to be missed out of the documentationdeveloped by individual organisations forparticular trades, but it is one of the majorcontributions of the ISDA/IIFM initiative. Ina sense it is that risk management/mitigationpart that has taken time.

Shari’ah Compliance

There is an ongoing debate in the Islamicfinance market about whether derivatives are

compatible with Shari’ah at all, but thatneeds to be put into the context of the factthat derivatives in the conventional sector arecontentious. Hardly a day goes by withoutthe media ‘having a go’ at derivatives.

Scholars accept that risk management is asensible thing for any business to be doing.Some of them would probably go furtherand say it is not just sensible; it is necessary.The message that comes down from thescholars is, that if you are hedging actualrisk, that is okay; there is nothing noncompliant about that. If you are speculatingthat is a completely different story.

You must have real transactions, realtransfers of ownership and risk, with nointerest involved in order to implementsome of these strategies. These caveats areincluded in an appendix to the derivativesmaster agreement published by the IIFM.Interestingly, with the exception of interest,these types of principles have applied tomany industries. For example, in the UKand many other countries until recently theonly authorised derivative activity forinsurers was hedging.

Enforceable Structures

Enforceability raised particular issues in thedevelopment of Islamic standarddocuments. In the documents that have beengenerated so far, the tahawwut masteragreement and the profit rate swapagreements, ‘wa’ad technology’ is used.Wa’ad is an acceptable Islamic instrumentthat can be binding on the individuals andorganisations involved and by bringing thattogether with contractual obligations, theagreements deliver enforceability.

Optimal Risk Management

The objective of the ISDA/IIFM initiativewas not to just develop documents that

IIBI Monthly Lecture Series –April–June 2012

NEWHORIZON July–September 2012IIBI LECTURES

were standard, enforceable and Shari’ahcompliant, but also delivered optimal riskmanagement and risk mitigation. From acontractual point of view the masteragreement has done what it can, but one ofthe major problems is the fact thatinsolvency laws vary from country tocountry. In some countries insolvency lawsrecognise the effectiveness of netting andclose out agreements, but in others they donot and unfortunately a lot of thejurisdictions to which Islamic finance isrelevant fall into the latter category.(Netting is where trading partners agree tooffset their positions or obligations as abasis for settling their outstandingobligations.)

The master agreements are an importantand necessary step, but it is not the end ofthe story. There are ongoing efforts topersuade various jurisdictions to changetheir laws to make enforceability possible.One recent success has been Russia, whichdid not have personal or corporateinsolvency laws. In the Gulf countries,however, there is currently no certainty thatnetting will be recognised. Malaysia andSingapore have relatively good positions,although Indonesia is a bit more debatable.

The Tahawwut Master Agreement

The Tahawwut Master Agreement is anumbrella that sits above all the transactionsthat take place. It has close out and nettingmechanisms to aggregate and maximise therisk management opportunity and it drawsheavily on the conventional standards thatISDA has developed over the years. Itsphysical layout is also very much in theISDA style, with which many organisationsare already very familiar, which makes iteasier to use.

If you look at the governing law section,there is no reference to Shari’ah in it. At anearly stage there was a discussion withscholars about the best approach toreferencing Shari’ah. At that point (andindeed this was confirmed towards the end ofthe drafting process) they said that no Islamicinstitution should enter into an agreementunless they were satisfied, having gonethrough their own internal processes, that the

proposed agreement was Shari’ah compliant.Once they have done that and entered intothe agreement in good faith, they haveaccepted the obligations; they are binding.Even if, some years down the line, there arequestions about whether the agreement wastruly Shari’ah compliant, there is no ability torenege on those obligations. The only courseof action is not to enter into any similaragreements in the future.

The discussion of the section on earlytermination was particularly protracted.The objective was to produce documentsthat were optimal in view of the treatmentof regulatory capital. The agreement wasdevised in order to compensate anon-defaulting party in the event that thecounter-party defaults as such an eventwould leave the non-defaulting partyunhedged requiring them to enter into anew hedging agreement which would becostly. Therefore, a musawamah mechanismis built into the master agreement wherebythe aggregate amount of the cost is treatedas an index and is used as the basis of thepurchasing price under a musawamahcontract. This mechanism allows the non-defaulting party to exercise a wa’ad of thedefaulting party in order to recover any lossvia the musawamah sale. It should,however, be noted that if the market hasmoved in the non-defaulting party’s favourwhereby it would have been cheaper tohedge, the defaulting party would also beable to exercise the wa’ad of the non-defaulting party thereby making any gainrecoverable as well as any loss. Thismechanism was very deliberately included inorder to facilitate the regulatory capitaltreatment of these transactions.

Profit Rate Swap Structures

When you have floating profit rate flows,the mechanism that is used to get themacross from one party to the other is on thebasis of a murabahah transaction. Thescholars are very clear that real movementof assets, money and risk is needed and allof this is built into the profit rate swapstructures. The obligation to enter into amurabahah is based on the wa’ad eachparty has given. The documentation hastried to allow parties to implement these

transactions, either by having two sales or,as is increasingly common in the market,single sale, where the profit element is thedifference between the fixed and floatingrates. There is also flexibility in terms oftiming, so that the murabahah can beentered into either at the beginning or endof the calculation period.

Conclusion

The growth of the market is bringing with itthe need for these sorts of products; riskmanagement and hedging are normal forboth Islamic and conventional finance.Limiting activities to risk management andavoiding speculation is normal in bothmarkets and that is why these products areperfectly acceptable; that is what has comeout of the discussions that have taken placewith scholars.

We have had to structure the documentationa little bit to make it work from a Shari’ahpoint of view. In other respects, however,the exercise has been exactly the same asany other attempt to develop standardiseddocumentation.

Habib Motani is a partner at CliffordChance specialising in derivatives, capitalmarkets and financial markets. He isinvolved in various initiatives to developstandardised documentation for Shari’ahcompliant derivatives and repotransactions.

NEWHORIZON Sha’baan Shawwal 1433 IIBI LECTURES

Family takaful, in Western terms lifeinsurance for the Muslim community, is afairly recent development. Bank AlJaziraTa’awuni was the first provider to open forbusiness in 2002. Mr Dawood Taylorreviews the development and progress oftakaful.

Shari’ah Issues

There is a broad spectrum of beliefs inrelation to takaful. At one end is there is noacceptance whatsoever of any form ofinsurance, either conventional or takafuland at the other even conventionalinsurance is believed to be acceptable toMuslims. It is difficult to understand thelatter point of view given the nature of theinvestments in conventional insurance andmore particularly the issue of transfer risk.In conventional insurance the client pays apremium and the risk is transferred to theinsurance company, whereas in takaful thepremium is paid into a mutual pool wherethe participants protect each other throughthe lifetime of their contracts.

In the development of takaful it is necessaryto have a Shari’ah board that isknowledgeable; prepared to work with thetakaful provider in each aspect of thecontract and ultimately issue a fatwa. It wasexpected that concerns about shari’ahcompliance would be the main obstaclewhen marketing takaful; however, the fatwaissued by the Shari’ah board overcame thisissue. Rather, the main obstacles faced bytakaful providers were exactly the sameones that a conventional insurer faces everyday – ‘we have no money; come back nextmonth.’

Takaful Products

The question that frequently comes up atconferences is, ‘Why can’t takaful productsbe different from conventional insuranceproducts?’ The answer is that Muslims facethe same problems as non Muslims. Bothcommunities need protection throughouttheir lives such as pension provision, criticalillness protection and education for their

children. One exception is policies coveringmarriage – in the Islamic community thecosts associated with marriage are veryhigh, but in general the needs of individualsare the same regardless of their religious orethnic backgrounds; there is no need todream up extravagant products that willapply to very few people.

The difference with family takaful is thatthey are effectively savings products, notpension funds. In the conventionalinsurance industry a policy holdercontributes capital, but the capital does notbelong to the policy holder; in takaful thepool of money created by the policy holder’s‘saving’ is available either to continue beinginvested in the takaful company, as a lumpsum repayment or to be drawn down inweekly or monthly payments.

In the current state of market development inAsia and the Middle East there is a need tocome in at the grassroots level; to have clientssave for the future. During the period of thecontract they will be paying a tabarru, acharitable donation into a mutual pool thatwill provide protection should there be anadverse event. If an individual simply had asimple savings account and 12 months downthe line that individual was killed or injuredin an accident, the family would only receivethe amount saved during that period; withfamily takaful the savings would be returnedplus a more significant protection element.Takaful never goes against the will of Allah;it is there in case of the will of Allah.

Risk Management

The IFSB (Islamic Financial Services Board)believe that in takaful, specifically familytakaful, there is a hybrid situation, which isneither a full joint stock operation nor a fullmutual/cooperative. It is effectively a jointstock, commercially-minded enterprisecoming into the Islamic financial servicesindustry to operate a takaful companycombined with the mutual, cooperativeprinciples that apply to the participantswithin the risk pool. This means there aresome potential governance and conflict ofinterest issues.

One of the primary issues is aroundunderwriting risk. In takaful, the risk is not

transferred to the operator; it is retainedwithin the risk pool, but the risk pool ismanaged by the operator on behalf of theparticipants. The operator must also ensurethat investment strategies are not to thedisadvantage of the participants.

It is acceptable in takaful for a percentage ofthe return on the investment pool to beshared with the operator, usually on thebasis of a mudabarah contract, but it canalso be done under a wakala contract.(Currently, under the IFSB rules, the takafuloperator may participate in any surplusgenerated by operating the underwriting ona wakala basis. There are other schools ofthought that believe an operator should notparticipate in any surplus, regardless of thecontract being used.) It is essential, however,to make sure the operator is not takingundue risks, which would be to thedetriment of participants in the scheme, aswell as the shareholders, the owners of thebusiness. Clearly unwise investmentstrategies would not only have a financialimplication, they would also be damaging toan operator’s reputation, which in turn

Dawood Taylor is Senior RegionalExecutive-Takaful, Middle East forPrudential Corporation Asia responsiblefor developing Life Takaful throughout theregion Dawood is a member of the IslamicFinancial Services Board (IFSB) TakafulGovernance and Takaful SolvencyCommittees and is also a member of theInternational Cooperative and MutualInsurance Federation (ICMIF) IntelligenceCommittee.

NEWHORIZON July–September 2012IIBI LECTURES

would damage their prospects in themarketplace.

Unique to takaful is the added burden ofShari’ah compliance. Operators need toensure that decisions taken at the Shari’ahboard level are implemented in productdevelopment, contractual terms and indeedin the overall running of the business.

Business continuity risk lies mainly in thepotential for operators to adopt high-riskinvestment strategies to keep prices down inorder to attract more customers. This couldresult in poor results and the issue of aqard-al-hasan (an interest-free loan) tomake good any deficit. If the operator failsto review their high-risk, low-price strategy,business continuity could be threatened.

A great many of the developments inIslamic finance have come fromconventional financial institutions thathave embraced the opportunity tobecome involved in an alternative methodof financing. This, however, has alsoproduced criticism, especially in relationto the degree to which transactionsremain Shari’ah compliant. Mr Asim Khandiscusses the issue.

Evolution of Islamic Finance

In order to be able to place the role ofconventional financial institutions inperspective, it is be helpful to revisit theevolution of the Islamic finance industry.Starting in 1975 through to 1990, Islamicfinance was concentrated on commercialbanking while syndication and Islamicconglomerates provided further initialimpetus for the growth of the industry. Fromthis initial period to 1991–2001, theexposure of Islamic finance grew from anestimated population of 20 million to100 million and brought about the growth

of private equity and fund management.After 2001, demand has increasedsignificantly and this has led to the creationof Islamic ‘window’ operations andsubsidiaries of ‘mega-banks’ in addition toconversions. Investment banking and capitalmarkets especially have brought significantgrowth to the market through structurednotes/sukuk and large-scale project finance.

Financial Transactions – Criteria forShari’ah Compliance

Islamic finance of course is an industry thatrequires transactions to adhere to theguiding principles of the Islamic tradition(i.e. Shari’ah). Shari’ah scholars haveestablished that corporations andinstitutions do not have any religion; butrather, it is their operations that determinetheir Shari’ah compliance. A corollary tothis is that Islamic finance focuses ontransactions rather than counterparties (the only exception to this being the casewhere the transaction relates to the equity stake of a counterparty). Accordingly,it is accepted that under Shari’ah,conventional companies can fullyparticipate in Islamic financial transactions,provided that such transactions adhere togenerally accepted Shari’ah guidelines.

In light of this, there are a number ofimportant considerations. The first is theunderlying purpose or stated intention ofthe transacting party. If a party has theintention to set-up a non-Shari’ah-compliantbusiness, the transaction cannot be Shari’ahcompliant. On the other hand, if a partyintends to set-up a Shari’ah-compliantbusiness (regardless of whether the party isa conventional institution or otherwise)there should be no objection. Furthermore,the underlying asset and the mechanism ofexecuting the transaction should beShari’ah-compliant. Finally, the legaldocumentation must capture theseconsiderations appropriately.

Conventional Financial Institutions –Shari’ah Considerations

If a conventional financial institution wishesto engage in Islamic finance, what do theyneed to consider? To begin with, there is a

need to appoint a Shari’ah SupervisoryBoard (SSB) – an independent body ofspecialised jurists in Islamic commercialjurisprudence. Another importantrequirement is the appointment of legaladvisors who will put together thedocuments for the transaction. A thirdaspect is the product documentation itselfand the legal advisors will need to structurethe product so that it will be acceptable tothe SSB. As such, a fatwa (legal opinion of aqualified jurist) will be issued after the legaland product documentation has beenprepared.

The fatwa plays a vital role in Islamicfinance. Typically, conventional banks useterm sheets as a marketing tool for theirproducts; however, when you areconsidering Islamic finance the fatwa isextremely important for Islamic investors.To address this importance, the fatwadocumentation should be released to clientson time so that any possible doubts aboutShari’ah compliance are addressed.

Another related aspect is the understandingof Shari’ah amongst the sales team. If thesales team do not have sufficient knowledgeto adequately answer questions aboutshari’ah, this impacts the image of theproduct and may lead to doubts aboutShari’ah compliance.

A final point is ‘on-going’ Shari’ahcompliance. The fatwa states that theproduct’s structure and legal documentationare Shari’ah compliant, but what about on-going compliance? These are the types ofquestions that are raised by investors and,therefore, the conventional institutionshould ensure a sufficient monitoring andShari’ah review process.

Boon or Bane?

It is critical for conventional financialinstitutions to realise the importance ofstrict adherence to Shari’ah principles. Inthe absence of this, such participation in theIslamic finance industry could be harmful tothe industry as a whole as well as to theinstitution themselves. On the other hand,the entry of conventional financialinstitutions into Islamic finance could help

NEWHORIZON Sha’baan Shawwal 1433 IIBI LECTURES

streamline industry practices and ensure thedevelopment of a robust industry ready tooffer pragmatic Shari’ah-compliantalternative solutions to modern-dayfinancial requirements in the view of thefollowing factors:

• Experience – benefit from greaterknowledge of products and markets

• Sophistication – sophistication withproducts and support to customers

• Infrastructure – making complex productstructures possible

• Customer base/reach – much wider forconventional entities

• Transaction size – can facilitate largetransactions

• Product research and development –significant investment in the area ofR&D

Case Study – Murabaha Sukuk Structure

Acknowledging that the participation ofconventional financial institutions does havepotential benefits for the Islamic financeindustry, what are the Shari’ah issuesgenerally raised from common structuresused by financial institutions?

A first issue is whether the structure involvesmurabaha or tawarruq. Some Shari’ahscholars have raised concerns regardingtawarruq and, as a result, limitations havebeen placed in legal documents stating thatonce the financial institution has attainedownership of the commodities they are notpermitted to sell them to the samecommodity broker from whom they boughtthem. It is also important to know what thecounterparty will do with thosecommodities. For example, if theconventional financial institution has a largecommodity trading desk, part of its normalbusiness is to buy and sell commodities.They hold these commodities on theirbalance sheet and consequently they have areason to buy commodities to enhance theircommodities trading business. If, however,the institution has no intention of keepingthe commodities on their balance sheet, thenwe have an indication of their intention,which is to sell immediately. These are theaspects that Shari’ah scholars considerbefore issuing a fatwa.

Another question is how will the proceeds(i.e. cash) be used. In the case of themurabaha sukuk the SPV (Special PurposeVehicle) uses the proceeds to buy thecommodity – that is the use of proceeds.The commodities are then sold to thefinancial institution. Thus, what thefinancial institution receives is not cash, butcommodities. From a Shari’ah perspective,the financial institution owns thosecommodities. Although it has an obligationto make a payment, it owns thosecommodities. It can use them for its owntrading purposes or for any other purpose.It can sell them the same day, the next dayor hold them on its balance sheet.Regarding the use of the proceeds,therefore, this is only applicable to the SPVto the extent that it uses the proceeds to buythe commodities.

It should be noted, however, that withdifferent mechanisms the use of proceeds isnot the same. For example, under a wakalahsukuk structure, the asset is going togenerate revenue; consequently, there will bea conventional institution managing aportfolio and the use of proceeds is theassets in that portfolio. With an ijarahsukuk structure, where a conventional bank sells a property to an SPV and leases it back, the use of proceeds concerns howthe cash was used to buy the property from the conventional bank. When,however, we are considering a murabahasukuk, we are looking at a sales transactionwhereby one party has price as itsconsideration and the other party an asset.In this instance, it is not appropriate to gobeyond the transaction and question howthe asset or cash will be used, unless of course additional information is available which would invalidate thetransaction.

A third question relates to whethermurabaha sukuk can be listed and traded.Firstly, it should be noted that murabaha isa debt and under AAOIFI guidelines, themurabaha sukuk can be traded but only atpar (although a different interpretation isfollowed in Malaysia where they allowmurabaha sukuk to be traded at a value thatis different to par). With respect to listing –this is not a Shari’ah requirement nor is it

necessarily a concern. If the sukuk is listed,it does not mean that it will be traded. Thereason why sukuk are often listed is becauseof associated legal, tax and economicbenefits that arise from doing so.

Conclusion

Islamic finance is for all and Shari’ah doesnot prohibit conventional financialinstitutions from entering into Islamicfinance. Furthermore, Islamic productsissued by conventional financial institutionsmust be approved by an SSB. To quote awell-respected Shari’ah scholar, DrMuhammad Elgari, ‘An institution has noreligion and therefore cannot be judged onreligious grounds. Our judgment is alwayson the structure of the transaction andwhether it is permissible or not and has thenecessary Shari’ah requirements.’

Asim Khan, Managing Director, Dar AlIstithmar, one of the first Islamic financeadvisory firms, is a chartered accountantwith many years’ experience in bothconventional and Islamic financialinstitutions as well as the oil and gasindustries across the Asian sub continent,the Middle East and Europe, working withtop tier organisations such asPricewaterhouseCoopers, KPMG andDeutsche Bank. He has also worked withworld renowned Shari’ah scholars from theMiddle East and Far East, coordinating theShari’ah review and sign-off process forclients. He has also helped his clients inraising Islamic finance and with placementof Islamic financial instruments.

Mohammad Altaf Madraswala, General Manager, National InsuranceCompany Limited, Pakistan

The course was designed in a very precise and practical manner toenhance the understanding and knowledge of the students. The coursecontents are authentic, duly disclosing the source, which furtherenhances its viability, while keeping in view practical market practicesprevailing in today’s banking and insurance industries.

Muhammad Zulhisham Zolkepli, Senior Executive Officer, TakafulBrunei Keluarga, Brunei Darussalam

Normally, in the industry, courses are covered in short one or two dayseminars, which I think is too intensive to achieve a good understandingof the subject. The IIBI Certificate in Takaful course, however, is unique

as its ‘distance learning’ method of study imitates a full class-basedcourse,while also providing a Certificate and transcript of achievement.

NEWHORIZON July–September 2012IIBI NEWS

Post Graduate Diplomas

To date students from nearly 80 countries have enrolled in the PGD course. The course isopen to those with a graduate degree or those who have completed the IIBI’s Diploma inIslamic Banking. In the period April to June 2012, the following students successfullycompleted their studies:

Abdul Jabbar, Consultant, UK

Idris Mukhtar, Nigeria

Mobeen Ahmed Khan, Pakistan

Sakhir Al Shankiti, Risk Reporting & Monitoring Manager, ICD/IDB, Saudi Arabia

Yasir Gulfraz, Quality Analyst, Caterpiller, UK

Usman Muhammad, Specialised Institutions and Discount Houses Group, Central Bankof Nigeria, Nigeria

Muhammed Huzaifah, Senior Executive – Shari’ah Audit & Compliance, AmanaTakaful Insurance, Sri Lanka

Oyindamola Mutiat Dada, Banker, GTBank, Nigeria

Mohammad Ahmed Nawaz, Senior Process Associate, Societe General, India

Mohamedi Ally, Islamic & Arabic Studies Teacher, West Midlands Swahili Association, UK

Mohammad Sami Khan Bundhoo, UK

Mohammed Aslam Merchant, Planning Consultant, Saudi Aramco, Saudi Arabia

Certificates in Takaful

The IIBI’s Certificate in Takaful waslaunched in July 2010 and is aimed atindividuals who wish to develop anunderstanding of the nature and basis oftakaful and its applications as an alternativeto conventional insurance. In the periodApril to June 2012 the following studentssuccessfully completed their studies:

Abdur Rasheed Abiodun Babalola,Nigeria

Muhammad Zulhisham Zolkepli,Senior Executive Officer, Takaful BruneiKeluarga, Brunei

Hamid Rustamov, Savings Consultant,GTZ, Tajikistan

Maher Ghneim, Internal Auditor,Central Bank of UAE, UAE

Nurul Huda Ahmad Nawawi, UK

Nurul Iman Azwan, Senior Executive,Islamic Banking & Takaful Department,Central Bank of Malaysia, UK

IIBI Awards Post Graduate Diploma and Certificate Qualifications

NEWHORIZON Sha’baan Shawwal 1433 IIBI NEWS

July

10–11: 3rd Annual Asia Islamic BankingConference, Kuala Lumpur, Malaysia

This event in Kuala Lumpur will addressissues such as asset management on Shari’ahprinciples, capital markets and equity anddebt and risk management in Islamicbanking.

Contact: Karthik NaikTel: +971 4 6091570Email: karthik.naik@fleminggulf.comwww.fleminggulf.com

10–12: International Takaful Summit,London

The two-day conference titled ‘Takaful andRe-takaful – Planning to Overcome theChallenges to Growth’ will be chaired by DrAlberto Brugnoni and will address topicssuch as regulations, risk management andmanaging liquidity pools. On the day prior tothe main conference, 10 July, there will be aone-day master class for which delegates canregister separately. A dinner on the evening of11 July will also see the presentation of theInternational Takaful Awards nominationsfor which close on 4 May 2012. This event isendorsed by the IIBI.

Contact: Randa BuarasTel: +44 (0)8861 2012Email: info@takafulsummit.comwww.takafulsummit.com/2012

September

7–9: Structuring Innovative IslamicFinancial Products, Cambridge

The Institute of Islamic Banking andInsurance’s ever popular residential summerworkshop will take place at FitzwilliamCollege, Cambridge this year. Theworkshop, in its 6th year, has interactivesessions and lectures from leading

practitioners focusing on innovation anddifferentiating Islamic financial productsfrom those offered by the conventionalfinancial sector. This year the leaders of theworkshop will include Dr Salman Khan,Head of the Shari’ah Office at a leadingGCC bank and Dr. Asyraf Wajdi Dato’Dusuki, Associate Professor and Head ofResearch Affairs, ISRA, Malaysia.

Contact: Farhan QuadriTel: +44 (0)20 7245 0404Email: farhan.quadri@islamic-banking.comwww.islamic-banking.com

10: 4th IIBI-ISRA Annual InternationalThematic Workshop 2012, London

The IIBI-ISRA Annual InternationalThematic Workshop is a unique event, heldin London, which brings together seniorindustry practitioners, Shari’ah scholars andacademicians to debate and discuss a themethat is relevant to the application ofShari’ah in Islamic finance. The last threeyears have included discussions on thetopics ‘Governing Law in Islamic Finance’,‘Managing Shari’ah Risk through Shari’ahGovernance’ and ‘Form versus Substance inIslamic Finance’. The programme can beattended by invitation only, therefore, pleasecontact IIBI if you wish to attend.

Contact: Rahim AliTel: +44 (0)20 7245 0404Email: rahim.ali@islamic-banking.comwww.islamic-banking.com

17–18: 1st Middle East Life and FamilyTakaful Summit, Dubai

This two-day summit will bring togetherlocal, regional and global player in life andfamily takaful to provide a review of thecurrent market in the Middle East. Inparticular it will examine the issue ofdistribution and its role as a key strategy ingrowing the life market.

Contact: Ms LogaTel: +65 6372 3184Email: loga@meinsurancereview.comwww.meinsurancereview.com

October

1–2: Issuers and Investors Asia Forum,Kuala Lumpur

The conference will include countrypresentations from Indonesia on Issuers Dayand from Sri Lank on Investors Day. Therewill also be a Takful and Retakaful Dayrunning in parallel with Investors Day. Byearly June 650 delegates had already beenregistered.

Contact: Cindy WongTel: +603 2162 7800 Ext. 46Email: Cindy.Wong@REDmoneyGroup.com

www.REDmoneyevents.com

2–3: Islamic Banking, Accounting andFinance Conference 2012 (iBAF 2012)

This conference will examine strategies forexpanding the reach of Islamic financeagainst a background of globaldisenchantment with conventional financial services. Its theme will be ‘Innovation and Transformation in Islamic Banking, Accounting and Finance; Issues, Opportunities andChallenges’.

Tel: +606 7986 460Email: ibaf2012@confbay.comwww.ibaf2012.webs.com

14–16: Islamic Finance in a ChangingWorld, Abu Dhabi

The conference will consider the significantpolitical and socio-economic developmentsthat have occurred recently and theirprobable effects on the performance andfuture position of Islamic financialinstitutions (IFI’s), regulatory frameworksand popularity of Islamic products beingoffered to the public, governments andbusiness firms.

Tel: +44 (0)1274 777700Email: IIFC@emeraldinsight.comwww.emeraldinsight.com

Diary of Events

NEWHORIZON July–September 2012BOOK REVIEWS

In a world today faced with financial crisesand moral dilemmas that are shaking thefoundation of the free-wheeling capitalisteconomy, this book is well worth reading.Mawdudi’s writings on Islamic economicsreaffirm the importance of a just economicsystem that has at its heart moral values andpublic welfare objectives.

The book is divided into two parts; part onedeals with the Islamic concept of economicwellbeing, while part two discusses somebasic features of the economic system ofIslam. Mawdudi relies on the concept ofeconomic wellbeing based on the teachings inthe Qur’an and elucidates the vision of theIslamic economic system, then goes on to dealwith the question of interest and the place ofZakat in social life, zakat being a mandatoryobligation on moral grounds requiringindividuals to distribute a certain percentageof what is deemed as excess wealth to the lessfortunate members in society.

In his introduction Mawdudi says, ‘Islam isprincipally concerned with the strictobservance of its basic principles on apermanent basis, under all circumstancesand all times, irrespective of the shape thatthe economic affairs of mankind may take.’In his conclusion, however, he considers therecodification of the economics of Islam.This is because he takes the pragmatic viewthat the present global scenario is not thesame as it was in the past. The forms ofeconomic dealings have changedconsiderably. While he argues that there isthe need to modernise, he also warns of ‘theway that a group of modernists amongst us

would like to recodify laws, guided andgoaded by their own whims. This amountsnot to a recodification of the Shari’ah Laws,but a daring attempt to distort them wilfully… their sole interest is to earn wealth, whileIslam impresses upon a Muslim the need toearn through halal means, and altogethershun anything haram.’

Mawdudi advocates an approach thatrequires rules and regulations forundertaking the task of recodification.These include a comprehensiveunderstanding of the Shari’ah, undertakinga complete overview ‘of the injunctionspertaining to a particular requirement inwhich legislation is required, followed by acareful study of these injunctions tounderstand the real objectives of the Law-giver’; having ‘a thorough knowledge of theprinciples of legislation and the stylefollowed by the Law-giver in order tocarefully observe these in legislation’ andlooking at the changing circumstances andsituation that call for modification, whileremaining within the dictates of theShari’ah, ‘its legal vision and its objectives.’He also reflects on two controversial areas -first on the general rules of exception, wherethe Shari’ah offers sufficient room to relaxthe rules in exceptional cases that may leadto hardship and injustice and second heexplains the compelling and exceptionalcircumstances that would justify therelaxation in case of interest, which, in hisview, in the realms of finance are very few.

While Mawdudi may have drawn upon theteachings of the Qur’an and Sunnah, he has

spelt out important elements of a paradigmshift in economic thinking, not necessarilynew, which requires economic pursuits totake place in the context of moral valuesand directed towards the achievement ofpersonal and public welfare objectives forthe betterment of society as a whole. Hisjudgement that the Islamic economic system‘is closely interlinked with its political,judicial, legal, civil and social system, whilethese are all based on its moral code’ shouldoffer pathways to genuine economicdevelopment and justice and fairness ineconomic dealings.

First Principles of Islamic Economicsby Sayyid Abu’l A’la Mawdudi. Publisher: The Islamic Foundation (2011)ISBN: 978-0-860037-482-3 ‘First Principles of Islamic Economics’ is a translation into English of the writings onIslamic economics by Abu’l A’la Mawdudi (1903 –79), an important Muslim scholar ofthe twentieth century. They were written to explain and elucidate the principles andinjunctions that govern the Islamic economic system, which is based on what theauthor refers to as ‘the twin concepts of justice and fair play’.

NEWHORIZON Sha’baan Shawwal 1433 BOOK REVIEWS

The book is divided into 39 chaptersproviding a concise summary of differentarguments. While Davies does occasionallyoffer his own opinions, the book wouldhave benefited had the author included hisown judgments on who or what was toblame. In the book a large number ofsuspects are identified, from greedyinvestment bankers, weak and ineffectiveborrowers, regulators delaying action and

central bankers without a long-rangeperspective in thinking and planning to theimpact of violent video games, whichapparently contributed to the under-performance of traders. Other potentialculprits point to the economists who talkedof rational decision making andinformation-efficient financial markets.

The book’s major shortcoming, like manyothers on the subject, is that it fails toanalyse the real intention behind thepractices of individuals. Rather thansuch practices being declared asimmoral, such practices are creepinginto the global financial system andbecoming accepted as a way of life. Hefails to comment on how bankers andother corporate interests lobbiedregulators and captured politicians towater down rules that appliedregulation of financial practices andunquestioning application ofaccounting rules. At time it seems thatDavies may have been trying to arguethings might be a little more complexthan placing the blame on the‘immoral’ conduct of ‘greedy bankers’.

Davies’ approach overlooks theevidence of human intentions andimmoral practices as well as thefailures of stricter risk and capitalmanagement requirements and thestrengthening of corporate governancethat allowed financial institutions andtheir accomplices to get away at timeswith some of the worst fraudulent

The Financial Crisis: Who is to Blame?by Howard Davies. Publisher: Polity Press, Cambridge (2010, reprinted 2011)ISBN -13: 978-07456-5164-4 ‘The Financial Crisis: Who is to Blame?’ by Howard Davies, former Chairman of theUK Financial Services Authority and Director of the London School of Economics andPolitical Science, focuses on the failures of the regulatory environment in preventingreckless lending and personal debt from growing and precipitating the financialcrisis.

practices. According to Warren Buffetfinancial innovation led to the design offinancial products that he viewed asweapons of mass destruction!

Even though Davies’ book does not describeclearly who or what is to blame for thefinancial crisis, which has continued toengulf the world since 2007, it does providesome insight into financial ethics. Theimportant debate here is that governments,regulators and stakeholders all need to beopen and less fearful of working with allsections of the world community to producea blueprint for reform that genuinelyaddresses the need to put in place a robustmoral behavioural code that regulates a justand fair financial system as well ashopefully offering solutions to the globalfinancial crisis.

There will be many who will oppose theintroduction of any form of moral code onthe grounds that it is considered a body ofreligious law although, as in the case ofShari’ah, it is quite capable of supervisingand regulating economic and financialtransactions to achieve human solidarityand a better world. There are surely manybenefits to be derived from the applicationof ‘religious’ values; it should not beignored that Christian values, whichunderscored much of the English andEuropean legal traditions and led to ageneral agreement on shared moral values,are still the foundation to the structure ofsociety not only in the Western world, butalso elsewhere.

NEWHORIZON July–September 2012GLOSSARY

An Islamic version of option, a deposit for the delivery ofa specified quantity of a commodity on a predetermineddate.

This refers to the selling of an asset by the bank to thecustomer on a deferred payments basis, then buying backthe asset at a lower price, and paying the customer incash terms.

A murabaha contract using certain specifiedcommodities, through a metal exchange.

A ruling made by a competent Shari’ah scholar on aparticular issue, where fiqh (Islamic jurisprudence) isunclear. It is an opinion, and is not legally binding.

Lit: uncertainty, hazard, chance or risk. Technically, saleof a thing which is not present at hand; or the sale of athing whose consequence or outcome is not known; or a sale involving risk or hazard in which one does notknow whether it will come to be or not.

A record of the sayings, deeds or tacit approval of theProphet Muhammad (PBUH).

Activities which are permissible according to Shari’ah.

Activities which are prohibited according to Shari’ah.

A leasing contract under which a bank purchases andleases out a building or equipment or any other facilityrequired by its client for a rental fee. The duration of thelease and rental fees are agreed in advance. Ownership of the equipment remains in the hands of the bank.

A sukuk having ijara as an underlying structure.

The same as ijara except the business owner iscommitted to buying the building or equipment orfacility at the end of the lease period. Fees previouslypaid constitute part of the purchase price. It is commonly used for home and commercial equipmentfinancing.

A contract of acquisition of goods by specification ororder, where the price is fixed in advance, but the goodsare manufactured and delivered at a later date.Normally, the price is paid progressively in accordancewith the progress of the job.

Gambling – a prohibited activity, as it is a zero-sumgame just transferring the wealth not creating newwealth.

A form of business contract in which one party bringscapital and the other personal effort. The proportionateshare in profit is determined by mutual agreement at thestart. But the loss, if any, is borne only by the owner ofthe capital, in which case the entrepreneur gets nothingfor his labour.

In a mudarabah contract, the person or party who actsas entrepreneur.

A contract of sale between the bank and its client for thesale of goods at a price plus an agreed profit margin forthe bank. The contract involves the purchase of goods bythe bank which then sells them to the client at an agreedmark-up. Repayment is usually in instalments.

musharakahAn agreement under which the Islamic bank providesfunds which are mingled with the funds of the businessenterprise and others. All providers of capital are entitledto participate in the management but not necessarilyrequired to do so. The profit is distributed among thepartners in predetermined ratios, while the loss is borneby each partner in proportion to his contribution.

An agreement which allows equity participation andsharing of profit on a pro rata basis, but also provides a method through which the bank keeps on reducing its equity in the project and ultimately transfers theownership of the asset to the participants.

An interest-free loan given for either welfare purposes or for fulfilling short-term funding requirements. Theborrower is only obligated to pay back the principalamount of the loan.

In a mudarabah contract the person who invests thecapital.

Reinsurance based on Islamic principles. It is amechanism used by direct insurance companies toprotect their retained business by achieving geographicspread and obtaining protection, above certain thresholdvalues, from larger, specialist reinsurance companies andpools.

Lit: increase or addition. Technically it denotes anyincrease or addition to capital obtained by the lender as a condition of the loan. Any risk-free or ‘guaranteed’rate of return on a loan or investment is riba. Riba, in allforms, is prohibited in Islam. Usually, riba and interestare used interchangeably.

Salam means a contract in which advance payment ismade for goods to be delivered later on.

Refers to the laws contained in or derived from theQuran and the Sunnah (practice and traditions of theProphet Muhammad (PBUH).

An authority appointed by an Islamic financialinstitution, which supervises and ensures the Shari’ahcompliance of new product development as well asexisting operations.

A contract between two or more persons who launch a business or financial enterprise to make profit.

Similar characteristics to that of a conventional bondwith the key difference being that they are asset backed;a sukuk represents proportionate beneficial ownership inthe underlying asset. The asset will be leased to the clientto yield the return on the sukuk.

A principle of mutual assistance.

A donation covenant in which the participants agree to mutually help each other by contributingfinancially.

A form of Islamic insurance based on the Quranicprinciple of mutual assistance (ta’awuni). It providesmutual protection of assets and property and offers joint risk sharing in the event of a loss by one of itsmembers.

A sale of a commodity to the customer by a bank ondeferred payment at cost plus profit. The customer thensells the commodities to a third party on a spot basis and gets instant cash.

The diaspora or ‘Community of the Believers’ (ummatal-mu’minin), the world-wide community of Muslims.

A promise to buy or sell certain goods in a certainquantity at a certain time in future at a certain price. It is not a legally binding agreement.

A contract of agency in which one person appointssomeone else to perform a certain task on his behalf,usually against a certain fee.

An appropriation or tying-up of a property in perpetuityso that no propriety rights can be exercised over theusufruct. The waqf property can neither be sold norinherited nor donated to anyone.

An obligation on Muslims to pay a prescribed percentageof their wealth to specified categories in their society,when their wealth exceeds a certain limit. Zakat purifieswealth. The objective is to take away a part of thewealth of the well-to-do and to distribute it among the poor and the needy.

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