Frontiers in islamic finance

Frontiers in Islamic FinanceMuhammad Hanif

Fellow CMA

2/12/2013 Muhammad Hanif ACMA 2

Why Islamic Finance

• About 1,500 Billions (25% of GlobalPopulation) is Muslim

• Riba (Usury & Interest) which is foundation ofmodern conventional banking is Prohibited forMuslims

• There are four sets of verses in Holy Qura’nabout Riba [Ar-Rum 30:39] [An-Nisaa 4:161] [Al-i-'Imran 3:130] [Al-Baqarah 2:275-281]


Why Islamic Finance

• Conventional Banking led to Financial crisisdue to lack of support from real assets

• Islamic Banking is asset based financing,hence can serve as hurdle in the way offinancial crisis

• Islamic Banking is equity based financingwhich discourage the passive behavior ofInvestors


Principles of Islamic Finance

• Prohibition of interest and usury in financial dealings. Al-Qura’n (30:39, 4:161, 3:130, & 2:275-281).

• Avoidance of Gharar (uncertainty) in a business transaction (Ayub 2007,page 57; Mansoori 2007, page 179; Ghazi 2010, page 237).

• Avoidance of Myser and Qimar (speculation) or any game of chance (Ghazi 2010, Ayub 2007). Myser is prohibited by Holy Qura’n [ 2: 219 and 5: 90]


Principles of Islamic Finance

• Profit and loss sharing. According to thisprinciple capitalist demanding profit on capitalshould also participate in loss as well (Khan 1989,page 71; Usmani 2002, page 87; Ghazi 2010, page 386; Khan 2007, page 307 &Shari’a standard 12).

• Financing for only Halal (permitted) businesses.


Features of Islamic Banking

• The principal activity of customer of Islamic financial institutions (IFIs) must not be prohibited by Islamic Shari’a.

• Islamic banks have to follow the principles of sales and purchase as given by Shari’a including five khiyars (stipulations).

• Islamic bank cannot claim additional amountfrom customer in case of default


Features of Islamic Banking• Islamic banks cannot service depositors like

conventional banking with a predetermine return.

• Islamic banks cannot avoid Shari’a compliance in their operations on the excuse of non conduciveness of existing legal & business framework.

• Islamic banks cannot enter into transactions of futures and forwards; gambling etc.


Features of Islamic Banking• Under partnership business IFIs cannot limit

their share in profit only also loss in partnership must be shared according to equity stake;

• IFIs cannot extend loans except Qarz e Hasna(charity loans)


Historic Development• First ever objection on receipt of interest from

banks was raised by Syed Abul Aala Modoodi• Objective resolution was passed in 1949

(Article 2-A)• First bank on Islamic Principles was

established in 1963 in Mitghamer (Egypt) andTabong Hajji program of Malysia

• Elimination of interest from economy foundplace in 1973 Constitution (Aticles 2, 31, 37,227)


Historic Development• Article 37 dealing with principles of policy

enjoins upon the state to eliminate riba as early as possible.

• Conference of Foreign Ministers of OIC in 1973 in Jeddah & Establishment of IDB

• Council of Islamic Ideology Issued a comprehensive report on “Elimination of Riba from economy”in 1980


Historic Development• Revolution of Iran 1979 which eliminated interest

from economy • Interest free banking economy-wide in Pakistan

1985, however optimism failed very badly• Great research work done by IIU and IPS• Decision of Federal Shari’a court (Justice Rtd Tanzeel

ur Rehman) in 1991• AAOIFI 1991 (By Nov 2007, 30 Shari’a standards and by June 2008, 23

accounting standards, 5 auditing standards, 6 governance standards and 2 codes of ethics were issued).


Historic Development• Raja Zafar Ul Haq Commission Report in 1997• Supreme Court decision (1999) [Justice retd

Taqi Usmani & Coaleagues; a land mark]• Establishment of Islamic Banking Department

in early 2000• Establishment of Meezan Bank (2003),

BankIslami (2006) Burj Bank; Albaraka;Emirates Global; Dubai Islamic; HSBC


Industry Overview• By the end of 2011, Global Volume US $1,289

Billions in more than 50 countries with above300 Instituions [IFSL-2012]

• Share of Middle East 80% followed by Southand Far East Asia region 15% and balance 5%from rest of the world [Hanif 2012]

• Islamic Finance shown growth and resilienceduring world financial crisis of 2007-08


Industry Overview US $ Billions

509

677

861933

1130

1289

0

200

400

600

800

1000

1200

1400

2006 2007 2008 2009 2010 2011


Industry Overview-Y-o-Y Growth

0%

5%

10%

15%

20%

25%

30%

35%

2007 2008 2009 2010 2011


Industry Overview• By the end of Sept; 2012, in Pakistan Volume

of Assets is PKR Billions 741; Deposits 627;Investment & Financing 571 [SBP-2012]

• No of Banks 18 (5+13) with branch network of977 [SBP-2012]

• Islamic Finance has shown tremendousgrowth in Pakistan during last nine years (04-12) at an average annual rate of 65% (Y-O-Y)[Hanif -2012]


Industry Overview-PKR Billions

71119

206276

366

477

641

741

5084

147202

283

390

521

627

0

100

200

300

400

500

600

700

800

Dec.05 Dec.06 Dec.07 Dec.08 Dec.09 Dec. 10 Dec. 11 Sep. 12

Assets

Deposits

Financing & Investments


Industry Overview-Growth YoY

58%

60%

62%

64%

66%

68%

70%

72%

74%

Deposits Financing Branch network Overall


Comparative Performance• Hanif et.al 2012• Study period 2005-09• Sample includes 22 conventional banks and 05

Islamic banks• Areas studied profitability, liquidity, credit risk

and solvency• All figures are based on Industry Averages


Comparative Performance-Profitability

Performance Measure

Conventional Banks Islamic Banks Comments

ROA 1.44% 0.26% Conventional Banking is dominating in profitabilityROE 14.26% 1.73%

CSR 52.80% 97.63%


Comparative Performance-Liquidity

Performance Measure


Net Loans/ Assets Ratio

53.65% 91.30% Conventional

banking is

dominating in

liquidity

management

Liquid Assets/ Customer deposits & Short term funds Ratio

96.00% 82.17%

Net Loans/ Deposits & Borrowings

58.49% 86.84%


Comparative Performance-Credit Risk

Performance Measure


Comn Equity/ Assets Ratio

10.10% 14.81% Islamic

Banking is

dominating

in credit risk

management

Total Equity/ Net Loans

18.72% 16.22%

ImpairedLoans/ Gross Loans

10.64% 00.65%


Comparative Performance-Solvency

To measure Solvency following model was used

S = 1.5* CA+1.2*EA +3.5* CAR+0.6*NPL+0.3*CI+04*LAPerformance Measure


Solvency Result

56.36% 91.95% Islamic Banking

is dominating

in Solvency

management


Products-Financing Tools• Deposits-Liabilities & Equity

• Musharaka• Mudaraba• Loans

• Financing-Assets• Selling [Murabaha, Salam, Istisna’a]• Rentals [Ijarah]• Partnership [Musharaka, Mudaraba, Diminishing Musharaka]

• Investments in Skuk and Marketable securities


Products-Financing Tools• Musharaka is a partnership in capital; management by all or any

one of the partner; No salary to a partner; Profit as per agreement,however share of sleeping cannot be more than active; loss must beshared according to equity stake; Very fruitful for cash financing tobusiness and industry [Shari’a Standard 12]

• Mudaraba is a partnership between capital and skill; Profit sharingas per agreement, however loss is of financier; very fruitful for smallbusinesses and self employment generation [Shari’a Standard 13]


Products-Financing Tools• Murabaha is a selling mode of financing where by cost and profit,

both are disclosed to customer; very useful in short term financingespecially overdraft facility [Shari’a Standard 8]

• Salam is a selling based mode of financing especially usefel foragricultural financing; Cash is provided to farmer in advance as a purchaseprice of produce to be delivered to bank later on [Shari’a Standard 10]

• Istisna’a is also selling based mode of finance designed for industrialfinancing; cash is provided in advance in return of goods to be delivered atcompletion to bank [Shari’a Standard 11]


Products-Financing Tools• Ijarah is a rental based mode of financing whereby asset is purchased

by bank to deliver to customer on rent; end of Ijarah may be in transfer ofasset from bank to customer; Practically it is used in auto-financing[Shari’a Standard 9]

• Diminishing Musharaka is a mixture of Musharaka andIjarah where by asset is purchased in joint ownership of bank andcustomer; Bank rent out his share to customer and receives rentproportionally; customer purchases share of bank in installments andfinally asset is transferred to customer; Practically it is used for housefinancing [Shari’a Standard 12]


Portfolio Make up [July-06 to Sep 10]

0%5%

10%15%20%25%30%35%40%45%


Capital Market• Equity Investments Equity shares are Musharaka based

investment Instruments with variable returns, hence allowed underIslamic financial system, while conventional bonds and Governmentsecurities are interest based with predetermined fixed return andprohibited [Shari’a Standard 12, 21].

• Skuk is an Islamic bond designed to meet the need of ready marketliquidity instrument; These are different from conventional bonds asreturn is not absolutely fixed. [Shari’a Standard 17] According to ISI EmergingMarkets, approximately 2000 issues of Skuk were held with Global volume ofaround US $200 Billion by the end of June 2010.

• In addition to corporate Skuk, Sovereign Skuk are also issued by the governmentsincluding Pakistan, Jordan, UAE, Thailand, Malaysia, Turkey, Indonesia, Bahrain,Qatar, Cayman Islands, Singapore, Germany, Brunei, Gambia and Kuwait.(www.123 accessed on 5th July, 2010).


Capital Market• Equity Investments Although investment in equities is allowed,

however in order to invest in shares of a company certain tests (of Shari’acompliance) must be qualified.

• There are about nine Islamic indexes globally engaged in screening ofcompanies by applying Shari’a Compliance tests including DJIM, FTSE, S&P,MSCI, HSBC, Ameri, BID, Azzad and KMI(Derigs & Marzban, 2008).

• In Pakistan KSE-Meezan Index (KMI-30) was launched in 2008. It is revisedsemi-annually in May and Nov based on Dec and Jun Positions

• There are above 30 mutual funds working in Pakistan


Capital Market- Screening Criteria KMI-30

• Halal Business of the Investee Company• Interest Based Financing: Interest based debts to asset ratio should be

less than 40%.• Shari’a Non-compliant Investments: The ratio of non compliant

investments to total assets should be less than 33%.• Purification of Shari’a Non-complaint Income: The ratio of Shari’a non-

compliant income to total revenue should be less than 5%.• Net Liquid Assets to Share Price: The market price per share should be

greater than the net liquid assets per share calculated as: (Total Assets – IlliquidAssets – Total Liabilities) divided by number of shares.

• Illiquid Assets to Total Assets: The ratio of illiquid assets to total assetsshould be at least 20%.


Global Impact of Islamic Finance

• Opportunity of Shari’a compliant financing• Petro dollars• Study of Islamic teachings by wider audience• Promotion of commonalities in Muslim Communities• Leadership role in global affairs• Wider participation of masses in financial system• Stability in financial system if get dominance


Challenges• Use of Kibor as bench mark for profit• Use of par value in selling of shares of IFI in House financing• Use of par value in purchase of skuk at the time of

redemption• Use of financial penalty in case of default by customer• Use of independent party guarantee of capital in case of skuk• Use of time value based computer softwares in calculation of

installments• Very minor use of profit and loss sharing, salam and Istisna’a

modes of financing• Non availability of cash financing for day to day operations

except through Musharaka


How to overcome ChallengesAnswer is well educated and trained Human Resource

YouResearch

Economy & Finance

Frontiers in islamic finance