Islamic Banking Explained

Islamic banking (IB) is derived from and governed by Shari’ah principles of Islamic law. These principles prohibit the levying of interest, involvement in unlawful activities, hoarding for profit and other transactions that result in injustice and exploitation.

The concept was explained at a seminar on Islamic Banking and Finance conducted by the First Global Group (FGG) last weekend. Muhammed Ikram Thowfeek, Chairman of FGG Sri Lanka, said, “Islamic banks are not charitable institutions, they are just concerned about protecting society while providing a return to their shareholders.” Indicating that it is a matter of form over substance, he provided the example of two supermarkets retailing chicken, where the one selling halal food would be preferred.

The asset base of the Islamic financial system is estimated at US$ 500 million, small vis-à-vis the conventional system that has had a head-start of over 250 years. However, it has been growing at 15% annually, faster the conventional system. ”We are not attempting to replace conventional banking,” clarifies Sheikh Essam Ishaq, Shari’ah Advisor at Discover Islam, Bahrain, “but provide a vibrant, practical alternative.”

Investor demand for Islamic banking products is high - certainly in the GCC, but elsewhere too. Standard & Poor’s has predicted that, to satisfy this appetite, global demand for Islamic finance will surge to US$ 4 trillion within five years.

The establishment of the Dubai Islamic Bank in 1975 is widely acknowledged as the genesis of Islamic banking. However, it was then perceived as “an eccentric manoeuvre from an eccentric place,” said Ishaq. IB survived the passage of time. Countries like UK, Thailand and Singapore have modified their banking legislation to permit Islamic banking. The Government of Thailand even has a 38% stake in an Islamic bank.

Speakers at the seminar were practitioners in the field and included Dr Mohammed Burhan Arbouna, Shari’ah Board Member of the United International Bank in Bahrain. While attempting to structure products in a Shari’ah-compliant manner, some firms have hoodwinked customers by merely changing the nomenclature from ‘interest’ to ‘profit’. For an existing bank to introduce IB, Dr Arbouna recommends a “firewall for money, accounting and employees”.

Because IB deals with real assets and services, all transactions should be backed by assets. ‘Sukuk’ is the Arabic word for asset-backed bonds, the global market for which is more than US$ 25 billion. Since you are not permitted to sell what is not yours, short-selling is disallowed.

Explaining the concept of ‘murabaha’ – a method of financing, Dr Arbouna explained how it differs from classical lending. The bank buys the asset from the seller and sells it to the buyer at cost plus a disclosed profit margin, with deferred payment terms. Any penalty paid by a defaulting buyer does not swell the coffers of the bank, but is donated to a charitable institution instead.

Six of the world’s top ten global banks are into Islamic finance. HSBC Amanah, for instance, is the global Islamic banking division of the HSBC Group.

How Malaysia Became A Dominant Force…

Speaking at the opening ceremony, Nazirah Hussain, Malaysian High Commissioner, described the strategic measures that her country had taken to become a regional hub of Islamic banking and finance. Malaysia’s aim is to be an investment gateway specializing in Islamic fund and wealth management, and a takaful (insurance) centre.

To accelerate growth, an executive committee comprising of government officials, regulators and industry leaders are working to create a more efficient delivery system.

The Immigration Department has accorded an “executive green lane” to the Malaysian Islamic Financial Centre (MIFC). This will help expedite applications by expatriates for long-term employment passes and, in turn, facilitate movement of expertise in Islamic finance.

Islamic banking, takaful and capital markets have been liberalized to allow the entry of new players. Fund managers of foreign Islamic funds also enjoy tax benefits. Islamic financial institutions are allowed 100% foreign equity ownership. Exemptions on stamp duty and taxation have been granted for foreign currency assets…

As a consequence, total Islamic banking assets have grown to 133 billion Malaysian ringgit (US$ 38 billion), accounting for over 12% of domestic banking assets. Takaful assets have increased to 7 billion ringgit and represent 6% of the insurance market.

Malaysia pioneered sukuk. More than two thirds of sukuk in the global market was issued in Malaysia. Outstanding Islamic private securities constitute 50% of the domestic corporate bond market.

While acknowledging that most Malaysians are Muslims, there could probably be a lesson there for Sri Lanka.

…And a Prescription for Sri Lanka

In conversation with Sunday Times FT, Thowfeek trashes the notion that Islamic finance is the exclusive domain of the Muslim community or that it promotes Islamic culture. He believes that IB can help Sri Lanka follow other Asian and Western economies in tapping the Middle East’s abundant liquidity.

Sri Lanka needs finance for its infrastructure and revenue-generating projects and Thowfeek believes that this can be met through Islamic financing.

After modifications to the Banking Act in March 2005, there is adequate flexibility for conventional banks to start Islamic banking windows and introduce some products. However, attempts to promote Islamic financing and deposit products have been feeble. These have been operated through financial institutions like Amana Investments and Ceylinco Profit Sharing.

What the country probably needs is a full-fledged Islamic bank… To enable that, Thowfeek places the onus squarely on the regulators. They have to perform a due diligence and play a proactive role – as regulatory institutions in other countries have done, he insists.

Although there are no authentic statistics on the IB market in Sri Lanka, Thowfeek guesstimates the figure at LKR 70 – 100 billion. The country has potential to become an IB hub for the entire Asian region, he says. Only if CBSL expresses interest and initiates action can Sri Lanka stand a realistic chance of competing with and overtaking other players. Government organisations, monetary authorities and the private sector must necessarily band together with Islamic banking institutions to make that happen.