Blessed Profits

Background and sources of Islamic Shariah|~||~||~|One seldom thinks of religion when it comes to finance or investing. Yet the last 30 years have been a watershed in the banking sector of the Middle East, especially in the area of Islamic banking and finance. The announcement last month of a $300 million deal between the Dallah Albaraka Group (DBG) and The International Investor (TII), to create the worlds largest Islamic financial services group (see story on page 10) shows that the industry has truly arrived on a global scale. The expansion of Islamic banking and the size of assets under management have also attracted non-Islamic banks that want a piece of the pie. The market is attractive by virtue of the 1.3 billion Muslims and an estimated $150-$200 billion in assets managed Islamically, a figure growing at 10%-14% per annum, depending on whom you talk to.As the industry has grown so have the range of products and services. But what exactly are the concepts of Islamic banking and finance? How are investments governed and what are the returns? Just how competitive are Islamic investment products and services to non-Islamic products? Unlike non-Islamic banks and equity markets that have regulatory bodies and the relevant authorities that monitor the industry and equity markets, the philosophies and principles of Islamic finance stem from the sources of Islamic Shariah Law: the Quran, the Sunna and Hadith (formal traditions of the Prophet Muhammad); Ijma and Qiyas. The variety of these sources provides Islamic jurisprudence with a flexibility that makes it applicable for each place and time. This in itself is interesting as stocks and a number of other financial products and services did not exist when Islam came into being.While Shariah is derived from the above sources, it was developed further by the ancient schools of law that emerged in the early part of the second century of Islam. Each of the Al-Hanafi, Al-Maliki, Al-Shafi and Al-Hanbali schools has its own jurisprudence and differs in its approach to the difficult issues that face Muslim society. In today’s financial world, each Shariah board has its unique view on investing and what products and services are legitimate. In Shariah law, there must be a marriage between money and work, initiative and risk that is just and equal. When a person lends money, the funds are used to create a debt or an asset. In the first case, Islam considers there is no justifiable reason why the lender should receive a return simply because he has made a loan. In the second, where money creates additional wealth, the question is why the lender should be entitled to only a small fraction (the interest) of the added value. The lender is a partner in the enterprise and not a creditor. According to Rushdi Siddiqui, director of the Dow Jones’ Islamic Market Index, some Muslims refuse to purchase stocks because practically all publicly listed companies have lending facilities, access to it, or both. ||**||Islamic finance concepts|~||~||~|Yet according to Siddiqui, a principal force in the creation of nine Dow Jones Islamic Market Indexes, this portion of Muslims may prefer to invest in venture capital. “The equity culture does not yet exist in the Muslim countries, hence, bank/debt financing has been the alternative. If Muslims were exclusively interested in an Islamic VC, then the Islamic banks or western banks with Islamic windows would be offering it as part of meeting market demand. They don’t. Islamic VC, as part of a diversified portfolio, is probably a more viable strategy,” says Siqqidui.In contrast, the evolution of global financial markets has attracted a larger segment of Muslims who invest in stocks and mutual funds that are publicly traded. Consequently, a set of laws and principles that apply to investing according to Shariah has been devised. Currently one can invest in managed funds, or online through iHilal.com or IslamiQ.com. Talks are underway regarding exchange-traded funds, and index linked funds as well. The range of products and services in the industry vary. “New products are being Islamically structured to target Islamic funds and resources: Islamic investment banking, fund management, project finance and private equity deals, leasing and trade finance are growing,” says Darren Stubing, chief banking analyst at the Capital Intelligence rating service. Citibank, which started serving the Middle East in the seventies, has tailored its products and services to Muslims. Citi Islamic, which operates out of Bahrain, offers a full range of products to corporate and institutional clients, from North Africa to the Far East. “We have had robust growth, our funds have performed well and we do Islamic transactions and all kinds of structures not just here in the region but all around the world. Our products are well known to our customers,” says Shehzad Naqvi, regional manager of Citibank for the Middle East.The industry will shortly witness the launch of the first Islamic credit card by Bahrain based ABC Islamic Bank. The card, which conforms to Shariah principles, will have an annual fee and customers will have the option to either pay the full balance, or 10% of the outstanding balance every month like a normal card, without paying interest, according to Mohamed BuQais, deputy general manager of ABC Islamic Bank. “Such cards will provide benefits similar to normal credit cards in terms of settlement and international recognition,” says BuQais. None of the Islamic banks, according to BuQais, offer online banking as of yet and the introduction of an Islamic card is a step forward to integrating Islamic banking with e-commerce. The 40 plus types of Islamic financial products and services on offer use various Islamic concepts such as Mudaraba, when one party provides capital for the other to carry out a project or business on a profit sharing basis. Musharaka, is a joint venture whereby profits are distributed according to an agreed ratio. In the event of losses, both parties share losses based on their equity participation. Murabaha, refers to the sale of goods at a price, which includes profit margin as agreed to by both parties. The validity of the contract rests on the price, costs, and profit margin being stated at the time of the agreement of the sale. Bai Bithaman Ajil, is the deferred payment of a sale based on a price, which includes a profit margin agreed to by both parties. Ijarah, or leasing, refers to an agreement whereby the owner leases equipment, building or other facility to a client at an agreed rental against a fixed charge, as agreed by both parties. Qardhul Hasan, is an interest free loan whereby the borrower is only required to repay the principal amount but can pay an extra amount at their discretion. Ijarah Thumma Al-Bai, is leasing for the purpose of renting or purchasing. Under the first contract a hirer leases goods from an owner at an agreed rental over a specified period. Upon expiry of the period, the hirer then enters a second contract to purchase the goods from the owner at an agreed price. What is most relevant to today’s contemporary world of fund investing is Murabaha.According to the widely popular Islamic-Finance.net site, funds operated in line with Murabaha sell commodities on a cost-plus basis, which financial institutions use as a mode of financing. Commodities are purchased for the benefit of the client and are then sold based on deferred payment at an agreed margin of profit added to the cost. ||**||Products and services in todays market|~||~||~|Shariah concepts have certainly defined and shaped the way in which Islamic finance has evolved to date. Investors have a choice to invest in one of 9 Dow Jones Islamic Market Indexes, which currently include the DJ Islamic Market Index (DJIM), the DJ Islamic Market Extra Liquid Index, the DJ Islamic Technology Index, the DJ Islamic US Index, the DJ Islamic Canadian Index, the DJ Islamic UK Index, the DJ Islamic Europe Index, the DJ Islamic Japan Index and the DJ Islamic Asia/Pacific Index. Another option is the FTSE Global Islamic Index Series, which has 5 indexes.Globally, the nine Islamic indexes are comprised of 1,860 companies from 34 countries. If they were an Islamic stock exchange, the nine combined would have a total market capitalization of $11 trillion, second largest after the New York Stock Exchange (NYSE), according to Siddiqui. Islamic indexes track a basket of equities that are Shariah compliant. The companies are not necessarily Islamic. However, they must meet the threshold that determines if they are halal or compliant with the criteria of Shariah. As is the case with Islamic banks, a Shariah board comprised of scholars must be appointed to screen companies before they become part of a fund or index and review products and services to ensure they are compliant. Different scholars have different opinions that determine which companies are suitable and which are not. DJIM covers two Muslim countries, Malaysia and Indonesia, and only 7 and 31 companies respectively. Yet, according to Siddiqui, the limited market review implies that even in Muslim countries many of the publicly listed companies are not operating in a Shariah compliant manner. The DJ Islamic Market in the US has 800 listed companies, Canada 97, Europe 429, the UK 138, Japan 188, Asia Pacific 411, Technology 500 and the Blue Chip 100. For companies to be considered in an Islamic Index, their business activities must be determined suitable and compliant with parameters set by the Shariah supervisory board. In order for a company to be listed in a fund and its shares bought and sold, it should neither borrow money on interest nor gain interest from the money it deposits. An operation that is involved with an interest related activity or riba disqualifies insurance companies, as well as commercial, and merchant banking entities. Other companies that are excluded from a fund include those that manufacture or sell pork, alcohol, and defence weapons, or engage in entertainment industries such as pornography, hotels and gambling or are involved in anything that is contrary to or violates Shariah. In addition to filtering out companies according to business activities, companies are also screened according to several financial ratios that determine if a company is too leveraged in proportion to its total assets. DJIM, for instance, omits companies whose total debt to total assets ratio exceeds 33%; those whose accounts receivable to total assets is greater than or equal to 45%; and if total cash and interest bearing securities to trailing 12 month average market capitalization is equal to or greater than 33%.However, exceptions apply to those companies that comprise of permissible and non-permissible activities. According to the Securities Exchange Commission of Malaysia, the core activities of the company should not violate the already mentioned criteria and the element of the business that is not halal or is haram should be very small compared to the core activities. Public perception or the image of the company must be good; and the core activities of the company should have importance and maslaha (benefit in general) to the Muslim Umma (nation) and the country. The haram element should be very small and involves matters such as umum balwa (common plight), uruf (custom) and the rights of the non-Muslim community, which are accepted by Islam. Islamic Indexes have at times outperformed their conventional counterpart indexes. There is a high correlation between Islamic indexes and their non-Islamic counterparts, according to Siddiqui. In 1999, all but one of the DJIMS outperformed their conventional counterparts, according to Siddiqui, the exception being the DJIM-TECH (84%) to the NASDAQ (86%). However, recent market volatility has affected performance. The DJIM has put a cap of 10% on any one company in each index to minimize any overriding influence a company may have and to prevents indexes from being dominated by large stocks. Those developing Islamic products and funds include some of the 200 existing Islamic banks as well as conventional banks like Al Baraka Islamic Bank, Al-Rajhi Banking and Investment Corporation, TAIB Bank of Bahrain, National Commercial Bank of Saudi Arabia, Shamil Bank, and National Bank of Kuwait. The recent growth of Islamic finance and the estimated untapped capital in billions of dollars has also attracted Citibank, Hong Kong & Shanghai Banking Corporation, Bank of Tokyo, Union Bank of Switzerland, Brown Brothers Harriman, Commerzbank and many others. Some Islamic funds are structured in a similar technique like that of conventional funds. They carry a load fee, also known as a sales charge. According to Siddiqui, Islamic funds may be more expensive compared to conventional counterparts with similar investment objectives.||**||Recent developments|~||~||~|Today, there are about 102 Islamic equity funds worldwide, targeting about 1.3 billion Muslims. According to the American-Kuwaiti consultancy, Failaka International Inc., Islamic funds and indices were not spared when the technology bubble burst one year ago, wiping out $3 trillion of the nominal value of America’s stock markets, one third of the country’s GDP. However, the parameters of Islamic finance have curbed the exposure of Islamic funds to the volatility in conventional mutual funds and the landscape and strategy of managing Islamic funds is changing, moving from, “Blue chip technology stocks like Microsoft, Intel and Lucent Technology to old economy stocks,” according to Failaka’s 2000 fourth quarter report. The best performing equity funds for the year were sector funds. The International Investor’s Small-Cap European Equity (+8.0%), Saturn Capital Corporation’s Amana Income (+3.5%), Commerzbank’s Al Sukoor European Equity (+3.2%) and Permal Asset Management’s Alfanar Europe (+1.3%) had positive gains for the year. In terms of global equity funds, the best performing was Alfanar Investment Holdings returning -8.4% and Al-Rajhi Global Equity with –9.8%, according to Failaka International. Darren Stubing believes that “both consumer and corporate banking will further drive the growth of Islamic banking, in terms of the actual size of assets in the market, and the number of new Islamic banks emerging.” The recent announcement of a $300 million deal, by the Dallah Albaraka Group (‘DBG’) and The International Investor (‘TII’) to combine DBG’s assets in a number of banking subsidiaries with TII to create the world’s largest Islamic financial services group echoes not only Stubing’s prediction but what many industry analysts maintain—the need for fewer banks in the Middle East. BuQais also believes that “it is a positive step towards transparency, healthy competition, development of products and services, as well as of benefit to customers.” Naqvi also believes it is a healthy development. “There is bound to be consolidation as the industry is fragmented. It makes more sense to have scale and broaden channels of distribution. As institutions become more specialized and develop more scale, consolidation will help alleviate the liquidity problem,” says Naqvi. In any merger it is usually the case that one of the respective parties will always come out stronger. However, consolidation does have a positive effect as well. Organisations can lower overhead costs; reduce operational overlaps, even out the cost of investment in technology required to compete with international banks and benefit from economies of scale. “Consolidation is a prerequisite to grow this market, we welcome announcements like this,” Mohammed Abdel Hadi, equity research analyst for the Middle East and North Africa at Merrill Lynch told Arabian Business.com.To be fair, the banking industry, and specifically the Islamic portion of it, is changing. Challenging issues are being addressed. The lack of liquidity is an underlying factor as is the absence of uniform regulatory infrastructure in light of the different views held by Shariah board scholars. “It is so important to have formal well regulated access to short term liquidity and this has been lacking,” says Elizabeth Jackson-Moore of Moody’s rating agency. Bahrain, a regional hub in the Middle East for offshore banking and a pioneer in nurturing the Islamic banking industry, recently issued the first Islamic government bills, worth $25 million, in an effort to meet the short term liquidity needs of Islamic banks and financial houses. Liquidity is a problem because cash positions are difficult, “as no money market exists on a comparable scale to conventional money markets in the US,” added Siddiqui.“One sweeping gesture does not solve problems facing the industry. Problems are solved by consolidation, and it is the professionalisation of participants in the market that is the most important aspect facing the industry,” says Naqvi. However, there is a conscious effort by the Bahrain Monetary Authority, the Islamic Development Bank and Bank Negara of Malaysia to raise the standards. Discussions on establishing an International Islamic Financial Market (IIFM) are underway. If successful, an integrated global Islamic financial system may emerge that addresses the liquidity needs of international Islamic banks and broadens the markets for Islamic finance and investment. More importantly, according to Izam Shah Ariff Shah at Bank Negara of Malaysia, it would encourage the development of Islamic financial products through the harmonization of Shariah issues. ||**||