Abstract: An article exploring the current challenges and opportunities for Islamic Finance.
A Breif Overview of Islamic Finance
Islamic finance principles
Islamic, or shariah-compliant, finance is concerned with the conduct of commercial and financial activities in accordance with shariah, or Islamic law. Islamic finance emphasises productive economic activity over pure speculation, and encourages transaction counterparties to share profits and losses in order to promote collaborative efforts. The main shariah principle relating to Islamic finance is the prohibition of riba, which essentially represents unearned excess or profit charged in connection with a transaction, and derived by the mere passage of time. This is generally thought to include a prohibition against charging interest in connection with the use of money. Other relevant shariah principles are the prohibition of: (i) gharar (undue uncertainty in a contract); (ii) maysir (impermissible speculation); (iii) qimar (transactions tantamount to gambling); (iv) investing in, or being involved with, haram products and activities (such as alcohol and gambling establishments); and (v) becoming unjustly enriched.
Islamic finance structures
Profit and loss sharing forms the bedrock of Islamic finance since Islam perceives that the ideal relationship between contract parties should be that of equals where profit and losses are shared. Shariah by no means prohibits the making of profit, but it does scrutinise the basis upon which profit is made as, for example, charging interest could exploit the client in a time of hardship whilst the financier's wealth is increased by no effort of its own. Islam instead empowers the financier to derive a profit by investing its money or other consideration directly (or indirectly through a joint venture arrangement, for example) in real assets using one or more of the Islamic finance structures discussed below. The financier will then generate a profit and recoup the principal sum invested in the asset by exercising its rights as an owner; using, leasing, or selling the asset. Here, unlike conventional finance, the money itself has not yielded the profit; instead the assumption of the risks and responsibilities as owner of the asset, or as a partner in the venture, has yielded the profit made by the financier. This highlights the preference of Islamic finance for equity over debt and seeking to deal in tangible assets. This also explains why Islamic finance can be used as a form of both asset backed financing and asset based financing.
The principal Islamic finance structures applied in a commercial context (either singularly or in combination) are:
- Ijarah (lease): a form of lease financing pursuant to which the usage (usufruct) of an asset or the services of a person are leased by the lessor to the lessee for rental consideration;
- Istisnah (procurement): a contract for the manufacture or development of an asset. Under this structure, one party engages a counterparty to construct an asset in accordance with agreed specifications, and agrees to purchase or lease the asset upon completion;
- Murabahah (cost-plus financing): an asset purchase transaction, in which a party purchases an asset from a third party upon the request of its counterparty, and then resells the asset to that counterparty. The sale price payable by the counterparty equals the original acquisition price paid by the first party plus an agreed return (i.e., cost-plus), and is payable on a deferred basis;
- Mudarabah (investment fund arrangement): an investment fund arrangement, under which one party (the rab al maal) provides capital to an enterprise while a second party (the mudarib) contributes work. The mudarib manages the enterprise's capital for a fee, and the mudarabah parties also share profits of the enterprise according to agreed percentages. However, only the rab al maal bears the risk of losing money on the enterprise;
- Musharakah (partnership arrangement): a partnership arrangement in which transaction parties contribute cash or property, or both, to a collective enterprise. The parties share profits according to agreed percentages (as with the mudarabah), but also share losses in proportion to their capital investments; and
- Sukuk (Islamic trust certificates): often referred to as 'Islamic bonds', sukuk are more akin to Islamic trust certificates representing an undivided beneficial ownership interest in an underlying asset where the return is based on the performance of that underlying asset. A sukuk issuer pays an agreed amount of the revenue produced by the sukuk assets to the sukuk holders.
Despite the significant growth of Islamic finance in recent years, 2017 continues to prove to be another difficult year for Islamic finance, primarily due a shifting global economic and political landscape, unresolved geopolitical conflicts, and the continued low oil price environment, which has led to major changes to spending policies in oil-exporting GCC countries (who, together with Malaysia and Iran, account for more than 80% of the Islamic finance industry's assets), and in-turn a significant reduction in economic growth in those countries. Other contributing factors are that: (i) sukuk have not been used by GCC governments and corporates as significantly as anticipated as an alternative source to close funding gaps and maintain spending, with those entities instead opting for conventional sources of finance given the low prevailing interest rates, and the perception that the process for issuance of sukuk is longer and more complex than conventional debt issuances; (ii) the lack of standardisation in the Islamic finance industry which compounds the perception of delay and complexity associated with issuing sukuk; and (iii) ambiguity over what is shariah-compliant which has been thrown into the spot-light by the events surrounding the ongoing Dana Gas case (discussed further below), which is proving to be one of the greatest challenges that the Islamic finance industry has faced in recent times.
Dana Gas' (an issuer based in the UAE) ongoing attempts in 2017 to render its US$700m mudarabah sukuk unenforceable on a number of grounds, one of which was that the sukuk were not shariah-compliant, have been the cause of great concern in the Islamic finance industry. Whilst Dana Gas has sought to bring proceedings to adjudicate on this matter in the Sharjah Federal Court of First Instance, a number of the sukuk documents are governed by English law, and so Dana Gas has also sought and obtained an interim injunction in the English courts preventing the sukuk holders from declaring an event of default or dissolution event in relation to the sukuk. At the time of publication, it was not clear whether there will be a full hearing of this matter before the English courts, but it was clear that a judgment in favour of Dana Gas could have wide ranging implications for the sukuk market, in terms of how such transactions are structured, and increase the likelihood of investors and rating agencies coming to the view that certain types of sukuk present a higher risk relative to corresponding conventional instruments, and offer issuers another ground to seek to declare their sukuk instrument as being not shariah-compliant.
Despite these challenges, Islamic finance has shown a willingness to be versatile and ready to overcome these challenges.
Islamic finance in Africa
Diversifying and increasing the customer base of Islamic finance is important to ensure that the market is not overly dependent on the economic outlook of a particular region or a particular commodity. To this end, Islamic finance provides major opportunities in Africa, where Islamic finance development has been growing steadily, with more countries in Africa offering shariah-compliant banking and issuing sukuk. With almost 60% of the world's uncultivated land and vast natural resources such as oil, gas and mineral deposits, Africa, dubbed Islamic finance's "new frontier", has proven itself to be an area of vast opportunity. Despite some high barriers to entry, such as regulatory setbacks, the issue of double taxation, and a lack of assets, there is clear demand for Islamic financing in Africa. In June 2017, the Africa Finance Corporation, a pan-African multilateral lender, was the first African government-backed entity to issue a three-year $150m sukuk. Islamic financing has also featured significantly as part of Egypt's landmark solar Feed-in-Tariff programme. Given the ethical foundations of Islamic finance, this ties in well with the United Nations' Sustainable Development Goals, in the context of Africa.
Islamic finance stakeholders are focussed again on standardisation by working on standard Islamic finance legal structures to be used to shorten and facilitate the sukuk issuance process. In particular, the Accounting and Auditing Organization for Islamic Financial Institutions, a non-profit industry-sponsored organisation, issues non-binding shariah standards developed in consultation with industry practitioners. Other influential bodies include the Fiqh Academy of the Organization of the Islamic Conference, the Shari'ah Supervisory Board of the Islamic Development Bank, and the Islamic Financial Services Board in Kuala Lumpur. These bodies, and individual shariah scholars, provide the context for Islamic finance generally, and play an important role on standardisation.
This is now perceived by investors as a key area to address given the ongoing Dana Gas case referred to above.
The end of LIBOR
In the UK, the Financial Conduct Authority announced in July 2017 that it would no longer sustain LIBOR, the primary reference rate used in floating rate commercial financing arrangements (and many other financial transactions including Islamic finance transaction), as a benchmark beyond 2021. This announcement has generated uncertainty in affected markets about existing transactions and the structuring of future floating rate transactions, or where LIBOR is used as a benchmark to calculate rent under an ijarah, for example. While there have been suggestions made by numerous market participants in the UK and US about new rates to replace LIBOR, it is too early for the financial industry to coalesce around one or more replacement rates. For Islamic finance, this presents an opportunity for it move away from LIBOR as a benchmark, which has been a constant criticism from shariah scholars and investors seeking no affiliation with a benchmark that is also used as part of calculating prohibited interest, but has had to be accepted (under the principle of necessity) given the lack of alternative benchmarks. It remains to be seen, however, whether a uniform shariah-compliant benchmark for Islamic finance products can be established and accepted
Despite slow growth, and that this year has done much to highlight the shortcomings with regard to standardisation and vulnerability to global shocks, there are many promising signs for the future of Islamic finance. Islamic finance is growing more worldwide as an ethical form of financing projects, which is supported by the report jointly published by the Islamic Development Bank (IDB) Group and the World Bank Group, "Islamic Finance: A Catalyst for Shared Prosperity?", and the synergies with United Nations' Sustainable Development Goals, particularly of relevance in Africa. Islamic finance would greatly benefit from more integration, in particular in relation to the types of sukuk issued, and the standardisation of the documents and processes used for such sukuk issuances.
- John Dewar is a partner, and Munib Hussain is a Senior Associate, at Milbank, Tweed, Hadley & McCloy LLP.