Modern Islamic finance is a young industry that has been attracting Muslims looking to invest based on Islamic principles, and also appeals to non-Muslims looking to diversify their portfolios by tapping into an attractive pool of investment resources. Mohieddine Kronfol, chief investment officer, Franklin Templeton Global Sukuk and MENA Fixed Income Strategies, provides an overview of recent developments in Islamic finance and touches on some of the challenges involving the standardisation—and regulation—of these instruments.
Mohieddine (Dino) Kronfol
Chief Investment Officer
Franklin Templeton Global Sukuk
and MENA Fixed Income Strategies
Chief Investment Officer
Franklin Templeton Global Sukuk
and MENA Fixed Income Strategies
The Development of Shariah Compliance Standards
The concepts underlying Islamic finance are very old; indeed, many aspects of the Western financial system that began to develop in renaissance Italy had Islamic roots. However, modern Islamic finance is a relatively young industry with its first stirrings in the 1960s and the first emergence of Islamic banks in the 1970s.
Having been established to meet religiously motivated requirements, early Islamic institutions differentiated themselves largely by the purity of their adherence to Shariah principles; specific jurisdictions tended to develop their own interpretations of Shariah principles, although agreeing on the fundamentals.
In recent years, the Shariah finance industry has expanded to include many individuals looking to invest based on Islamic principles, but also seeking a satisfactory return, and, to an increasing extent, non-Muslims looking to tap into an attractive pool of investments. The development has led to calls for increased regulation and standardisation of Islamic products, with initiatives being undertaken by a number of authorities. In our opinion, the drive towards regulation and standardisation should be treated with caution as prescriptive standards could stifle innovation, while the Islamic community’s emphasis on individual understanding and lack of a central authority means that the goal of universally acceptable standards may be difficult to attain. Rather, we would advocate the development of principal standards that would leave room for innovation, while increased transparency amongst individual practitioners would enable market participants to make clear judgments about the acceptability of their products.
Global Reach of Islamic Finance
Although the roots of the Islamic finance industry are in banking services—and bank deposits remain by far the largest source of Shariah-compliant assets—other types of assets have become increasingly significant, particularly for the Islamic asset management industry. Shariah-compliant equity funds were an early diversification from the original bank-based business. Takaful, an Islamic product akin to insurance, has been growing in significance, while financial professionals have been investigating ways to bring Waqf, or Islamic endowments (currently largely based on property) into the financial mainstream. Perhaps the most dynamic area of development is in Sukuk, commonly referred to as Islamic bonds, an asset type that has been seeing rapid growth and that has tended to be the principal area of activity as different financial centres look to capture shares of what is seen as a fast-growing market.
Sukuk is the plural of the Arabic word Sak, literally translated as title deed. They are financial certificates structured to comply with Islam’s prohibition on the charging or paying of interest (known as Riba) that grant an undivided interest or share in an underlying asset along with the profits, cash flows and risk commensurate with such ownership. Sukuk are often referred to as the Islamic equivalent of bonds.
While a conventional bond is a promise to repay a loan, Sukuk constitute partial ownership in a lease (Sukuk Al Ijara), a business or a partnership (Sukuk Al Musharaka), receivables (Sukuk Al Murabaha), a project (Sukuk Al Istisna), or an investment (Sukuk Al Istithmar). In other words, Sukuk represent ownership of real assets, whereas conventional bondholders own debt.
The three most popular Sukuk contracts by issuance volume are Sukuk Al Ijara, Sukuk Al Musharaka and Sukuk Al Murabaha.
- Sukuk Al Ijara are sale-and-leaseback structures that use revenues from an underlying asset such as a building to pay investors.
- Sukuk Al Musharaka are derived from the word “Shirkah,” meaning partnership, in which all partners contribute capital and labour. Profit is shared among partners at an agreed-upon ratio or a declining basis. Losses, however, are shared in proportion to the contributed capital.
- Sukuk Al Murabaha refer to a contractual agreement according to which a financier buys a good or an investment and then sells it to a customer with a markup on a deferred basis.
At present, Malaysia leads the industry with US$164 billion in issued Sukuk in 2014, representing more than 60% of the overall market. London was a distant second with US$38 billion1 and Dubai third with US$21.1 billion,2 with both cities striving to close that gap. London has shown a willingness to accommodate Sukuk in the tax code, and offers strength in ancillary services such as legal, insurance and educational resources rooted in its significance as a historical centre of conventional finance. Dubai is looking to build on its strengths as a major trading and travel hub through a holistic approach to Islamic economic activity, seeking to dominate industries such as Halal (permitted under Shariah law) food and Islamic tourism as well as finance. At the same time, Dubai’s government has been active in promoting the emirate as an Islamic economic centre by influencing businesses with links to the state to raise finance through Sukuk issuance. Indeed, in terms of listing Sukuk on domestic exchanges, Dubai has passed Malaysia, according to Nasdaq Dubai.
Meanwhile, smaller players are also looking for a share of the market. Dubai is being challenged in the Middle East by markets such as Qatar, Oman and even its neighbor in the United Arab Emirates (UAE), Abu Dhabi. And, Bahrain has long sought a role as an arbiter of Shariah adherence. The Accounting and Auditing Organization for Islamic Financials Institutions (AAOIFI), established in Bahrain in 1990, is probably the nearest the industry comes to an internationally recognized authority. Turkey and Tunisia are also looking to build Islamic finance industries. In Europe, Dublin and Luxembourg are looking to take market share from London, while Johannesburg is aiming to establish itself as the leading Sub-Saharan African centre for Islamic finance, in competition with Lagos. In Asia, Indonesia is starting to compete with Malaysia, while Hong Kong is emerging as a potentially important centre for Sukuk issuance. In all, approximately 30 countries worldwide have issued one or more Sukuk.
Saudi Market and Islamic Finance
The emergence of two previously reclusive Islamic powerhouses—Saudi Arabia and Iran–could have a significant impact on the development of Islamic finance. As a leader of Islamic thought in the Middle East and globally, Saudi Arabia’s interpretations of Islam as it relates to financial affairs could become influential. Although its equity market’s opening to international investors is quite restricted at present, and the Sukuk opening is still to come, we believe that over time both will extend and become transformative not just for Saudi Arabia but the Middle East as a whole. We would anticipate that the experience of catering to international investors will likely lead to improvements in regulation, transparency and product structuring that will render both Shariah equity and domestic Sukuk markets in Saudi Arabia increasingly appealing to Sukuk investors.
Iran, meanwhile, is the domicile of the largest stock of Islamic assets globally, as a result of banning the payment of interest throughout its banking system in 1983.3 After exclusion from global financial markets for many years, partly through choice and partly due to sanctions, the recent accord with the international community over nuclear industry development could open the way for sanctions to lift and for Iran to participate in the global Islamic finance industry. The reintegration of Iran into global Shariah markets could be of immense significance, in our opinion.
Development and Innovation within Shariah Markets
The Islamic banking system is itself seeing some interesting new developments that could extend the reach of more sophisticated Shariah-compliant products. Evolving banking solvency requirements are driving demand for subordinate, perpetual and lower-tier Sukuk as banks that previously held reserves largely in cash deposits at central banks look for more efficient balance sheet structures, which has the effect of widening investment choices for outside investors.
On the liability side, the Malaysian government recently launched an initiative relating to bank deposits, still the largest portion of Shariah-compliant assets overall, that could expand the scope of Sukuk, particularly if the Malaysian example is followed elsewhere. The Islamic Financial Services Act of 2013 is a measure aimed at modernising and clarifying earlier legislation on Islamic Finance. Measures involving deposits invoked an explicit division between contracts with capital guarantees (deposit accounts) and those without (investment accounts), with the latter no longer eligible for protection under the government’s deposit insurance scheme.
The new regulations are due to be finalised shortly and represent an interesting experiment to test whether depositors are prepared to accept a measure of capital risk in exchange for more returns, or whether the traditional role of banks as custodians of their clients’ money will dominate, leaving the investment account structures to wither away and Islamic banks less differentiated from their conventional counterparts.
Implications for International Investors
As the number of centres of Islamic finance grows, questions around local interpretation could increase, though, in our opinion, the difficulties sometimes appear overstated. Even leaving aside the special case of Iran, local finance traditions in many Islamic countries differ in some respects. Non-Islamic majority countries, such as the United Kingdom and Hong Kong, present different issues. Although such countries naturally tend to avoid controversial interpretations of Shariah as they bid to establish themselves, the activities of sophisticated financial professionals can lead to the development of innovative products that can require interpretation. The challenge for Islamic finance is to achieve a degree of uniformity in the treatment of assets, providing comfort to international investors, when the underlying principles governing such treatments necessarily have local roots.
For many practitioners of Islamic finance, the solution to the issue of variability of interpretation is the establishment of detailed common standards. A number of countries with large Shariah-compliant financial industries have moved to establish national Shariah boards to provide specific standards for products within their jurisdiction. Malaysia led the way in 1997, while in more recent years, countries including Indonesia, Oman, Pakistan, Nigeria and Morocco have established or announced similar bodies. Recently, the UAE joined the trend announcing its intention to have a federal Shariah board.4 The Dubai Financial Market followed a slightly different route, announcing specific guidelines for Sukuk issuance in April 2014 that complemented a 2007 document dealing with issuing and trading shares in a Shariah-compliant fashion.
Many commentators have called for global Shariah standards to be established. The emergence of national and international Shariah boards has been seen as a positive development. Although they can provide solid guidance to originators and users of financial products, they come with their own problems. A further issue with national and international boards is that detailed discussions and a search for consensus can be time consuming. A standard for currency hedging took some seven to 10 years to be established, for example. With the Sukuk market developing quickly, a standard can become outdated with new product features simply not envisaged at the time of promulgation, creating an appearance of non-adherence. Faced with commercial pressures to issue products, banks will often go their own way rather than await guidance from the national board.
An Alternative Approach—Principal Standards and Practitioner-Driven Solutions
We agree that the development of accepted international standards is an important step required if Islamic finance is to fulfill its current promise and become a truly global industry. To that end, well-resourced and professionally supported Shariah boards have value in speeding up decision-making. We would support the development of principal standards, clearly stating unacceptable practices, but otherwise leaving room for interpretation and development. The onus then falls on product originators to be as transparent as possible in laying down the nature of their products and their rationale in Islamic law. Potential buyers of the products can then clearly understand what is being offered and why. As long as the legal theory underpinning particular products is clearly mapped out in the prospectus, the product can then prosper or fail according to its acceptability within the industry. Over time, a market-driven consensus on the structure of Islamic products should become clear.
At Franklin Templeton, we have adopted strategies to ensure Shariah compliance that we believe represent industry best practice. Our Shariah board is made up of distinguished scholars drawn from a variety of Islamic traditions. The scholars provide initial approval on investment objectives and strategy, as well as ongoing supervisory and monitoring services to ensure continuous adherence to internationally accepted Shariah principles and standards. Some 40,000 individual securities are monitored for Shariah compliance using sophisticated algorithms to drill down into their business activities and balance sheet structure. For those businesses with acceptable primary functions, but some involvement in haram (prohibited) activities, we are able to isolate the haram income streams and confirm necessary purification payments. As it regards our Sukuk activities, the scholars are involved on a security-by-security basis, and all derivative products that are considered are also investigated and approved. To further improve our transparency, we are in the process of creating a Sukuk rulebook that will clearly document our standards. The rulebook will allow interested parties to understand clearly the nature of the products that we deem acceptable and the rationale for our views. The Shariah boards of potential customers will be able to make a fully informed decision on whether to invest.
An Evolving Asset Class
The growth of Islamic finance in terms of both value and the proliferation of countries participating clearly demonstrates to us solid and sustainable levels of demand for the industry and its underlying values. The widening geographic spread and technical complexity of the Islamic finance industry have led to a desire for uniformity of interpretation that is hard to achieve given the many different Islamic traditions that have to be taken into account. Although we understand the calls to supply definitive standards through the establishment of national and international Shariah boards, we would caution against over-prescriptive regulation. In our opinion, with the freedom to innovate and with sufficient transparency shown by product originators, the community of Islamic finance participants can evolve by consensus to produce satisfactory, market-based solutions so that the industry can become both a strong competitor to conventional finance and a source of unique investment options that can appeal both to Islamic and conventional investors.
Mohieddine Kronfol’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year.