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.
What Are Sukuk?
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
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