Islamic Finance and the Rules of Islamic Law Finance Essay

The financial industry has historically played an important role in the economy of every society. Banks mobilise funds from investors and apply them to investments in trade and business. The history of banking is long and varied, with the financial system as we know it today directly descending from Florentine bankers of the 14th - 17th century. However, even before the invention of money, people used to deposit valuables such as grain, cattle and agricultural implements and, at a later stage, precious metals such as gold for safekeeping with religious temples. Around the 5th century BC, the ancient Greeks started to include investments in their banking operations. Temples still offered safe-keeping, but other entities started to offer financial transactions including loans, deposits, exchange of currency and validation of coins. Financial services were typically offered against the payment of a flat fee or, for investments, against a share of the profit. The views of philosophers and theologians on interest have always ranged from an absolute prohibition to the prohibition of usurious or excess interest only, with a bias towards the absolute prohibition of any form of interest. The first foreign exchange contract in 1156 AD was not just executed to facilitate the exchange of one currency for another at a forward date, but also because profits from time differences in a foreign exchange contract were not covered by canon laws against usury. In a time when financial contracts were largely governed by Christian beliefs prohibiting interest on the basis that it would be a sin to pay back more or less than what was lent, this was a major advantage. During medieval times (1,000 - 1,500 AD), Middle Eastern tradesmen would engage in financial transactions on the basis of Sharia'a, which incidentally was guided by the same principles as their European counterparts at the time. The Arabs from the Ottoman Empire had strong trade relationships with the Spanish, and established financial systems without interest which worked on a profit- and loss-sharing basis. These instruments catered for the financing of trade and other enterprises. As the Middle Eastern and Asian regions became important trading partners for European companies such as the Dutch East India Company, European banks started to establish branches in these countries, which typically were interest-based. With the increasingly important role Western countries started to play in the world economy, conventional financial institutions became more dominant. On a small scale, credit union and co-operative societies based on profit- and loss-sharing principles continued to exist, but their activities were very much focused in small geographical areas. Although it was not until the mid 1980s that Islamic finance started to grow exponentially.

Literature review

Islamic finance is based on shariah, an Arabic term that is often translated into "Islamic law." Shariah provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business, and law. Shariah-compliant financing (SCF) constitutes financial practices that conform to Islamic law. Major principles of shariah that are applicable to finance and that differ from conventional finance are: Ban on interest (riba): In conventional forms of finance, a distinction is made between acceptable interest and usurious interest. In contrast, under Islamic law, any level of interest is considered to be usurious and is prohibited. Ban on uncertainty: Uncertainty in contractual terms and conditions is not allowed, unless all of the terms and conditions of the risk are clearly understood by all parties to a financial transaction. Risk-sharing and profit-sharing: Parties involved in a financial transaction must share both the associated risks and profits. Ethical investments that enhance society: Investment in industries that are prohibited by the Qur'an, such as alcohol, pornography, gambling, and pork-based products, are discouraged. Asset-backing: Each financial transaction must be tied to a "tangible, identifiable underlying asset." Under shariah, money is not considered an asset class because it is not tangible and thus, may not earn a return. Some question how lenders profit from financial transactions under Islamic law. For instance, in a real estate setting, SCF takes the form of leasing, as opposed to loans. Instead of borrowing money, the bank obtains the property and leases it to the shariah compliant investor, who pays rent instead of interest. Earnings of profits or returns from assets are permitted so long as the business risks are shared by the lender and borrower. Ijarah: An Ijarah contract refers to an agreement made by the Islamic Banking Institution (IBI) to lease to a customer an asset specified by the customer for an agreed period against specified instalments of lease rental. An Ijarah contract commences with a promise to lease that is binding on the part of the potential lessee prior to entering the Ijarah contract. Istisna: An Istisna contract refers to an agreement to sell to a customer a nonexistent asset, which is to be manufactured or built according to the buyer's specifications and is to be delivered on a specified future date at a predetermined selling price. Murabaha: A Murabaha contract refers to a sale contract whereby the IBI sells to a customer at an agreed profit margin plus cost (selling price), a specified kind of asset that is already in their possession. Mudarabah: A Mudarabah is a contract between the capital provider and a skilled entrepreneur whereby the capital provider would contribute capital to an enterprise or activity which is to be managed by the entrepreneur as the Mudarib (or labour provider). Profits generated by the enterprise or activity are shared in accordance with the terms of the Mudarabah agreement, while losses are to be borne solely by the capital provider unless the losses are due to the Mudarib's misconduct, negligence and breach of contracted terms. Musharakah: A Musharakah is a contract between the IBI and a customer to contribute capital to an enterprise, whether existing or new, or to ownership of a real estate or moveable asset, either on a temporary or permanent basis. Profits generated by that enterprise or real estate/asset are shared in accordance with the terms of Musharakah agreement whilst losses are shared in proportion to each partner's share of capital. Salam: A Salam contract refers to an agreement to purchase, at a predetermined price, a specified kind of commodity not available with the seller, which is to be delivered on a specified future date in a specified quantity and quality. The IBI as the buyer makes full payment of the purchase price upon execution of a Salam contract. The commodity may or may not be traded over the counter or on an exchange. Sukuk: A Sukuk (certificate) represents the holder's proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset. Takaful: An equivalent to the contemporary insurance contract whereby a group of persons agree to share a certain risk (for example, damage by fire) by collecting a specified sum from each person. In case of loss to any one of the group, the loss is met from the collected funds.

Islamic finance in Mauritius

With the sub-prime crisis challenging conventional banking and financial products, there is mounting interest in Islamic products which comply with the principles of shariah law. The size of the global market for shariah compliant products is estimated at $800 billion. The increase in wealth in Islamic countries (especially in the Middle East with its accumulation of petrodollars), the growth in the Muslim population, the huge capital requirements for infrastructure projects across the Muslim world as well as the active participation of investors and sovereign nations in Islamic capital market have not only resulted in a remarkable growth in the Islamic finance industry but have also led to the development of a wide range of shariah compliant products. Mauritius has a long tradition of commercial banking dating back to 1812 and has historically adopted a cautious attitude to banking development. Until 2004, banking was split into two separate banking regimes - offshore and onshore - with only about ten offshore banking units admitted in Mauritius. The application process was rigorous and required applicants to submit audited financial statements for the previous five years. Since 2004, however, the legal framework has been rationalized and the Banking Act amended such that all banks are now governed by one single Banking licence. The banking legislation provides for prudential regulations with respect to banks' concentration of risk, weighted capital adequacy ratio, income recognition and classification of loans and advances for provisioning purposes, maintenance of accounting and other records and internal control systems. The Bank of Mauritius, the regulatory and supervisory body, has endorsed the Basle II Capital Accord and adopted the Basle Committee's Core Principles for effective supervision of banks. The Bank of Mauritius has also set up a calendar for all banks to be compliant to the provisions of Basel II framework by December 2008. Furthermore, the Bank of Mauritius forms part of the Offshore Group of Banking Supervisors and are a founding member of the Eastern and Southern Africa Banking Supervisors Group which is a Financial Action Task Force (FATF) style body for the region. In August 2008, amendments were made to the Banking Act 2004 that now allows banks in Mauritius to provide Islamic Banking services. Many banks showed an immediate interest in setting up Islamic windows, thus paving the way for Islamic banking in Mauritius. With the introduction of Islamic finance, Mauritius has a great opportunity to diversify its financial sector and provide new services in the fields of banking, wealth management and investment based on shariah Compliance. Since then in Mauritius too, there is a growing demand for shariah compliant products based on the sharing of risks and rewards. Over the past few years the government has taken an array of measures to encourage the development and promotion of Islamic banking and financial services. This has led to HSBC offering Islamic banking services in Mauritius. Islamic insurance (takaful) and Islamic leasing (ijara) are also available in Mauritius while microfinance is being offered by credit cooperative societies based on Islamic principles such as murabaha(deferred sale).Mauritius is also an active player in the global Islamic finance industry. Indeed, a combination of fiscal and non-fiscal factors has made Mauritius particularly attractive as a jurisdiction in which to structure Islamic financial products. A number of shariah compliant global funds have already been set up in Mauritius and there is an increasing interest in Mauritius as a place to structure Islamic bonds (sukuk). A number of shariah compliant funds have been set up in Mauritius because of its attractive taxation regime. Mauritius generally imposes a flat rate of income tax of 15%. However, funds holding a Category 1 Global Business Licence are effectively taxed at a maximum rate of 3% and can end up paying no income tax depending on the foreign tax credit. Dividends paid by a Mauritius company are exempt from tax and there is no capital-gains tax in Mauritius other than on sale of immovable assets in Mauritius. More importantly, Mauritius has entered into double taxation agreements (DTA) with 33 countries; this makes it particularly attractive for efficient tax structures. For example, a Mauritius fund does not pay any capital-gains tax upon the disposal of shares in an Indian company. Mauritius's strategic position in the middle of the Indian Ocean between Africa and Asia, and its time zone (four hours ahead of Greenwich Mean Time) makes it a preferred jurisdiction for structuring investments into those emerging markets. It has a multicultural society and a pool of qualified professionals able to speak English, French, and an ancestral language such as Hindi or Arabic, thus easing communication with clients in the Middle East and other Arabic-speaking countries. Mauritius has adequate anti-money laundering legislation and KYC (Know Your Client) regulations in place to curb the risk of attracting unlawful funds. In addition, Mauritius is not blacklisted by the OECD or Financial Action Task Force (FATF).

How it is regulated in Mauritius

Amendments were brought to the Banking Act 2004 by the Finance Act 2007, that existing banks licensed under the Banking Act 2004 are deemed to be licensed to carry on Islamic banking business through a window and may be granted licence by the BOM to conduct Islamic banking business eclusively. Every IBI shall conduct its business on the premise that its operations and financial means are in consonance with the ethos and value system of Islam. The parameters defining financial intermediation as conducted by the IBI shall be drawn in compliance with Shari'ah rules and principles. IBI shall either set up a Shari'ah advisory board comprising a minimum of 3 members or appoint a Shari'ah advisor. As an interim measure, IBIs may, among themselves but with prior consent of the Bank of Mauritius, set up a common Shari'ah advisory board, subject to the following conditions: (i) the common Shari'ah advisory board shall be instituted at the initiative of the IBIs that do not intend to have their own Shari'ah advisory board/ Shari'ah advisor, or alternatively by the Mauritius Bankers Association Limited. (ii) the common Shari'ah advisory board shall provide advisory support in Shari'ah matters, including the validation of financial products, exclusively to the IBIs that do not have their own Shari'ah advisory board or Shari'ah advisor; (iii) while ensuring that every member of the common Shari'ah advisory board abides by the principle of confidentiality, adequate measures shall be put in place to assess and deal with any conflict of interest that may arise out of the arrangements made for the IBIs to have recourse to a common Shari'ah advisory board. The Bank of Mauritius shall review the feasibility of continuing the above arrangement at an appropriate time in the light of future developments, more particularly the growth of Islamic banking in Mauritius.

General Principles

The prudential requirements of IBIs shall primarily subscribe to the Core Principles for Effective Banking Supervision of the Basel Committee on Banking Supervision (BCBS), and build upon the international standards set by BCBS by accommodating for specificities of Islamic finance. The current framework as prescribed is broadly based on the global prudential standards and guiding principles advocated by the Islamic Financial Services Board (IFSB) which is an international standard-setting organization that promotes and enhances the soundness and stability of the Islamic financial services industry.

Risk Management Processes

An IBI shall take an integrated and holistic approach in the management of risks that are borne on account of specificities of the Islamic financial products offered by it. An IBI shall, in conformity with Shari'ah's principle of prohibition in generating profit without the bearing of risks, implement a comprehensive risk management strategy in respect of the modes of financing which are essentially either (a) asset-based, (b) profit-and-loss sharing, being partnership or joint venture agreements between two parties based on Shari'ah's principle of Musharakah, or (c) profit-sharing and loss-bearing as defined under Mudarabah contracts. Accordingly, the IBI shall define and adopt risk mitigation techniques appropriate for each type of Islamic financial instrument held in its portfolio. 33. The IBI shall implement a sound investment strategy that is in harmony with its business objectives, while giving due consideration to the risk profile of its financial instruments and the interests of its investment account holders. A comprehensive approach to the investment strategy shall be put in place and shall comprise: (i) feasibility studies of projects and appropriate due diligence of investment partners; (ii) adoption of consistent valuation methodologies applicable for each financial instrument; (iii) monitoring of the transformation of risks inherent at each stage of the investment lifecycles; (iv) the setting up of a well-designed management information system for reporting and monitoring of risk exposures; (v) constant evaluation of market risk exposures arising from price fluctuations of the tradable assets held; and (vi) application of Shari'ah permissible risk mitigation techniques that will reduce the impact of any capital impairment on the investment projects. The IBI shall develop instruments of risk mitigation that are permissible and enforceable under Shari'ah rules. Such instruments may include collateral that shall be subject to regular valuation, insurance coverage for value of the assets, and compensation of claims from a lessee following a loss that materializes due to negligence or breach of contract on the part of the lessee. The IBI shall have an adequate process for determining allowances for doubtful debts that include counterparty exposures, and for estimating impairment in the value of leased assets. Subject to relevance for each type of financial instrument held in its portfolio, the IBI shall set aside provisions for the losses in accordance with the requirements of the Guideline on Credit Impairment Measurement and Income Recognition. An IBI shall establish a liquidity policy framework that primarily takes into account the liquidity exposures inherent in current account deposits which are placed in the custody of the institution and are payable on demand. An effective system of liquidity management shall be put in place such that cash flow projections incorporate all commitments and funding requirements pertaining to fiduciary duties of the IBI towards its investment contracts. In order to meet its overall liquidity requirements, the IBI shall a priori have recourse to Shari'ah compliant funds while having due consideration to the constraints existent in the financial market.

Transparency and Market Discipline

An IBI shall establish an effective disclosure regime that promotes and reinforces international standards on transparency of financial reporting by addressing elements that are specific to Islamic financial services. Transparency is a basic principle of Shari'ah which has a decree forbidding concealment of evidence. Lack of transparency is viewed as emanating from an asymmetry of information which may give rise to unfair advantage in a transaction. Accordingly, an IBI shall make accurate, timely and meaningful disclosure with respect to the investment accounts held in its portfolio, while giving due recognition to the protection of propriety and confidential information. An IBI shall adopt disclosure principles that will enable market participants to assess relevant key information to enable them to monitor the performance of their investments, and to have an understanding of the methodologies used for profit calculation, asset allocation, and whenever applicable, the mechanics of smoothing of returns. It is viewed that disclosure of material information leads to market discipline in terms of prompt adjustment in price and quantity, and will provide incentives to the IBI to avoid excessive risk-taking in the pursuit of its activities. An IBI shall abide by transparent financial and non-financial reporting practices that will work towards promoting soundness and stability of Islamic financial system.

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