HARMONISING CONTRACT-BASED SHARI`AH REQUIREMENTS & MARKET REALITIES: WILL IT WORK? Professor Dr Engku Rabiah Adawiah Engku Ali International Islamic University Malaysia rabiah@iium.edu.my Islamic Finance Intellectual Discourse 18-20 October 2016 Melaka, Malaysia
INTRODUCTION It is often said that Islamic finance has to fulfill 2 major requirements in order for it to be viable: Shariah requirements Market requirements However, the main question is, is this achievable? Will it work? This presentation attempts to look into this issue, highlighting: The challenges in harmonising contract-based Shariah requirements and market realities with some examples/case studies The way forward? 2
CHALLENGES? Islamic Finance does not operate in a vacuum It exists in an ecosystem comprising various inter-connected segments: socio-economic norms & culture; legal & regulatory environment; tax regime; political landscape; financial reporting framework; etc. Sometimes, this ecosystem (market realities) does not provide the ideal environment for a successful harmonization to happen 3
THE ECO-SYSTEM IN WHICH ISLAMIC FINANCE CO-EXISTS Environment: Ecological issues Force majeure Disaster management & relief Social: Human capital Human nature strength & weaknesses Human preferences Technology information, media Managing human perceptions & idiosyncrasies Islamic Finance Politics: International policies Government policies Political will Conventional economy/ financial system: Conventional ethos Interest-based system Competition Legal: Law Court system Taxation Accounting requirements/ treatments 4
MAIN CHALLENGE: SOCIO-ECONOMIC NORM & CULTURE Market requirements are normally dictated by socioeconomic norms & culture of the people Are market norms & practices value-neutral? Conventional worldview vs Islamic worldview? Capitalistic worldview vs khilafah worldview? 5
ISLAMIC WORLDVIEW ON WEALTH CREATION & ENJOYMENT? Aims at creating value, whilst observing Shariah principles & philosophies: Wealth as a trust accountability & responsibility Avoidance of oppressive transactions prohibition of riba etc. Promoting a fair & just way of doing finance win-win deals Avoidance of uncertainty, ambiguity & concealment of material information in contracts prohibition of gharar, misrepresentation & fraud Promoting disclosure & transparency in commercial deals Trustee role to use resources in a fair & accountable manner for the good of all (balance between individual interests & societal interests) 6
UNIQUE VALUE PROPOSITION OF ISLAMIC FINANCE? Financing real economic activities that seek to promote the quality of five basic essentials: Religion, life, intellect, property and family relations; Based on the extent of the needs: Necessities (daruriyyat) Needs (hajiyyat) Complementaries (tahsiniyyat) Prioritisation in the use of economic resources to achieve optimal use based on need analysis maqsad hifz al-mal 7
DIVERGENCE BETWEEN CONVENTIONAL WORLDVIEW VS ISLAMIC WORLVIEW? CONVENTIONAL WORLDVIEW ISLAMIC WORLDVIEW - MAQASID AL-SHARI`AH 8
DIVERGENCES BETWEEN ISLAMIC WORLDVIEW & PREVALENT SOCIO-ECONOMIC NORMS? Profit maximization vs responsible & fair use of resources Risk return appetite: Al-ghunm bil-ghurm profit comes with liability vs risk transfer with maximisation of return Expectation of fixed return plus capital guarantee Credit consumerism & leveraging Moral hazard: Breach/lack of trust Negative attitudes 9
MAIN CHALLENGE: LEGAL & REGULATORY ENVIRONMENT Definition of banking & financial business? Conventional understanding of deposit taking & financing: purely lending & borrowing transactions Islamic banking and finance: based on trade & partnership: not within the conventional understanding Necessitates change in the law & regulation, e.g. IBA, IFSA 2013 Tax issues Requires tax neutrality provisions to provide level playing field Prudential regulations: risk weightage & capital charge Not friendly to some Islamic contracts: e.g. profit & loss sharing contracts 10
A NOTE ON IFSA 2013 A noteworthy claim about IFSA 2013 is that it provides the foundation for the shift towards a contract-based regulatory framework by providing legal recognition to the contractual requirements in accordance with the Sharīʿah, thus ensuring alignment in terms of legal and regulatory treatment of Islamic financial transactions with the underlying Sharīʿah contractual principles (MIFC, 2014). In fact, this Act has been hailed as a landmark legislation, setting a global benchmark that could be used to develop more comprehensive regulatory frameworks that promote greater legal and operational certainty in Islamic finance (MIFC, 2014). 11
MAIN CONTRACT-BASED SHARIAH REQUIREMENTS VS MARKET REQUIREMENTS Contract-based Shari`ah Requirements Sale contract: Requirement of asset Pre-determined fixed price Some restrictions in the trading of some financial assets e.g. debt/receivables Ijarah/lease contract: Requirement of asset Durability of asset Requirement of usufruct Ishtirak/partnership contract: No guarantee on capital No guarantee on profit Liability for losses no preferential treatment in loss absorption Market & Commercial Requirements Sale contract: Difficulty to find suitable asset intangibles/financial assets? Tax issues (e.g. RPGT) Preference for floating rate to hedge against price risk for long-term financing Ijarah/lease contract: Difficulty to find suitable asset Impracticality to transfer asset for the duration of financing Ownership risk & loss of usufruct risk Ishtirak/partnership contract: Risk weightage capital charge Want guarantee on capital & profit Ability to take collaterals, credit enhancements 12
Market & Commercial Requirements ADJUSTMENTS NEEDED? Sale contract: Difficulty to find suitable asset intangibles/financial assets? Tax issues (e.g. RPGT) Preference for floating rate to hedge against price risk for long-term financing Ijarah/lease contract: Difficulty to find suitable asset Impracticality to transfer asset for the duration of financing Ownership risk & loss of usufruct risk Ishtirak/partnership contract: Risk weightage capital charge Want guarantee on capital & profit Ability to take collaterals, credit enhancements Adjustment made to Harmonise the Divergence? Sale contract: Introduction of commodity houses & use of tawarruq Tax exemptions/neutrality Use of ibra to achieve floating rate effect Combination of debt & non-debt assets according to the ratio Ijarah/lease contract: Forward lease Service agency arrangement: maintenance & insurance/takaful cover Asset substitution Ishtirak/partnership contract: Third party guarantee on capital Tanazul of profit share PER, top-up promise, etc. 13
DOES THE HARMONISATION WORK? Case Study of Sukuk
SUKUK MARKET Phenomenal growth of sukuk market Sukuk one of the most talked about sector of Islamic finance Why sukuk? Raising finance (funds): Sovereign Corporations For what? Infrastructure development Working capital Project finance Etc Benefits? Potentially cheaper cost, liquid & tradable instrument in financing development, projects & real economy 15
SUKUK: BALANCING MARKET REQUIREMENTS WITH SHARI`AH REQUIREMENTS Market / commercial goals Fulfilment of Maqasid al Shari`ah Shari`ah compliance requirements 16
THE BEGINNING: SUKUK AS ALTERNATIVE TO BONDS It all started with the thinking that an alternative to conventional bonds & debt securities is needed Malaysia began with its debt-based bonds & debt securities using buying & selling contracts in the like of BBA & murabahah as early as 1990 Some what met the basic bonds & debt securities behaviour that it was meant to replace, i.e.: Debt in nature, with a fixed rate coupon Capital & profit can be guaranteed & secured Tradable (based on the official Shariah opinion in Malaysia) Fit fairly well in the conventional, legal & regulatory understanding of bonds/debt securities Can use the existing automated electronic trading platform Practical problem asset is always needed in the structure 17
MEETING SHARI`AH REQUIREMENTS: DIFFERENCES IN SHARI`AH OPINIONS The Islamic debt securities market managed to grow in the Malaysian domestic market during the 1990s, but failed to attract global recognition & acceptance Main issue: the creation of debt via sale & buy-back arrangement construed as bay` al-`inah that most of the scholars in the other markets disapproved Trading of the papers on the secondary market sale of debt (bay` al dayn) with discounting also been disapproved by scholars in other markets. 18
SUKUK AL IJARAH: THE BREAKTHROUGH? 2001 onwards the market started to experiment with lease-based structures A new understanding emerged sukuk ijarah represent real/tangible asset that is sold & leased back to the obligor with profits in the rental payments This marked an important transition in market understanding Islamic securities need not necessarily evidence debt (like conventional bonds) Sukuk ijarah managed to meet most market requirements for an alternative to bonds, i.e. fixed/floating rate coupon, can guarantee / secure capital & profit, tradability, etc. Practical problem remains asset is always needed in the structure 19
MUDARABAH & MUSHARAKAH STRUCTURES Essentially equity in nature no debt Necessitates a change in regulation in Malaysia from PDS Guidelines 2000 to Islamic Securities Guidelines 2004 & later Sukuk Guidelines 2011 Have certain features that are not conventional in bonds market: No guarantee or security on capital / profit No fixed rate on the coupon only indicative rate is allowed Yet, have certain features that are perceived positively Can be structured to be tradable Do not necessarily need an asset to begin with 20
MUDARABAH & MUSHARAKAH STRUCTURES: MEETING THE MARKET REQUIREMENTS Between 2004 2008: the market devised techniques to minimise the unconventional features of mudarabah & musharakah sukuk: Purchase undertaking Liquidity facility top-up promise Hurdle rate & incentive fee / reward 2008 pronouncement by AAOIFI Shari`ah Board Post pronouncement? Back to sukuk ijarah? Sukuk wakalah bil istithmar? Commodity Murabahah? Try ABS? Accept the equity features as they are & be transparent about it? Other options?? 21
SIZE OF CORPORATE SUKUK APPROVED BASED ON SHARIAH PRINCIPLES Size of corporate sukuk approved based on Shariah principles in 2015 Source: Securities Commission Islamic Capital Market Statistics The proportion of murabahah sukuk has grown further in the 1H of 2016 to 85% of the total corporate sukuk approved based on Shariah principles; whilst musharakah and wakalah constitute 1% each; and the remaining 13% is combination (Source: Malaysian ICM Bulletin, 2016, Vol 11, No.1) 22
THE ECO-SYSTEM NECESSARY FOR A HEALTHY & SUSTAINABLE ISLAMIC FINANCIAL SYSTEM Good Promotion & Marketing Strong & Effective Shariah Framework & Governance Strong & Competent Human Capital Continuing Education & Training Islamic Financial System Strong Legal Support: Law, Legal services & dispute resolution Efficient & Cheap Information System & Databases Strong & Timely Research & Development Function Friendly political, accounting, tax & risk management regime 23
CONVERGENCE BETWEEN SHARI`AH & COMMERCIAL GOALS COMMERCIAL GOALS SHARI`AH GOALS 24
SHAR`IAH COMPLIANCE CREATES VALUE Abu Ishaq al Shatibi: God made this blessed righteous Shari`ah accommodating and convenient and thus won the hearts of human beings and invoked in them love and respect for law. Had they had to act against convenience they could not have honestly fulfilled their obligations Shari`ah Compliance = Accommodating & Convenient 25
PROTECTION OF WEALTH/PROPERTY (HIFZ AL MAL) Protection (حفظ األموال) Available/ Accessible (الرواج) Clarity (الوضوح) العدل ( Justice (في األموال Stability (الثبات) 26
OUR POSITION? Gaps? Where? Why? How? 27
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