The rise and acceptance of Islamic finance can be counted among the most significant innovations the financial industry has witnessed. A lot has been accomplished by innovatively addressing the financial needs of customers within the framework of underlying tenets of religious faith. What are the challenges and opportunities going forward?
The Pillars of Islamic Finance
Islamic finance is an outcome of the need to extend the tenets of religious faith to economic activity in such a way that benefits are evenly shared among all the stakeholders and the economy as a whole (see box: Basic Pillars of Islamic Finance). Some of the other underlying features of Islamic finance include:
- Time due of money. Under Islamic finance, time due of money is not recognized, i.e. once the sale price is fixed for financing, even if the asset were to become 'non-performing' the institution1 cannot claim more than the pre-fixed sale price. The dues to the institution, once fixed, remain fixed.
- Asset backed: Typically all Islamic structures have an underlying asset backing the deal. As such, financing under Islamic structures has a propensity to control inflation.
- Means and end: Though profitability can be stated as a common 'end' for both Islamic and conventional financial institutions, the Islamic institutions carefully structure and adhere to procedures and process steps (means) to ensure that the profits earned are in line with the Shari'a prescriptions.
- Process orientation: Each of the financing structures is composed of processes and tasks. Even if a transaction was to be fulfilled by missing 'one task', the transaction will be rendered invalid in the eyes of Shari'a. For example, in a Murabaha transaction, the institution is permitted to earn profit only as a reward for risk undertaken as evidenced by the institution taking prior possession of the asset. If the institution did not have the prior possession (and hence the risk of destruction) the transaction would be invalid.
The Journey So Far
Flexibility
Institutions have demonstrated flexibility and innovation in structuring financing under multiple structures. For example, property finance (ready-built) can be extended under Murabaha, Ijarah or even Diminishing Musharaka. Typically this flexibility offers customers choice to opt for financing under any of the available structures. Also, since the institution cannot be expected to manage the 'asset layer' on its own, the concept of agency (Wakalah) is deployed both at procurement level and post-sale level (e.g. maintenance in an Ijarah contract) where the customer itself is appointed as the agent.
The balance between customer and institution
Islamic finance principles ensure that a mutually beneficial balance is maintained between the customer and the institution. The customer, for example, is protected in an Ijarah transaction if the asset were to be totally destroyed owing to factors beyond the customer's control. The customer also benefits from upfront clarity since typically the deal and the underlying documentation are structured in an unambiguous manner (to rule out 'Gharar' - uncertainty). Also 'mutual consent' is required for any modifications/alterations to any of the partnership-based structures. These underlying principles ensure that the customer is duly represented in the deal right through the term. The structures also ensure that the institution is not placed in a position of disadvantage. Islamic institutions face greater risks since they go beyond the financing layer to the underlying 'asset layer'. As such, built-in structures in terms of security deposit (Hamish Jiddiyah), documentation e.g. unilateral promise/undertaking, trust deed, etc., ensure that institution's interests are duly protected.
Innovation
Institutions have been introducing products based on innovative structures, such as:
- Credit cards based on annual fee (Ujr) without any other profit element added.
- Utilization of concept of Tawarruq (tripartite sale) for addressing the liquidity needs of the customers.
- Leverage of services Ijarah towards financing education, medical treatment etc, thereby eliminating the need to extend monetary financing to customers.
Collaborative network
Financing based on structures like Istisna'a and Salam require an institution to enter into independent parallel contracts. Such contracts are entered into with manufacturers and buyers of the underlying asset respectively. Thus the institution acts as an interlinking factor by managing a collaborative network of demand and supply.
Collaboration with conventional banks
Increasingly conventional banks are collaborating in syndicated financing deals with the institutions. Large deals based on Ijarah, Musharaka structures are being financed in this manner.
The Basic Pillars of Islamic Finance
- Basis of Shari'a: Shari'a (Islamic law) forms the basis of the framework of Islamic finance. The Shari'a is derived from five sources - The Holy Qur'an, the Sunna of the Holy Prophet (PBUH), 'Ijma' - consensus among the jurists, 'Qiyas' - analogy and 'Ijtihad' - reasoning.
- Schools of thought: Over time, various schools of thought have shaped and lead the development of Islamic finance. The popular schools are: Hanafi, Maliki, Shafi and Hanbali.
- Prohibitions: The following are specifically prohibited - 'Riba' - interest, 'Gharar' - uncertainty, 'Maysir' - gambling, hoarding, and dealing in unlawful goods or services. Islamic institutions structure their products and processes to ensure total compliance.
- Basic Islamic Finance Structures: The popular Islamic financing structures are:
- Musharaka - A partnership structure that represents a 'joint enterprise' in which all partners share the profit and loss of the joint venture. Various products such as financing imports, exports, working capital, project finance, etc., can be structured using this concept.
- Mudaraba - A partnership structure where contribution is from one partner and management is by the other. Various deposit products are structured using this concept.
- Murabaha - A sale structure where a specific commodity is sold on a cost-plus basis. Various products like auto/vehicle loans, goods loans, property loans and equipment loans are structured under Murabaha. This is the most popular mode of financing.
- Ijarah - A sale structure based on rentals for usage of underlying asset/services. Comparable to 'leasing' product from the conventional world, it is a very popular mode of financing.
- Istisna'a - A sale structure where the underlying asset is to be built. Various products like project financing, construction financing are structured under Istisna'a.
- Salam - A sale structure that provides for future dated sales against advance payment.
Challenges and Opportunities: How to Progress
The players for the Islamic finance market can be viewed in three categories:
- Conventional Islamic banks.
- Commercial banks with an Islamic finance window/subsidiary.
- Commercial banks evaluating an entry into Islamic finance.
The challenges and opportunities facing each of these categories of institutions will be different given different points of departure (where they are) and points of arrival (where they want to be). Some of the possible areas that need greater focus from a 'conventional Islamic bank' perspective are discussed below at two levels: external and internal.
External to the institution
Growth markets and scope of services
Institutions are subject to 'dual compliance' viz both Shari'a and regulation of the land (where the institution is domiciled). Viewed as 2x2 matrix - with X axis as 'regulation of the land' with 'permissible' and 'non-permissible' options and Y axis as Shari'a regulation with 'permissible' and 'non-permissible' options, the scope of operations of Islamic institutions is limited to a 'single quadrant' that has permissibility under both the laws. In traditional home markets where there is greater alignment between both the laws, the scope of services is relatively higher. With conventional banks providing Shari'a compliant products in home markets under the 'Islamic window'/'subsidiary' route, pursuit of growth outside the home markets will be an imperative. Institutions that attempt to enter newer markets will have to measure the alignment and levels of 'co-existence' between the two sets of regulations and determine the scope of services.
Standardization - a fine balance
The permissibility of a structure for an institution is in the hands of the Shari'a board of that particular institution. Based on extensive discussions, reasoning (Ijtihad), analogy (Qiyas) and the resultant consensus (Ijma) - a structure is approved or declined by the Shari'a board. On the other hand leading institutions like the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) are working hard to align principles on a collective basis. A fine balance is required between the collective initiatives (collaborative space) and institution specific initiatives (competitive space) to ensure that standardization is achieved while keeping the flame of innovation alive.
Fee services/transaction banking
Institutions are comfortably placed in providing transaction services like payments, collections, account services, utility payments, etc to their customers. These services do not have an element of financing and are rendered for a fee. This could be an area that Institutions can attempt to grow on. This could also be one of the first services to be offered when institutions are looking at entering new markets. Latest advances in transaction banking like XML based messaging (ISO 20022) and trade services utility (TSU), etc can be fully leveraged.
Benchmarking
Selective benchmarking against conventional banking is a powerful tool that can provide useful insights into new product development. Conventional banks have always been up against restrictions and have been successful at arriving at acceptable business practices to ensure smoother operations. For example, intercompany lending (liquidity solutions) in
Internal to the institution
Product configuration and process orchestration
It is a challenge to create and maintain the IT systems in such a manner that they continuously support the current products and also implementation of new product innovations on an end-to-end basis. Also some of the deals may be supported by the systems only to the extent of booking with little or no support in 'origination' and 'servicing', leaving such activities to be fulfilled manually. Deployment of process orchestration systems will assist in step wise fulfillment and visibility of processes. They also aid in wiping out possibilities of process non-compliance, which in some cases could render the transaction invalid in the eyes of Shari'a.
Greater operational risk
Owing to participation in the 'asset layer' there are additional sets of risks an institution is exposed to. These risks also vary depending upon the nature of the underlying asset and the financing structure. For example, in a normal lease the contract is terminated in case of complete destruction of the asset, whereas in a forward lease the contract is not terminated. Also, non-obtention of documents that essentially protect the interest of the institution like promise to purchase, trust deed, etc. could affect the enforceability and result in financial loss. Along with traditional risks (known in conventional banking) all such risks arising out of the structures of financing have to be identified, measured, monitored and managed at the institutional level.
Cost management
It is sometimes opined that Islamic financial services tend to be on the more expensive side than the comparable services of conventional counterparts. While fees can be charged for services rendered (Ujr) and all permissible expenses incurred by the institution under structures like Mudaraba are deductible, the institution will only be better off in utilizing offshore leverage and/or similar measures, that could effectively contribute to lowering the differential in cost of services and also contribute to a better profit pool available for sharing with customers under investment schemes (Mudaraba) and/or partnerships (Musharaka).
KYC norms
Know your customer (KYC) is equally important in Islamic finance. If the business/purpose for which the finance is being extended is prohibited in Shari'a, the whole transaction would be void. Also, such information can be a significant contributor to choose the structure under which finance is extended. For example, if working capital finance is extended under the Musharaka structure there is every possibility that the customer can project lower profits at the expiry of term, leading to a lower share of profits for the institution than are otherwise due. Hence it is very important to factor in the latest customer information prior to extending finance through a relevant structure.
E-documentation
Islamic finance tends to be document-intensive. This is because typically each transaction has multiple phases - contract, procurement, sale, financing and servicing. Various documents are required to be completed during the various stages of the deal. Completing all the documentation at once may render the transaction void. Also 'elapse of time' between the stages is some times primary to the acceptance of the structure itself (e.g. Tawarruq). Adoption of e-documentation can obviate the need for multiple physical meetings, evidence the elapse of time and also alleviate the need to maintain paper and related storage and retrieval costs.
Credit risk scoring and modelling
Products may be offered not only on the basis of assessment of customer's credit worthiness but also by linking the customer assessment to the risks of the structure of financing. For example, products for low risk customer segments can be structured on a Musharaka basis (sharing) whereas for relatively riskier customer finance may be extended on a Murabaha (cost-plus sale) basis. Also it is to be noted that some of the leading scholars believe that Musharaka and Mudaraba are the ideal structures and where possible, such structures are to be preferred over structures such as Murabaha. Risk scoring and modelling tools could assist in moving customers with a good track record from sale based structures to partnership (Musharaka and Mudaraba) structures thereby increasing the representation of partnership structure based advances in the overall portfolio.
Conclusion
Institutions have made a significant difference in their home markets. The time is ripe for them to 'up' their reach and scale. There are opportunities in the guise of challenges. Concerted effort both in the collaborative and competitive space will ensure that the institutions make concerted progress in many markets.
By: Venu Gopal, Tata Consultancy Services - Hari
The author would like to thank Vijaysankar CG for his contribution to this article.
1In this article, the word ‘Institution’ means ‘Conventional Islamic Financial Institution’ unless otherwise mentioned.
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