The UK Islamic Finance Council and ISRA released an insightful analysis, “Enhancing Shari’ah Assurance” looking at the areas where Islamic finance could improve the process of Shari’ah certification, audit and disclosure (you can request a copy from IFC).
The report covered briefly the issue of Islamic financial institutions’ purification of non-Shari’ah-compliant activities, where incidental income from non-Shari’ah-compliant sources or penalty fees collected to ensure timely payment by customers is identified and donated in a way that does not benefit the IFI, either directly or indirectly.
The report identified that “the disclosure of purifications and charitable disbursements is limited” and suggested that the Shari’ah audit should include testing of both the identification of non-Shari’ah-compliant income and its distribution. This is much broader than just whether the IFI recognizes the penalty fees as income or not.
The review should identify “the nature of the charities supported and their social impact”, confirmation that management has not benefited from the disbursement and identification of whether the charities are ‘related parties’ (e.g. they have close connections with the management of the IFI).
I think this is an important recommendation and the degree to which the Shari’ah review is documented and made available for scrutiny by investors, customers, and the broader public will provide greater confidence in the oversight of Islamic financial institutions.
There are genuine (and some not genuine) critiques of how IFIs handle non-permissible income and whether there are ways that the disbursements could provide hidden benefits for the IFI and its management (the report mentions using the penalty income for sponsorship, where the institution would receive non-monetary benefit from the additional publicity).
This may seem nitpicky, but there are important rationales behind more intense scrutiny of the use of non-Shari’ah-compliant income by Islamic financial institutions, and it is easier to put in tough rules ex ante than it is to clean up the damage caused if an IFI were to be found using non-permissible income for its (or its management’s benefit). Additional disclosure is required as well to allow for comparison between the review practices between IFIs and also provide assurance that the audit process was conducted with sufficient rigor.
On Friday, the bankruptcy court authorized an unusual settlement between Arcapita and Standard Chartered (SCB) with respects to their secured murabaha that matured in March 2012.
Murabaha agreements require up front disclosure of both the cost of the asset, as well as the profit, and the date when the cost plus profit (based on LIBOR) is due. Typically, the intent of a murabaha is to create a debt that finances the activities of the borrower. That is somewhat controversial when the financing is obtained using commodities (through tawarruq), since the intent is to create a debt that is due upon maturity, with a profit to the financier, which replicates a conventional interest-based loan. However, it has its place in Islamic finance where an alternative is unavailable.
In the settlement with SCB, Arcapita is pushing the bounds of murabaha financing to ends that might be necessary within the bankruptcy case, but which has the intent of replicating a part of conventional finance that Islamic finance is widely understood to avoid.
Specifically, there is not supposed to be an excess paid beyond cost plus pre-specified profit if the debt is paid after the maturity date. Yet, in the settlement between Arcapita and SCB, the two parties are entering into a new murabaha facility that builds in accrued but unpaid profit from the period of time between the original maturity and the execution of the new murabaha facility.
The structure of the transaction is not disclosed in the document filed with the court (beyond being a new murabaha), but it will include in the profit both the profit payments going forward, as well as the accrued but unpaid facility after the first murabaha facility matured.
The new murabaha structure is easy to understand (again, another sale with deferred repayment including profit), but the inclusion of profit ‘accrued by unpaid’ after the first murabaha matured looks like a backdoor way to provide additional gain to SCB on the first murabaha beyond what was specified in the original murabaha.
From the perspective of the form of the transaction, this may be acceptable, but when viewed in totality, it looks like a backdoor way to avoid the restriction on fixing the cost and profit at the outset in the murabaha. In my estimation, it represents a cynical exploitation of the form-based approach towards Islamic finance by ignoring the intent of the parties in entering into another murabaha.
During the past week, Reuters reported that the Qatar Central Bank (QCB) extended the ban on Islamic windows to the Qatar Financial Centre (QFC) to “create a consistent approach to Islamic windows within the State”.
After reading the Reuters article, I went back to the 2011 IMF Article IV consultation on Qatar, which included an appendix looking at the effects of the QCB directive. The IMF found that “The growth rate of total loans including Islamic financing of the five conventional banks was 12.7 percent in this period, while total financing activities by the three Islamic banks declined by 0.6 percent”.
The IMF report only looked at a few months of data (February to June 2011), so I wanted to see what the longer-run impact was with the additional quarters since then. I re-ran the analysis looking at five large Qatari conventional banks (QNB, CBQ, Doha Bank, Ah Ahli Bank of Qatar, and IBQ) and three Islamic banks (QIB, Masraf Al-Rayan and QIIB).
The data I compared was net loans for conventional banks and Islamic financing for Islamic banks, using data starting at the end of the first quarter of 2011 through the end of June 2012.
The result is the same as what the IMF found: conventional Qatari banks saw loan growth of 48.3% between March 31, 2011 and June 30, 2012, while Islamic banks financing growth was 36.8%, a difference of 11.5%. If the QCB was hoping to see the elimination of Islamic windows at conventional banks lead to greater growth in Islamic finance, it was not a success (although this analysis doesn’t account for what Islamic banks’ growth would be absent the QCB directive).
However, since Islamic assets in Qatar accounted for 31% of the total assets (and 21% were at Islamic banks), if the directive had led to Islamic assets moving to wholly Islamic banks, that would have been a shift in 10% of the total assets (roughly QAR17.4 billion). That amount represents 76% of the total growth in Islamic bank’s assets during the period, so it would lead to markedly higher growth in financings for Islamic banks.
There are good explanations for the QCB directive (ensuring complete segregation of deposits and capital, the ability to target monetary policy better, and dealing with the differences in accounting standards). However, encouraging greater growth does not seem to be an outcome, something which is important for other countries to consider when planning their own regulatory approach to Islamic windows.
During the last week, HSBC announced it was pulling out of most of the markets where it offers Islamic finance (specifically the UK, the UAE, Bahrain, Bangladesh, Singapore and Mauritius), with the exception of wholesale Islamic financing and sukuk products. HSBC Amanah’s decision is noteworthy because of how many years it has been involved in the industry.
There has long been a tension between wholly Islamic banks (mostly located and operating in only one country) and the global banks that offer Islamic finance through Islamic windows. While there has been a lot of growth in the industry’s reach through these Islamic windows, and they have put significant competitive pressure on the industry as a whole to become more efficient, they also have a cost.
The global banks have crowded out wholly Islamic banks, which may have limited the ability of these Islamic banks to grow outside of their home markets. Without the brand recognition that the global banks have outside of their home markets, they are at a disadvantage.
Global banks have also stymied the development of wholly Islamic banks that face higher funding costs, and reduced profitability from having to compete with the conventional banks’ Islamic windows. This is the flip side of the positive competitive pressure that banks like HSBC introduce in the market that lowers the spread between the cost of Islamic banking and conventional banking.
While the decision from HSBC was rightly seen as newsworthy, it should not come as a surprise. First, many European banks have retreated back towards their home markets to some degree as they deal with the ongoing European debt crisis. Second, HSBC is a truly massive bank (it has $2.65 trillion in assets) so any segment of its business has to be pretty big to move the needle, and this looks to be at least some of the reason why it is retrenching to the larger Islamic finance markets in Malaysia and Saudi Arabia, with a limited presence in Indonesia.
It will be interesting to see whether other banks with Islamic windows reach a similar conclusion and open the smaller markets to wholly Islamic banks. That would be a more natural way to make the transition towards wholly Islamic banks than the Qatar Central Bank directive which shut down conventional banks’ Islamic windows.