Islamic finance in Australia Part 1 - Introducing Islamic finance

Islamic-Finance-1.jpg
13 July 2012

Islamic finance has been around for centuries but has been exponentially increasing since the oil boom of the 1970s, developing innovative structures along the way as an alternative to conventional finance. It’s emerged as one of the fastest growing segments on the global financial services landscape. According to Ernst & Young’s inaugural World Islamic Banking Competitiveness Report 2011-2012, Islamic banking assets globally are predicted to reach US$1.1 trillion this year (a rise of 33% from 2010 levels).

In September 2008, the Government commissioned a report into how to position Australia as a leading financial services hub in the Asia-Pacific region.  The result was the Johnson Report, which made a number of recommendations including two specific recommendations relating to regulatory barriers and tax treatment issues affecting the development of Islamic finance.  The Government has slowly but actively undertaken other initiatives to explore this emerging market, including sending a delegation in April 2010 headed by Minister Nick Sherry (the Assistant Treasurer at the time) to the Middle East to explore opportunities for Australia. 

The measured development of Islamic finance in Australia is essentially due to ‘education’ and ‘regulation’.  The first challenge for the Government, and those keen on seeing Islamic finance grow in Australia, is education.  That is, educating Australia’s Muslim and non-Muslim population to understand what Islamic finance is and what opportunities it presents to Australia’s financial services sector.  

Part 1 of this emerging markets article aims to assist in the ‘education’ process by introducing Islamic finance.  Part 2 will look more closely at the second challenge, being regulation and the difficulties it brings to developing Islamic finance in Australia.

What is Islamic finance and how is it different to conventional finance?

Islamic finance is essentially an economic system based on trade and investment principles prescribing ethical and moral considerations.  Many see it as a subset of ethical or socially responsible investing.

A key distinguishing feature of Islamic finance is that money must be made from genuine trade or economic activities.  Money cannot be made from money.  As such, Islamic finance prohibits the charging of interest (replaced with the concept of ‘profit’ from trade activities) and requires that wealth should be achieved in lawful ways promoting mutual consent, timeliness, honesty and goodwill.  These “Shariah” principles distinguish Islamic finance from conventional finance.

“Shariah” refers to compliance with Islamic legal principles.  These principles are primarily derived from:

(a)   The Qur’an; and

(b)  The traditions of the Prophet Mohammed, known as “Hadith”.

 What are the key principles?

The key principles governing Islamic finance products and transactions include:

Prohibition of “Riba” (interest)

Conventional banking is based on the premise of lending money in return for a premium known as ‘interest’.  Islam prohibits this premium because money should be earned or profit made from taking part in trade activities.  Money earned without undertaking any trade or risk taking is prohibited.

Requirement for underlying assets

Distinct from conventional transactions, Islamic transactions that are sale- or lease-based are required to have an underlying asset.  In the absence of this, the contract will be void.

Avoidance of “Gharar” (uncertainty) or

“Maisir” (gambling)

Islamic transactions must be certain to satisfy Shariah compliance.  Further, transactions based on speculation or gambling are prohibited as returns should only be made from transactions where the parties have exerted some effort.

Profit sharing

The concept of profit sharing is unique to Islamic finance.  This is evident in various Islamic structures that have emerged (which will be considered below). 

Shariah compliance

This is a key aspect of Islamic finance.  It adds an additional layer of governance to institutions offering Islamic products, requiring that the institution ensures Shariah compliance is met.  A failure to do so would mean that an institution cannot claim to be Shariah compliant.

Unlawful activities

Another important and controversial feature of Islamic finance is that trading or investing in certain activities is considered unlawful.  This requires that the underlying asset or investment be Shariah compliant.  Prohibited activities or investments include those relating to:

  • non-halal foods such as pork;
  • intoxicating drinks;
  • entertainment and pornography;
  • tobacco; or
  • weapons.

The prohibition extends to all aspects of the supply chain for such products including their production, distribution and transportation.

Governance

While the key principles governing Islamic finance appear on their face to be relatively clear, their exact scope leads to varying interpretations from Islam’s four main schools of thought.  These varying interpretations could be seen as an obstacle to the development of Islamic finance.

To address this issue, governing bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have been established to prescribe international standards and guidelines. 

These guidelines are not limited to the design of a financial product but extend to a financial institutions’ operating standards, IT procedures, risk management and marketing, as well as accounting and auditing considerations.  The standards assist with measuring compliance across jurisdictions and help to ensure uniformity of practice across the industry.

Further, there is a requirement to establish either a Shariah Advisory Board or Shariah Supervisory Board.  In certain jurisdictions an Islamic bank or banking window will not be issued a licence unless a Shariah board is established.  The role of these boards is to ensure Shariah compliance in respect of an entity’s products and transactions, key features of each are detailed below. 

A Shariah Advisory Board is usually appointed by conventional banks that offer Islamic products or that have established an Islamic banking window and typically advise on certain financial products.  A Shariah Supervisory Board is appointed by Islamic financial institutions and has a wider role and responsibility for overseeing the day-to-day activities of the institution as a whole.  These boards are typically governed by standards established by AAOIFI, which include the requirement for members to have certain expertise and be independent.

Comment: The AAIOFI and IFSB guidelines and standards may provide some comfort for counterparties, regulators and governments looking at Islamic financial products.  However the exact scope of supervision and enforceability of these guidelines remains to be seen, particularly in jurisdictions that have not yet made the standards binding.  The standards are currently only binding in Bahrain, Sudan and Dubai.  As such, the standards will not be binding on all Islamic financial institutions.

What financing products or structures have emerged so far?

Islamic financing structures have been developed to address market needs for Shariah compliant products.  Many would argue that these products are similar to conventional products but have been repackaged to address Shariah principles.

Islamic finance product development and innovation is quite broad and has yet to reach its peak.  Some of the key financing structures that have emerged so far include:

1.           Equity based financing

The two main structures used in equity financing are “Mudarabah” and “Musharakah”.

  • Mudarabah (financier is merely a silent partner or investor)

This is commonly used or intended to be used in project financing and venture capital financing.  Under this arrangement, one party provides the finance and the other the expertise and management.  The parties agree to distribute profits at a pre-agreed ratio.  The financial risk is borne solely by the finance provider.

  • Musharakah (joint venture or partnership arrangement)

This is commonly used to finance the acquisition of assets.  This form of arrangement is applied to trade financing.  The finance provider and its partner will each contribute capital on an agreed profit-sharing ratio.  The financial risk is shared among the parties in proportion to their capital contributions.  Management of the venture can be outsourced.

2.             Debt-based financing

While there are many structures that have emerged within the realm of debt financing, the key structures are:

  • Murabahah (cost plus arrangements)

This arrangement is used for asset financing.  It essentially involves a sale under which the vendor acquires an asset then sells the asset to the buyer at cost plus a mark-up.  This avoids the payment of interest.

  • Ijarah muntahia bi tamleek (lease ending with ownership)

This arrangement is also used for asset financing (for example car or equipment financing), similar to a conventional hire-purchase arrangement.  It involves a combination of lease and sale.  The bank acquires an asset and then leases the asset to the customer for a particular period.  The bank provides the customer with an undertaking to sell the asset to the customer at the end of that period.

  • Salam (and parallel salam) and Istisna’ (and parallel istisna’)

These are essentially deferred sale arrangements under which a contract is entered into for the manufacture of a product, to be delivered at a future date.  A salam arrangement is more widely used for the manufacture of agricultural products or resources such as minerals or coal.  An istisna’ arrangement, on the other hand, is used where there is a proposed construction of a large project such as a building or highway.  Payment is made in advance under a salam arrangement whereas there is more flexibility with respect to the terms of payment under an istisna’ arrangement.

Comment:  The Murabahah model identified above requires that the underlying asset change hands on two occasions.  First, when purchased by the bank or financial institution, and secondly when it is sold to the buyer at cost plus a mark up.  In Australia this results in the payment of stamp duty on two occasions under the one transaction.  As at the date of this publication, Victoria is the only state in Australia that has amended its stamp duty laws to eliminate the double payment of stamp duty on such transactions.  No other State or Territory has done so.  Further, a capital gains event may also be triggered.

3.            Capital market instruments

  • Sukuks’ (Islamic bonds or investment certificate)

Sukuks’ are a product of securitisation.  This involves:

(a)        aggregation of assets; and

(b)        packaging of assets into marketable securities.

Sukuk holders essentially hold a monetary-denominated certificate entitling the holder to participate in the returns generated by the assets held in a special purpose vehicle (SPV).

The table below highlights the distinctive features of Islamic bonds versus conventional bonds:

Sukuk

Conventional Bonds

Hold an undivided beneficial interest in the underlying assets (held by an SPV set up for this purpose)

Contractual debt/debt security

Entitlement to share of revenue generated by assets

Obligation to repay debt (principal and interest) to holders at a particular date

Can be traded on secondary market

Can be traded on secondary market

Issued by governments and corporations

Issued by governments and corporations

Many types of Sukuk structures have emerged.  The most common, however, is the “Sukuk al-Ijarah”.  The structure is one that is derived from the sale and leaseback concept.  The basic principles of this structure are:

  • issuer sells asset to investors via an SPV for monetary value;
  • investors subscribe to the SPV;
  • asset is leased (by the SPV) to the issuer for a rental fee;
  • SPV issues investors with bonds or investment certificate; and
  • proceeds of rental fee distributed among investors on a pro-rata basis.

Comment: As at the date of publication, no Sukuk’s have been issued in Australia.  It is forecast that the global Sukuk market could reach $125 billion this year.

4.            Islamic funds

An Islamic fund closely resembles a conventional fund.  It is essentially a common pool of funds contributed by investors for the purpose of investment.  The relationship between the fund manager and investors is based on a Mudarabah partnership (see above).  Returns in the fund are not guaranteed.  Profits and losses in the fund are shared by investors equally.

The key feature that distinguishes Islamic funds from conventional funds is that Islamic funds must generate profits from lawful means.  Islamic funds include equity funds, commodity funds, property funds, mixed funds and superannuation funds.

The most common is the Islamic equity fund.  Like its conventional counterpart, the Islamic equity fund invests in listed stock.  However unlike its conventional counterpart an Islamic equity fund (and Islamic funds generally) must adhere to the following key rules:

  • underlying investment must be Shariah compliant (stock cannot be acquired in a company that undertakes or invests in unlawful activities);
  • the business of the underlying investment must not contravene Shariah (such as a financial services company providing interest-earning products); and
  • the business of the underlying investment may have some interest-bearing accounts.  If this constitutes less than 5% of the entire company (a ratio that may differ between various schools of thought) then investment is Shariah compliant but the fund will need to ‘purify’ its return/profit by giving 5% of the dividend to charity.  If more than 5% of the fund consists of interest-bearing accounts, investment in the stock of that company is prohibited.

The purification process referred to above is commonly included in the constitution of the fund or the fund’s investment procedures and approved by the Shariah board.  Typically, the purification of what is referred to as ‘tainted income’ (because it includes interest) emanating from such investments involves donating that tainted income to charity.  Varying opinions exist regarding the exact percentage, process and scope of the purification process.

Most international Islamic equity funds invest in stock appearing on various Islamic indexes, including the Dow Jones Islamic Market Index and the Standard and Poor’s Global Benchmark Shariah Index.

Comment: Earlier this year Thomson Reuters and Crescent Wealth (Australia’s first Islamic wealth manager) jointly launched the Thomson Reuters Crescent Wealth Islamic Australia Index.  This index is the first of its kind in Australia and compliments Crescent Wealths’ equity fund, the Crescent Australian Equity Fund, launched in 2011.

5.            Takaful (Islamic Insurance)

The Islamic alternative to conventional insurance is known as “takaful”.  “Takaful” in Arabic means “guaranteeing each other” and has at its core the system of “tabarru”, which refers to making donations or gifts. 

The table below highlights the distinctive features of takaful versus conventional insurance:

Takaful

Conventional Insurance

Contract of donation.  No commercial aim, based on a mutual assistance scheme

Sales contract between insurance company and insured/policy owner

Profit sharing or compensation according to Shariah principles

Indemnity paid to policyholder in return for consideration (premium paid)

Profit (money) must be invested according to Shariah investment principles

Insurance money invested in conventional instruments (i.e. stocks and other financial products including interest earning products)

Uncertainty in contracts of donation is tolerated because the nature and objective of these contracts is not to make a commercial gain.  Takaful operates on the premise of shared responsibility, mutual cooperation and assistance which provides protection against financial risk (or mutual indemnification of loss). 

Policyholders under the takaful model cooperate with each other with a common purpose, namely to provide security against risk.  Takaful is in many respects similar to conventional mutual insurers.

Varying structures of takaful (including Wakala, Mudarabah, Ta’awani and non-profit models) have been developed in different regions.  Like other financial products, takaful is structured in a manner that addresses the key Shariah principles (noted above). 

The two most common structures are:

  • Wakala (agency)

Under this model participants agree to cooperate with one another and to contribute donations to a common fund.  Further, they agree to share risk amongst themselves and to compensate one another from the takaful fund for loss suffered.  A Wakeel (agent) is appointed to manage the fund.  The Wakeel may be entitled to a management fee or a performance fee.  However the Wakeel is not entitled to share in the profits of the fund.

  • Mudarabah (profit and loss sharing)

Under this model, a company acts in partnership with the participants.  The company and the participants agree to share profits on the basis of an agreed ratio.

Comment: Takaful offerings to date have been predominately concentrated in Muslim countries.  There are opportunities for other countries with large Muslim populations such as Australia to tap into this market.  At present, there are no takaful or Islamic insurance offerings in Australia.  The key hindrance for takaful globally is the limited availability of Shariah compliant reinsurers.  In Australia, the key challenge will be identifying what regulatory structure takaful would fit under and what licensing requirements would be triggered.

Where to from here?

This paper has introduced Islamic finance and the key structures and concepts on which it is established.  Australia’s financial services industry is one of the most sophisticated and innovative in the world.  It has also proven to have one of the safest economies, having navigated through the global financial crisis better than many other developed nations.  The Government is keen on developing Australia as a financial hub in the Asia-Pacific region.  Former Assistant Treasurer Nick Sherry said in his keynote address at the 2010 Islamic Finance Conference that the Government sees “Islamic finance as a fundamental part of that endeavour”. 

Part 2 of this paper will extend this introduction and consider whether the Australian market is ready for Islamic finance and what opportunities and challenges lie ahead. 




The content of this publication is for reference purposes only. It is current at the date of publication. This content does not constitute legal advice and should not be relied upon as such. Legal advice about your specific circumstances should always be obtained before taking any action based on this publication.


Related Content

Contacts

Jeremy King

Partner. Melbourne
+61 3 9672 3431

Profile

Michael Chaaya

Partner. Sydney
+61 2 9210 6627

Profile