An overview of Islamic Finance.
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An overview of Islamic Finance.
A little-known sector of world finance until a few decades ago, Islamic finance has experienced a strong progression for several years and represented, in 2015, nearly 1,700 billion euros of assets worldwide; it will reach approximately 2,900 billion in 2021.
The term Islamic finance covers all financial transactions and products that comply with the principles of Koranic law, i.e. the sharia, which implies, in its implementation, the prohibition of interest, uncertainty, speculation, the prohibition of investing in sectors considered illicit as well as the respect of the principle of sharing losses and profits.
The principles of Islamic Finance.
The promoters of Islamic Finance put forward a certain ethics and in particular the fact of giving another meaning to the financial industry by putting it at the service of society and people.
This idea of ethics in finance is based on the Qu'ran, which repeatedly mentions certain restrictions in financial matters, such as verse 275 of Sura 2, which states: "... God has permitted selling and forbidden usury...". Thus, this "moral" finance, respecting the precepts of Islam, notably bans the use of any form of interest, speculation and investment in sectors considered harmful to society. On the other hand, it requires that any transaction be backed by a tangible and real asset: real estate, infrastructure... The actors of this finance practice the rule which postulates for the Sharing of Profits and Losses in that the lenders of money must also be investors and consequently assume a part of the risks.
In its daily practice, Islamic finance is based on five cardinal principles. These "five pillars of Islamic finance" contain 3 negative and 2 positive principles:
- Principle n°1: Prohibition of "riba" (interest, usury);
- Principle n°2: Prohibition of "gharar" and "maysir" (uncertainty, speculation);
- Principle n°3: Prohibition of "haram" (illicit sectors);
- Principle n°4: obligation to share profits and losses;
- Principle n°5: principle of backing by a tangible asset
In addition, a Sharia compliance council (made up of recognized Muslim juris consults) validates the Islamic character of a financial product or transaction. As Sharia compliance is the cornerstone of Islamic finance, financial institutions that offer Islamic products or services must set up a Sharia Compliance Board to advise and ensure that the operations and activities carried out by these banking institutions are in line with Islamic ethics and therefore respect the principles of Sharia.
From this point of view, the Sharia Board gives legitimacy to the practices of Islamic finance and at the same time strengthens the confidence of shareholders and the public by validating that all practices and activities are in compliance with the Sharia.
What is Islamic finance?
Islamic finance shares the aims and foundations of "conventional finance" with the added concern of respecting the Sharia, i.e. all the precepts of the Muslim religion. The essence of Islamic finance can therefore be formulated in a very simple way: Islamic finance operations are based on Islamic principles defined by the Fiqh or Islamic jurisprudence which is based on three texts:
The Quran: is considered by Muslims to be the literal transcription of the word of God. About 15 verses, out of a total of 6,236 verses, apply specifically to finance.
The Sunnah: includes all of the Prophet's comments and interpretations of the Holy Book (the Quran). It is composed of ''hadiths''. It describes the acts and words of the Prophet Mohamed and his companions.
Ijtihad: gathers the efforts of interpretation when there is a debate (for example if neither the Quran nor the Sunna answer a question). This effort of interpretation can be done by consensus of the scholars, by analogical reasoning and by considering the primary source of Islamic law.
The five cardinal principles of Islamic finance.
As mentioned above, Islamic finance is based on five cardinal principles, which are in a way the five pillars of financial Islam and which contain 3 negative principles and 2 positive principles.
1- Prohibition of Riba.
The term "Riba" is used in Islamic law to describe any advantage or surplus received by one of the contracting parties without any acceptable and legitimate counterparty from the point of view of the Sharia. This prohibition has been laid down for example in Verse 275 of Sura 2 of the Qur'an. Riba has two main forms:
â— Riba-Al-fadl: This is any concrete surplus received in a direct exchange between two things of the same kind that are sold by weight or measure. Example: Money is exchanged in person but in different quantities.
â— Riba-Al- nasi'ah: The surplus collected upon the discharge of a due, the payment of which was explicitly or implicitly set as a condition in the contract, due to the time granted for the deferred settlement. Example: The money is not exchanged at the time of the transaction but at a later time (existence of a time factor). Riba-Al- nasi'ah is the most common type in society, especially through credits, loans and investments offered by traditional banking institutions and financing organizations.
What differentiates Riba in its two forms from the sale of a good or service is that the consideration received is only considered acceptable in Muslim law if it is intended to compensate for something legitimate, such as:
- the loss of value from the use of a property (in the case of renting a property),
- the effort put into the realization of an object (in the case of the sale of a good produced by the seller)
- or the work done to obtain a material good and the risk involved in taking it over (in the case of the sale of a good bought from someone else).
According to the French orientalist Jacques Austruy in, l'islam face au développement économique, collection économie et humanisme, éditions ouvrière, Paris 2006, the prohibition of Riba in all its forms seems to be one of the consequences of the egalitarianism sought in the Muslim law. According to him, this prohibition is based on the double affirmation that time belongs to God alone and cannot be sold, and that money in itself is not productive. Thus, the lender is forbidden to get any benefit from his loan, unless this benefit is freely granted by the borrower after repayment of the loan and without constituting a tacit or explicit condition at the time of formation of the contract.
2- Prohibition of "Gharar" and "Maysir".
The first attempts to define ''Gharar'' are found in Al-Muwatta' in which Maalik B. Anas not only mentions the authentic Hadith prohibiting the practice but also discusses the concept; in general, it is accepted that a transaction is contaminated by ''Gharar'' if there is uncertainty about:
â— The existence of the object of the transaction;
â— One or more characteristics of the object for sale; for example: species or quantity;
â— One or more characteristics of the contract itself; e.g. the time of the transaction;
The Sharia requires through Surah’s 2 (v.188) and 4 (v.29) in business and commerce, that it is not permissible to enter into any transaction that contains Gharar. Gharar can be defined as any non-negligible vagueness in any of the goods exchanged and/or which is inherently hazardous and uncertain. This is the case in particular:
- when the sale involves a commodity that is not precisely determined.
- when the transaction is concluded without the price of the goods being clearly fixed.
- when the transaction concerns a specific good that the seller does not yet possess.
- when the transfer of ownership is conditional on a hazardous event.
This corresponds in conventional finance to forward products or transactions characterized by an obvious uncertainty as to their realization, such as futures, swaps or other more complex financial products like Subprimes.
Similarly, the Sharia prohibits transactions based on Maysir (see for example Qur'an, Sura 5, Verses 90-91). Etymologically Maysir was a game of chance; in the economic field it refers to any form of contract in which the rights of the contracting parties depend on a random event. Thus, every contract must have all the clauses fundamental to its formation (such as the object, the price, the time of execution and the identity of the parties) clearly defined on the very day of its conclusion. Muslim jurists also strongly encourage the satisfaction of all preconditions before the contract is signed.
The calculated risk of an investment is permitted under Shariah law, but the prohibition of futures contracts involving Gharar and Maysir is based on the fact that the risk of false anticipation of market developments could jeopardize the realization of transactions based on uncertainty, speculation, or even the criminal possession of privileged and prior information. Muslim jurists also justify the prohibition of such transactions by the need to direct available funds to the financing of the real economy, instead of letting them feed financial bubbles empty of any productivity and useful wealth.
The Sharia also requires that no Muslim should deal in assets that are deemed illicit or Haram. Indeed, there are requirements as to the nature of the activity in which an investment remains consistent with moral and religious imperatives as dictated by Islam. Thus, gambling, activities related to alcohol, pig breeding or even armaments, the film industry that provokes or suggests debauchery and activities related to pornography in particular constitute prohibited investment sectors in Islam. This principle of exclusion can be found in ethical finance in favor of sustainable development and in socially responsible investment.
From a financial perspective, the underlying of any type of contract must also be Sharia-compliant. Typically, in the case of equity investments, a number of sectors whose activities are considered unlawful should be excluded from the investment universe.
4- Principle of Profit and Loss Sharing
Islamic finance is often referred to as "participatory"; based on the functioning of participation contracts, it has set up a system based on the Sharing of Losses and Profits (commonly called the "3P" principle in French,’’ Partage de Pertes et Profits’’). This system makes it possible to associate financial capital with human capital, and requires that the participation must be fixed in a proportion and not by a profit at the signature of the contract.
More concretely, an investor must entrust his funds to an entrepreneur with whom he will share the profits according to the performance of the underlying asset, he must also share any loss with this entrepreneur if it is not due to negligence or gross negligence of the latter. Thus, the client of an Islamic bank has practically a shareholder status in the investments linked to his contracts and his income takes the form of dividends. It is in this sense that Islamic finance is considered to be related to venture capital and private equity.
5- Asset Backing
Any financial transaction must be backed by an asset to be valid under Sharia law. The tangibility of the asset means that any transaction must be backed by a tangible, real, material and above all owned asset.
This principle of asset backing strengthens the potential for stability and risk control, and reassures us of the problems of disconnection between the financial and real spheres.
The principle of tangibility of assets is also a way for Islamic finance to participate in the development of the real economy by creating economic activity in other areas.
In addition to these guiding principles, Islamic Finance works to provide its clients with specific financial instruments.
What are the financial instruments offered
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In order to promote Islamic finance schemes to attract investors, Islamic banks mainly offer two products. These measures concern two of the main tools of Islamic finance and, in particular, "murabaha", which is a sale contract under which a seller sells an asset to an Islamic financier who resells it to an investor in return for a price payable in the future (instalment sale) and "sukuks" which are securities representing for their holder a debt security or a loan whose remuneration and capital are indexed to the performance of one or several assets by the issuer. These assets are allocated to the payment of the remuneration and the repayment of the sukuk or similar products.
1- Murabaha.
One of the main financial instruments of the Islamic finance is the "Murabaha", a form of interest-free borrowing. Its principle:
In commercial banking, when a client wants to buy a house, the bank makes the purchase on his behalf. The client repays the amount of the property in one or more instalments, plus a commission fixed in advance. At the end of the contract, the bank transfers ownership of the property to the client.
In market finance, when a financial institution wishes to invest its funds in an Islamic model, the counterparty collecting the deposit will place the funds under a real asset (most often a commodity). Again, the elements exchanged will be predefined in a contractual framework, with commissions and profits known and fixed. At the end of the contract, the real asset is sold on the markets to ensure the payment of the capital, the commissions and the profits.
2-The Sakk.
Another instrument is "sakk" (plural Sukuk), a form of bond financing.
They allow companies and sovereign issuers who wish to do so to comply with Sharia principles. They are financial products backed by a real asset with a fixed maturity. The sakk confers ownership of the issuer's assets, and the holder receives a portion of the expected profit at virtually no risk. This form of bond is similar to asset-backed securities, except that sukuk do not pay interest but profits.
To remember:
Developed rapidly in the 1970s in the Gulf countries, Islamic finance is developing along three fundamental lines:
â— Attraction for an "alternative and ethical finance" in opposition to the "conventional finance" since 2008;
â— Increase in religious rigor among Muslim populations worldwide;
â— Political will to develop Islamic finance among the general public.
The objectives and foundations of Islamic finance are identical to those of "conventional finance". What distinguishes Islamic finance from conventional finance is the respect of the Sharia and all the precepts of the Muslim religion.
The Sharia Board determines the "Sharia Compatibility" of organizations or financial products. Also, the organization of the Sharia Boards varies according to the geographical areas. The Sharia Board can be attached to the regulator (as is the case in Malaysia) or set up within the financial institutions (as in the Persian Gulf monarchies).
Islamic Finance is based on 5 major principles of the Muslim religion: 3 "prohibitions" and 2 "recommendations":
The 3 "prohibitions": Prohibition of interest (Riba), prohibition of uncertainty (Gharar) and speculation (Maysir), prohibition of illicit sectors (Haram) such as alcohol, pork, pornography, weapons, etc.
The 2 "recommendations": Profit and loss sharing (as a corollary, no separation between the asset and the related risk), backing of any commercial operation with a tangible asset.
The development of Islamic finance requires, in the countries concerned, an adaptation of the legislative, regulatory and fiscal frameworks. It would also be desirable to work for the establishment of an international system of alternative dispute resolution such as arbitration and mediation to support this important part of the world economy. The evolution of the concept of arbitration which has become more complex, encompassing more fields and dealing with more issues, has led for instance the Gulf States as well as Malaysia to codify the Arbitration of Islamic Finance Transactional Disputes through the i-arbitration Rules of 2021.
It emerged 50 years ago in countries with large Muslim populations seeking to ensure that their funding sources were governed by Sharia requirements and Islamic principles. The global Islamic finance market is segmented by:
a- financial sectors: Islamic Banking, Islamic Insurance "Takaful", Other Islamic Financial Institutions (OIFL), Islamic Bonds "Sukuk’’;
?b-Islamic Funds. Gulf Coop Council (GCC): Saudi Arabia, UAE, Qatar, Kuwait, Bahrain, Oman and Middle East and North Africa (MENA): Iran, Egypt, Rest of middle east & North Africa);
c-Geographic segment: Southeast Asia & Asia-Pacific: Malaysia, Indonesia, Brunei, Pakistan and Rest of Southeast Asia and Asia-Pacific: Europe, United Kingdom, Ireland, Italy, Rest of Europe.
World Development Outlook of Islamic Finance.
According to https://www.lafinancepourtous.com , despite an estimated outstanding amount of more than $2.8 trillion, Islamic finance represents only a little more than 1% of conventional finance. In other words, its activity remains relatively marginal since this form of finance is essentially practiced in the Middle East countries, which, with some $2,000 billion, represent nearly 70% of its total assets.
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However, there has been a significant acceleration in the last five years. According to the Islamic Corporation for the Development of the Private Sector, this growth is not expected to slow down in the coming years. Indeed, it estimates that the financial stock of Islamic assets will reach 3,693 billion dollars in 2024.
In terms of its development prospects, it should be noted that Islamic finance is not only aimed at the 1.5 billion Muslims. Several Western countries are interested in it because it presents interesting characteristics in terms of transparency and banking regulation.
On this point, the United Kingdom is a forerunner. The Financial Services Authority has created standards for these new financial products and has opened a specific department dedicated to Islamic finance. In 2004, the Islamic Bank of Britain opened its doors, a first in Western Europe.
In Germany and France, with a combined population of nearly 9 million Muslims, Islamic finance has not yet penetrated the traditional banking market. In other words, no major bank in Germany or France offers its clients the possibility of investing in so-called "sharia-compatible" products, i.e. products that comply with Islamic law.
However, some initiatives have emerged. In Germany, the Turkish Islamic bank Kuveyt Türk has established itself in Frankfurt and other major German cities such as Berlin by marketing banking products such as "sharia-compatible" mortgages.
In France, there is currently no Islamic bank in the strict sense. However, many "traditional" credit institutions now offer banking products and solutions that comply with the principles of Islamic finance.
Sources: https://www.lafinancepourtous.com ?
Limitations to the development of Islamic finance in the world.
1-All banking institutions marketing so-called "sharia-compliant" products must be validated by an Islamic body in charge of this control: The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
2- The imprint of religious principles on Islamic products can be a hindrance in the process of integration and standardization of this type of product in the conventional financial system.
3- Islamic finance products must take the form of financial products (conventional credits, term accounts and passbook accounts being prohibited), and must, like each financial product marketed, have an approval issued by the Financial Markets Regulatory Authority.
Where does Africa stand in this market segment?
The situation in 2021 seems alarming for the continent. In the June 8, 2021 issue of ‘’Jeune Afrique Economie’’, Wahida Mohamed, founder of the Islamic Fintech Hub of Sub-Saharan Africa, states that the growth of Shariah-compliant banking products has stalled due to a lack of legislative change. Indeed, while, according https://www.pewresearch.org/religion/2011/01/27/the-future-of-the-global-muslim-population/ , sub-Saharan Africa will overtake the Middle East and North Africa in the next 20 years to become the region with the second largest Muslim population in the world, behind Asia-Pacific, these regulatory barriers have prevented the emergence of specifically Islamic financial services to meet this growing demand in Africa.
These regulatory barriers are said to be related to high capital requirements, lengthy application processes and the lack of open-banking legislation, not to mention the "fear of the word sharia" which can deter some investors as mentioned by Wahida Mohamed.
However, Nigeria, the sub-Saharan African country with the largest Muslim population and the largest consumer market on the continent, is a pioneer in this field as the most advanced in Islamic finance. The legislative basis for Islamic finance was adopted in 1991, and Habib Bank has operated an Islamic banking window since 1992. The Central Bank of Nigeria joined the Islamic Financial Services Board (IFSB) in 2009 and established an interest-free banking unit in 2010. In addition, in 2011, Jaiz Bank was licensed to operate as a full-fledged Islamic bank, the first of its kind in Nigeria, and the country also has guidelines for the Takaful insurance sector and an advisory body that oversees Islamic banking.
In light of this, it is imperative to invest in both human capital and institutional redesign, including "proactive regulation" that would provide guidelines for Islamic Fintech while facilitating access to finance.
In this sense, Wahida Mohamed suggests "incubator-type schemes to allow Islamic fintech start-ups to test their technologies on the market while ensuring sufficient consumer protection", or "the creation of Islamic fintech units and national sharia advisory councils within central banks".
It wouldn’t be useless, moreover, to evolve the various African legislations in order to strengthen the issuance of financial instruments such as Sukuk which, according to the experts, "have a role to play in the implementation of green projects in Africa".
While the proportion of Muslims in the population of sub-Saharan Africa is expected to rise from 16% in 2015 to 27% in 2060, Moody's estimates that Shariah-compliant assets from the area account for only 1% of global Islamic banking assets.
In other words, Islamic finance is a sector that holds a lot of opportunities for Africa since some major initiatives related to Islamic finance in this region of the world have been launched. For example, the Central Bank of West African States (BCEAO) and the Inter-African Conference of Insurance Markets (CIMA) have issued regulations governing Islamic finance activities in their respective areas.
In the same vein, the Moroccan Insurance and Social Security Supervisory Authority announced on 17 June 2022 that it had granted approvals to six participatory banks to present Takaful insurance products, while in Cameroon, for example, the signing on 2 June 2022 in Sharm El-Sheikh in Egypt, of a partnership agreement between the Islamic Corporation for the Development of the Private Sector (ICD) and Afriland First Bank (AFB) in the amount of 26 billion CFA francs (40 million euros), will allow Cameroonian companies to develop their activities that are eligible for Islamic financing.
In addition, Afreximbank and the International Islamic Trade Finance Corporation (ITFC) have signed a $250 million Murabaha financing agreement to support Africa's response to the economic challenges posed by the ongoing geopolitical turmoil.
In East Africa, the Government of Kenya has, since the years 2017-2018 undertaken a set of initiatives to develop Islamic finance in the country. These initiatives which are part of efforts to mobilize local funds and make Nairobi a regional hub for the sector while boosting the Islamic banking sector by financing infrastructure projects in a country where Muslims make up about 10% of the population of some 44 million.
For example, the government's ambitions for Islamic finance have been noted, with the aim of revising the legislation governing Islamic finance with a view to issuing a first sukuk in fiscal 2017.
However, although the Moody’s agency notes significant potential for the sector, particularly in South Africa, Nigeria and Senegal, as well as the individual wills deployed by certain States, there is a lack of real convergence of these synergies in order to harmonize the matter as in the Gulf countries or Malaysia.
And yet, in view of the crucial stakes involved in the development of an Africa in full demographic, economic and industrial growth, it would be illusory and counterproductive not to unite political wills in order to reach a harmonized legislation that would allow regulating and facilitating the access to companies operating in the Continent, all sizes included, to this alternative model of access to credits advocated by Islamic Finance.
There are many examples of successful legislative cooperation at both regional and continental levels to draw inspiration from.