Islamic Finance: The Way Forward

The principles of Islamic finance have been around for centuries but modern-day finance sectors still do not fully understand the advantages of Islamic finance.

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Islamic finance, in its simplest terms, can be defined as finance with ethical considerations in the way financial transactions are conducted. Although the ethical principles embedded in Islamic finance are rooted in theological beliefs, Islamic finance is in fact a modern-day concept that only came about in the last 60 years.

The first few research papers on Islamic finance were published in the mid-70s. Today, such research is widely accepted as part of mainstream economics and finance, with many research papers published within the last decade in top scholarly journals such as Journal of Banking and Finance and Journal of Financial Economics.

“We have indeed come a long way. It is currently a small sector but the sector is expanding,” says Professor Mohamed Ariff Syed Mohamed from Sunway University Business School. With over 240 papers and books to his credit, Professor Ariff is a prominent researcher in the areas of accounting, economics, banking and finance, as well as Islamic finance.

His interest in Islamic finance started in 1989 out of mere curiosity but has since developed into a passion that fuelled his career. For the past 30 years, his research revolved around Islamic banking, capital market investments, sukuk (debt), money markets and waqf (endowments).

“Since my major works are in mainstream economics and finance, I am interested to see how mainstream theories in economics and finance can be applied to Islamic banking and finance. More specifically, I look into the impact of Islamic financial instruments on bonds, stocks and others found in financial markets.”

Islamic finance is rapidly growing worldwide but Professor Ariff believes that there is still a need to understand Islamic finance better in academia and across the industry.

Quoting the example of mainstream mortgage finance, he says that banks are just mere financiers with no risk sharing. This is different in Islamic finance whereby borrowers share in the risk of this financing. This leads to different meanings on how a contract is established and risk is shared.

“Sadly, this has not been fully recognised in practice by banks, as many do not yet understand the full precepts of Islamic banking.”

If the contract is based on the principle of risk-sharing between borrowers and lenders, then collecting a contract fee from the borrowers becomes an anomaly. Professor Ariff argues that fee for mortgage is a historical relic.

“Whenever a customer makes purchases, he or she is not required to pay a fee to purchase that item. Why then should a financier charge a fee in addition to benefitting from the difference between the sum paid with interest and the sum borrowed?”

Professor Ariff believes that modifications and reforms of modern finance practices in mainstream banking, finance and insurance sectors are required to make the financial system more stable and for borrowers to feel safer.

“We also need simpler solutions to financing without additional costs such as legal costs and auction fees imposed on borrowers. Lenders would also be protected under strict ethical lending via asset-backed lending, where money is borrowed for a specific production purpose as opposed to consumption purposes.”

Asset backing as a principle helps to ensure that borrowers do not borrow far too much — a common issue that causes many indebted companies as well as governments to go under during financial crises (i.e. 1997 Asian financial crisis). For the Islamic mortgage model to be fully compliant as asset-backed, borrowers should not borrow more than the value of the assets in place, which acts as a natural limit on borrowing.

“The amount borrowed needs to be backed by the assets of the borrowers, not as a collateral because the assets are transferred to a company that is jointly-owned by the borrowers until the borrowed fund is returned. Risk is therefore, equally shared between the lenders and the borrowers.”

When borrowers default in payment, mainstream banks normally seize assets in joint-stock company via court approval. Under asset-backing principle however, lenders are protected as they are already joint owners of assets held outside the control of the borrower. Professor Ariff believes that this practice, if adopted by all parties, will make the financial system more stable.

Despite such equitable principles, he notes that the industry as a whole is still not giving needed attention to fully refining its practices.

“Most sectors, including the banks, have not come to a stage of fully understanding the principles and practices of Islamic finance. In fact, they are likely to consider Islamic finance as a work-in progress with more to be learned, which augurs well for the future.”

Professor Ariff’s passion has driven him to collaborate with kindred scholars in producing a series of books that have made an impact on the formal study of Islamic finance worldwide.

“We received a seed funding of A$306,000 from the Australian Research Council in 2006 as well as three Australian financial institutions with the express aim to publish authentic literature in the emerging field of Islamic finance as a sub-discipline of finance.”

Professor Ariff believes that the Islamic finance market, which is based on strong ethically-approved financial standards derived from Islamic religious doctrines, is slated to grow further. In the last 18 years or so, mutual funds are regrouping under the umbrella of “socially responsible funds” with principles that are broadly similar to the ethics advocated in Islamic finance.

Professor Ariff comments that focus should be placed on in-depth research to refine the practices that have been around for centuries and are now being examined in the light of modern-day methods.

Islamic Finance in Brief: The Six Major Areas

Islamic Banking

The first Islamic bank was established in Egypt in 1963. It was later shut down due to political upheavals but the seed of the idea was planted. In the 1980s, Islamic banks began to grow across 76 countries mostly due to demand from 56 Muslim-majority countries. Today, there are over 60,000 mainstream banks offering financial products, with the more prominent ones being members of the Basel-based association. There are also some 250 to 300 Islamic financial institutions that are similar to banks. Collectively, these banks and financial institutions have developed close to 60 banking products and own total assets estimated to be worth between US$2 and US$3.3 trillion.

Capital Market

The Islamic capital market grew later from applying several criteria to identify which of the approximately 400,000 stocks traded in some 125 stock markets are acceptable under Islamic doctrines of fair financial transactions. This began in the 1990s when the Dow Jones Group was approached by investors who wanted a list of companies that conducted business in accordance with financial and production principles under Islamic legal requirements. This led to the birth of the Dow Jones Islamic Index, which lists companies that are compliant with Islamic ethical standards. Subsequently, 24 other countries including Malaysia followed suit in developing such market indices. Furthermore, mutual funds subscribing to the same principles started to sprout in several countries. As of 2018, there are some 388 socially responsible investment funds adhering to the same principles.

Insurance Market

Mutual insurance, which has been carried out by joint-stock companies for centuries, is a new field in Islamic finance. Under the mutual insurance principle as introduced by the Puritans in the United States some 200 years ago, an insurance company is owned by policy holders and thus, all net profits are accrued to the insured. This stimulated the growth of mutual insurance in other parts of the world such as Japan and Taiwan. In the same manner, the Islamic equivalent of mutual insurance is the Takaful insurance, also known as Islamic insurance, which came about in the mid-1990s.

Sukuk Bond

The mainstream bond market in some 120 countries around the world is worth a total of US$150 trillion, doubling in size of the share market. Bonds help firms and governments raise funds for investments and are issued by various organisations while investors are the public lending to these organisations. The late 1990s saw the growth of the sukuk market, also known as the Islamic debt market, which is based on a risk-sharing principle with asset-backing by lender-cum-borrower to reduce the risk of default. Financial and tax laws in 18 countries have been amended to create a level playing field for this new market to grow under Islamic principles. It is estimated that US$1.2 trillion worth of issues have been made to date. This is a market with big potential and is expected to grow rapidly in the coming years.

Money Market

The base interest rates in an economy are determined by investors’ demand for short-term money market instruments widely known as Treasury bills. For 20 years, such instruments which are compliant with Islamic principles have been issued mainly for interbank transactions in the overnight and short-term end of borrowing. Malaysia and Turkey became the first two countries to issue Islamic money market instruments. The size of the money market is normally three times the size of the capital market of a country.

Waqf and Zakat

Waqf, pronounced as Waqaf, is an endowment made by an individual (sometimes a group) to provide charitable assistance to the needy and the poor. Waqf contributions can be either monetary or nonmonetary (i.e. land) and are used for social causes. In addition to waqf is the concept of zakat, which is money voluntarily given each year by the faithful — usually 2.5% of individual wealth — to the needy and the poor. Both waqf and zakat have been around for centuries as sources of welfare and it is only within the last decade that there is a growing attempt to manage these sources as potential assets that can better serve the community.

 

Professor Mohamed Ariff Syed Mohamed
Sunway University Business School
ariff@sunway.edu.my

 

This article appeared in Spotlight on Research (Volume 3).