Islamic finance: the status quo and challenges Masao Yanaga Graduate School of Business Sciences, University of Tsukuba. Tokyo 112-0012, Japan  [email protected] Abstract: During the past five decades, Islamic banking has grown rapidly in terms of size and the number of players. Islamic banking is currently practiced in more than 50 countries worldwide. Islamic finance is among the fastest-growing financial industries. In addition, Islamic finance has played and is expected to play a significant role in microfinance. There are, however, several challenges in order to develop Islamic banking. Because of ban on riba (interest), an important feature of Islamic banking is its profit-and-loss sharing (PLS) scheme, which is predominantly based on the mudarabah and musharakah. Accordingly, borrowers share profits and losses with the banks, which in turn share profits and losses with the depositors. Moral hazard problems associated with ex-post information asymmetry, however, are especially significant in PLS financing because the entrepreneur (borrower) has incentive to under-declare or artificially reduce reported profit. As easily realisable investments are not sufficiently available and Islamic financial markets are immature, the ability of Islamic banks to optimally manage their funds is limited. There is need for liquidity support in the form of lender of last resort facility. Appropriate legal framework of Islamic banking and finances is indispensable. The classic commercial, banking and company laws contain provisions that are narrowly defined and prohibit the scope of Islamic banking activities within conventional limits. Above all, because of the attachment of Islamic banking operations with real business transactions, Islamic banks are exposed to tax disadvantages.

1. Introduction

On one hand, bottom-up experiments in Egypt

The first modern Islamic banking can be traced

illustrated the feasibility of Islamic banking.

back to the establishment of the Mit Ghamr

These small rural experiments have grown to a

Savings Bank in Egypt in 1963. During the past

rapid growing industry in many countries,

five decades, Islamic banking has grown

spreading from the Middle East to East Asia.

rapidly in terms of size and the number of

On the other hand, the establishment of the

players. The market share of Islamic finance in

Islamic Development Bank (IDB) in 1975 in

the banking systems of the Gulf Cooperation

Jeddah gave impetus to the diffusion of Islamic

Council (GCC) countries at end-2008 was in

banking. A lot of interpretation of Shari’ah law

the range of 11-35 percent, compared with 5-24

is necessary in order to implement Islamic

percent in 2004. Islamic banking is, moreover,

banking. Under the support and cooperation of

currently practiced in more than 50 countries

the IDB, Shari’a scholars have begun to pay

worldwide. Current global Islamic finance

attentions to and addressed this problem. The

assets stand at US$800 billion and could hit

creation of the Islamic Financial Service Board

US$4 trillion by 2015. With an annual average

(IFSB), with a mandate to set prudential

growth rate of between 10 and 20%, Islamic

standards for Islamic banks in 2002 is

finance is among the fastest-growing financial

noteworthy for Islamic banking diffusion as

industries. According to Rivlin [1], two factors

well.

were crucial to this remarkable development.

In addition, Islamic finance has played and is

expected to play a significant role in

grounds that interest rates are a form of

microfinance. In fact, The Mit Ghamr savings

exploitation, inconsistent with the notion of

project would now be called a microfinance

fairness. Riba implies an improper

programme. It seems, however, that

appropriation of other’s property and is bad for

microfinance services, including some

efficient resource allocation.

Shari’ah-compliant, in the Arab region tend to be limited to credit for enterprise, rather than

(2) Prohibition of maysir and of gharar

building or purchase of homes or home

Qur'an prohibits maysir (games of chance) and

improvement. It is said that murabahah is the

of gharar (chance), which is increasing one’s

most commonly used Islamic transaction.

wealth by chance rather than productive effort.

Murabahah is a transaction that involves in

maysir refers to unnecessary uncertainties in

general a sale at a cost plus a profit margin

business or daily life, such as those arising

(corresponding to an amount of interest). In this

from playing in a casino. Thus Islamic banks

type of transaction, a financier acquires from a

abstain from transactions that are privy to

supplier specified assets, such as merchandise

speculation. While entrepreneurship itself could

or equipment requested by a customer, the

be interpreted as a form of gambling, taking

financier then sells it on a deferred payment

inherent risks in business is permitted. In

basis to the customer at the acquisition cost

practice, however, the distinction between

plus an agreed profit margin.

speculation and entrepreneurship effort is often difficult.

2. Characteristics unique to Islamic Banking There are four characteristics in particular unique to Islamic banking: prohibition of riba, prohibition of maysir and of gharar, prohibition of haram activities, and zakat.

Qur'an bans gharar contracts as well. gharar contracts are doubtful or uncertain contracts, such as contracts to take excessive risk or undertaking a business venture without sufficient information. This ban intends to minimize both conflicts between contracting parties and misunderstanding among parties. In

(1) Prohibition of Riba Riba is similar to monetary interest. The term riba is defined as “a means excess, increase or

this respect, Shari’ah-compliant lending is collateralised by tangible assets, capital is rewarded with a return on investment.

addition, which correctly interpreted according to Shari’ah terminology, implies any excess compensation without due consideration.” [2] According to Islamic jurisprudence, the payment of a fixed sum, based on pre-determined rate of interest on monies lent and received, contravenes Shari’ah [3] on the

(3) Prohibition of haram activities As Shari’ah bans haram (illegal) activities, Islamic banks have a code to finance only halal (legal) activities. In other words, they lend to business entities or individuals involved in

activities deemed to have a negative impact on

In practice, however, Islamic banks vary in

society or to be haram according to Shari’ah,

terms of the level of risk sharing. For example,

such as gambling, narcotics, adult

on the funding side, profit sharing investment

entertainment and alcohol. In this aspect, the

accounts (PSIAs) are being replaced in a

principles of Islamic banking are often

number of Islamic banks by time deposits

structured around ethical precepts and social

based on reverse murabahah transactions.

accountability.

These deposits do not have the risk-sharing features of PSIAs, since the return on them is

(4) zakat

guaranteed. In addition, demand deposits,

Zakat, which is one of the five tenets of Islam,

which do not share profits or losses, represent a

is designed to redistribute income to provide a

significant part of deposits in some banks. On

minimum standard of living for the poor

the asset side, risk sharing (e.g. mudharabah,

because Muslims believe that justice and

musharakah) is the exception rather than the

equality in opportunity are indispensable for a

rule: most financing is in the form of

society to function. In countries where zakat is

murabahah contracts or installment sales,

not collected by the state, Islamic banks

making credit risk the main risk faced by

establish zakat funds and contribute to religious

Islamic banks, similar to conventional banks.

institutions.

The Capital Adequacy and Risk Management standards issued by the IFSB suggest that the type and size of financial risks in

3. Profit-and-loss Sharing (PLS)

Shari’ah-compliant contracts are not

Scheme

significantly different from those in

Because of ban on riba, an important feature of

conventional contracts.

Islamic banking is its profit-and-loss sharing

Mudharabah (Profit-sharing) is a transaction

(PLS) scheme, which is predominantly based

involved a capital contribution by a financier in

on the mudharabah and musharakah.

an enterprise managed by an entrepreneur while

Accordingly, borrowers share profits and losses

musharakah (Joint-venture) can be deemed as a

with the banks, which in turn share profits and

partnership agreement between two or more

losses with the depositors.

parties to contribute capital to a specific

In addition, Islamic intermediation is

enterprise. In both types of transaction, profits

asset-based. Islamic banks share the risk in

generated from the enterprise are shared in

mudharabah and musharakah contracts and

accordance with the terms of the respective

conduct sales contracts in most other contracts.

agreement. Losses are to be borne, however,

Provision of capital goods, inventory, and

solely by the financier in a mudharabah

consumer durables has formed the core of

transaction unless the losses are due to the

revenue streams of Islamic banks.

Business Operator’s misconduct, negligence or

breach of contracted terms while losses are

of the most developed countries because Bank

shared in proportion to the respective partner’s

Negara Malaysia, the Malaysian Central Bank,

share of capital in a musharakah transaction.

introduced the Islamic Interbank Money

Other typical contracts, which involve sales

Market (IIMM) on January 3, 1994. The scope

contracts, engaged by Islamic banks include

of activities of the IIMM included the purchase

murabahah and ijarah. Ijarah is a transaction

and sale of Islamic financial instruments among

in which a financier acquires specified assets

market participants (including the Bank),

from a supplier, such as equipment required by

interbank investment activities through the

a customer, and collects rental installments,

Mudharaba Interbank Investment (MII) Scheme

including repayment of the acquisition cost and

and so on [4].

a return equivalent, that is, in substance,

In addition, the Malaysian government has

regarded as a (finance) lease transaction while

issued Government Investment Issues (GIIs) so

finance lease contracts might contradicts with

that Islamic financial institutions can sell them

Shari’ah.

to the Bank Negara Malaysia as and when required to meet their liquidity needs.

4. Moral Hazard Problems information asymmetry are especially

6. Need for Appropriate Legal and Supervisory Frameworks

significant in PLS financing because the

Appropriate legal framework of Islamic

entrepreneur (borrower) has an incentive to

banking and finances is crucial. The classic

under-declare or artificially reduce reported

commercial, banking and company laws

profit. Similarly, in the case of mudharabah,

contain provisions that are narrowly defined

the entrepreneur has an incentive to undertake

and prohibit the scope of Islamic banking

high-risk projects because the entrepreneur is

activities within conventional limits.

actually given a call option whereby he or she

For example, Japan allows foreign subsidiaries

gains on the upside but bears no losses at all on

of Japanese banks to carry out some types of

the downside.

Islamic finance activity while Japanese banks

Moral hazard problems associated with ex-post

themselves or their domestic affiliates are not

5. Difficulty in Liquidity Management

permitted to engage in [5]. This is partly

As easily realisable Shari’ah-compliant

because of the idea that banks should be

investments are not sufficiently available and

segregated from the risks inherent in real

Islamic financial markets are immature, the

business transactions since prudence and sound

ability of Islamic banks to optimally manage

banking operation is a key for national

their funds is limited. There is need for

economy and depositors’ protection.

liquidity support in the form of lender of last

It seems, however, that the attitude of Japanese

resort facility. In this respect, Malaysia is one

supervisory authority might be passive.

Nothing ventured, nothing gained. Several

These problems were solved to some extent, as

countries, including Malaysia and the United

mentioned above, in May 2011. A Bill to

Kingdom, have already developed and

amend the Asset Securitisation Act and relevant

implemented supervisory policies and measures

several tax laws cleared the Diet. The aim of

for Islamic banking.

this legislation is to create a level playing field for sukuk as conventional bonds in order to

7. Need to Eliminate Tax

facilitate sukuk. Firstly, the amendment to the

Disadvantages

relevant tax legislation provides in regard with

Above all, Islamic banks might be exposed to

book-entry special bond-type beneficial

tax disadvantages partly because of the strong

interests an exemption from taxation on

link of Islamic banking operations to real

distribution of profits payable to foreign

business transactions, partly because of ban on

corporations and nonresidents while domestic

riba, in several countries including Japan while

banks and other Japanese financial institutions

Islamic finance developed countries such as

are exempted only from withholding tax on

GCC countries, Malaysia and the United

distribution of profits. Secondly, the conditions

Kingdom have already met this challenge.

for deductibility of dividends paid by a special

There is no specific provision for Islamic

purpose trust (SPT) have been amended and the

finance in current Japanese tax laws except for

special bond-type beneficial interests will be

recently introduced special treatment for

exempted from the requirement that more than

Islamic bond (sukuk), the Japanese tax

50% of the amount of bonds issued must be

treatment of Islamic finance must be considered

offered domestically. Thirdly, a re-purchase

according to general Japanese tax rules and

transaction of the underlying asset from SPT to

practice. Therefore, some tax issues might arise

the originator (or the settlor of the SPT) will be

in regard with Islamic finance in the future: the

exempted from registration fees, and real estate

treatment of consumption tax, registration fees

transfer taxes (in respect with a SPT involving

and real estate transfer taxes on murabahah,

real estate as an underlying trust asset) with

which involves a sale and purchase; the

regard to special bond-type beneficial interests

treatment of profit/loss distribution based on

in the SPT. Lastly, foreign corporations will be

mudharabah or musharakah contracts --

exempted from capital gain tax upon sale of

whether the distribution of profits which is

special bond-type beneficial interests.

deemed in economic substance as similar to the payment of interest be treated the same as the latter; the categorization and treatment of sukuk for Japanese tax purposes, especially in regard with withholding and deductibility of funding costs.

References [1] Rivlin, P. (2008), The Development of Islamic Banking. Orient, III/2008, 4-11. [2] Usmani, M. (2002), Meezan Bank’s

Guide to Islamic banking. [3] Qur'an 2:276. [4] Islamic Interbank Money Market, About IIMM .

[5] Yanaga, M. (2009), Islamic Finance and Financial Services Regulation in Japan. Journal of International Banking Law and Regulation, 24 (4), 200-205.