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Doubtful and Mixed Capital in Islamic Financial Institutions

By: Dr. Zaharuddin Abd Rahman, Shariah scholar and lecturer at the faculty of economics and management sciences at the International Islamic University, Malaysia
01 January, 2012

One of the most debated issues in Islamic finance is around the initial capital of Islamic banks and takaful companies, especially when initiated by a conventional parent company. Some people doubt the purity of the capital in Islamic banks and takaful companies and as a result question whether these organisations are truly Islamic when their capital is not completely halal. The Facts There are two points to be made in relation to this issue: 1. Money itself is not unlawful, but becomes prohibited through the way it is procured, i.e. not in line with the Shariah law. Sin does not move with the money from one party to another. This is unlike an item that is physically prohibited such as pork or liquor. Regardless of where the pork is or whether it is already mixed with another item, it will still be prohibited and will contaminate other permissible items through any form of contact or convergence. 2. Capital earned by the parent companies of Islamic banks may not be entirely from prohibited businesses. Part of the capital is sourced from individuals and permissible government and private organisations, therefore, it is possible that the funds originated only from permitted sources even if combined with prohibited income. Readers should be aware that the initial capital of Islamic banks and takaful companies is confirmed as being from permitted and halal sources. Scholars Opinions There are differences of opinion among scholars regarding this issue. The majority of Hanafi scholars, Ibn Qasim from the Maliki sect, Hanbali and Ibn Taimiyah are of the opinion that it is permissible to do transactions with the owners of mixed capital when the majority of the capital comes from permitted sources. Ibn Nujaim was reported as saying, When the majority of the total capital or its income is permitted, there is no problem in accepting their gifts and food as long as there is no clear sign showing that it is prohibited. Conversely, when the majority of the capital or its income is prohibited, then any gift or food from them is not permissible except after it is confirmed as clean (permissible).bn Qudamah alternatively said, When you know (or are told by people whose income is mixed) that the commodity, supply or food comes from permissible sources, thus they are permissible.

A few prominent scholars such as As-Syawkani and al- Muhasibi are also of the opinion that it is permissible to perform transactions with the owners of mixed funds if only a minor portion of it is permitted. Their supporting arguments, among others, include: 1. The Prophet and his companions performed transactions with the Meccan people before Hijrah, when most of them were non believers. There was never any mention of The Prophet prohibiting any form of transactions with them, even though most of their wealth came from prohibited sources. 2. The Prophet also had financial dealings with the Bedouin Arab community, who associate Allah with others, during a journey to Madinah. Their wealth was known to originate from prohibited sources as well. 3. During the migration of the The Prophet, he transacted with the Jews from amongst the people of Madinah and the Bedouin Arabs who permitted what was prohibited in Islam. If those transactions were prohibited, surely The Prophet would have disallowed them from the very beginning. 4. The Prophets taqrir (endorsement) by letting his companions trade and enter into financial transactions with non believers previously involved in robbery and non permissible transactions is also evidence. 5. When Islam allows financial transactions with non-believers, it also means Islam allows financial transactions with Muslims whose wealth is a mixture of permissible and non permissible. 6. The companions of The Prophet also dealt with robbers in Madinah at the time of Yazid bin Muawiyah; none of them forbade it. 7. When such transactions are impeded, problems will arise especially in a period where it is difficult to locate a company with 100% permissible income. We can also consider the stand of Ibn Masud (may Allah be pleased with him) on dealings with a company or an individual whose wealth is mixed.

It was said that a man came to Abdullah Ibn Masud and said, I have a neighbour and I know nothing of his wealth except it is soiled and prohibited and he invited me to his house. I feel reluctant to accept and reluctant not to. Ibn Masud said, Accept and attend to his invitation, verily sins (from the prohibited wealth) is (solely) on him. (Narrated by Al-Baihaqi, 5/335; Al-Baihaqi is of the opinion that this narration is frail)

Imam Al-Ghazzali used to say, Verily, if prohibited wealth is widely spread within an area and it is difficult to move out of it (the area), thus it is permissible to have deals (with it) even beyond the emergency boundaries, because if the people were limited to only emergency boundaries, thus human life will end, systems will be damaged and at that point religious affairs will also be damaged and Islam will collapse (because nothing can be done without the role of wealth). What Does This Mean? The capital in a conventional bank, therefore, cannot be regarded as prohibited in its totality and must not be rejected as the initial capital for Islamic banks and takaful companies. Of course it is better for banks to ensure that only the permitted portion is used and separated specifically for Islamic banks, takaful companies or their Islamic banking departments. Even so, it is not compulsory (wajib) to do so.

If a small portion of prohibited capital exists within the total capital used as the initial capital for an Islamic bank, I believe it is Qard Hasan (non-interest bearing loan) from the conventional parent company to its subsidiary. The majority of contemporary scholars are of the opinion that it is not a problem for a parent company to give a loan to its subsidiary with the condition of repaying the loan later. In fact, some scholars such as Dr Zaki Badawi issued a fatwa that it is permissible even if it is an interest bearing loan. This is because they are considered one company and the fund is simply moving from one pocket to another. The Practical Approach Even if the opinion of prohibition is used, Islamic banks can still cleanse the doubtful capital by repaying the loan and giving a portion of its profit to charity. The transition and strengthening process of the Islamic financial system must be supported. It is impossible for a conventional bank or company to shift to an Islamic system without the aid of sufficient capital or finance, therefore, in line with the objective of Shariah (Maqasid Shariah), this process must be allowed to enable the transition process, notwithstanding the use of a portion of capital that is obviously prohibited. There is then the matter of using profits from permitted business, which have raised initial capital either through theft or from prohibited sources. In this matter, Imam Malik, Imam As-Shafie, Imam Abu Yusof and Sheikh Zufar Huzayl agree that the thief has a right to the profit earned by his permitted investment even if the initial capital was prohibited, nevertheless he must return the stolen money (money used as his business or investment capital) to the rightful owner. Based on this scholastic ijtihad, we assume that Islamic banks should take profits from their businesses or investments even if the capital used was initiated from prohibited sources. This, however, is a worst case scenario. This issue needs to be clearly understood, because confusion on this matter might make Islamic banks look un-Islamic or even worse, similar to conventional banks. Dr Zaharuddin Abd Rahman is a Shariah scholar and lecturer at the Islamic University of Malaysia, as well as being an associate lecturer at the Markfield Institute of Higher Education in the UK. He is also a Shariah advisor to several financial organisations in both Malaysia and the GCC and a regular contributor to several publications focussing on Islamic financial issues.

http://myoneacademy.blogspot.com/2012/01/risk-managementinstruments-still.html
Friday, January 20, 2012

Risk management instruments still lacking at Islamic financial institutions (By IFN)
(See IFN):Islamic finance has proven to be more resilient amid financial crises, but experts believe that more can still be done to manage risks. Despite Islamic banks high liquidity, namely; in the form of cash, the industry still lacks the necessary depth to manage risks effectively, commented Jaseem Ahmad, the secretary general of the Islamic Financial Services Board. In that sense, there is still a shortage of Shariah compliant instruments and securities. A capital market is being developed but it is still not as liquid or as deep as we would want it to be; and it needs to be deeper, Jaseem was quoted as saying.

Hence, there is room for substantial improvement in the equity management framework; as more instruments will afford Islamic banks more opportunity for risk management. In addition to providing the banks access to a wider range of instruments, the banks should also be incentivized and provided with the necessary resources to strengthen their capabilities. Jaseem also noted that even high levels of loss-absorbing capital could be negated if risk management frameworks are not sufficiently strong and in spite of Islamic banks practising more conservative banking methods. There is a very high ratio of tier one capital and common equity among Islamic financial institutions which is loss-absorbing; and the kind of capital that Basel III has brought in now for conventional banks, he noted. However, insufficient risk management and risky activities can still lead problems to crop up at any bank, even if it is an Islamic bank, added Jaseem.

http://www.businesstimes.co.tz/index.php?option=com_content&view=article&id=1641:lack-ofcredit-rating-and-the-survival-of-the-islamic-banking&catid=37:column&Itemid=60
Lack of credit rating and the survival of the Islamic banking
Written by Admin Friday, 06 January 2012 11:08

HENNIE VAN GREUNING & ZAMIR IQBAL Islamic finance is a rapidly growing part of the financial sector in the world. Indeed, it is not restricted to Islamic countries and is spreading wherever there is a sizable Muslim community. More recently, it has caught the attention of conventional financial markets as well. According to some estimates, more than 250 financial institutions in over 45 countries practice some form of Islamic finance, and the industry has been growing at a rate of more than 15 percent annually for the past five years. The markets current annual turnover is estimated to be $350 billion, compared with a mere $5 billion in 1985, according to the recent study on Risk Analysis of Islamic Bank by Hennie van Greuning and Zamir Iqbal of the World Bank. Since the emergence of Islamic banks in the early 1970s, considerable research has been conducted, focusing mainly on the viability, design, and operation of deposit-accepting financial institutions, which function primarily on the basis of profit- and loss sharing partnerships rather than the payment or receipt of interest, a prohibited element in Islam. Whereas the emergence of Islamic banks in global markets is a significant development, it is dwarfed by the enormous changes taking place in the conventional banking industry. Rapid innovations in financial markets and the internationalization of financial flows have changed the face of conventional banking almost beyond recognition. Technological progress and deregulation have provided new opportunities, increasing competitive pressures among banks and non-banks alike. The growth in international financial markets and the proliferation of diverse financial instruments have provided large banks with wider access to funds. In the late 1980s, margins attained from the traditional business of banking diminished. Banks have responded to these new challenges with vigor and imagination by forging ahead into new arenas.

At the same time, markets have expanded, and opportunities to design new products and provide more services have arisen. While these changes have occurred more quickly in some countries than in others, banks everywhere are developing new instruments, products, services, and techniques. Traditional banking practicebased on the receipt of deposits and the granting of loansis only one part of a typical banks business today and often the least profitable. New information-based activities, such as trading in financial markets and generating income through fees, are now a major source of a banks profitability. Financial innovation has also led to the increased market orientation and marketability of bank assets, which entail the use of assets such as mortgages, automobile loans, and export credits as backing for marketable securities, a process known as securitization. A prime motivation for innovation has been the introduction of prudential capitalrequirements, which has led to a variety of new financial instruments. Some instruments are technically very complicated and poorly understood except by market experts, while many others pose complex problems for the measurement, management, and control of risk. Moreover, profits associated with some of these instruments are high and, like the financial markets from which they are derived, are highly volatile and expose banks to new or higher degrees of risk. These developments have increased the need for and complicated the function of risk measurement, management, and mitigation (control assessment). The quality of corporate governance of banks has become a hot topic, and the approach to regulation and supervision has changed dramatically. Within an individual bank, the new banking environment and increased market volatility have necessitated an integrated approach to asset-liability and risk management. Rapid developments in conventional banking have also influenced the reshaping of Islamic banks and financial institutions. There is a growing realization among Islamic financial institutions that sustainable growth requires the development of a comprehensive risk management framework geared to their particular situation and requirements. At the same time, policy makers and regulators are taking serious steps to design an efficient corporate governance structure as well as a sound regulatory and supervisory framework to support development of a financial system conducive to Islamic principles. This IMF publication provides a comprehensive overview of topics related to the assessment, analysis, and management of various types of risks in the field of Islamic banking. It is an attempt to provide a high-level framework (aimed at non-specialist executives) attuned to the current realities of changing economies and Islamic financial markets. This approach emphasizes the accountability of key players in the corporate governance process in relation to the management of Islamic financial risk. The Islamic financial system is not limited to banking; it also covers capital formation, capital markets, and all types of financial intermediation and risk transfer. The term Islamic financial system is relatively new, appearing only in the mid-1980s. In fact, earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either interest-free or Islamic banking.

However, interpreting the Islamic financial system simply as free of interest does not capture a true picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating social justice, risk sharing, the rights and duties of individuals and society, property rights, and the sanctity of contracts. An Islamic economic system is a rule-based system formulated by Islamic law, known asShariah. The Shariah consists of constitutive and regulative rules according to which individual Muslims, and their collectivity, must conduct their affairs. The basic source of the law, in Islam, is the Quran, whose centrality in Islam and influence on the life of Muslims cannot be overemphasized. Its chapters constitute the tissues out of which the life of a Muslim is tailored, and its verses are the threads from which the essence of his or her soul is woven. It includes all the necessary constitutive rules of the law as guidance for mankind.However, it contains many universal statements that need further explanation before they can become specific guides for human action. Hence, after the Quran, the Prophet Muhammads sayings and actions are the most important sources of the law and a fountainhead of Islamic life and thought. The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, which seek to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islams teachings on the work ethic, distribution of wealth, social and economic justice, and role of the state. The Islamic financial system is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. Credit risk management for Islamic banks is complicated further by additional externalities. Especially in the case of default by the counterparty, Islamic banks are prohibited from charging any accrued interest or imposing any penalty, except in the case of deliberate procrastination. Clients may take advantage by delaying payment, knowing that the bank will not charge a penalty or require extra payments. However, the major techniques used by Islamic banks to mitigate credit risk are similar to those used by conventional banks. However, in the absence of credit-rating agencies, banks rely on the clients track record with the bank and gather information about the creditworthiness of the client through informal sources and local community networks. Using collateral and pledges as security against credit risk is a common practice among all Islamic banks. The bank might ask the client to post additional collateral before entering into a murabahah transaction. In some cases, the subject matter of murabahah is accepted as collateral. Posting collateral as security is not without difficulties, especially in developing countries. Typical problems include illiquidity of the collateral or inability of the bank to sell the collateral,

difficulties in determining the fair market value on a periodic basis, and legal hindrances and obstacles in taking possession of the collateral. Due to weak legal institutions and slow processing, it becomes difficult for the bank to claim the collateral. In addition to collateral, personal and institutional guarantees are also accepted to minimize credit risk.

http://www.bt.com.bn/business-national/2012/01/18/islamic-banks-urged-develop-moreinstruments-manage-risks

Islamic banks urged to develop more instruments to manage risks

UBAIDILLAH MASLI BANDAR SERI BEGAWAN Wednesday, January 18, 2012 ISLAMIC financial institutions (IFIs) should develop more products for them to better manage risks, in light of the recent financial crisis that has affected public image and trust in the global banking sector, experts said here yesterday. The secretary-general of Islamic Financial Services Board (IFSB) said that Islamic banks were more conservative than their mainstream counterparts and generally had the capital required under the new Basel III framework, which began implementation last year. "There is a very high ratio of Tier One capital and common equity (among IFIs), which is loss-absorbing and the kind of capital that Basel III has brought in now for conventional banks," Jaseem Ahmad said. "When I say that our banks have been conservative, what I mean is that they have not generally engaged in the kind of very rapid (and very risky) expansion of asset and credit that conventional banks have. So, Islamic financial banks are well-capitalised," he added. Although Islamic banks had a high level of liquidity, Jaseem said since it was in the form of cash, it lacked the depth necessary to effectively manage risks. This gave the banks room for "substantial improvement" in the equity management framework in Islamic finance, he added. "In that sense, there is still a shortage of Syariah-compliant instruments (or) securities. A capital market is being developed but it is still not as liquid or as deep as we would want it to be. And it needs to be deeper," he told The Brunei Times. "We need to have more instruments to give Islamic banks greater opportunity for this management than they currently have."

The long-term objective was then to ensure that Islamic banks had access to a wider range of instruments, while also encouraging them with incentives and the provision of resources to strengthen their respective capabilities. "You can have high level of capital loss absorbing capital but if your risk management framework is not strong and if your conduct is geared towards risky activities, then there will be problems for any bank, even if it is an Islamic bank," Jaseem said. The secretary-general of the Kuala Lumpur-based international standard-setting body for IFIs was speaking on the sidelines of an IFSB seminar discussing Syariah issues on regulatory capital and risk management, held at a hotel in Gadong. One of the guest speakers of the seminar, the CEO of CIMB Islamic Bank Bhd of Malaysia, Badlisyah Abd Ghani discussed the issues surrounding alternatives for Syariah-compliant subordinated debt and hybrid capital as well as structuring Syariah-compliant substitutes for convertible contingent capital, under the Basel III framework. Based on Malaysia's experience, Badlisyah said in his presentation on regulatory capital that there was "no Syariah issue" in converting debt to shares if the required features were clearly stated in Sukuk structure. However, he cautioned that it may require additional structure based on Bai Inah or Commodity Murabaha. This would also lead to the bank incurring additional costs such as the brokerage fees in determining the share price. "However, there will be insufficient acceptable assets (fixed assets or Iljirah assets) to be the underlying assets as some Syariah scholars do not allow trading of sukuk which are sale-based 'receivable' assets," Badlisyah said.