Is There a Secret Book I Don’t Know About?

ISLAMIC BANKING PRODUCTS ARE EXPENSIVE?

It is one of the mysteries of the universe that there is this perception that Islamic Banking products are MORE EXPENSIVE than the Riba products counterpart. It never fails to surprise me that in Malaysia, whenever I open the session for Q&A after a talk on Islamic Banking, that the question put to me was “Why is Islamic Banking financing products more expensive than conventional banking products?”.

Honestly, I wondered if this question comes from the possibility of everyone reading from the same exact book published many many years ago, making that one point of contention again and again. Which book have people been reading? Can someone pass me this book? It seems everyone is reading or referencing the same book which says “Islamic Banking products are expensive”. Can someone tell me about it?

So I decided to ask around. I asked the persons asking the question on why does he/she say that? In what scenario? Which product? What feature of the product makes it expensive? In all attempts, they replied “It is the general view that Islamic Banking is more expensive”. But they have yet to give me any evidence when I asked for their source.

Amazing

This is like a scary bedtime story that parents tell their children if they don’t behave. So now I am asking around for specific scenarios on why they made such comments. From what I gathered, these are some of what I think people are referring to. But I couldn’t be 100% sure, so please, do leave your comments and scenarios (and details) for me to evaluate and respond to.

Because, for the past 20 years (in Malaysia at least), this claim of “Islamic Banking products are more expensive than conventional banking” are simply not true.

YES, THERE ARE DIFFERENCES

Of course, before I delve deeper into this perception, there are differences in Islamic Banking that requires additional items or costs, but mainly these are operational costs or documentary costs or management costs which are linked to mainly Shariah requirement on Aqad. For conventional banking, it is just a loan agreement, For Islamic Banking, a trading transaction may occur, and if it does… there may be additional costs.

But these costs are usually absorbed by the Bank itself, and hardly passed on to the customers. So why would it be more expensive for the customer, if the Bank is absorbing these “costs” as part of their cost of doing Islamic Banking business?

And additionally, the costs borne by the Bank for doing Islamic Banking business are not significantly higher. The Bank have to remain competitive as well, either against conventional banks or other Islamic banks as well. So the costs, if significant, will not be passed to customers to remain competitive. It should be on par with other players in the market.

FINDING THE REASONS

As far as I can tell, some of the perception on Islamic Banking is more expensive than Conventional  products are based on these:

  1. Selling Price – In some Islamic Banking products, there are trading requirements (Murabaha / Tawarruq / Istisna’a / BBA) and one of the tenets of valid sale is that there must be a Selling Price. Selling Price is the sum calculation of all the Installments the customer has to pay over the period of financing. The formula is that Selling Price = Monthly Installment x No of Months of Financing. Once this is agreed, it cannot change; anything above and beyond the agreed Selling Price (maximum) is considered Riba. Conventional Banking products do not have this as they only declare the Installment amount per month based on prevailing rate. Truth is, no one really know how much they eventually pay under conventional banking product, because there is no capping of the amount they may pay. The tenure can be extended, the installment can be increased, the rates may be revised upwards under conventional banking. There is no control of how much (maximum) conventional banking can collect from the customer. If conventional banking products add up the installments over the period of time, they can also see the amount equivalent to a Selling Price ie total amount payable over the tenure. But they don’t, because it ties their hands from collecting more. So, is Islamic products more expensive? It is possibly the opposite i.e. cheaper than conventional due the maximum Selling Price compared to a conventional loan without any maximum amount (sky is the limit).
  2. Ceiling Rate – Islamic Banking products may work on either a fixed rate structure or floating rate structure. If the structure is a fixed rate structure, it looks similar to the above. If is floating rate structure, then there is a need to put up a Ceiling Rate (a maximum rate that Shariah allows us to charge) for the purpose of the Aqad, where the certainty of price is required.  However, once the Aqad has been concluded (Selling Price is contracted), the day-to-day running of the financing is charged at the Effective Profit Rate (usually below the Ceiling Rate) which is reflective of the prevailing market rates. Which is what the conventional banking products are charging. This makes the actual amount paid for Islamic Banking product at par with conventional banking products. The difference between the Ceiling Rate and the Effective Profit Rate is not charged on the customer therefore given as a Rebate on price (Ibra’). For example, if the Ceiling Price for the Aqad is 10% and the Effective Rate for day-to-day is 6.0% (ie customer is charged only 6.0%), then the difference of 4.0% is a pricing rebate to the customer. So, is Islamic products more expensive? No. It is on par after pricing Rebate. In fact, having a Ceiling Rate provides additional “protection” for an Islamic Banking customer i.e. during times of high volatility of Base Rate / Funding Rate, the Ceiling Rate serves as a rate protection for the customer. For example, should the all-in rate of the financing increase to be 13% or 14.0%, the customer’s rate will not exceed the Ceiling Rate of 10%, therefore saving the customer the excessive rate during periods of uncertainty. So, during period of high volatility of rates, the Ceiling Rate will not be exceed thus making the product cheaper than the Conventional product.
  3. More Documents – I acknowledge that some Islamic products do require additional products as a package. But as for main documents, where the most charges are incurred including stamp duties, are usually the same as any conventional banking product. Maybe there are earlier perception that because of the Selling Price based on Ceiling Rate, the stamp duty will be more expensive. It is not true. Stamping will still be made based on the principal amount even for an Islamic facility. Furthermore, secondary documents are usually stamped at nominal amount i.e. $10 per document. The additional documents for Islamic product, if we assume requires 5 additional, will cost the customer $50 extra. That is not significant.  So, is Islamic products more expensive? For documents, maybe. But it is dependant on structure and the additional documents will be stamped nominal value.
  4. Early Settlement Rebate – I probably understand and agree with this point, provided it was made 15 years ago! Traditionally, when a customer takes a loan with a conventional bank and want to do an early settlement after a few months, an early settlement penalty was charged. For an Islamic Banking products, when BBA was offered many years ago, the method was to give a “reduced discretionary rebate” on the unearned profit. This means maybe some Islamic Banks want to earn the same early settlement penalties (like a conventional bank) via a reduced rebate as rebates are by nature, discretionary in the eyes of Shariah. However in 2011, BNM issued a specific guidelines on the treatment of rebate for early settlement of Islamic sale-based financing products. The guidelines ensures that the rebate given is mandatory, with a specific formula to be adhered to. The guidelines also included the required disclosures for transparency purposes. In short, Islamic Banks cannot charge early settlement compensation (only a couple of scenario where it is allowed) and the rebate given must follow a strict formula. So, is Islamic products more expensive? There might be a case for this argument before 2010 (for early settlement cases only) but with the Ibra guidelines issued in 2011, the product would possibly result in at par or cheaper than a conventional bank product.
  5. Commodities Trading Fees – This is a recent phenomena. A lot of structures are riding on the popular Tawarruq structure, and this structure involves the buying and selling of commodities via brokers or established trading platform and there are Trading Fees being charged. Generally, for retail consumers, the trading fees are absorbed by the Banks; you will never notice it. But for Large Corporates dealing in hundreds of million deals, a trading fee may be noticeable. However, these fees are also deemed small enough to be ignored. The standard trading fees at Bursa Malaysia is $15 for every $1,000,000 commodities traded. That’s 0.0015% charge. For a $100 million transaction, the trading fee will only be $1,500. I have not seen any Corporate customers refusing to pay this trading fees. And there are some brokers who are even charging lesser rates. So, is Islamic Banking more expensive? Only for Tawarruq, there is additional costs but for the quantum, I do not believe 0.0015% is considered significant, or expensive.

It really is testament that the men and women in the industry were always looking to enhance, resolve and improve on contentious practices to serve the public. The products were always evolving to be better for the consumers. In fact, I believe we are at the stage that some of the offerings under Islamic Banking is CHEAPER than the conventional banking products due to certain fees and charges and treatment on the account are instructed by Shariah Committee.

IT IS A PERCEPTION THAT NEEDS CORRECTION. IT IS NOT CLEAR WHICH PART OR PRODUCT FEATURE THAT THE PUBLIC PERCEIVES AS MORE EXPENSIVE. IS IT THE RATE, THE PRICE, THE PENALTIES?. IS THERE ANY UNFAIR TERMS LEADING TO THIS PERCEPTION.  

COULD ISLAMIC BANKING FINANCING PRODUCTS ACTUALLY BE CHEAPER THAN CONVENTIONAL LOANS?

In some scenarios, I do believe so.

There are many areas that is governed by Shariah decisions formulated to protect or benefit customers for fairness. Especially in areas of fees and charges and compensation. IF YOU WANT TO KNOW MORE ABOUT ISLAMIC BANKING PRODUCTS BEING CHEAPER THAN A CONVENTIONAL BANKING PRODUCT, CHECK OUT MY COMING POST.

I really hope someday someone will pass me this mystery book to read. We are in 2017 and so much have changed in the past decade. Huge and big regulations have been introduced and most of it with heavy input and consideration from the Shariah Advisory Council (SAC) of BNM. These are learned individuals that I believe are not greatly motivated by money. There are huge responsibilities on their shoulders thus the decisions made will be for the benefit of customers in mind.

Again, I invite readers to provide me with the latest findings where it is believed that Islamic Banking is more expensive than conventional banking products. Let us discuss and evaluate them based on actual facts.

Wallahualam

 

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Religiosity

Sometimes, as a practitioner, we wonder what motivates a person to subscribe to Islamic Banking products. Is it really based on the attractive features of a product, trying out something new, or is there an ingrained desire to subscribe to a Sharia compliant product? I know many non-Muslims subscribe to Islamic Banking products based on the intrinsic benefits afforded by the products, such as a more fairer penalty terms, transparent fees and charges, and flexibility in settling the accounts early.

But what of Muslims? How can we understand the triggers that encourage a Muslim to subscribe to a Sharia-compliant product?

I came across this writing by Dr Hanudin Amin which mentions a term that I hardly hear in the industry; Religiosity. It refers to the conceptual level of a person’s “piousness” to be marked into different levels (index), and he aptly split it into 3 general categories i.e. 1) Pious Religious, 2) Moderately Religious, and 3) Off-Hand Religious. His paper suggests that the Pious Religious group tends to accept Islamic Banking products more compared to other groups (in his study it’s focused on Home Financing-i). It also proposes that perhaps it is worthwhile to consider packaging Islamic Banking products based on the different levels of “Religiosity” to better appeal to them. This may indeed widen the scope for acceptance as products may be perceived differently by different people, although essentially it is the same product.

To read a bit more on the study, do have a read on the research below.

RELIGIOSITY INDEX FOR ISLAMIC HOME FINANCING IN SABAH

By Dr Hanudin Amin*

Excerpt :Earlier muslim scholars have supported the finding that a consumer’s religiosity has a significant effect on consumption in a muslim context (e.g. Elgari, 1990). Someone who approaches an Islamic bank for a mortgage is endowed with a certain level of iman. Bendjilali (1995) believes that choosing interest-free financing is blessed by Allah (SWT), hence it is rewarded. Bendjilali (1995) points out that:  “A muslim consumer who approaches the Islamic bank to get a loan for a real transaction to be financed through murabaha mode is endowed with a certain level of iman. The degree of iman will indicate the degree of compliance to the Shariah”.

For full Article, click on this link.

Tell us what you think. Should Islamic Banking products designed to a specific level of religiosity or can the one-size-fits-all approach appeal to everybody? Comments appreciated.

*The author is an Associate Professor/Dean at the Labuan Faculty of International Finance, Universiti Malaysia Sabah, Labuan International Campus. He has a PhD from the International Islamic University Malaysia (IIUM) in Islamic Banking and Finance (PG310163). He can be contacted at hanudin@ums.edu.my

Islamic Banking Operating Model

For the past few months, there have been some earnest discussions on whether Islamic Banking is operating under the right model or type of institutions. Comments by prominent scholars on the suitability of certain Islamic contracts in a financial institution sparked debate on the types that are suitable for operating Islamic contracts. Before I attempt to also put my piece in the mix, there were also questions asked to me on which of the existing models can actually be the right fit. There is still confusion on the types of institutions operating in the market.

Before we look deeper, it is worthwhile to recap the available models in Malaysia.

THE ISLAMIC WINDOW OPERATING MODEL

We  have to start somewhere. Islamic Windows as a starting point, provides the best opportunity to build capabilities at the lowest costs while the business is being developed. The intention is to identify the requirements for system and invest minimally to assess feasibility and operational gaps. This allows the Bank to build the infrastructure at an acceptable pace. This is also a pre-cursor to further/larger infrastructure investments if there is a decision to expand the business into a subsidiary.

This model relies on the existing conventional infrastructure where all the processes, operations, sales, channels, finance, branches, compliance, audit and all functions are provided by the conventional bank. It is a leverage model where the Islamic Banking Windows are more like a “manufacturer” of products. Islamic Banking Windows churn out the products and services (like a factory), and delivers them to the conventional team as part of the suite of products offered by the conventional bank. In such structure, Islamic Banking Windows are just a “segment” of products on offer. Just like Corporate Banking products. Commercial Banking products. Wholesale Banking products. Private Banking products. Retail Banking products… and Islamic Banking products.

The advantage of this model is the low set-up cost. The business rides on existing infrastructure and hires specialists in each function. There is no need to set up a different branch as those Islamic products are sold directly by the existing branches and channels sales team. Balance Sheet discloses Islamic Banking Window performance as part of the Notes to the Account. Shareholders’ Capital, however must be separately allocated, accounting ledgers managed separately and the Single Customer Exposure Limit (SCEL) will be 25% of the allocated Capital. A head of Islamic Banking Windows will report directly to the conventional banking CEO, where business decisions are made.

Not many banks operates under the Islamic Banking Windows model. The main reason is the lack of product range i.e. competing with conventional banking products of the same branch, and the small scale of business limited to its SCEL, and no autonomy of business decision which must be aligned with conventional products.

THE ISLAMIC SUBSIDIARY  MODEL

Islamic Subsidiary rides on the strength of the Parent Bank, which is the conventional bank. The model used is still a leveraged model, but the Islamic Subsidiary can choose which services or function they want to “outsource” to the conventional bank (at a fee chargeback, of course). The idea of a Subsidiary is to be independent, so all cost consideration must be taken into account. Decision to open Islamic Banking Branches can also be made, and BNM supports this expansion via Islamic Banking Branches.

However, being a Subsidiary Bank can also be a burden to set-up. A differentiated system or process or operation team requires cash for its set-up. At the early stages, such investment cash will be limited, and when cash is available for investment, the development of the Subsidiary Bank must then align with the conventional bank. So it can be a chicken and egg situation where to expand you need to earn but to earn you need to expand (and spend).

Most of the conventional banks offers Islamic products via Islamic Banking Subsidiary. The main advantage is that decisions are autonomous in a Subsidiary, there is more control of marketing and sales and branches, and the Bank (as an independent entity) can chart its own course. However, there will still be influence from the parent (as the majority shareholder) and the products and services offered are generally aligned to the products and services offered by the parents. The SCEL for Subsidiaries are also dependent on the strategy of the parent Bank, where it can choose to invest heavily or adequately for the operations of its subsidiary.

FULL FLEDGED ISLAMIC BANKS

These are standalone banks that generally are not under any conventional banking influence. The products and services may be consistent with the offerings in the market, but it is not an obligation to follow. In theory, Full Fledged Islamic Banks have the capacity to offer new-to-market products, based on the approvals obtained from Shariah Committees and BNM.

There is room for innovation and experimentation of new structures via Full Fledged Islamic Banks, although they must still governed by the financial ratios and controls for other types of banks and financial institutions, using conventional measuring tape which could lead to a “penalty” cost for doing business.

For example, a debt based home financing based on Tawarruq will incur a capital charge of 50%-100% but in a Musyaraka Financing, that capital charge will cost 100%-400% which will be an “expensive” proposition simply because it is measured against conventional financial ratios.

Personally, I believe Full Fledged Islamic Banks should follow a different set of financial ratios catered to reflect the type of risks an Islamic Bank CAN take, should the Islamic Bank look to offer products such as Mudaraba, Musyaraka, Istisna’ or even Salam. To allow for pure innovation, the financial ratios and treatment of capital and assessment of risks should be differentiated to reflect the nature of the products offered. While Basel requirements can be used as benchmark to ensure stability, an “Islamic” Basel will be even more meaningful where it can fully address all the real risks faced by Islamic Banks deploying Profit Loss Sharing (PLS) and equity-based structures such as Mudaraba and Musyaraka. Slowly, BNM is recognising these differences for measurement and has taken small steps to differentiate, such as the introduction of treatment of Investment Accounts (IA), the Liquidity Coverage Ratio (LCR) treatment, Capital Adequacy Framework for Islamic Banks (CAFIB), and the removal of Reserve Funds (reserves from paying of dividends) from Islamic Banks recently. It is my sincere hope to one day see an “Islamic” section in future Basel releases as well.

The main challenge for a Full Fledge Islamic Bank, is the costs of building the franchise from ground zero. To compete with a conventional bank, the Islamic Bank must invest similarly in its infrastructure and achieve operational efficiency and scale as soonest as possible. The payback period and Return on Investment and Return on Equity remains important for long term sustainability. SCEL is dependant on how big the Bank intends to grow. Another key consideration is the ability for the Islamic Bank to build a strong source of cheap deposits for the funding requirements.

NOTE

Of course there are other structures that can be attributed as Islamic Financial institutions such as cooperatives, development banks, and investment banks. But the most common are the above variations and these structures fit into strategies identified by the bank. In most cases, BNM prefers to see development coming from the Full Fledged Islamic Banks and Subsidiaries. These should be the drivers for the growth of Islamic Banking.

Wallahualam

The Wayang Kulit of Islamic Finance: Book Review

Islamic Finance in The Global EconomyIslamic Finance has seen many criticisms for the past decades, ranging from whether the right model was introduced in the first place, to questions on the mirroring of conventional products into islamic alternatives, accusations of Hilah and back-door riba, suitability of certain contracts in the banking space, and even the end accomplishment of the Maqasid of Sharia via a financial intermediary model.

Practitioners and regulators (including Sharia scholars) have been hard at work to address these issues (which the public seems to assume we are not aware of in the first place!!!). To a certain extent, a lot of the issues have been / are being addressed (whether to its full satisfaction or otherwise), but it is also important to be able to sit and identify areas where further improvements can be made.

Ms Rosana has become an avid observer of Islamic Finance practices and its shortfall, and found literatures that she hopes to bring forward into the constructive discussion with the industry. Her review today covers the book by Ibrahim Warde : Islamic Finance in the Global Economy (2010).

Review by Rosana Gulzar (Excerpt)

This book by Ibrahim Warde, a US academic, is among a few in the genre of political economy of Islamic finance. Although a much needed subject, it is hardly discussed in classrooms apparently due to political sensitivities. That may be the reason why this book stands out in its contribution but it can also very well stand on its own merits. The content is refreshingly intellectual, critical and direct. But even as I find it to be the most enlightening book I have read on the subject, I wish for more.

The question is, what is ‘political economy’? Or what does the subject cover? It is a fascinating field of economics which goes beyond the simple study of processes. Instead of describing production and trade as if they operate in silos or the often used phrase in economics, ceteris parabus (assuming all else stay constant – seriously, which world is that?), the study of ‘political economy’ combines theories from political science and sociology to bring about a fuller and more realistic perspective on how a country is run. A branch of political economics even draws from other academic areas such as culture and history. This definition from Investopedia is to me, the most appealing though it is arguably not the most reliable source: “International political economy is ultimately concerned with how political forces like states, individual actors, and institutions shape systems through global economic interactions and how such actions effect political structures and outcomes”.

The study of political economy is vital, I argue, in Islamic finance because how does one begin to understand a phenomenon without a frank discussion on the forces shaping it. To borrow from the Indonesians, who are the real dalangs (puppeteers) in this wayang kulit (traditional puppet-show)? Who are pulling the strings? As Warde says, “Quantity, not quality, is the defining feature of writings on Islamic finance. The recent boom in Islamic finance has resulted in a flood of writings that add very little to our understanding of a complex and multifaceted phenomenon. Overall, scholarship is marred by four flaws: the ‘authorised’ nature and pre-ordained conclusions of a significant portion of it; narrow geographic focus and lack of comparative analysis; reductionism (religious, financial, and legal); and faulty assumptions about the relation between theory and practice (p. 8).” In short, we have barely scratched the surface.

TO READ FULL COMMENTARY ON THE BOOK, CLICK ON THIS LINK

TO GO TO MS ROSANA GULZAR PAGE, CLICK ON THIS LINK 

To have an open and honest discussion, do have a read a give us your thoughts, especially on the political economy aspect of Islamic Finance. Comments and feedback welcome.

Popular Islamic Finance Terms

While Islamic Banking in general has been codified since early 1980’s in Malaysia, the familiarity to Islamic Banking or Finance terms remain a challenge. Terms like Mudarabah or Musyarakah or Wakalah remains difficult to remember but also it’s meaning have been lost to many, although there has been many attempts to communicate the various glossaries already available.

This makes the layman to go back to something more familiar, in most cases it is conventional banking, simply because of the ingrained understanding of conventional banking terms and terminologies. Some become “allergic” to Islamic terms simply because of the fear of failing to explain and understand the “arabic” terms. It does seem a daunting task to remember the terms, and understand what they mean.

So, I picked up a simple slide from a friend from IBFIM ie Haji Razli Ramli (his introduction available here in this website – click here) and made it into  a simple slide.

Get familiar with the terms for Islamic Finance, the easy way. Click on this 1-minute video. Share this video with friends. Know the meaning of those Arabic word. It’s quick and simple. In both English and Bahasa Malaysia. Comments are also appreciated.

Also, you can download the file into your desktop or mobile at the following links:

Share out to your friends. Thank you.

 

Disruption : Islamic Contracts

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Under IFSA 2013, it is no longer about Product Innovation. It is about Product Compliance.

2 weeks ago I had a session with some bright individuals discussing the Islamic contracts commonly used in Corporate Banking financing structures. We went through almost all the available Islamic financing contracts such as Murabaha, Ijara, Musyaraka and Mudharaba, where I highlighted that all these contracts now have their own Policy Document issued by Bank Negara Malaysia (BNM). The Policy Documents, in my opinion, are a concise version of a lot of Sharia regulations and great reading source. It becomes a reference point where management roles and responsibilities are outlined, operational behaviour laid down, and theoretical basis is justified and explained.

It is a matter of time, I told the participants, that these Policy Documents are taken in their full context and finally developed into a comprehensive structure with clear compliance to Sharia requirements. We, as Islamic Bankers, are in for an exciting period of development where we will have a chance to develop “real” Islamic banking contracts.

The moment I said that, I realised it is NOT TRUE!!!

THE IMPACT OF IFSA 2013

The popular belief is that IFSA 2013 is meant to realign all the Islamic Banking regulations in the Islamic Banking Act, Takaful Act and various major guidelines into a single overarching Act. IFSA 2013  consolidates the various practices into more clarity and re-classification of concepts. However, the perception that Islamic Banking in Malaysia as an innovative development hub would no longer hold true. “Innovation” was the key thinking and pride-point prior to IFSA 2013; now I believe the right word is “Compliance”.

163170_477596024332_7522334_nWhen we first started the Islamic Banking journey in late 1990’s and early 2000s, BNM encouraged a lot of product innovation from Banks as there were no existing guidelines. We looked at the various structures that provides the desired outcomes and discussed with Shariah Committee on the design and component of products without breaching Sharia rules. BNM was supportive on us developing these “innovative” products. Some may have been controversial (such as Bai Inah, Bay Ad Dayn, Wadiah and Bai Bithaman Ajil) but it encourages discussions alongside the mantra that “whatever is not explicitly prohibited, is permissible“. Sometimes we were forced to think outside of the box, especially for sophisticated products mirroring conventional. We also received support from Sharia Committees whom temporarily approved “innovative” products with the understanding that over time, a better solution were developed as replacements.

Now with the issuance of the Policy Documents, such innovation becomes limited. Innovation is now ring-fenced around compliance to Shariah rules (either from regulators or internal Shariah Committee), and the Banks are expected to follow these rules to the letter. Breaches to these rules becomes the responsibility of the Bank’s Shariah Committee and detailed deliberation is greatly expected to provide the solution. Compliance first; if it is not covered in the documents, it probably cannot be done without a lot of effort.

CHOOSING THE SIMPLEST ALTERNATIVE

With compliance now being the vogue vocabulary with BNM, Banks had to look hard to the Policy Documents to ensure the requirements are identified and gaps filled for fear of breaches or fines. The gap analysis falls into the line whether “are we complying to the requirements?” and not “how do we do this without it becoming a gap or compliance issue?”. Both Shariah and Bank’s Product teams would now look on how to comply with Policy Documents instead of using the Policy Documents as a reference to develop a product.

What I noticed since 2014 is the obsession to comply with Islamic contract requirements, and if the team feels it is difficult to comply, the next logical step is to avoid such contract altogether and seek an alternative contract which is easier to comply with. For example, the Murabaha Policy Document issued in 2014. I have to say it is a beautiful document, and outlines the requirements for Murabaha Purchase Orderer (MPO) that reflects the full Sharia requirements of ownership transfers, risk taking, profit and management of actual assets.

These requirements, which in the eyes of many Banks, may be difficult to fully comply with due to many reasons: shortage of expertise, systems infrastructures limitation, people understanding, complicated processes, operational risks, credit issues and fund management requirements. Instead of the risk of breaching the Policy Documents, Banks opt for something less “complicated” which offers “similar” structure. The default solution is Tawarruq Arrangement i.e. Commodity Murabaha.

Or, the teams looks at Ijara Policy Document. It outlines further the roles and responsibilities of lessor and lessee, while the asset remained in the Bank’s ownership throughout the lease tenure. Again, if a roadblock occurs where a Bank cannot fully comply… Tawarruq Arrangement provides a quick solution. With very defined rules outlined in Tawarruq Policy Documents, the Banks are confident that offering Tawarruq will not breach any guidelines.

Tawarruq, therefore becomes the default Islamic contract in the market. When I asked the participants during case-studies to the question “What contracts should be used for this structure?”, the answers are unanimous “Tawarruq”. And they are not wrong.

DISRUPTION IN ISLAMIC CONTRACTS

155228_469014969332_6259944_nMaking Tawarruq as the “all-problems-solved” structure is having an unfortunate result to the industry. While the issuance of the Policy Documents as a reference was to galvanise the development of various Islamic contracts, the Banks have an easy way out in Tawarruq. Now, the rest of the contracts are in danger of being sidelined in favour of continuous development in Tawarruq.

For example, the Home Financing product which had evolved from BBA in the 1980s to Diminishing Musharaka in the 2000s. When BBA was introduced, practitioners and Sharia teams identified several practical issues that over a period of time needed to be resolved such as ownership transfer, rights to sell, and sale of properties under construction. These issues led to the development of Diminishing Musharaka as an alternative solution.

But with Diminishing Musharaka, there are still operational and legal issues that have yet to be resolved until today. For example, the “right” contract to be used for period of construction, the application of Ijara and the extensive outlining of Wakalah roles and responsibilities. Failure to understand the issues and provide real solutions puts the Bank at risk. There are also legal infrastructures that have yet to be addressed such as land joint-ownership by the Bank (as a partner), and different practices of land offices for the registration of Bank as a partner. These are roadblocks (and credit risks) to the Banks to take the structure further.

THE DOUBLE-EDGE SWORD OF TAWARRUQ

25547_378676189332_2665364_nMalaysia is in danger where I foresee that one day the industry itself will became the absolute global expert in Tawarruq and Commodity Murabaha. With Bursa Suq Al Sila as the leading commodity trading platform for the country, backed by the government (as a national bourse), the Tawarruq structure is expected to evolve into an efficient Islamic-structure engine. The processes of Commodity Murabaha will become seamless, and may even integrate into a Bank’s core banking system, the operation for buying and selling commodity will become commonplace and familiar, and this will result in effective processing, awareness of Shariah risks, compliance to trading requirements and well as reduction in overall operational risks.

Banks will one day become so well versed in Tawarruq, they will question the need for other types of Islamic contract, where they may not able to fully comply with.

With such development, more and more:

  1. capital investments will be made into perfecting the Tawarruq infrastructure, and Banks will also be able to comply with BNM requirements by investing in human capital familiar with Tawarruq.
  2. product structures will be developed around Tawarruq and once these products are established, it will be difficult to unwind as a prefered product simply due to the ease of the Tawarruq contract requirements.
  3. variations and hybrid products will be introduced based on Tawarruq, or containing elements of Tawarruq to solve “difficult scenarios” for compliance.

We will one day have an innovative and world class Tawarruq product, but no development in the other major Islamic contracts. Innovation will stall and Banks will choose quick returns and operational ease of Tawarruq. It is a dilemma of the industry where it is heading to “one” major solution for almost all “sale-based products”.

It is unfortunate if Banks chose to abandon the other contract alternatives, where such contracts will never reach its full operational and theoretical potential.

Hoping that a Bank will take the lead to develop products based on all the various Policy Documents instead of relying on only Tawarruq and its variations. The industry needs expansion and enhancement and by focusing on only Tawarruq, the industry will not be able to explore exciting products and expand its horizon. The Policy Documents, as beautifully written as they are, may tragically one day just becomes an academic relic issued by BNM.

Wallahualam.

Earlier writings on Tawarruq and Commodity Murabahah:

  1. Reliance on Commodity Murabahah
  2. Financing : Commodity Murabahah and Tawarruq

Interesting article in LinkedIn