Islamic Banking and Finance: Role and Relevance in a Recessionist Economy (Part 3)
he concluding part of an interview conducted by a research group from the Indian Institute of Management, Bangalore, (IIMB) which recently talked to BIJU ABDUL QADIR, Executive Editor of YOUNG MUSLIM DIGEST, on the implications of the growing interest in Islamic Banking and Finance for a recession-hit economy such as the one in place now.
Q: Considering the large infrastructure projects are currently under development, do you think Islamic Banking (through product features of Istisna’a) can help?
A: [Continued from February 2014 YMD issue] With the introduction of Istisna’ as a mode of financing, it has now become possible for the Islamic Development Bank to finance working capital needed for the production of capital goods. But the most common area of financing through the contract of Istisna’ up to now is in house-building finance. Perhaps this is due to the infancy of the manufacturing sector in most Muslim countries or due to the general policy in Islamic banking where the goal of Islamic financial institutions in an Islamic state should take into consideration the goal of achieving the basic needs of the society, of which housing is one of paramount importance. In the Gulf states, for instance, where the establishment of Islamic banks, synchronised with rapid building expansion and increasing revenues of these countries as a result of the 1970s oil boom, a considerable part of investment has gone into the housing sector. The construction industry was the field where Istisna’ has played a prominent role and where the investment of a single Islamic bank reached billions.
On the other hand, the Islamic Development Bank (IDB) has been generally financing economic infrastructure through loans. This is because financing of infrastructure has been the exclusive zone of the public sector. However, in recent years, the financing of economic infrastructure projects has witnessed a shift from the public to the private sector. It has, for several reasons, been realized that some infrastructure projects may be more efficiently financed and managed by the private sector. These projects are those that have regular and reliable cash flows, such as telecommunication, power generation, transmission and distribution, toll roads, airports, seaports, pipelines and water supply and sanitation. Granted that the development of infrastructure is a prerequisite of general economic development, the Islamic banks should look to support these projects since they have shifted from the public to the private sector. Istisna’ will give the Islamic bank a mode of financing infrastructure projects that cannot easily lend themselves to financing by way of installment sale or leasing.
The Islamic bank can use Istisna’ as a buyer by contracting with industrial and manufacturing institutions, or with any artisan to manufacture or construct for it some commodities with specific description. Then, it can sell them after receipt, for cash, installed or deferred payment through Murabahah or a similar product. This way, the Islamic bank will be involved in direct investment. But this ability of the Islamic bank will depend on the legislation of the country where it operates from for, in practice, some Islamic banks are disallowed from direct involvement in commerce. The bank may also enter an Istisna’ contract in the capacity of seller to those who demand the purchase of a particular commodity. Then, it will draw a parallel Istisna’ contract in the capacity of a buyer with another party to make or manufacture the commodity agreed upon in the first contract. The Malaysian Parliament intentionally gave Islamic banking business a general and, therefore, a very wide definition so as to give as much flexibility and scope as possible to Islamic banks to enable them to grow, expand their operations, and to evolve into viable competitors to conventional institutions.
The effectiveness of Istisna’ can be shown with figures from recent times. In the Dubai Islamic Bank, for instance, and in the field of real estate activity in particular, Istisna’ rocketed from zero in 1990 to 49% in 1994 as compared to Murabahah which plummeted from 100 to 51% in the same period. According to Ibrahim al-Ghafaly, the Deputy General Manager of Al-Rajihi Banking and Investment, Istisna’ represents a vehicle which allows flexible payment options and now constitutes 27% of Al-Rajihi’s portfolio. This represents a major shift from Murabahah. So major, in fact, that its effects are likely to be reflected throughout the Islamic-finance sector.
A proper study of the contract of Istisna’ reveals a major shift from its concept in the classical analysis as necessary transformations are required to enable this important method of investment to play its role in the modern framework of transactions. However, notwithstanding the broad definition given to ‘Islamic banking business’ in the Islamic Banking Act (1983) in Malaysia, and although the area of application of Istisna’ is the fastest growing sector in the Malaysian economy, Bank Islam Malaysia has not yet benefited from this golden opportunity. Other financial institutions are restricted by law to be involved in trade and manufacturing.
Istisna’ has all the potential to be one of the leading modes of investment in Islamic banks, at least from a strictly practical point of view. But in spite of this attractive picture of Istisna’, certain practical issues could pose problems. Islamic banks must be responsible for any defect in their product. Any clause by the Islamic banks to exclude their liability from any defect in the manufactured item shall be considered null and void due to the special character of Istisna’. This is while some Islamic banks, that have retained the structural form inherited from the conventional banks, are unable to handle certain rules of the Islamic law of transactions. Thus, some Islamic banks authorize the customer, on their behalf, to finalize the contract with the sub-contractor. Wakala is, of course, valid but here it might prove better for the Islamic bank to form a special department on Istisna’ to conclude terms with the sub-contractor. A special team of experts to supervise the fulfillment of the Bank’s obligations must also be put in place.
Finally, despite the successful implementation of Istisna’ by some Islamic banks, it seems that the full potentials of this contract have not been totally used, especially with regard to the possibility of issuing Istisna’ certificates to raise funds or to manage liquidity. Yet, this is an issue which needs separate investigation.
Q: Some of the product features like Wakala are considered to be hawala based. Do you think such products be restricted in Indian context? If yes, how can it be implemented?
A: Wakala is an Islamic financial contract whereby an investor places cash with a bank which then uses it to buy qualifying financial assets. In return, the investor gets a commission and a share of the profits generated by the funds. This is while Hawala is a contract which allows a debtor to transfer his debt obligation to a third party who owes the former a debt. The mechanism of Hawala is used for settling international accounts by book transfers, thus obviating the need for a physical transfer of cash. As against this, Wakala is a trusteeship meant to properly channel customer investment through the Islamic Bank which in this case is the Wakeel (or Trustee).
If developments in Europe and elsewhere are any indicator to what is in store for this instrument of Islamic Finance in India, this should not be too much of a worry really. Two years ago, in 2007, the European Islamic Investment Bank (EIIB) became the first UK bank to offer the Islamic money market instrument known as Wakala that had the approval of the Financial Services Authority (FSA). According to the EIIB Managing Director, John Weguelin, Wakala emulates the characteristics of a conventional money market placement. To him, Wakala allowed a much more efficient recycling of short-term liquidity in the Islamic banking system and, as such, its introduction was a significant step forward for Islamic Finance in the UK to be able to offer to UK and non-UK depositors. An official statement of the EIIB went on to record that following an agreement with the FSA, the Wakala can be treated as a deposit product for UK banking regulation purposes.
Q: In case of Mudarabah, unlike conventional deposits, the returns are expected to be highly variable and could even result in losses. How will this be perceived by the investors?
A: But this is what Islamic Banking is all about: Profit and Loss sharing (PLS). This is not unlike any business enterprise where profit as well as loss cannot be ruled out as an eventuality. Of course, the entrepreneur or businessman would make it a point to understand the feasibility and profit maximization possibility of any venture into which he might invest.
Nobody is fool enough to invest in what would seem a losing venture. Thus possibility of loss is minimized to the extent decipherable at the outset. Mudarabah is an investment partnership, whereby the investor (or the Rabb al-Maal) provides capital to the entrepreneur (the Mudarib) in order to undertake a business or investment activity. While profits are shared on a pre-agreed ratio, losses are born by the investor alone. The Mudarib loses only his share of the expected income. The investor has no right to interfere in the management of the business, but he can specify conditions that would ensure better management of his money. In this way Mudarabah is sometimes referred to as a sleeping partnership. A joint Mudarabah can exist between investors and a bank on a continuing basis. The investors keep their funds in a special fund and share the profits before the liquidation of those financing operations that have not yet reached the stage of final settlement. Many Islamic investment funds operate on the basis of joint Mudarabah.