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The Islamic financial system – Part 2


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By Ravi Abeysuriya

 

How big is Islamic Finance in Sri Lanka and how long has it been around?

An industry that began in 1997 has since witnessed the entry of many players subsequent to the amendment to the Banking Act in 2005. These include one fully-fledged Islamic Financial Institution (IFI) and many Islamic Banking Units (IBUs), sometimes referred to as Islamic “windows”. The institutions straddle the entire financial spectrum, from commercial banking, leasing, insurance, across to the capital and equity markets. 

Whilst the initial stages witnessed the entry of players on an ad hoc basis, recent events suggest a paradigm shift in the Islamic Finance landscape. Several leading commercial banks and Non-Banking Financial Institutions have entered the arena and the strength of their performances even during a short period of time bodes well for the future of the industry. 

There are over twenty licensed institutions in the IBF industry. Constituents include commercial banks, NBFIs, insurance companies and capital market intermediaries (under the purview of the Securities and Exchange Commission of Sri Lanka). In fact, most of the large indigenous banks have entered the IF market and it is not entirely implausible that international banks could also follow, given that some of these international banks with a local presence already offer Islamic Banking in various countries across the global financial landscape.

 

The end result of Islamic Banking and conventional banking is the same. Why do they appear similar?

The validity of a transaction does not depend on the end result, but rather the process and activities executed, and the sequence thereof in reaching the end. If a transaction is done according to the laid down rules it is permitted, even if the end result of the product may look similar to conventional banking product.

For example, a person who owns Rs.100 and wants to earn Rs.10 over, so he has two options available:

  • To lend another person for one month with the condition that he will return Rs.110 after one month
  • To purchase an item worth Rs.100 and sell it to another person for Rs. 110 on credit for one month.

In both the cases he earns Rs. 10, however the first case it is prohibited because it falls into the category of interest and the second case it is permitted because it falls into category of Trade. The same is also true for Islamic and conventional banking. Therefore, it can be concluded that it is the underlying transaction that makes something permitted or prohibited, and not the result itself. Apparently, Islamic banks may look similar to conventional banks, however the contracts and product structures used by Islamic banks are quite different from that of the conventional bank. 

 

Are not Islamic banks just paying interest and dressing it as profit on trade and investments?

No, Islamic banks accept the deposits on pre-agreed profit- and loss-sharing basis. These deposits are deployed in financing, trading, or investment activities by using its specific modes of finance. The profit so earned by the bank is passed on to the depositors according to the pre-agreed ratio which, therefore, cannot be termed as interest.

 

Another grievance of the people is that Islamic finance is more expensive than conventional finance. Is this true? 

Not necessarily. Islamic finance is an alternative financial system based on certain principles. Being competitive in terms of rate and service are an essential element for any institution to exist in the financial market. Therefore, Islamic financial institutions do maintain market competitive rates which are par with conventional finance, which may appear to be expensive for some. 

 

If Islamic banks do not invest in interest based activities, then how do they generate profit to pay to their customers?

The Islamic bank uses its funds in various trade transactions, investment activities and services which are compliant to its laid down principles whilst earning profits out those activities. The profit earned from such activities is passed on to the depositors according to certain pre-agreed terms.

 

Islamic Banks use interest-based systems like the AWPLR (Average Weighted Prime Lending Rate) as a benchmark while determining the profit, how can Islamic Banking be said to be Islamic?

Islamic banks should ideally have their own benchmark system for determination of profit. Since the industry is yet to develop its own benchmark, it is using the available local benchmark for the time being. However, using Interest Rate benchmark for determining the profit of any permissible transaction does not render the transaction as invalid. It is the nature/mechanism of the transaction that determines its validity or otherwise.

For example, Mr. A and Mr. B are two neighbours. Mr. A sells liquor which is prohibited in the Islamic faith, whereas Mr. B, starts the business of soft drinks. Mr. B wants his business to earn as much profit as Mr. A earns through trading in liquor. Therefore he decides that he will charge the same rate of profit from his customers as Mr. A charges over the sale of liquor. Thus he has tied up his rate of profit with the rate used by Mr. A in his business.

One may say that Mr. B uses an undesirable benchmark in determining the rate of profit, but obviously no one can say that the profit charged by him is not acceptable, because he has used the rate of profit of the business of liquor only as a benchmark.

The same is true for Islamic banks, it is most desirable and preferable that Islamic bank develop their own benchmark; however in the absence of any such alternative, interest rate-related benchmark can be used.

 

In what avenues do banks inv-est the funds of depositors?

The funds received as deposits, also called ‘Term Investments’, have varying maturities from 3, 6, 9, 12, 24 and 60 months.  These funds are used in various short term and long term investments / financing transactions. 

Short term investments are placed with Islamic financial institutions under Savings / Short Term Investments with maturities within 12 months.  These funds are generally channelled to finance Trade Finance transactions and other Working Capital financing which are payable within 12 months.  This is to maintain the required liquidity to meet the withdrawals in Savings and Short Term Investments at maturity. 

Long term finance such as Leasing, Housing and Project Financing are generally funded by the longer Term Investments with maturities over 12 months. 

 

In the stock market, how do we determine what stocks are permitted? Is there a list that is freely available?

In Islam the general rule on all transactions are considered as “permissible” unless there are prohibitions in Islamic jurisprudence. Accordingly, investing in stocks in the stock market is considered permissible. 

However, prior to investing, it is important to consider qualitative and quantitative factors of the universe of stocks that is being considered for investments.  

For example, if the business itself or its subsidiary is involved in an activity which is non-permissible (liquor, tobacco, gaming, pork-related, adult entertainment/pornography etc.), Islamic financial institutions are not allowed to invest in such stocks / companies. 

If the business activity is permissible, the income generated from non-permissible activities (interest income), interest-based financing and interest-based loans need to be further analysed according to certain financial ratios / parameters which need to be satisfied prior to investing. 

The universe of stocks that are permitted for investments that meet with the above criteria is termed the White List of stocks. 

 

 

(The writer is President – Association of Alternate Financial Institutions. The AAFI engages in activities in furtherance of the Islamic Finance industry in Sri Lanka.)


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