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Current Issues in Finance
–Farooq, M. and Zaheer, S. (2015). Are Islamic banks more resilient during financial panics? Pacific Economic Review20, 101-124.
–Minhat, M. and Dzolkarnaini, N., 2019. Digital assets, cryptoassetsand cryptocurrencies. The Malaysian Reserve,25 February.
–Minhat, M. and Dzolkarnaini, N., 2018. Islamic finance: risk sharing as sustainable risk management. Islamic Finance News, 15 (8) Feb. Also available at this link.
–Minhat, M. and Dzolkarnaini, N., 2018. Has the Islamic finance industry prospered with integrity? The Malaysian Reserve, 27 Aug.
–Minhat, M. and Dzolkarnaini, N., 2017. Corporate governance in the Islamic finance industry. Islamic Finance News, 14 (49) Dec. Also available at this link.
–MinhatM & Dzolkarnaini N., 2017. Which firms use Islamic financing? Economics Letters, 150, pp. 15-17. Available at:
–Minhat, M. and Dzolkarnaini, N., 2016. Islamic corporate financing: does it promote profit and loss sharing? Business Ethics: A European Review, 25(4), pp. 482-497.
–Minhat, M. and Dzolkarnaini, N., 2016. Islamic Finance (Chapter 14) in Brigham, Ehrhardt, and Fox. Financial Management: Theory and Practice(EMEA Adaptation), Cengage Learning. M Minhat (2019) 3
•Islamic finance in the UK
•Profit-loss or return-risk sharing (PLS) theory
•The prevalence of non-PLS instruments
–Moral hazard-risk avoidance theory
–Camouflaged interest theory
–Camouflaged leverage theory
•Would Islamic finance reduce systemic risk?
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Islamic finance in the UK
•The UK has been positioned as the leading Western country and Europe’s premier centre for Islamic finance (TheCityUK, 2015)
–The Islamic Finance Development Indicator (IFDI) for the UK was the highest amongst other Western countries
–Five licensed Islamic banks (e.g. Al Rayan), and over twenty banks offering Islamic financial services
–The first Western country to issue sukuk(i.e. £200 million ijara-based sukukwith five years to maturity)
–Emerged as a key global venue for sukukissuance, whereby a total of 57 sukuk, amounting to USD51 billion, have been listed on the London Stock Exchange (LSE)
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Islamic finance in the UK (cont’d)
•Islamic finance contributes to and aims to increase investment in the UK’s infrastructure development
–This includes financing for The Shard, Battersea Power Station regeneration, London Gateway, the Olympic Village, the redevelopment of Chelsea Barracks, and over 6,500 homes in the North West and the Midlands (TheCityUK, 2015)
•The UK government established an Islamic Finance task force in March 2013 to work towards raising London’s profile as a centre for Islamic finance
•All-Party ParliamentaryGroup on Islamic Finance (APPGIF) was also established to give the Islamic finance industry a voice in Parliament
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All-Party ParliamentaryGroup on Islamic Finance (APPGIF)
•To address issues as they arise such as Sukukissuances, inclusivity, regulation and taxation whilst positioning the UK as the European hub of Islamic financial services, and also to play a wider role in promoting ethical finance.
•Held its inaugural stakeholder meeting in November 2017.
•The latest meeting was in March 2019. It was attended by stakeholders from Edinburgh Napier University.
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Co-chair of APPGIF, Lord Sheikh, with stakeholders at a meeting held at the UK’s House of Lords
Profit and loss sharing (PLS) theory
•Islamic finance promotes profit-loss sharing (or risk-return sharing)
•Islamic finance permits equity financing that is consistent with fair dealings and promotes risk-sharing and consistent with Shariah(Islamic law)
•Fixed return (e.g. interest-based) debt financing is prohibited because it discourages risk-sharing
•It is predicted (or believed) that:
–a proper and widespread implementation of PLS will create a fair and stable financial system
–the interest-based credit-led financial system has fuelled systemic risk; ‘risk-shifting’ is not sustainable because default is contagious in the web of interconnectedness
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Prohibition of riba
•Ribarefers to ‘exploitative addition’
–any additionto, or an increase of, a thing (money or goods or other form of instruments) over and above its original size or amount lent, in which involved an exploitationof the economically weak by a strong and resourceful entities
•Examples of riba:
–fixed return e.g. interest on debt (borrowing/lending)
–premium over spot price due to deferred payment
–excessive/unfair or unjustifiable profit in trading
•Trading is permitted but ribais prohibited
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Why interest on debt is prohibited?
•Interest on debt financing is prohibited because:
–money is viewed as medium of exchange, therefore, not to be traded
–money does not create a surplus value by itself
–income or return to be derived from real effort or activity rather than mere exposure to credit risk
•No free lunch, except in the case of genuine gift or donation (e.g. zakat received)
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•Promotes ‘partnerships’ between stakeholders
–firm’s shareholders, managers with ownership stakes and other suppliers of financial capital
–each partner/counterparty (rabbul-mal) contributes financial capital and can choose to contribute human capital (i.e., management skill/expertise) to actively manage the underlying investment activities
•Profits are shared according to pre-determined ratios, and losses are shared according to capital contributions
•Musharakahis apreferred Islamic financing instrument because it is consistent with the Islamic concept of fairness (Ayub, 2007)
•Key difference between musharakahand conventional equity financing: equities are more liquid
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Other financiers
Managers with financial capital
Moral hazard-risk avoidance theory
•Practical issues associated with musharakahfinancing from conventional lens
–Agency problem: suppliers of financial capital (i.e., non-managing partners) will expose to greater asymmetric information environment and potential moral hazard of the managing partners (Ayub, 2007)
–Risk aversion: not economically feasible for non-managing partners (e.g., banks and bond investors) to actively engage in managing or monitoring the underlying activities because they conventionally require returns lower than those demanded by equity investors. Return on debt is always set to be lower than the return on equity (Modigliani and Miller, 1958)
•The popularity of non-PLS instruments (e.g., murabahah)
–a rational response to risk-averse financiers’ contracting environment in the presence of severe agency problem or moral hazard (Aggarwal and Yousef, 2000)
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•‘Cost-plus sale’ trading contract whereby, at least in theory, counterparties to the contract bargain on a margin of profit over known cost (or principal amount) of an underlying item
•Similar to conventional debt, the payment of the principal plus agreed mark-up is made on a deferred basis as in murabahah-mu’ajjal
•Murabahah-mu’ajjalwith long-term maturity is known as al-bai-bithamanajil(BBA)
•A financier such as an Islamic bank will finance a specific investment or purchase intended by aconsumer
•The financier’s exposure to the consumer’s default risk is minimised if the underlying asset or investment is also viewed as a collateral
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•This shows BBA from theoretical perspective: assumes no legal requirement for the bank’s consumer to enter into Sales & Purchase contract with the property developer
•A financier buys the underlying property and sell it to the consumer at a cost plus mark-up for a deferred payment
Islamic Bank
Property developer
Cost + mark-up (deferred)
Tangible underlying (e.g., property)
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Tangible underlying (e.g., property)
BBA -Example
•On date 0:
–The consumer has commissioned the property developer to build a property
–The developer needs £2.7m today from the consumer to finance the construction
–Therefore, the consumer enters into a BBA contract with the Islamic Bank:
•Islamic Bank disburses £2.7m on spot to the developer
•The consumer agrees to buy forward the property at £2.7m plus 10% mark up (£270k) which is to be paid on date T M Minhat (2019) 16
BBA -Example (cont’d)
•On date T (long term):
–The consumer buys the property from Islamic Bank and pay £2.97m
–The title deeds is transferred from Islamic Bank to the consumer
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Murabahahas practised
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Islamic bank purchased the property from the consumer and sell it back at a much higher price (mark up contains interest?)
Camouflaged interest theory
•A financier’s mark-upin BBA can be justified for the:
–Liabilities associated with ownership of the underlying until resale (e.g., consumer’s inability to fulfil buying obligation)
–After resale risk in case the underlying itemis defective whereby consumer may claim for loss from the financier as a seller
•However, murabahahas practised is often viewed as “back-door” ribaor “disguised interest” and, hence, not Sharia-compliant (Khan, 2010)
–A mark-up or profit charged by an Islamic financier tends to mimic the interest rate charged by conventional financiers on identical conventional debt
–According to the IFRS, profit earned by a bank under murabahahcould be viewed as being akin to interest, and therefore would be accounted for as interest revenue (ACCA, 2012)
–Absence of genuine trading?
•Practical or economic issues associated with musharakahpaved way to ‘abuse’ murabahah?
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Global use (or abuse?) of murabahah
•Empirical evidence of murabahah’spopularity amongst Islamic banks:
–Murabahahbank financing around the World (2006): Al RajhiBank (42%, ), Kuwait Finance House (62.7%), Dubai Islamic Bank (55.6%) and Bank Islam Malaysia (89.7%); Ijarahbank financing of Al RajhiBank (57.5%) [Khan, 2010]
–Islamic bank financing around the World (1995):): Murabahah(45.1%) and ijarah(10.7%), musharakah(16.3%) and mudarabah(6.5% ) [Aggarwal and Yousef, 2000]
–Islamic bank financing in Malaysia (2004): Murabahah-mu’ajjal(56.9%) and Ijarah(24%), musharakah(0.4%) and mudarabah(0.1%) [Chong and Liu, 2009]
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•Scientific evidences gathered from Islamic banks by studies shown on the previous slide did not incorporate non-bank Islamic financing such as sukuk
•Since bank financing is not the only means of corporate or government financing, the evidence gathered did not fully capture the extent of Islamic financial instruments (IFIs) used by borrowing entities, especially since growing of sukukissuance in later years (Wilson, 2008)
•According to the Central Bank of Malaysia, by the end of 2007, Malaysiaproduced the world’s largest sukukmarket, accounting for 68.9% of the world’s Islamic bonds (Rating Agency Malaysia, 2009)
•The UK has emerged as a key global venue for sukukissuance, whereby a total of 57 sukuk, amounting to USD51 billion, have been listed on the London Stock Exchange (TheCityUK, 2015)
•The first sukukissued in the UK was ijara-based sukuk
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•Basic IFIs as musharakah, murabahahand ijarahhave been utilised to form various complex sukukstructures
•There are at least ten types of sukukrecognised by theAccounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
•In theory, sukukcan be viewed as PLS instruments
–AAOIFI defines sukuk(derived from the word “sakk,” the singular form of sukuk), as a certificate, stating that, “investment sukukare certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity” (para 2, AAOIFI, 2008).
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(As Seller)
(As Lessee)
(“Potential obligation to repurchase underlying”)
Issuer SPV
(As issuer and Trustee)
(in the capital market)
(As Put option seller)
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Sukukissued to the market by theissuingentity (SPV)
Sukukinvestorsinvest the amount required
Originator sells to SPV the underlying asset to be financed through sukuk
SPV buysthe underlying asset
Originator sells a put option to SPV (i.e., right to sell the underlying assets at anexercise price in the future, defined as during the duration or upon the expiry of the sukukcontract)
SPVbuys the put option from the originator
Originator leases back the underlyingasset from SPV
Originator pays rental/leaseto SPV on regular basis
SPV distributesthe rental/lease payment to sukukholders
SPV exercises the put option, hence selling the underlying backto the originator
Originatoris obliged to pay the exercise price when buying the underlying back from the SPV
The proceed from sellingthe underlying asset is distributed to sukukholders
Sukukas practised
•In reality, the PLS feature introduced in sukukmay not materialise whilst its arrangement tends to mimic the arrangement of conventional bonds:
–Some sukuksseem to provide sukukinvestors a put option (i.e., right to sell the underlying assets) which could give rise to an obligation for the originator to repurchase the underlying asset upon either default payment or maturity (Jobst, 2007) [i.e. investors do not share risk]
–Such a ‘repurchase undertaking’ by the originator exposes it to an obligation to pay back the agreed exercise price of the underlying [i.e., redemption of a bond in conventional sense]
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Sukukas practised (cont’d)
•In some cases, the ownership of the underlying assets were not normally even transferred from the originator to the financiers (i.e., sukukinvestors), which raised the question of who actually exposed to the risk associated with the underlying asset
–This means sukukinvestors have no recourse to sukukunderlying assets in the event of the originator’s default [e.g., Investment Dar (Kuwaiti’s firm)]
•The guaranteed nature of return from investing in sukukis contrary to PLS because sukukinvestors do not share the downside potential of the underlying assets
•It was reported that 85 per cent of sukukhad breached sharia principles (Oakley, 2008)
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Case study -example
•Nakheelsukukwas issued in 2006, listed on the Dubai International Financial Exchange and expired in December 2009. The sukukwas issued via a special purpose vehicle, NakheelDevelopment Limited, to finance a property development project (i.e., Dubai Waterfront) of NakheelHoldings. A fixed return on the certificates was calculated on the basis of 6.345 per cent per annum to be paid semi-annually on 14 June and 14 December. The bursting of Dubai’s real estate bubble in 2008, coupled with the global recession and financial market crisis contributed to the inability of the underlying project financed by Nakheelsukukto generate the expected income (IMF, 2010). Despite the underlying project’s failure to generate income, NakheelHolding used liquidity from other sources to honour returns to Nakheel’ssukukholders. Later, when Nakheel’sliquidity worsened, outright default was prevented through a bailout by Abu Dhabi’s government, and all the sukukholders were paid out. This case clearly illustrates that sukukinvestors did not share the downside potential of the underlying projects, which is more consistent with conventional bonds than with PLS theory.
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Camouflaged leverage theory
•Sukukis viewed as a less obvious method of increasing corporate leverage or ‘camouflaged debt’ especially for firms with less ability to access conventional bond markets
•Godlewski, Turk-Arissand Weill (2013)
–The presence of a strong demand for sukukfrom Islamic financial institutions, coupled with the limited supply of sukuk, signifies supply shortages that could make this instrument easier to sell as compared to conventional bonds
–Therefore, financially weak firms that are no longer able to issue conventional bonds might still have access to sukukfinancing, and less efficient market may be expected to overvalue sukuk
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Is Islamic financing ‘abused’ by risky firms?
•Minhat& Dzolkarnaini(2016):
–Less profitable and/or highly levered firms (i.e., risky firms) are more likely to resort to Islamic financing.
–PLS instruments are negligibly used amongst corporate firms
–The economic significance of murabahahas an alternative to PLS is indisputable. 30% of IFIs used by sample firms was in the form of murabahahfinancing.
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IFIs in corporate financing
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Islamic financial instruments (IFIs)
MYR billion
Murabahah(including BBA)
Islamic term notes and commercial papers
Unclassified sukuk*
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Would Islamic finance reduce systemic risk?
•“Such a crisis would not have occurred under an Islamic financial system—due to the fact that most, if not all, of the factors that have caused or contributed to the development and spread of the crisis are not allowed under the rules and guidance of Shariah. The current global financial crisis is largely seen as a real test of the resilience of the Islamic financial services industry and its ability to present itself as a more reliable alternative to the conventional financial system” (Kayedand Hassan, 2011)
•Do we have empirical evidence?
•If IFIs substantially similar to interest-based instruments, and are abused by firms to camouflage (increasing) leverage, would this not creating another form of credit bubble?
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What about cryptoassetsand cryptocurrencies?
•Scholarly views about the permissibility of the above mentioned assets are rather mixed
•Arguments against the use of these assets are based on the prohibition of gharar
–Ghararis excessive level of uncertainty (or information asymmetry) caused by lack of clarity in transaction
–Maysir(gambling) is an extreme form of gharar
•Islamic finance promotes real productive effort (trading) rather than pure reliance on chance (speculating) to generate income
•Read further: Minhatand Dzolkarnaini (2019)
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•Association of Chartered Certified Accountants (ACCA) (2012) Global alignment: bringing consistency to reporting of Islamic finance through IFRS.
•Ayub, M., 2007. Understanding Islamic Finance. John Wiley & Sons: England.
•Chong, B. S. and Liu, M., 2009. Islamic banking: interest-free or interest-based?, Pasific-Basin Finance Journal, 17, 125-144.
•Financial Times, 17 June 2008. Sukukmarket: clarification of rules does market a favour.
•Financial Times, 26 May, 2014. By the Book.
•Godlewski, C. J., Turk-Ariss, R. and Weill, L. (2013). Sukukvs. conventional bonds: a stock market perspective. Journal of Comparative Economics 41, 745-761
•Kayed, R. N. and Hassan, M. K. (2011). The global financial crisis and Islamic finance. Thunderbird International Business Review 53, 551-564.
•Khan, F. (2010). How Islamic is Islamic banking. Journal of Economic Behavior& Organization 76, 805-820.
•Oakley, D (2008) Sukukmarket: clarification of rules does market a favour. Financial Times, 17 June.
•Presley, J.R., Sessions, J.G., 1994. Islamic economics: the emergence of a new paradigm, The Economic Journal, 104, 584–596.
•Rating Agency Malaysia (2009). The truth about sukuk. Jan 1.
•TheCityUK(2015) The UK: leading Western Centre for Islamic Finance, November.
•Warde, I. (2000). Islamic finance in the global economy. Edinburgh University Press.
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