Status and Development of Islamic Finance in Sub-Saharan Africa.

By: Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu, and Etienne B. Yehoue.

The Islamic finance industry has been growing rapidly in various regions, and its banking segment has become systemic in some countries, with implications for macroeconomic and financial stability. While not yet significant in Sub-Saharan Africa (SSA), several features make Islamic finance instruments relevant to the region, in particular the ability to foster SMEs and micro-credit activities. In a recent paper, we provide a survey on Islamic Finance in SSA where on-going activities include Islamic banking, sukuk issuances (to finance infrastructure projects), Takaful (insurance), and microfinance. Should they wish to develop the market, policy makers could introduce Islamic financing windows within the conventional system and facilitate sukuk issuance to tap foreign investors. The entrance of full-fledged Islamic banks would require addressing systemic issues and adapting crisis management and resolution frameworks.

The financial sector in SSA has been growing rapidly in the past two decades. New products have been introduced and financial institutions are playing an increasing role in financial intermediation, including cross-border financial intermediation.

However, Islamic finance remains small, although it has potential given the region's demographic structure and potential for further financial deepening. As of end-2012, about 38 Islamic finance institutions-comprising commercial banks, investment banks, and takaful (insurance) operators-were operating in Africa. Out of this, 21 operated in North Africa, Mauritania and Sudan, and 17 in Sub-Saharan Africa.

Botswana, Kenya, Gambia, Guinea, Liberia, Niger, Nigeria, South Africa, Mauritius, Senegal and Tanzania have Islamic banking activities. There is also scope for development in Zambia, Uganda, Malawi, Ghana and Ethiopia, as all but Zambia has relatively large Muslim populations-Zambia is interested in using Islamic finance instruments to fund investment in the mining sector. In Uganda, the central bank has started the process of amending its banking regulations to allow for the establishment of Islamic banks and three Islamic banks have applied for a license.

Islamic finance is still at a nascent stage of development in SSA. The share of Islamic banks is small, and Islamic capital markets are virtually non-existent (there were small Sukuk issuances in Gambia and Nigeria). At the same time, the demand for Islamic finance products is likely to increase in coming years. At present, about half of the region's total population remains to be banked. Furthermore, the SSA Muslim population, currently at nearly 250 million people, is projected to reach 386 million in 2030 and financial activities are expected to rise as a share of GDP. Many countries are expected to introduce Islamic finance activities side-by-side conventional banking. Opportunities for the development of Islamic finance are expected to comprise retail products to small and medium-sized enterprises. The sub-continent's growing middle class, combined with its young population is an opportunity for Islamic finance to expand its services. SSA's large infrastructure needs will also provide an opportunity for Sukuk issuance to channel funds from the Middle-East, Malaysia, and Indonesia. For example, recent issuance of a Shari'ah-compliant bond by Osun state in Nigeria and South Africa could start a trend in favour of sukuk, especially if planned sukuk by Senegal.

Developing Islamic Finance in Sub-Saharan Africa

The development of Islamic Finance could increase the depth and breadth of intermediation, extending the reach of the system (e.g. extension of maturities and facilitation of hedging and risk diversification). At the same time, the much larger non-Muslim population could find Islamic financial instruments attractive in broadening the range of available options, particularly for SMEs and micro-credit. Moreover, financial deepening and inclusion could be further enhanced if new instruments are inspired from Islamic finance, but without necessarily being Shari'ah certified. The development of partial risk guarantees, as in Mauritius, could be seen as an example.

In addition, SSA countries could tap into growing Islamic financial markets to meet infrastructure financing needs. By opening doors to Islamic finance, SSA can seek to attract capital from Muslim countries whose savings rates are high and projected to grow. In particular, sukuk financing, which is expanding in other countries, could be a useful tool to finance infrastructure investments.

Lastly, Islamic financing can help develop small and medium enterprises and microfinance activities, given those African households and firms have less access to credit from conventional banks compared to other developing regions. Islamic banks can tap a segment of depositors that do not participate in interest-based banking. They can also promote SMEs' access to credit through expanding acceptable collaterals by extending funds on a participatory basis in which collateral is either not necessary or includes intangible assets.

Through its different forms-windows, full-fledged banking, investment banking, and Insurance-Islamic finance activities ensure appropriate leverage and help limit speculation and moral hazard. It should be noted, however, that they are also subject to constraints and risks, most notably the difficulties and costs involved in supervising and monitoring and the reputational risk implicit in some products that are not properly certified as compliant with Islamic principles.

For countries that want to develop Islamic finance in their jurisdictions, a strategy could contemplate the following steps: launching a public awareness campaign, providing the needed infrastructure (i.e. amending as needed laws and accounting and prudential frameworks), building capacity at the central bank (especially on supervision), and considering the need to set up an appropriate liquidity management framework and introduce adequate monetary operations instruments.

This blogpost is based on the academic study "Islamic Finance in Sub-Saharan Africa: Status and Prospects", prepared by Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu and Etienne B. Yehoue.

CAN ISLAMIC BANK INCREASE FINANCIAL INCLUSION?

Can Islamic Banking Increase Financial Inclusion? In a recent IMF working paper published in February 2015, shows that there is "a possible link between the presence and activity of Islamic banking and financial inclusion" despite of a mixed picture due to number of reasons such as weaknesses on the financial infrastructure of those countries studied, lack of conducive regulatory environment, lack of qualified Islamic banking talent among others.

What is the global situation on financial self-exlusion due to religious reasons? Researchers observed that "Worldwide financial exclusion for religious reasons seems relatively small, but the share varies notably across countries and can be particularly high in certain Muslim countries. For example, the share of adults citing religious reasons for not having an account is 34 percent in Afghanistan, 26–27 percent in Iraq and Tunisia, and 23–24 percent in Djibouti and Saudi Arabia. However, other Muslim countries exhibit relatively low levels of religious self exclusion: virtually zero in Malaysia, 2½–3 percent in Kuwait and the United Arab Emirates, and 4½ percent in Sudan."

Why lower rate in Malaysia, Kuwait, UAE and Sudan? Reaserchers could not attempt to shed light on this question. I would argue that may be due to the fact that Islamic banking has been in those countries since 1960's and others 1980's. North Sudan for example have no conventional bank since 1970's. Therefore, self-exclusion because of religion is irrelevant in this country so can be said of Malaysia, Kuwait and UAE which have significant number of Islamic Banks.

Is there any previous evidence of a link between Islamic banking and Financial inclusion? Researchers observed that "The World Bank 2014 GFDR presents some encouraging results: Islamic banking is found to be positively related to financial inclusion; while Muslim countries in general tend to exhibit lower levels of financial inclusion, Islamic banking is associated with a lower incidence of religious self-exclusion and with a lower share of firms citing access to finance as a significant obstacle. However, there is also reason for caution. Using micro-level data, Demirguc-Kunt, Klapper, and Randall (2013) find that, once relevant individual characteristics are accounted for, although Muslims are less likely to have an account or save in a formal financial institution, they are no less likely to borrow from one, and the greater observed religious self-exclusion of Muslims seems to arise solely in sub-Saharan African countries."

Why the greater religious self-exclusion of Muslim seems to arise solely in Sub-Saharan Africa? I would argue, one amongs many reasons could be linked to increased awareness of Islamic teachings in financial matters as well as awareness of the erroneous operations of conventional banking system. However, an indept research is required to shed more light on the subject.


Policies for enhancing financial inclusions.

Reaserchers offer the following recommendations to enhance financial inclusion through Islamic Finance:

1. Improvement of the current operating model of Islamic banks. "Islamic banks may need to improve their current operating model so as to attract depositors and serve SMEs, which have so far been excluded from the formal financial sector for religious considerations.One option is to create separate SME business units within Islamic financial institutions, to understand the market dynamics of these firms, and to tailor Islamic financial instruments to their specific needs." This can be achieved by:
A. Providing better training to bank personnel in Shari’ah-compliant instruments and to streamline the execution of Islamic transactions, especially those related to financing applications for SMEs.
B. Introduce credit evaluation techniques such as behavioral scoring and an early warning system to better price and reduce risk exposure to SMEs, which will help develop equity related instruments (musharaka and mudaraba ) and ijara for SMEs.
C. Explore the potential of private equity (PE) and venture capital (VC), both of which seem well suited to Islamic models of finance. In this regard, Bahrain provides an example of the successful introduction of an Islamic VC bank focused on financing SMEs.
D. Establishing Islamic equity funds for SMEs could also be a possibly beneficial source of finance, especially for high-risk SMEs that lack access to conventional bank finance and cannot afford the compliance costs associated with listing in capital markets. "Developing a Shar’iah-compliant financial market (equity and sukuk), where both the instruments and trading process would be in line with the Shari’ah requirement for transactions (Bacha and Mirakhor, 2013), could help alleviate the finance constraints on SMEs."

2. Private and public sector initiatives to strengthen the role of Islamic finance in broadening financial access. "The development of Islamic microfinance could offer more effective tools for improving financial inclusion than conventional microfinance. On the funding side, Islamic microfinance companies can mobilize additional resources such as zakat and waqf, and on the lending side they mainly use financial instruments that are based on Profit and Loss Sharing (PLS) schemes such as mudarabah and musharaka rather than loans, avoiding the imposition of oppressively high interest rates on poor households and small entrepreneurs." This can be achieved by:
A. Allowing Islamic banks to open microfinance branches or to developa Shar’iah-compliant finance model for microfinance.
B. Qard-al-Hassan40 resources ( normally Islamic banks offer current accounts using Qardh Hassan contract) should be made available to Islamic microfinance institutions to reduce the burden of high interest charges on their borrowers (Iqbal and Mirakhor, 2013).
C. Zakat funds could be used to cover the default risk of microenterprises and to build capacity and skills of micro-entreprenuers.
D. Use sukuk to securitize credit facilities granted to microenterprises and SMEs and provide additional funding for this excluded segment of the economy.

3. Institutionalization of Islamic redistributive mechanisms such as zakat, sadaqat, qard-al-Hassan and waqf(Mohieldien and others, 2011). The aim of institutionalization is to formalize and standardize operations and to enhance the effectiveness of these instruments for addressing the lack of financial inclusion in Muslim countries and Muslim communities. This can be achieved by:
A. Setting up a nonprofit financial institution funded by waqf that would provide Qard-al-Hassan to poor consumers (Elgari (2004)).
B. Establishment of an awqaf fund to provide investment and working capital financing to microenterprises (Mohieldien and others (2011)).

4. Establishment of an Islamic partial credit guarantee scheme (IPCG) or extension of the existing PCG to Islamic banks with the aim of reaching underserved groups such as SMEs and startups, especially at a time when governments are improving credit information and creditor rights (see the experience of Jordan, which recently established a Shari’ah-compliant loan guarantee). Successful IPCGs may consider a coverage ratio closer to international standards (around 30–40 percent), fees could be closely tied to risks, and systematic assessments should be conducted regularly to ensure cost-effectiveness and customer satisfaction (Saadani and others, 2010).

5. Improvement of financial infrastructure. This can be achieved by:
A. Introducing private credit bureaus, the enlarging of credit reporting of utilities and retailers, and the coverage of both personal and commercial credit information.
B. There is also a need to improve credit protection, because, as shown earlier, the region ranks low in the area of credit rights as
measured by the legal rights index. This may require enlarging the pool of assets acceptable as collateral,adopting collateral regimes, and developing out-of-court enforcement mechanisms.
C. Increase bank competition due to its positive link with financial inclusion. "Increased competition could help to push Islamic and conventional banks to develop business lines beyond large corporations and expand the SME segments of the market. This could be done by easing entry into banking, developing the capital market, and reducing loan concentration though prudential measures."

Finally, consumer protection, financial education, and a sound regulatory and supervisory framework for Islamic finance could be helpful in encouraging households and enterprises to use Shari’ah-compliant instruments. Government and regulators also need to support improvements in access, especially through Shari’ah-compliant financial instruments, and consider better access a goal as important as financial stability (Mohieldien and others 2011).

Socially Responsible Investments and Islamic Finance

NEWHORIZON July – December 2014.

Islamic finance could already claim to be ethical in its approach. The industry is based on adherence to a set of morals and principles enshrined in Shari’ah. It eschews investment in gambling, alcohol, pornography, armaments and tobacco, all of which are considered haram by Islam. It also forbids riba, which it sees as the exploitation of one person or group by another leading to unjust gains.

There is, however, a growing cadre of investors, Muslim and non-Muslim, looking for something more. They are looking for positive discrimination in favour of projects that bring some gain to society rather than simply screening out unacceptable forms of investment. Various terms are used to describe these investments including socially-responsible, sustainable or green, although the term that seems to be gaining the greatest traction currently is socially-responsible investing (SRI), perhaps because it is a more all-encompassing term that better describes a wider range of investments designed to benefit mankind as well as providing a return for investors.

These investors want, for example, to support renewable energy rather than fossil fuels; sustainable agriculture rather than schemes that involve deforestation and affordable housing rather vanity building projects targeted at the super rich. Such aims sit well with the teachings of the Prophet (PBUH) expressed in the Qur’an, which enjoin believers to do nothing that would cause harm to the environment and to mankind in general.

Clearly, some investments, which would be Shari’ah compliant, would not meet the additional requirements of socially-responsible investments, e.g. investments in fossil fuel extraction and processing. This article is not suggesting that all Islamic funds will want to take the extra steps needed to be able to apply the ‘socially-responsible’ epithet to their funds, but Islamic finance industry is beginning to take an interest in this segment of the market, developing policies and products to meet an apparently growing demand. Those that do go the extra mile are hoping to increase the industry’s footprint in the financial world by appealing to non-Muslim investors as well as to Muslims.

A Brief Historical Background

The concept of socially responsible investing is not new, nor is it exclusive to Islam. For example in the 18th century, the Methodists, a non-conformist Christian sect, discouraged its adherents from investing in tobacco, alcohol and gambling. In the 19th century the Quakers pioneered the idea that profit should not be made at the expense of the people employed in factories, providing decent, affordable accommodation and education for their workforces. It was not until the latter part of the 20th century, however, that people began to be aware of the damage that certain types of human activity could do to the world in which we live. For a long time these early environmentalists were seen as sandal-wearing, bean-eating eccentrics until science began to demonstrate that our exploitation of the planet’s resources were causing such harm to the environment that we were in danger of irreparably damaging the world in which we all live.

In the last 10 15 years the socially-responsible investment industry has been moving slowly out of the shadows and increasingly into the mainstream. For example, the Climate Bond Initiative has reported that $11 billion of green bonds were issued in 2013; by the end of October 2014 the figure was already more than $32 billion, suggesting the market could double by the end of the year. The Climate Bond Initiative is confidently forecasting the market will double again in 2015 to $100 billion and this is just one single element of the broader ‘socially-responsible’ investment space.

In the past the Islamic finance industry has often been criticised for being merely emulators of conventional finance, looking for ways to offer conventional finance products in a Shari’ah-compliant form. In the socially-responsible investment space Islamic finance with its declared adherence to certain moral values and principles has a real opportunity to be the trend setter and the latter half of 2014 saw a number of significant announcements designed to position the Islamic finance industry firmly in the forefront of this market trend.

Framework for Socially-Responsible Sukuk

In the late summer of 2014 the Securities Commission Malaysia (SC) launched the Sustainable and Responsible Investment (SRI) Sukuk framework to facilitate the financing of sustainable and responsible investment initiatives. ‘The introduction of the SRI sukuk framework is part of the SC’s developmental agenda to facilitate the creation of an eco-system conducive for SRI investors and issuers and is also in line with the rising trend of green bonds and social impact bonds that have been introduced globally to facilitate and promote sustainable and responsible investing. Combined with Malaysia’s leading position in the global sukuk market, this framework will further enhance the country’s value proposition as a centre for Islamic finance and sustainable investments’, said Datuk Ranjit Ajit Singh, Chairman of the SC.

The SRI sukuk framework is an extension of the existing sukuk framework and therefore, all the other requirements in the Guidelines on Sukuk continue to apply. The additional areas addressed in the framework for the issuance of SRI sukuk include utilisation of proceeds, eligible SRI projects, disclosure requirement, appointment of independent party and reporting requirement. The types of projects that are eligible include sustainable land use, sustainable waste management, renewable energy, energy efficiency projects, affordable housing and urban revitalization.

It is likely that the first sukuk to be issued under the new guidelines will come from Malaysia’s state-owned sovereign wealth fund, Khazanah Nasional Bhd., which is reported to be considering an issue in the second half of 2015 to fund expansion in its education and renewable energy businesses.

Dubai’s Green Investment Programme

Dubai launched its Dubai Integrated Energy Strategy 2030 (DIES) in 2010 and began deployment in 2011 under the guidance of His Highness Sheikh Mohammed bin Rashid Al Maktoum, Vice


President and Prime Minister of the UAE, and Ruler of Dubai. The DIES sets the strategic direction of Dubai towards securing sustainable supplies of energy and enhancing demand efficiency.

In 2014 the Dubai Supreme Council of Energy (DSCE) and the World Bank signed an advisory services agreement to partner together and design a funding strategy for Dubai’s green investment programme, which is expected to involve green bond and sukuk products.

Sukuk for Vaccines

In December 2014, the International Finance Facility for Immunisation (IFFIm) issued a $500 million, three year sukuk to fund immunisation programmes. It is the largest ever debut issue by a supranational non-profit organisation and the largest Sukuk al-Murabaha issuance in the public markets and is also the largest inaugural Sukuk offering from a Supranational.

The sukuk was oversubscribed, even with its unique structure for sukuk market participants. IFFIm achieved strong diversification in its investor base with 85% of the order book coming from new and primarily Islamic investors. The regional distribution of investors was 21% based in Asia, 11% in Europe and 68% in the Middle East and Africa. Banks took 74% and central banks/official institutions took 26%.

The hope is that it will encourage other similar humanitarian institutions to use the market.

Agricultural Investment Opportunities in Canada

AGInvest Properties is a Canadian-based company that owns and manages farmland in Ontario. In June 2014 they launched a scheme to offer Shari’ah-compliant investment partnership opportunities with the aim of increasing the inflow of capital into the Canadian agricultural sector. To do this they have signed a partnership agreement with Bahrain’s Shari’ah Review Bureau, who provide outsourced Shari’ah certification and advisory services.

The aim is to provide Islamic investors in Canada and elsewhere with investment opportunities in arable farmland, which they believe is a sustainable sector, to some extent insulated against the prevailing somewhat depressed economic environment around the world.

Stimulating Green Sukuk

The Green Sukuk Working Party (GSWP) was established in late 2014 by the Clean Energy Business Council (MENA), the Climate Bonds Initiative and the Gulf Bond and Sukuk Association (GBSA) to promote and develop Shari’ah-compliant financial products to invest in climate change solutions.

GSWP is a collaboration of experts in project development, environmental standards, capital markets, actuarial compliance and Islamic finance.

The GSWP will:

• Design green sukuk architecture, so that product issuers can offer and investors can access products with confidence about their compliance with Shari’ah law and ethical standards.
• Promote the concept of green sukuk and other green Islamic finance products to governments, investors, product originators and other interested parties.
• Engage with governments and development banks about supporting appropriate project development and the growth of a green sukuk market.
• Inform the market by promoting best practice, convening industry forums and developing template models.

Caveat Emptor

When an idea begins to take off, everyone will want to jump on the bandwagon and get a slice of the action. The food industry is a good example As people have become more aware of the need to avoid excessive amounts of fat, sugar and salt in their food, the food industry has scattered terms like ‘low fat’ or ‘low sugar’ on their product labels. They should more accurately have labelled them ‘lower fat’ or lower sugar’, because a little research will demonstrate that some of these products are only 5-10% lower than the standard product.

The problem with any plain language term is that it can mean exactly what a product or service provider wants it to mean. A casual search will reveal a number of Islamic financial service providers who are using the term ‘socially responsible’, when in fact they are doing no more than complying with current Shari’ah requirements. Yes, they are avoiding investments in alcohol, tobacco, etc., but there is no positive discrimination in favour of investments that are beneficial to society and no avoidance of industries such as petrochemicals, which may meet Shari’ah requirements, but would be unacceptable to SRI investors.

Obviously, Malaysia’s decision to regulate socially-responsible sukuk is very helpful. The fact that they have defined very clearly the types of projects that can be included and required disclosure of precisely how the proceeds of sukuk issuance will be used provides SRI investors with a high degree of assurance that they are going to get what they want. Other national regulators would do well to consider following Malaysia’s lead and perhaps the Green Sukuk Working Party has a useful role to play here. The sukuk for vaccines from the International Finance Facility for Immunisation offers investors a similar degree of assurance.

Ultimately, however, it is definitely a case of buyer beware. Unscrupulous providers in both conventional and Islamic finance will attempt to cash in on a trend that looks as though it is finally getting off the ground.

Islamic Insurance or Takaful

NEW HORIZON July-December 2014

Overview of Takaful

Islamic insurance, and, more broadly, Islamic finance, place special emphasis on social welfare as a criterion of business practice. In addition to the importance placed on welfare, there is also a strong focus on discouraging wealth maximisation. Islamic insurance tends to incorporate both of these ideals in its approach to affording security to individuals in the form of insurance. Thus, Islamic insurance is a cooperative model of insurance.

There are no counterparts to conventional insurance in classical Islamic law. Islamic insurance is an innovative modern approach to dealing with demand for an instrument that can reduce one’s exposure to certain types of risk. Under its conventional form, insurance is similar to a gamble and would be a violation of the rules of gharar. In a conventional agreement, an insured person pays a cash premium in exchange for a promise made by the insurer that it will pay a certain amount in case of a given future contingency. There is no guarantee that the future contingency will ever come to pass and disputes about whether the contingency has occurred or pre-existed the contract have bred enormous litigation. Thus, the insured is taking a gamble and the insurer is benefiting from this gamble. Under conventional insurance practice, the operation of insurance is also heavily reliant on principles of interest. Insurance companies often invest their premiums in interest-bearing investments, which also invokes the prohibition against riba.

An influential Islamic scholar, Mustafa al-Zarqa, made an argument for the acceptability of conventional insurance practices as insurance contracts in the aggregate pose very little uncertainty, since the risk for which the parties are contracting can be valued.

This argument was not enough to quell the general unease pious Muslims have with the idea of conventional insurance. Thus, a new approach emerged which shifted the conceptual focus of insurance away from individual contractual agreements and towards the institution of insurance’s benefit to society as a whole.

Islamic insurance shifts the focus to a broader lens—insurance as a collective endeavour, which is an alternative to the bilateral relationship that exists in the conventional model. It is this institutional approach that forms the basis for takaful. This collective model grew out of the social insurance practices that were practiced at the beginning of Islam, such as al-diyah (blood money), a practice in which the relatives of a killer paid money to the heirs of the deceased in order to allow the killer to escape his legal burden. These amounts were to be paid by way of mutual collaborations in which money was set-aside in case the need arose for its use.

Takaful, which literally means solidarity, is a system in which members decide to protect each other from loss. In line with Islamic ideals of welfare and charitable giving, the system is a collective enterprise that allows a community to pool together resources in order to assist members of the community in times of need resulting from casualty or loss. Professor Tom Baker characterised the differences in the theoretical underpinnings between conventional and Islamic insurance: conventional insurance seeks to eliminate risk for the individual, whereas Islamic insurance aims for risk elimination within a given social group.

While the scope of insurance policies within the takaful model may vary, they are governed by the principles of either a wakalah or mudharabah contract or a mixed model borrowing from both. The basic structure of a takaful arrangement is as follows:

1. a takaful company is organised;
2. members make periodic payments that the company maintains in individual accounts for each member;
3. these amounts are invested in Islamically sound financial products. As part of the contract, the members agree that if any of them suffer a covered loss, then each will make a proportionate gift from their accounts to cover that loss.

The legality of this contract is derived from the idea that gratuitous acts allow for a higher degree of uncertainty and from the Maliki (one of the four schools of thought in Sunni Islam) opinion that gift promises can be binding. Under this framework, the insurance pool is more akin to a charitable institution as opposed to a profit-earning institution, because the insurance company does not act like an insurer in the conventional sense; instead, it manages the business aspect of the cooperative on behalf of the members.

Finally, under a takaful model, there is generally a governing body, known as a Shari’ah board that regulates the takaful company to ensure that the products being offered by the company are within the confines of Islamic law (Shari’ah). The salient characteristic of takaful companies is that profits are shared by the policy holders rather than given to third-party shareholders as is the norm in conventional insurance companies.

Islamic Law and Finance:An Introduction

NEW HORIZON July-December 2014 issue.

Islamic Law in General

In understanding Islamic finance, it is important to start with a brief overview of Islamic law, because Islamic finance is the application of Islamic law to financial and commercial transactions.

1. Islamic law (Shari’ah) is derived from the Qur’an (Islam’s holy book) and the Sunnah (actions and sayings of Prophet Muhammad).
2. The interpretation and application of Islamic law is known as fiqh.
3. There are four mainstream schools of Islamic jurisprudence within the Sunni tradition: Hanafi, Maliki, Hanbali and Sha‘afi.
4. Each of these schools has certain nuanced differences in their respective approaches to interpreting Islamic law. Since Islamic law has developed over 1,400 years, there is not always uniformity in application or interpretation of the governing principles.
5. A third element in Islamic law is ijmaa, or scholarly consensus, in interpreting the Quran and Sunnah. The lack of uniform consensus among scholars voids ijmaa in a particular area of law, thereby allowing for the existence of diverse but equally valid legal holdings. As is the case with many areas of Islamic law, Islamic financial transactions can take many forms depending on the school of thought employed.

This paper will not delve into the different applications of Islamic law to financial transactions under each school of thought. Instead, it will focus on the most common financial structures currently in use. Islamic finance, as a viable alternative to traditional finance, grows out of two major shifts.

• First, Islamic finance has developed in response to the globalisation of financial markets and the adoption of Western financial institutions throughout the world‘s economies. Institutional and contractual practices originating in the Western world have embedded themselves in the economies of the Muslim world.
• Second, Islamic finance is part of a larger trend that began in the 1970s. That trend is the shift towards reintroducing Islamic law in many parts of the Muslim world. Despite this trend, laws and legal institutions derived from Western legal systems remain the dominant modal system.

One of the challenges in developing and applying Islamic law in a wholly Western financial system is that many of the common financial instruments have no counterpart in Islamic law. So, while classical Islamic law may offer a complete body of commercial and contract law, it is important to note that the current Western system of commercial and contract law does not neatly fit into the pre-existing scheme. Thus, Islamic scholars are required to evaluate and determine which Western modes of financial transactions are acceptable and how Islamic law can be interpreted and applied to modern financial instruments to bring them within the purview of Islamic law. As the demand for certain types of financial products grows, Muslim scholars will be pressed to develop Islamically acceptable alternatives. Islamic finance has become the most innovative element of contemporary Islamic law.

According to Frank Vogel, a former Professor at Harvard Law School and a leading expert on Islamic Law generally, Islamic financial analysis can be broken down into two approaches. First is the Islamic law aspect, which aims to characterise modern financial behaviour in terms of Islamic legal rules. This approach accounts for Islamic law‘s concern with individual action and the welfare of the individual as a task delegated to the state.

The second approach is steeped in Islamic economics. Here, the aim is to develop Islamic economies as a viable alternative to the Western economies that predominate. In order to be viable, the Islamic economies must produce more beneficial outcomes than do their Western counterparts. In shaping this new economic theory, economists would, for example, look to Islamic moral principles and legal institutions (e.g., requirements on giving charity). However, since this approach is still in developmental form, Islamic rules ground Islamic finance without much regard for economics. Furthermore, many Muslims are willing to pay a premium to ensure that their business transactions are in line with Islamic principles without having as much concern for profit-maximising outcomes.

Islamic Contract Law

In order to understand modern Islamic law, a brief primer on Islamic contract law is necessary. Islamic contract law centres around rigid nominate contracts that do not have counterparts in conventional finance. Unlike the ideal of freedom of contract, a basic underpinning of the objective theory of contracts adhered to in common law jurisdictions such as the United States, there is no generalised theory of contracts in Islamic law. In particular, the freedom to contract will always be limited by Islamic legal rules that prohibit all transactions involving interest, or riba. Thus, even when the Ottomans introduced a civil code in the 17th century, a general theory of contract was not developed. Instead, jurists developed a number of nominate agreements with their own sets of rules. This structure of nominate contracts grew out of pre-Islamic contracts that were common in the time prior to the 6th century. These nominate contracts were studied and amended to comply with Islamic principles. A number of mechanisms to validate contracts falling outside the nominate scheme were also developed by jurists. An absolute right to contract, however, still remains undeveloped since contracts that violate prohibitions on riba or gharar (uncertainty) cannot be valid.

Contracts under Islamic law were necessary for a limited type of contractual transactional forms under which business was conducted. These contracts led to the development of a set of rigid, trade-based contracts that lay the foundations for contemporary Islamic contracts to be used and developed in the Islamic finance industry.

The prototypical contract was the contract of sale, or bay’. The basic form of the sale contract transferred ownership of some lawful, fixed property immediately deliverable for a determined price. All other contracts derived their form by analogy to the sale contract because Islamic jurisprudence dealt with that method in great detail.

Some typical contracts in Islamic finance included those for loans, gifts, sales, sales at a mark-up (murabaha), leases (ijara), joint ventures and partnerships (musharaka, mudharabah), manufacture and construction contracts (istisna) and agency contracts (wakalah). These contracts are instruments currently in use by Islamic banks and conventional banks offering Islamic products.

The primary focus in this paper will be on mudharabah and wakalah contractual forms. Islamic insurance companies typically use wakalah (agency) and mudharabah (joint-venture partnerships) contracts or a mixed model of a wakalah and mudharabah scheme.

A wakalah contract allows for full representation in most contractual arrangements. The contract can be gratuitous, where the agent provides management without compensation or fee-based. The contract, however, is revocable at will by either party. There are certain rules that militate against the possibility of revocation, but the authority of the agent depends on continued consent from the principal. In the insurance context, this allows an agent to act as manager under a fee-based arrangement.


Another commonly used contract is a murabaha contract. A murabaha contract is essentially the sale of a good with a certain mark-up built into the price. This mark-up can reflect any cost the seller may encounter in the deal. An istisna contract is very

similar to a construction loan. It is a payment arrangement between a buyer and seller for a particular good spread out over a period of time, such as the payment for the manufacturing of a house over the period it is being built. Ijara contracts parallel traditional leases. This kind of contract can either be a lease with a purchase option or a lease of an item that will revert back to the owner upon termination. One key difference between a traditional and Islamic lease is who has responsibility over upkeep of the item. In a traditional lease, the responsibility lies with the lessee; however, in an Islamic lease the responsibility falls to the lessor.

A second key contract form in Islamic insurance is a mudharabah arrangement. A mudharabah contract is an equity investment that is a profit-sharing agreement between two parties. In this type of arrangement, one party supplies the capital, while the other supplies management oversight and entrepreneurial skills. Profit is shared amongst the parties according to an agreed-upon, predetermined formula and risk is carried by each party. The risk carried is in line with the type of investment, money or time each party provides.

Finally, an equity arrangement between two or more parties is known as a musharakah contract. Here, each party contributes both managerial expertise and money according to an agreed-upon formula.

While there is no general theory of contract law, there are certain conditions that agreements must fulfil. In general, there is the requirement of good faith that is derived from the Qur’an: [Fulfil the covenant of God when you have entered into it, and break not your oaths after you have confirmed them ....] Islamic finance scholars have interpreted this verse and many others to read an element of good faith into contractual relationships. Good faith, honesty, disclosure, truthfulness and sincerity make up the moral attributes of a contract. Beyond these requirements, there are three key prohibitions that should not be part of any contract.

The first is a prohibition on interest. While some scholars debate the permissibility of interest in financial transactions, the vast majority of traditional scholars agree on its total prohibition. The prohibition against interest can be found in both the Qur’an and Sunnah. A Qur’anic verse on this point states, ― Allah has permitted trade and has forbidden [interest]. This prohibition‘s importance is evinced by the verses directly addressing the impermissibility of interest. This concept sets Islamic financial transactions apart from conventional business practices. In conventional finance, interest is part and parcel of the structure of most transactions.

The second obligatory prohibition is that against uncertainty or gharar. A well-known saying of the Prophet elucidates this point, stating: ― whoever buys food, let him not sell them until he has possession of them. This rule of fiqh voids the sale of nonexistent or uncertain objects, even if the relative risk is very low. This relates in a sense to the final prohibition that forbids gambling or maysir in Islamically compliant contracts. The Qur’an states, ― intoxicants and gambling ... are an abomination ... eschew these such that ye may prosper. The reasoning for this prohibition stems in part from the idea that gambling may create enmity amongst people.

These prohibitions have broad implications and are equally applicable to insurance contracts. Insurance typically involves risk, uncertainty and interest and therefore it poses a unique challenge to Islamic law. Under traditional Islamic law, the game-oriented risk profiles of insurance would not meet the requirements of a legally-valid contract between parties. In order to work around this inherent obstacle, Islamic scholars have taken a somewhat unique and innovative approach to insurance, which will be explored in the next section.

SUKUK UPDATES AROUND THE WORLD

According to the Thomson Reuters Group, the first nine months of 2014 saw sukuk issuance grow to $99.3 billion, 25% higher than the first nine months of 2013. It was also a landmark year in that four non-Muslim countries issued their first sovereign sukuk – UK, Hong Kong, South Africa and Luxembourg.

The full year, however, looks as though it will fall short of 2012’s record issuance. One of the major factors at the end of the year was the decision of Malaysia’s sovereign wealth fund to postpone a significant issue in the final quarter of 2014 until the first quarter of 2015. Analysts are also cautious about 2015 because of tumbling oil prices in late 2014 and early 2015. For example, between late September 2014 and the end of the year, Bahrain’s dollar-denominated sukuk maturing in 2018 dropped 1.3%.

This may be balanced by a number of countries who are considering first-time sovereign sukuk. These include Oman, Jordan, Kenya, Kazakhstan and the Philippines.

Goldman Sachs Try Again

Goldman Sachs failed to get sukuk issuance off the ground in 2012, when they were widely criticised for failing to observe Islamic financial principles in the proposed structure. Critics suggested that it was reverse tawarruq, which the International Council of Fiqh Academy have declared impermissible as it is a disguised form of usury. Questions were also raised about how the Irish Stock Exchange, chosen to handle the issuance, would ensure the sukuk traded at par value and thus avoid the accusation of trading in debt, which is forbidden under Shari’ah law. The last nail in the coffin was the suggestion that Goldman Sachs could well divert the proceeds of the sukuk into the financing of conventional banking activities, which again is an impermissible activity.

Details of the proposed sukuk are far from certain at the time of writing. Representatives of Goldman Sachs were due to meet potential investors in the Gulf in mid September. Reuters have reported that the issue is expected to be at least $500 million, with a tenor of between five and 10 years and backed by commodities and crude oil. The proceeds of the sukuk will, it is suggested, be used in a commodities business that is part of the Goldman Sachs group of companies.

Oman to Issue Sukuk in Early 2015

Reuters have reported that Oman is set to issue $1.3 billion worth of sovereign debt in 2015. This issue will be a mix of conventional bonds (around $800 million) and Islamic sukuk (around $500 million). A local sovereign sukuk will be welcomed by Oman’s embryonic Islamic banks, which currently have very limited choice of Shari’ah-compliant investment products

Sukuk Screening Service Launched

San Francisco-based IdealRatings, Inc. has launched what they claim is the first ever screening system for sukuk. They say that their research-based online screening service is designed for Islamic investors and treasuries aiming to balance their portfolios with low-risk, fixed-income instruments, which conform to the mandates defined by their Shari’ah boards. They believe their product addresses one of the key challenges of sukuk, which is the compliance risk due to the disparity in Shari’ah opinions and acceptance of sukuk structures and terms.

IdealRatings’ service allows investors to screen sukuk against different Shari’ah guidelines as well as defining their own custom guidelines. This will enable them to construct a portfolio of sukuk that conforms to both their Shari’ah mandate and their own investment standards. IdealRatings has also designed and launched a series of sukuk indices to support Islamic fixed-income portfolio management.

IdealRatings have developed their solutions with the help of Alinma Bank, a fully Shari’ah-compliant bank in Saudi Arabia and the most recent bank to launch in that country. Speaking on behalf of Alinma, Yasser Al-Marshde, the general manager of Alinma’s Shari’ah group, said, ‘Compiling, analysing and screening sukuk documentation is indeed an enormous effort and this intuitive, intelligent service, with its impressive technical solutions and features, helps sukuk investors screen global sukuk against the requirements set by their Shari’ah Boards.’

Bader Al-Omar, Shari’ah Group Head at Jadwa Investment, a leading Saudi investment firm and one of the principal inspectors to the new service, said, ‘Over the past two years, we have worked closely with IdealRatings to ensure the successful launch of this revolutionary sukuk screening solution. This is part of our overall strategy that focuses on supporting the advancement of Shari’ah-compliant financial and investment tools available in the industry. We are confident that this platform will contribute to a better understanding of sukuk compliance for all.’

Maybank Diversify into US Dollar Denominated Sukuk

In late October 2014 Maybank Asset Management launched the Maybank Global Sukuk Fund, the first they have issued denominated in US dollars. The Maybank Global Sukuk Fund is an open-ended fund, which will initially be available only in Malaysia, although Maybank is talking to overseas counterparts with a view to distributing the Fund in other markets. It is expected to appeal to investors with moderate risk appetite seeking regular income through a portfolio of sukuk and Islamic liquid instruments with a medium to long term investment horizon. The minimum investment amount is $100,000 (US).

The fund will invest in part in Gulf-originated sukuk. This is an unusual move given the fact that the Malaysian sukuk market accounts for more than 60% of the world total.

Indonesia Raise $1.5 billion

In early September the order book for Indonesia’s $1.5 billion 10-year sukuk was more than six times oversubscribed, reducing the yield from 4.625% to 4.35%. This was a remarkable result for a country, which 12 months earlier had been in the grip of a financial crisis that had hit several emerging economies and struggling with a current account deficit of $10 billion. The sukuk was sold to investors in the Middle East (35%), Asia (30%), The US (20%) and Europe (15%).

The success of the sukuk is being attributed in part to hopes that incoming President Joko Widodo will take firm action on the vast fuel subsidies that are considered to be a significant element in Indonesia’s economic problems. Whether he will succeed in cutting these subsidies is a moot point. His predecessor tried and was rewarded with widespread rioting.

In Brief on Sukuk

Turkey’s Dogus Group whose interests range from financial services, through construction and automotive to media and tourism, have been given regulatory approval to raise $370 million through a corporate sukuk.

In late August Hong Kong embarked on a road show taking in Singapore, Doha, Dubai and London to market the sukuk they issued in September. The effort paid off as the $1 billion five-year ijarah sukuk was nearly five times oversubscribed. The geographical split of investors was 47% Asia, 36% Middle East, 11% US and 6% Europe. Most investors were financial institutions (55%), with the rest divided between the public sector (30%), fund managers (11%), insurers (3%0 and banks (1%).

Several emerging economies are reported to be considering issuing sovereign sukuk following the success of issues by Turkey and Indonesia. Oman has already stated its intention to issue sukuk in early 2015 (see above) and others such as Jordan, Kazakhstan, Tunisia, Bangladesh, Kenya and the Philippines are rumoured to be on the cusp of announcements.

At the beginning of 2015 Bangladesh’s Central Bank launched a programme of weekly sukuk issues. The objective is to provide local lenders with a short-term liquidity tool. Auctions of the profit-sharing sukuk will be held every Thursday.

Pakistan’s Mobilink, the country’s largest mobile communications provider, plans to issue a sukuk worth nearly $70 million in early 2015. The money raised will be used to fund network expansion. The issue is unusual because it includes a partial credit guarantee amounting to about 14% of the total amount to be raised. The profit-sharing ethos of Islamic finance means that credit guarantees are rare.

In the last quarter of 2014 South Africa issued a $500 million sukuk priced at 3.19%. The five-and-three-quarter year sukuk was four times oversubscribed, with 59% of investors coming from the Middle East and Asia.


In November 2014 Pakistan sold a $1 billion five-year, ijarah, sovereign sukuk. The profit rate was 6.75%.

The issue was made through a Special Purpose Vehicle (SPV), the Second Pakistan International Sukuk Company.

Luxembourg issued the first Eurozone sovereign sukuk in October 2014. While the €200 million, five year ijarah sukuk was successful, it was only two-times oversubscribed, which have been disappointing to the Grand Duchy given that the UK’s issue was 10 times oversubscribed, Hong Kong’s five-times and South Africa two times. The profit rate at just below one-half a percent may have had something to do with this relatively modest demand.

In early January 2015 Dubai Islamic Bank issued a £1 billion perpetual Tier 1 sukuk, which was 2.5 times oversubscribed. The issue was initially priced at 7% but following the strong demand was tightened to 6.75%.

The Indonesian Government is planning to broaden the range of assets it uses to back sukuk. To date Indonesia has used infrastructure projects as collateral, but now the Government is looking at the procurement of goods and services such as computers and cars to underpin future issuance.

Aiming to strengthen governance and boost the attractiveness of sukuk to investors, Pakistan’s regulators have published new rules for the issuance of sukuk. The new rules require issuers to structure sukuk in accordance with AAOIFI (Accounting and Auditing Organisation for Islamic Finance Institutions) standards. , as well as those set by the local regulator. The rules require issuers to conduct an annual audit to ensure the sukuk conform to Shari’ah requirements. Sukuk must also carry a credit rating not lower than triple BBB.

Standard & Poor’s has updated its criteria for Islamic bonds to distinguish more clearly between issuers and sponsors of sukuk. For example, sukuk will be rated on a par with the sponsor’s senior unsecured rating if they provide contractual commitments by the sponsor to make payments that ultimately cover periodic distribution and principal amounts. The agency said it did not expect the new criteria to lead to upgrades or downgrades of the sukuk that it rates, but it might withdraw a rating if terms and conditions did not meet the criteria. It estimated this might happen in fewer than 5% of cases.

The Dubai-based Emirates airline, has hired eight banks to arrange a sukuk that will be guaranteed by Britain’s export credit agency. This is the first time that the UK’s export credit agency has guaranteed an Islamic bond. The chosen banks are Citigroup, HSBC, JP Morgan and National Bank of Abu Dhabi as the joint structuring agents, with Abu Dhabi Islamic Bank, Dubai Islamic Bank, Emirates NBD and Standard Chartered also acting as joint lead managers. It is rumoured that the issue will be upwards of $500 million, with a 5-10 year tenor.

Source: New Horizon July-December 2014 issue.

IN BRIEF ON ISLAMIC FINANCE IN AFRICA.

In late November 2014 Morocco approved a finance bill that will allow the establishment of Islamic banks and permit private companies to issue Islamic debt. The bill was passed unanimously. The opportunity to set up Islamic banks will be open to both local and foreign organisations, although it is believed foreign organisations may be actively encouraged to partner with local organisations, rather than setting up wholly owned subsidiaries.

Tunisia has amended its laws governing insurance to provide a legislative framework for takaful. Comments from within the Tunisian insurance industry suggest that takaful will account for between 10% and 12% of all insurance business in Tunisia by 2020.

Tunisia’s Banque Zitouna has raised $9.7 million in capital through an issue of ordinary shares, which have been taken up by the Islamic Development Bank (IDB). This gives the IDB an almost 21% share in the bank, which is Tunisia’s only fully-fledged Islamic lender.

In Tanzania, Mr. Paul J. Ngwembe, Director Legal Enforcement, of Tanzania Insurance Regulatory Authority (TIRA) disclosed that TIRA is at the final stage of drafting Takaful Regulations with a view to setting up a regulatory mechanism of Takaful in the country. He added that TIRA encourages all stake-holders to attend Takaful training workshops so as to acquire the requisite know-how of this system.

Dubai Islamic Bank has opened a subsidiary in Kenya. Having received an approval from Central Bank of Kenya to enter the market, it has started to recruit staffs to enable it complete its formation process. It is expected to start operations in the last quarter of 2015. Upon launch, this will be the third full fledged Islamic bank to operate in the country.

WHERE ARE WE ON THE LEGAL, SUPERVISORY AND REGULATORY FRAMEWORK FOR ISLAMIC BANKING IN TANZANIA?

There has been sound evidence that a country with Islamic banking regulations is seriously posed to fast-move the growth of Islamic banking in the country. As a result, more countries are in consultations with renown organizations and entities such as World Bank and Malaysia International Islamic Finance Centre among others to assist on formulation of Islamic Banking Laws or revision of existing laws to embrace Islamic banking operations.

Tanzania is among the countries that realized the need to relook its existing banking laws in order to take necessary changes to provide required legal and supervisory framework for Islamic banks. Two years ago, Tanzania took initiative to request World Bank to advise the Bank of Tanzania on formulation of legal, supervisory and regulatory framework for Islamic banking. I had an opportunity to meet World Bank delegation given the tasks for consultations in May 2013.

Since then, there is no progress on what was advised by the World Bank Team. In November 2014, i learned that the World Bank Team tabled the proposed framework to BOT timely for consideration. When I had an opportunity to inquire when should stakeholders expect it to be discussed, there was no clear timeline as to when this framework shall be discussed by stakeholders before its adopted.

What is going on with BOT to seat with this important matter for months without any sign of progress? For how long Tanzania shall be a follower in East African Community rather than leader when it comes to matter of economic significance? Don't we aspire to be a regional hub for Islamic Finance if we could not attain been a financial center? Don't we desire to attract foreign investors in the financial sector to widen our financial services outreach and supplement our financial inclusion strategy? Don't we want to increase youth employment in the formal sector? Don't we want economic partnership with Middle East beyond the social and political relationship?

Lets us all push for answers to these questions.

Wabillahi Tawfiq.