Money Market – a Shariah Anomaly

Conventional wisdom states that money must generate returns all the time, even when it is idle. Hence the creation of the money market, a place for trading idle money. When there is a trade, there will be a price; and the price of money is the interest rate. What determines the interest rate? Other than the forces of demand and supply; monetary policy, expectation of changes in the base rate and inflation also influences the price of money.

The money market is also a place where mismatches in banks’ assets and liabilities are rectified. Banks with excess funds (liabilities > assets) will sell (lend) the excess cash in the money market and banks facing a shortage of funds (assets > liability) will buy (borrow) money from the market.

The money market ensures liquidity is managed and is therefore crucial to ensure the banking system and the economy works smoothly.

Why then do I say that the money market is an anomaly in Shariah based finance?

Firstly, my understanding is Shariah prohibits the trading of money because money is not a commodity; it is merely a tool to facilitate trade. Money is potential capital, useful only when put into productive economic use.

Secondly, money is a ribawi item, one which cannot be exchanged unless it is equal in value and transacted spot. The following hadith is the basis of this ruling.

The Prophet s.a.w. said “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt should be exchanged like for like, equal for equal and hand to hand [on the spot]. If the types of the exchanged commodities are different, then sell them as you wish, if they are exchanged on the basis of a hand-to-hand transaction. (Sahih Muslim)

Therefore, the act of lending overnight money at 3%, contravenes the above hadith because (1) the exchanged value differs and (2) it is not exchanged on spot basis.

Then Tawarruq came along. Liquidity management in a Shariah compliant manner is now possible via the buying and selling of commodities (which does not leave the warehouse and is reused again and again for subsequent transactions). The route is longer but the objective is met nonetheless, money is exchanged in different amounts at different times, made “permissible” due to the presence of the trade. It sounds like a hilah to me because the whole transaction is undertaken merely to circumvent Shariah ruling on riba. It also does not entail any direct economic activity. The biggest beneficiary is the commodity brokers, getting paid for facilitating a seemingly pointless transaction.

No doubt, there will be times of excess liquidity and it does not make economic sense to keep the potential capital idle without generating any income.

This excess liquidity can be channelled towards financing short term projects or providing short term funding. Trade financing would be a good place to start. Retailers/traders usually buy from suppliers or wholesalers or manufacturers on credit terms. Banks could offer a short term murabahah facility to finance this type of transactions in the form of a 3 day, 1 week, 2 week or 30 day murabahah financing. This would channel the excess liquidity towards funding real economic activity.

Another way to absorb the excess liquidity is by way of a short term lease. A clearing house needs to be set up. The clearing house shall own a pool of tenanted properties. When a bank (or anyone for that matter) has excess liquidity, they will purchase property from the clearing house and the rental will be paid to them. When they need the cash, the property will be sold back to the clearing house at market value. In most cases, the purchase and sale price would be the same as it is quite unlikely for real estate values to fluctuate very much in the span of a few weeks.

Both methods entails actual economic activity and the returns from the investment are generated from actual economic activity.

There is always a Shariah based solution to every financial need. If there isn’t, the financial transaction is probably not in tandem with Shariah in the first place.

Liquidity Management via Commodity Trading?

I’m not a Shariah scholar but I think I know a “hilah” or legal trick when I see one.

Selling and buying back a commodity (Bai Inah) between two parties is obviously a legal trick undertaken to circumvent the laws of Shariah. What about artificially trading and exchanging commodities between 3-4 parties? By artificially I mean the trading of the commodities does not bring any economic benefit apart from facilitating the movements of cash and enabling a sum of money today to be returned at a later date inclusive of the “profit”. Hey, I just described Commodity Murabahah Tawarruq.

I have been made to understand and have always believed that Shariah based trade and finance must involve real and productive economic activity. Transferring commodities within seconds does not create any productive economic activity. Transferring commodities for this purpose tantamount to a legal trick, hilah. Correct me if I’m wrong.

Commodity Murabahah exist for liquidity purposes. Without it, how will Shariah based financial institutions manage their liquidity? Maybe the answer lies in how Shariah based financial institutions look at liquidity management. Do they need it in the first place? Deposits undertaken under the contract of Mudharabah are not demand deposits, they are investments, and liquidating investments has its steps and conditions. Savings deposit under the contract of Wadi’ah is for safekeeping and is not supposed to be utilised. If they are, then the onus is on the FI to meet the withdrawal demands of the customers.

Conventional banks use customer deposits to fund loans. They face the problem of matching short term liabilities with long term assets. Shariah based FI do not face the same dilemma because they are NOT supposed to fund financing with customer’s (Wadi’ah) deposits. Financing are done on a profit sharing basis, it is done in a partnership. Therefore, any financing arrangement is between the customers, and the FI merely acts a facilitator, arranger, manager or if they commit their own capital, as a partner and hence liquidity issues might not occur.

What I’m trying to say is, if Shariah based financial institutions undertake Shariah based financing exactly how it is supposed to be done, they won’t need legal tricks. There is no need to complicate things just to conform to the conventional norms.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any economic activity but instead it creates debts.

Tawarruq is a tripartite arrangement between a bank and two commodity brokers. The bank will undertake a Tawarruq transaction whenever it gives out loans (or in a more Shariah compliant term – financing) or when the bank requires funds.  The modus operandi is as follows:

1. The bank will procure commodities or metals from a broker at price P, payment is spot.
2.  The bank will then sell the commodity to the customer (borrower) at price P plus profit, payment is deferred as per the financing agreement.
3. The customer then instructs the banks to sell the commodity/metal back to the market at price P, payment spot. The customer gets his cash from the “sale proceeds”.
4. The commodity is bought and sold within minutes and never leaves the warehouse. All this buying and selling action has no real economic value. Only the brokers make money.

•  The operations is reversed if the bank wishes to borrow from another institution.

To me, Tawarruq is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. I hope Commodity Murabahah will be next.

Will There be a New World Financial Order? by Pankaj Kumar (The Star, Business section, 21 January 2009)

Copy of the email I sent to the Editor of The Star, commenting on the need for an alternative financial model.

Dear Editor,

Quoted from Pankaj Kumar's article in The Star 21 January 2009:

"The simple argument is that asset managers or hedge fund managers do not need crude oil or other commodities for that matter or even currencies in their books.They have no business to be in these markets if they are purely speculating on price movements.They should stick to basic investment in asset classes, that is, genuine companies that use these commodities for real markets, real products and real profits. And yes, we do need a new world financial order to get rid of speculative activities which have time and again created asset bubbles and financial manias."

I cannot agree more with Pankaj's observation and would like to point out that an alternative financial order is already in place – Shariah (Islamic) based Finance.

The principles of Shariah disapprove of uncertain contract terms, prohibit gambling and abhor speculative practices. Unfortunately, these elements are prevalent in most financial instruments of late which ultimately caused the fallout in the financial markets that we are experiencing now. If undertaken in its true form, Shariah based financing can eliminate most of the problems associated with conventional financing as laid out by Pankaj in his article.

The key is however, to practice Shariah based financing as it should be, according to the principles of Shariah and not as a conventional product with an Arabic name. Shariah based finance is totally different in all respects from the conventional finance and banking the world has seen and grown to love for the past 100 years. It would be disastrous and detrimental to the development and growth of Shariah based finance if practitioners (and regulators) continue to develop so-called Shariah products based on the conventional platforms and norms.

What is needed is a paradigm shift in the way we approach and view Shariah based finance. We need to accept that although the objectives of Shariah based financing are similar to that of conventional finance, the means of achieving it is drastically different. Different here does not mean changing the product name or adding a few clauses in the transaction documents. The difference is in the mechanics, determination of profits (pricing), contractual obligations and relationship of all parties, the risk analysis and management, recovery methods, source of funds, utilisation of proceeds and remedies in the event of default.

In order for Shariah based finance to prosper, practitioners must not only be well versed in the laws of Shariah but more importantly understand the objectives of Shariah. The market also needs to be made aware of the uniqueness of Shariah based finance. Only then can we see the emergence of the true form of Shariah (Islamic) finance.

Regards,

Eurozone Predicament – Could Shariah Based Finance Avert the Crisis?

The Eurozone crisis is caused by fractional reserve banking and interest based lending and borrowing. 

A very strong statement/accusation but I will stand by it and I am sure I’m not the only one with that view. In fact, any financial or economic crisis will have roots in the fiat monetary system and lending with interest.

The beginning of the 21^st century saw low interest rates and easy credit fuelling a borrowing binge. This spree caused prices of assets, real estate in particular, to soar. Rising prices ‘invited’ a new group of investors into the market – the speculators, and their presence made things even worse. Banks too made things worse by lending to people who were not really credit worthy or lending to people amounts beyond their ability to repay.

Similarly, in the Eurozone, countries which are not creditworthy were allowed to borrow beyond their means, often hiding behind the credit strength of stronger countries;, in this case, Germany. These governments took advantage of the opportunity and cashed in on the cheap funding to finance everything from infrastructure to social benefits.

Everyone seemed to forget that what goes up must come down; the economy is no exception.

In 2008, everything collapsed. The US housing bubble burst and the whole world followed suit. House prices crashed, banks went bust, stock markets crashed, pension funds lost money, unemployment rose and everything fell apart.

Now everyone is poorer.

Let’s try to imagine if things were done according to Shariah rules. Profit and loss sharing (PLS); a ban on speculative activities and prohibiting the creation and trading of ‘gharar’ and ‘maisir’ infested financial instruments would almost certainly prevent the bubble from appearing in the first place. If the bubble doesn’t exist, it cannot burst.

Imagine if businesses carried out investments on a PLS basis where returns on investment (i.e. cost of funds) matches the actual returns of the investment and not burdened by movements in the rate of interest. The problem with interest based bank lending is that it does not care how much the business is making (or losing); all it wants is their money back plus interest. PLS on the other hand is directly linked to demand and supply and the real economy; when times are good, partners have more to share but when times are bad all partners share the smaller pie (or absorbs the losses). It all boils down to the intention of the investor (lender, in conventional terms); adopting PLS means riding the waves of the economy, insisting on interest based lending could mean not getting anything if the economy crashes.

Imagine if properties are acquired on a (pure) diminishing partnership basis. The buyer (borrower, in conventional terms) and financier jointly purchase a property which the buyer rents at the market rental rate. Being a joint owner, part of the rental is attributable to the buyer him/herself which is then used to purchase equity in the property from the financier. If times are bad, the buyer can choose to only pay the portion of the rental owed to the financier and if times are good, he/she can choose to buy more equity in the property. The rental is market determined and not influenced by movements in interest rates.

Investment bankers are smart people. They are so smart they come up with all kinds of solutions to earn themselves a commission and bonus. However, some of these solutions may only be good for the banks and not for the customers. In most of the solutions, the element of gharar and maisir are clearly present. To make matters worse, some of the instruments can be used to speculate and gamble. These are the recipes for disaster and are exactly what mortgage-backed securities (MBS) and collateralized debt obligations (CDO) are.   The U.S. Senate's Levin–Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." Shariah based finance would not have allowed such instruments to flourish (although I personally know of some bankers who wanted to create a “Shariah compliant” CDO!).

Therefore, I conclude that the Eurozone crisis (and the global financial meltdown of 2008) was created by;

1. Fiat money;
2. Interest based lending;
3. Unjust and unethical business practices (lending to those who can’t afford, selling potentially worthless credit notes etc.)
4. Gharar; and
5. Masir.

Mudharabah and Musharakah are NOT Debt Contracts

The following is an article I wrote in 2009.

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively in 2008.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers; they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws (Shariah) and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower relationship, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank; it is only concerned with the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met on time and in full by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally according to the invested capital. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Risk management in Islamic finance concerns the viability and potential profitability of a given project and has nothing to do with the investors’ personal ability to repay the capital.

Islamic financial transactions cannot involve anything prohibited by Shariah. The prohibitions include dealing in riba, alcoholic beverages, gambling (maisir), pork related industries, unethical practices such as prostitution and environmental damaging industries.

Uncertainty (gharar) is another major prohibition in Islamic finance. Uncertainty refers to events that are beyond the normal control of man such as profitability of a certain venture. It is therefore unlawful from the Islamic perspective to guarantee a predetermined amount of profit before the venture or project is concluded as the amount of profit generated is beyond the control of man. Of course effort and controls can be undertaken to ensure profitability but the actual amount cannot be determined at the onset.  

Being just and equitable does not mean at the expense of profits. Viability and profitability should be the main determinant in deciding to enter into a business transaction. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid.

Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions when the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not expected to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity and therefore has no price and cannot be traded. They are merely an intermediary to facilitate a transaction and therefore have no value on its own. The value of money is how much goods and services it can obtain.  Any exchange of money must involve not merely a trade but a productive economic activity. Any exchange of money with money must be of equal value and on spot basis, otherwise it will result in riba. Islamic economic prohibits hoarding of money. Zakat ensures that money is not kept idle and unproductive. Hoarding money will curtail economic activity and will result in economic hardship.

Islamic finance is all about financial transactions in a just and equitable manner. All parties involved in the transaction are expected to share the gains and bear the risks equitably. Islamic finance is not only for Muslims, it is for everyone who wishes to enter into an equitable financial transaction.

Riba

The prohibition of riba is the foremost issue in Islamic banking and finance. The literal definition for riba is “excess”, “increase”, or “growth”.

In Islamic banking and finance context, riba is often equated with interest. It is not inaccurate to equate riba with the interest rate but the term riba has a broader definition.

The following are the definitions of riba given by some scholars;

Abu Bakar ibn al Arabi – riba is excess in return of which no reward is paid.

Abu al Ala al Maududi – a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specific period. Riba contain the following elements:

i) Excess over and above loan capital

ii) Determination of the excess in relation to time

iii) Stipulation of the excess in the loan document

http://hazariba.com/DefinitionRiba.shtml - a forced increase of value in the medium of exchange (money/commodity) that is loaned or swapped.

Engku Rabiah Adawiah – an increase or excess which accrues to the owner in exchange or sale of a commodity or by virtue of a loan arrangement, without giving in return equivalent counter value to the other party.

From the above definitions, we can see that any excess earned over the principal amount is considered riba if it is earned without putting in any effort and without assuming any economic risk. The difference between riba and profit is that profits are earned from a productive economic activity whilst riba is earned without doing anything.

Socio-economic justice is one of the main objectives of the Islamic faith. The definitions above show that riba guarantees that only one or some of the contracting parties benefits from the transaction at the expense of the other parties. Therefore, Islam prohibits riba to ensure that the principles of just and equity is preserved, enabling all contracting parties to share the benefits equitably.

Types of riba:

Riba al fadl – excess accruing in sale or barter transaction

Riba al nasiah – excess accruing from a loan transaction (similar ribawi items) in relation to time

Prohibition of Riba in Quran:

1st stage – Surah al Rum verse 39 (Makkah) – call to abolish interest bearing loans and give alms instead.

2nd stage – Surah al Nisaa verses 160-1 (Madinah) – riba was also prohibited to the Jews (reminder)

3rd stage – Surah Ali Imran verse 130 (Makkah) – stronger prohibition

4th stage – Surah al Baqarah verses 275-281 (Makkah) – Strict law prohibiting riba, establishes clear distinction between trade and riba and defines riba as any increment (however small, whatever the reason) added to the principal. Instructing to only receive principal and waive repayment if borrower is in hardship. Cites the consequences for indulging in usury.

Hadith on the prohibition of Riba

Sahih Muslim, Book 010, Number 3854: Abu Sa'id al-Khudri (r) reported Allah's Messenger (pbuh) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand. He who made an addition to it, or asked for an addition, in fact dealt in riba. The receiver and the giver are equally guilty.

Islamic Banking in Singapore

This was my final posting on SBF. I intend to maintain a similar tone for this blog with the emphasis on redefining how Islamic banking (in my opinion) should work. I hope to receive comments on my views, constructive or otherwise. Nevertheless, all views are very much appreciated, I’m sure in one way or another they will enhance our knowledge on Islamic banking and finance.

MONDAY, MAY 24, 2010

Islamic Banking in Singapore

Reuters reported that DBS, Singapore and south East Asia’s largest bank is scaling down on its Islamic banking operations, signalling the city-state’s efforts to promote Shariah banking are not bearing fruit.

DBS’ Islamic Bank of Asia (IBA), Singapore’s only wholly-owned full licensed Islamic bank, suffered a loss of US$77.1 million (RM256 million) in 2009 after making specific allowances on debt owned by customers in the Gulf region. The bank had US$725 million in assets as at end-2009, including US$453 million in payments due from non-bank customers. A source had earlier told Reuters the Islamic unit of DBS planned to get out of the lending business entirely. (Reuters; May 24, 2010)

What struck me was the statement on “lending business”. I have argued in the past and still maintain my stand – Islamic banking is not about lending. Islamic banking is all about putting resources together and sharing risks and rewards in an economically beneficial business venture. Any lending should be kept at a minimum and should only be for exceptional cases and given interest free.

So, given my stand, I’m not surprised that Islamic banking is not making much headway in the non-traditional markets. While the traditional markets (read Muslim countries) have the added advantage of having religious obligation as a marketing tool, the non traditional markets needs more than that to push Islamic banking. Focus has to be on the uniqueness of system, the part that differentiates it from conventional banking. One of it is that it promotes risk and reward sharing instead of just plain borrowing and lending.

It is often lamented that Islamic finance lack knowledgeable practitioners. I want to add that the industry also lacks knowledgeable investors. By knowledgeable investors I mean investors who appreciate what Islamic finance stands for. For as long as investors demand a solution that mimics conventional products, Islamic finance will not take off, even in traditional markets.