Islamic finance is quickly breaking out of its niche in the financial world and becoming a respected part of the mainstream. Personal Finance explains how interest-free banking works, the ethical principles behind it, and what is on offer in South Africa.
Those of us brought up in the Western way of doing business may find it difficult to understand how sharia-compliant banking - banking according to Islamic law, which forbids the paying or receiving of interest, among other things - could possibly work. How can one do banking without the use of interest?
If you think outside the box, you will realise that it is quite feasible. Here's a hint: think of banks less as the heartless, profit-driven entities they are often portrayed as in the media and more as socially responsible partners in business.
And don't confuse interest with returns. A return on an investment may include interest, but not necessarily. Returns may be simply a share in profits.
Doing business the Islamic way has a long history - it's as old as Islam itself. However, in modern times it's only relatively recently that Islamic finance has come into its own. (See "Islamic banking in modern times", as Part II of this story here).
Apart from the emergence of wholly Islamic banks, such as the Al Baraka group, which operates in South Africa, many established Western banks now have specialised Islamic banking divisions - we have two in this country: Absa and First National Bank (FNB).
There is also an increasingly wide range of sharia-compliant investment products and services available to individual and institutional investors locally and internationally, and sharia-based indices are appearing on many of the world's stock exchanges, including the JSE Shariah All Share index and the JSE Shariah Top 40 index on our own (see "Sharia indices", below).
This flurry of activity is largely the result of the increasing purchasing power of Muslims worldwide. With the sharia-compliant option now open to them, more and more Muslims, who previously had little choice but to bank in the conventional manner, even in Muslim countries, are choosing to go this route.
The route is open to everyone, not only people of the Islamic faith, and it is beginning to appeal to non-Muslims attracted by its underlying ethical principles, particularly in the aftermath of the global credit crisis.
Ebi Patel, the chief executive of IslamicFinance, a division of FNB/WesBank, says: "The awareness and interest among non-Muslims regarding Islamic finance has been steadily gaining momentum. Locally, the chief executive of Bankseta , at the launch of Islamic finance training, is said to have commented on how Islamic banks proved to be most resilient during the economic meltdown. And last year, in an article published by the Vatican, the Pope was reported to have commented on how perhaps adopting Islamic banking principles would have prevented the credit crisis."
Patel is referring to an article that appeared in the Vatican's official newspaper, Osservatore Romano, in March 2009. "The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service," the article said.
Amman Muhammad, the managing director of Absa Islamic Banking, also sees a broadening of public awareness, and says a third of his division's client base is non-Muslim. "Islamic banking is available to any individual or organisation wanting an alternative to conventional banking - for example, people who want the comfort of knowing that their funds aren't being invested in industries such as tobacco, alcohol, gambling or pornography. Islamic banking is also an attractive alternative because all loans are asset-backed," he says.
Naturally, the sector's prime target group is the local Muslim population, which is about two percent of South Africa's total population, or about a million people.
Muhammad says that although a niche Islamic bank was launched in South Africa 20 years ago, full-service banking has been available to the South African market only since 2006. There are no formal statistics available, but Muhammad reckons that only about 10 percent of South African Muslims have converted to Islamic banking, which, he says, leaves a lot of room for growth.
But are banks and investment houses that have established Islamic finance divisions genuine in their approach to a different, more ethical way of doing business, or are they trying to woo Muslims by paying lip service to these principles while keeping their business models essentially the same?
Sector leaders believe the Islamic way is genuinely different, the main reason being that all banks and asset managers offering sharia-compliant products must have in place a sharia supervisory board - made up of local and/or overseas-based Islamic clerics and scholars who have the respect of the Muslim community - which oversees and monitors activities. Speaking for the FNB operation, Patel says: "We are governed by our own sharia board and have a strict policy in regard to adhering to sharia. Ultimately, we are held accountable by a greater authority."
Bilal Jakhura, who heads the sharia department at the Durban-based Al Baraka Bank, an offshoot of the international Al Baraka group, says: "Provided that an institution has a competent and reputable sharia supervisory board that adheres to internationally accepted standards of sharia compliance, it is difficult to conceive that an approved Islamic product would be Islamic by name only. The fundamental principles are such that the final product would necessarily be different. It is for this reason that Islamic financial institutions have had to approach regulatory authorities in order to obtain specific dispensations that relate to them."
Jakhura is referring to proposed changes in legislation to accommodate sharia-compliant finance in South Africa.
One area of concern is regulation 28 of the Pension Funds Act, which governs how and into which asset classes retirement savings may be invested. Definitions in the Act need to be broadened to include sharia-compliant investment instruments.
Another is taxation. In this year's Budget speech, Finance Minister Pravin Gordhan said that, to enhance South Africa's attractiveness as a viable hub from which "businesses can extend their African and other worldwide operations", the government will "review the tax treatment of financial instruments to ensure appropriate accommodation of Islamic-compliant finance".
The draft Taxation Laws Amendment Bill, which is likely to be voted into law this year, proposes that financial products structured according to Islamic models (see "Banking transactions", below) be placed on an equal footing with conventional products. One benefit of this is that investors in these products will be able to enjoy the same tax exemptions on returns as those receiving interest from conventional instruments. Another is that multiple taxation in certain transactions is avoided.
Adam Ebrahim, the chief executive of Oasis, a Cape Town-based asset manager that specialises in low-volatility asset management and has a wide range of sharia-compliant products, is excited about these developments. His firm has played a big role in talking to the government and regulators such as the Financial Services Board about what needs to be done to facilitate the growth of Islamic finance in the region.
Ebrahim says: "Countries are looking at this as a way of becoming globally competitive and are looking at positioning their local financial service sectors as hubs for their regions. So South Africa's strategy is to be a financial service hub for Africa, because if you're a regional hub in anything, it creates jobs, a demand for property, economic activity."
With amended regulations in the pipeline, Ebrahim sees an important future role for Islamic finance in partnerships with the government on infrastructure projects. He says: "Infrastructure spend, which normally involves income-generating power stations or roads or ports, really lends itself to structuring products in the Islamic way, so you have real assets that have long-term income-generating capacity - and you are able to raise funding for that type of project very easily from this source."
Sharia principles
Although Muslim scholars may differ in their interpretation of the finer details, sharia-compliant finance is based on a handful of fundamental ethical principles, on which most agree:
- "Riba" is prohibited.
Riba literally means excess or increase, but is widely translated as usury, and commonly refers to the concept of interest.
Jakhura says: "In the context of contemporary banking, riba for the most part relates to the excess (interest) charged on a loan as compensation for the period of repayment of the loan. Since this period is not a valuable (tradable) property in Islamic law, it has been declared unlawful. Riba in this form has also been prohibited in the Old and the New Testaments."
Jakhura says some of the wisdom behind the prohibition of riba is that a predetermined fixed rate of return on capital lent leads to injustice because there is an uneven distribution of risk and reward. One party bears the risk, while the other party receives a reward, irrespective of the outcome of the borrowed amount. This ultimately leads to the concentration of wealth in the hands of the rich, he says.
- There is a shared responsibility for profit and loss between borrower and lender.
A good example of this in conventional finance is buying shares in a company. As a shareholder, you enjoy a share of the company's profits if it does well, and bear a share of its losses if it does badly.
Jakhura puts it in another way: "A basic principle in Islamic commerce is that for a profit to be earned, a corresponding risk must be assumed. For this reason, the lessor (bank/financier) in an Islamic financial lease assumes the risk of destruction of the asset. This is in stark contrast to the conventional finance lease, where the risk of destruction of the leased asset lies with the lessee."
- Investing in businesses that provide goods or services considered contrary to sharia is prohibited.
These include interest-governed financial institutions such as conventional banks, insurance and financial services companies; the entertainment industry, including hotels, casinos, cinemas, nightclubs and music; and companies manufacturing, selling or offering alcohol, pork, gambling, pornography, prostitution, weapons or tobacco.
- Transparency is demanded of all parties in a financial transaction.
Sharia forbids deception ("gharar") by, for example, exaggerating a product's worth or concealing a defect.
- Transactions must be backed by tangible assets, and trading in indebtedness is prohibited.
Ebrahim says this rules out speculative investing and trading in derivatives. He says: "You cannot invest in derivatives, because there are no hard assets behind them, or any financial engineering. And you can see what the world has been like - we got into trouble because of financial engineering. So there is no financial engineering. We fund and promote the real economy."
Banking transactions
The types of financial transaction widely used in Islamic finance, based on the above principles, are: a profit-sharing agreement, a sales-based agreement and a lease agreement.
- Profit-sharing agreements traditionally occur between a lender and an entrepreneur. In a joint partnership, or "musharaka", the bank will help finance a company through establishing a joint venture. The bank's return on the loan for the venture is an agreed percentage of the company's profits. This would be similar to a conventional simple venture capital deal, where the financier that provides start-up capital becomes a joint shareholder.
Another type of agreement is trust financing, or "mudaraba", whereby one party provides expertise and managerial skills, and financing is fully provided by the other party. Profit is shared according to an agreed ratio, but the risk of loss lies with the provider of the capital. This can work for financing or for investing.
Jakhura says bank deposits are often structured on a mudaraba model. "This is essentially a partnership where one party (the depositor) provides capital and the other (the bank) provides investment management and expertise. Profits (made through investments by the bank) are shared between the bank and depositors on an agreed profit-sharing ratio," he says.
- A common sales-based transaction is "murabaha". Instead of lending money for an item, the bank buys the item and sells it to the buyer at a higher price, allowing the buyer to pay it back in instalments. For example, a buyer needs R100 000 to buy a car. The bank pays the lump sum for the car and sells it to the buyer for, say, R120 000, which the buyer pays off over five years in 60 fixed monthly instalments of R2 000. Ownership transfers on the conclusion of the sale. In some cases the item is registered in the buyer's name from the start of the transaction; in others, registration in the buyer's name is delayed until the last repayment has been made.
- In a lease-based agreement, known as "ijara", the bank buys the asset and leases it to the lessee for a fixed term. The rate at which the asset is leased may be fixed or it may fluctuate if linked to a defined benchmark. Depending on the agreement, the bank may retain ownership of the asset at the end of the term or transfer ownership to the lessee.
Pros and cons
Islamic banking, like conventional banking, has its advantages and disadvantages. Your moral or religious convictions aside, it's ultimately a matter of individual choice.
- Bad debt.
One area where the difference is marked is that of bad debt, which, if kept low, benefits both the bank and its clients.
The issue of defaults and bad debt is a thorny one among conventional bankers. But where the "greater authority" of which Patel speaks is involved, bad debt appears to be very low. Generally, there is a high degree of mutual trust between borrower and lender, and this may be attributable, apart from their shared religious convictions, to the risk/profit-sharing approach, which fosters co-dependence.
Says Absa's Muhammad: "The lender and the borrower enter into a partnership. Because of this partnership model, the performance record of our clients is good. We've actually not recorded any defaults, except for a tiny (less than one percent) portion of our client base that have requested debt relief."
Both FNB's IslamicFinance and Al Baraka also have minimal bad debt. Patel says at his division arrears and bad debt are "negligible" compared with conventional banks. Jakhura says that, at Al Baraka, "for the financial year ending December 2008, the impairment for credit losses was 1.36 percent of income earned from finance transactions".
According to the Reserve Bank's Financial Stability Review, bad debt (impaired advances) in the South African banking sector overall stood at nearly six percent in December 2009.
As a safeguard, Islamic banks, like their conventional counterparts, may ask for collateral on loans. Jakhura says: "The level of security required by an Islamic bank would not be very different to what a conventional bank requires, as the Islamic bank has the responsibility of protecting its depositors too."
- Banking charges.
If you thought you might avoid the sorts of service fees that caused "grave disquiet" at the Competition Commission's banking inquiry, you may be disappointed.
At Absa Islamic Banking and FNB IslamicFinance, clients pay the same fees as Absa and FNB clients banking conventionally. At Al Baraka, fees are "competitive", Jakhura says, and they have to be approved by the bank's sharia supervisory board.
In its report released in 2008, the banking inquiry's panel took particular issue with penalty fees, such as those for rejected debit orders. It recommended that "dishonour penalties" be capped at R5 per instance, which in its opinion was enough to cover the cost to the banks. In practice at Absa, FNB and Al Baraka, the fee on a current account for a dishonoured/rejected cheque or debit card payment is R100 or more.
Comparing current accounts, a cash withdrawal at a branch at Absa, whether you have an Islamic account or a conventional one, is R17.50 plus R1 per R100. At FNB it is R23.50 plus 1.1 percent of the withdrawal amount, on both Islamic and conventional accounts. At Al Baraka it is markedly less: R10 on an amount of R2 500 or less and 50c per R100 on amounts over R2 500. A bank-guaranteed cheque will cost you R50 at FNB or Absa, and R75 at Al Baraka. However, Al Baraka does not charge a monthly administration fee, which varies at the other banks, depending which banking package you choose.
- Loans.
If you want a loan, for example for a house or a car, Islamic financing agreements offer fixed repayments, which are an advantage to many. Muhammad says fixed repayments give clients peace of mind in an unstable interest rate environment. However, one may argue that, on housing loans at least, conventional banks also offer fixed interest rates, and that the disadvantage of fixed rates is that clients lose out if rates go down.
Jakhura makes the point that, in a murabaha finance transaction, once the price between the bank and client has been fixed, it cannot be changed if, for example, the client delays in payment. If that happens, he says, the bank will, after having provided the client with reasonable opportunity to repay the outstanding amount, act on the security/collateral provided for the financing. "This is acceptable from an Islamic perspective," he says. "Security may be in the form of a personal surety, a pledge over the asset or a cession over other financial assets."
- Deposit accounts.
On the savings side of banking, Islamic banks do not fix rates of return on deposits, as this would be tantamount to paying interest, but they pay out a predetermined share of profits to depositors. Muhammad says: "The profit-share that we distribute among our clients at the end of each year is determined from the profits we earn from investing our target savings and savings book through Absa investments."
Jakhura says that, at Al Baraka, "all profits from financing activities enter into a common pool and are then divided between the bank and depositors in the ratio of 40 percent to the bank and 60 percent to depositors. The advantage of this model is that if profits in the pool increase, the depositors benefit."
Although rates/returns are not guaranteed, you do have access to past performance figures if you want to deposit money in a savings account. For example, at Al Baraka, year-on-year profits (as at April 23, 2010) for depositors ranged from 4.94 percent on a 35-day lump-sum deposit to 6.27 percent on a two-year deposit. Rates fluctuate weekly.
Apart from not knowing exactly what the return on your bank deposit will be, a disadvantage is the lack of credit card or overdraft facilities at Islamic banks. Debit cards, however, are permissible and available, but they must have a positive balance.
Sharia-compliant investing
Just as South African Muslims are increasingly using Islamic banks for their day-to-day banking activities, so they are turning to sharia-compliant investments for their longer-term needs and retirement funding.
Some of South Africa's major financial institutions now offer such investments, both for institutional and individual investors, and there is a variety of products on offer from smaller asset managers. These range from retail unit trust funds - and even a sharia-compliant exchange traded fund - to pension funds and retirement annuities (see "What the investment houses offer", below).
Several issues confront the sharia-compliant fund manager, who must work within the guidelines laid down by the fund's sharia board. These are: in which companies may I buy shares, and in which other asset classes, apart from equities, may I invest? Within these parameters, how can I achieve a well-diversified portfolio, thereby managing risk?
Equities form the major portion of most sharia-compliant portfolios. But managers may invest only in companies that are sharia-compliant in their line of business (see under heading "Sharia principles"). In screening companies, financial criteria are also taken into account. These concern how much debt a company holds and how much of its own investment income is not sharia-compliant.
Aadila Manjra, who manages the Stanlib Shariah Equity Fund, says equity selection is clear-cut: "There are very clear, pre-set guidelines that the fund adheres to. These include both sector exclusions and stringent financial ratios. The financial ratios screen for companies with excess debt, accounts receivable and interest income. I like to think of this as some sort of a risk management measure, especially the debt test, which helps to highlight companies that could run into financial stress. Our investment process involves purchasing quality companies with distinct competitive advantages and a significant margin of safety. This also aids in risk management."
No equity investment will render income that is totally sharia-compliant - at least a small portion of it is bound to derive from interest. Ebrahim says this "impure" income, which, in the case of Oasis normally amounts to less than one percent of annual returns on an equity fund, is set aside at the behest of the sharia board and donated to charity.
Like Manjra, Ebrahim subscribes to the approach that by selecting only good quality, financially stable companies you offset the risks traditionally associated with equities as an asset class.
"If you have companies with reduced debt," Ebrahim says, "it substantially reduces the risk for your portfolio. Yes, there are times - when interest rates are coming down - when highly indebted companies may outperform ... but the real advantage comes in the fact that there's less debt, so you have a lower incidence of problem investments."
Also, the fact that Islamic investing is ethical, Ebrahim says, adds to the stability and long-term viability of the investment. " are supposed to treat people in a friendly way, so litigation risk is largely mitigated. In a world where you treat your people poorly, they may go on strike, it'll affect your customers ... so if you operate ethically, over the medium to long term, you may have much higher productivity. And if you operate in an environment-friendly way, you're going to have less issues around complying with increasingly harsh environmental rules, because it becomes part of your ethos.
"So the incidence of lower debt, hard assets, and being ethical substantially reduces the risk profile over the cycle. And our experience is that although the return profile may be different, we haven't compromised returns at all."
Looking at the other asset classes, fund managers may invest in property, because there is a tangible asset behind the investment, and in commodities such as precious metals. But they may not invest in conventional bonds or the open money market, which are interest governed.
Sharia-compliant equivalents of both bonds and cash instruments are now available to investors. A sukuk is a form of bond backed by tangible assets (see "Sukuks and the Dubai crisis", below), and deposits at Islamic banks are acceptable as an alternative to conventional money market investments.
The Stanlib Shariah Equity Fund, for example, is currently invested about 85 percent in equities and about 15 percent in cash. For the cash portion of the portfolio, Manjra says, "we invest in Islamic term deposits and savings accounts that work according to the sharia principle of murabaha. This means that instead of earning interest on our invested cash, we actually earn a predetermined profit mark-up."
Regarding precious metals, Manjra says the NewGold ETF, a non-interest product that invests directly in gold bullion, is sharia-compliant. However, she says her fund's investment philosophy prevents it from investing in gold. "Our investment process is bottom up and we do not attempt to predict different economic scenarios. Investing in gold is essentially a call on the economy," Manjra says.
Oasis, which offers the broadest range of sharia-compliant funds to both individual and institutional investors in South Africa, and possibly the world - from local funds to global and offshore funds - has a relatively large stake in property. Says Ebrahim: "We put in place a property portfolio to ensure we have a different inflation-hedge risk profile. So that allows diversification, and that works really well, because we have a good South African property portfolio and a global portfolio."
Through broadening their product ranges to include sharia-compliant investments that also comply with regulation 28 of the Pension Funds Act (which limits exposure to equities), Oasis and other fund managers have made significant inroads for Muslims (and non-Muslims) into the South African retirement fund market. But Ebrahim says there is still a way to go because some employers and retirement fund trustees are averse to change.
"South Africa has a relatively small Muslim population, but they are relatively sophisticated, so you need to give them choice in their retirement plans, which is a democratic right. Now, increasingly, choice is in place for people to meet their needs. However, at this point, trustees have been slow to react. But if, from a company point of view, you can be seen to have modern practices of providing for your staff; if you can increasingly provide your staff with the most appropriate reward structure, the most appropriate savings for retirement, you gain a competitive advantage," Ebrahim says.
- See here for Part 2 of this story.
This article was first published in Personal Finance magazine, 3rd Quarter 2010. See what's in our latest issue