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Seymour J. Mansfield
Founding Partner
Ronald Tan on Islamic Banking
Islamic banking-a tiny fringe experiment in the 1960s in Egypt and Malaysia--has become a powerful and growing sector of mainstream consumer and business finance and investment worldwide used not only by religious Moslem people and business owners but more recently by choice by a growing segment of non-Moslems for its perceived competitive advantages.
The genesis of Islamic banking actually stems from common religious teachings of all Abramhamic religions prohibiting the charging of interest by money lenders. Judaism first (in the Torah), followed by Christianity (in the Bible and early Church doctrine) and then Islam (in the Koran) all condemned the charging of interest for use of mere money. Indeed, usury until the 16th Century was illegal as the charging of any interest or fee whatsoever for the use of money. Various artifices were used under the early common law to allow credit by loopholing illegal usury in English speaking countries until the 1545 Act of Henry VIII permitted the open charging of interest and fees on loans. Today, in the United States and Europe, usury laws do not ban all interest charges. The categorical religious proscription has been abandoned, in favour of a confounding crazy quilt of laws which determine whether or not there are any maximum interest rates or fees and which vary dramatically by state, country, type of lender, type of borrower, the use and amount of the loan, and other factors.
That bridge from outright ban to regulation has never been crossed by Islam and the corresponding rules of the Shariah, which prevail either by law or by religious influence in countries where Moslems are in the majority and by the strict practices of devout Moslems where they are minority populations. Today, there are an estimated 1.25 billion practicing Moslems worldwide; they are majority populations in many countries in the Mid-East and South Asia, and they are large and growing immigrant populations and new citizens in Europe (now estimated at 20 of 450 million in the EU) and the Americas (estimated at 6 to 7 of 307 million in the US). Thus, it is no wonder that the demand for a system of finance serving the same purpose as conventional banking but meeting the prescripts of the Shariah and the Islamic rules regarding such transactions (Fiqh al-Muamalat), has made Islamic Banking a permanent and growing sector of the consumer and commercial finance system worldwide. Islamic Banking and investment from its humble beginnings in the 1960s now encompasses more than an estimated 350 banking institutions and over 250 mutual funds, and also many conventional banks and investment funds have now established lending and investment programs complying with Islamic principles.
In the US, this is most visible in and around Detroit, Michigan and Chicago, Illinois, driven by Moslem admonitions against paying or earning interest. Strictly interpreted, the rules make it tough for a devout Moslem to buy a house (traditional mortgages are off-limits), finance a major purchase (no credit cards), or put together a diversified portfolio (no bonds). Investing in stocks is limited as well: companies involved in forbidden activities (such as lending, gambling, and serving or making alcohol) are prohibited. While Islamic law does make exceptions to the ban on interest, if one's family is at stake, the exceptions are open to complex and controversial interpretations.
Thus, closer to this Firm's home state, right here in Minnesota, to help narrow the home ownership gap among Moslem immigrants, the Minnesota Housing and Finance Agency is the first US state housing agency to launch a program offering Islamic mortgages for carefully qualified low-to-moderate income home buyers. The state buys and resells a home to the buyer at a higher price, and the Islamic compliant mortgage loans are underwritten by Chicago-based Devon Bank, one of the largest Islamic lenders in the US. The down payment and monthly installments all mimic the payments of a thirty-year fixed-rate loan, except there is no interest, because the higher up-front price already has built in an implicit market rate interest factor.
Given its growing and significant place in mainstream finance and investment internationally and in the US, in order to better understand the religious and legal underpinnings of this burgeoning economic phenomenon, we are pleased to present the following primer on Islamic banking and financing, authored by my colleague and legal scholar, law partner Ronald Tan of Tay & Partners - our Kuala Lampur, Malaysia based fellow member of Lawyers Associated Worldwide (LAW).
Although Malaysia represents it is a country of only 27 million, and has only a 60 % Moslem population, Malaysia was the leading pioneer of Islamic banking and today leads the world in Islamic banking and investment. All its conventional banks and finance companies also are allowed to offer Islamic banking products to Moslem and non-Moslem customers alike, but funds and activities must be segregated and not co-mingled. As of August 2009, Standard & Poors reported that Malaysia was the biggest issuer of Sukuk, Islamic bonds, comprising over 45% of the US$9.3 billion in 2009 issuances. As Business Week observed in 2005:
Malaysia has positioned itself as the Mecca of Muslim finance. That has given it bragging rights in a region where it has long been overshadowed by established financial hubs such as Hong Kong and Singapore.
Ronald graduated with a B.Commerce (Economics) in 1994 and an LL.B in 1996 from Monash University, Melbourne, Australia. He was admitted as an Advocate and Solicitor of the High Court of Malaya in 1997.
Heading the Firm's Debt Capital Markets practice, Ronald specializes in both equity and debt capital practice. His capital markets expertise has been recognized in Asia Law Profiles 2005-2006, the International Financial Law Review's 'The Guide to the World's Leading Financial Law Firms' in 2004, and the Martindale-Hubbell's International Law Directory in the same year. Ronald's experience also extends to top-tier corporate law and cross-border M&A, in which he has advised numerous blue chip and Fortune 500 multi-national companies. He has also conducted various seminars on Capital Market Reforms, Islamic Bonds, REITs and Investments in Malaysia.
A Primer on Islamic Banking
Ronald Tan, Partner
Tay & Partners
There is still a common misconception that Islamic banking is only available to Muslims or at best, is limited only to micro-finance and retail loans.
Far from it; Islamic banking is available to all investors and nowadays encompass the entire range of banking and financial products and services including sophisticated capital market instruments such as structured bonds and hedging. The Islamic banking industry also includes the fast growing Islamic fund and insurance (takaful) industry.
The Islamic finance market is a highly lucrative market estimated at US$360 billion globally and growing at 15% annually, albeit beginning from a lower base than conventional banking and finance. With the global economy still reeling from the worse recession since the Great Depression, Islamic banking and especially Islamic capital market products are increasingly looked upon as an attractive alternative source of fund raising.
What exactly is Islamic banking?
Islamic banking simply means banking and finance which adhere to the rules and principles of Islamic law (Shariah). One of the chief principles of Shariah law is the prohibition against the charging of interests. Interests on loans are viewed as usury; Islamic finance is therefore commonly structured instead along the lines of trade sales or investments where profits/margins derived from such sales or investments are permissible.
Another feature of Islamic finance is the requirement that it must be asset-backed. The conservative nature of Islamic finance was credited for the relatively low default rate among Islamic loans and bonds even during the height of the global financial crisis.
Other principles include the prohibition against involvement in "sinful" activities such as the production of tobacco, alcohol and weaponry. Viewed in this light, Islamic finance may be considered as a form of ethical financing.
Islamic bonds
Islamic bonds and conventional bonds differ in the way the bonds are structured. Islamic bonds commonly known as Sukuks must comply with the rules and principles of Islamic law which prohibit the charging of interests.
The additional layer of structuring typically involves an underlying asset-backed transaction (this is usually real estate although commodities and receivables have also been utilized). The issuer and investors of the Sukuks will pre-agree the profits/margins/return, providing certainty to both parties and to the transaction.
The Sukuk holders will hold an undivided beneficial ownership in the assets and are entitled to share in the profits generated from the Sukuk assets or the share in the proceeds from the realization of the assets. This differs greatly from a conventional bond where bondholders do not have ownership rights over the issuer's assets but merely possess collateral/security interests. It provides greater security for the Sukuk investors given that there are actual assets underlying the Sukuk. In light of the recent financial crisis which was caused by toxic debts which were premised on debts supported by a house of cards, this makes Sukuks increasingly appealing to both Muslim and non-Muslims investors.
The popularity of Sukuk has seen issuers as diverse as the Saxony-Anhalt State in Germany (they issued a €100.0 million Sukuk in 2006) and Sukuks are gaining popularity as a safe investment by conventional banks, insurance companies and funds.
Financial crisis
The Islamic finance industry was not spared from the ripple effects of the global financial crisis. Although it was initially viewed as an oasis of sorts from the financial crisis because of its asset-backed requirements and conservative nature of investments, the crisis eventually squeezed credit from the Islamic finance system.
Despite that, signs are emerging that the Islamic finance industry has weathered the storm and are rebounding. The London Stock Exchange has recently welcomed a US$750 million Sukuk issued by CBB International Sukuk Company (No.2) on behalf of the Government of Bahrain. This is the first Sukuk to be listed in Europe in year 2009 and it highlights London's standing as a key global venue for Islamic finance.
Further, more and more non-traditional Islamic financial centres such as Singapore and Hong Kong have begun to jump onto the bandwagon and have declared their intentions to become Islamic financial centres.
Malaysia
Notwithstanding the emergence of these new financial centres as well as the financial centres in the Middle East, it is an indisputable fact that Malaysia has always been the market leader in Islamic finance. It has an enviable 30 year track record in Islamic finance with the full complementary tax and regulatory regime firmly in place.
Malaysia is the world's leading issuer of Sukuks and has the world's largest Islamic bond market. In Standard & Poor's Ratings Services recent report published on 2 September 2009, it was noted that Malaysia accounts for 45% of the global Sukuk issuances in the first seven months of 2009 and is the leading country of Sukuk issuance.
To cement its market leader position, the Malaysian Islamic Financial Centre (MIFC), a joint initiative by the Central Bank and the Securities Commission, was launched in 2006 to develop and internationalize the Malaysian Islamic capital markets. Efforts were made to attract foreign issuers to issue Sukuks from Malaysia. Eligible foreign issuers such as sovereigns, quasi-sovereigns, multilateral development banks, multilateral financial institutions and multinational corporations can issue bonds in Malaysia.
Issuers are also given the flexibility to issue their bonds either in Ringgit/RM (the official currency of Malaysia) or in any foreign currency of their choice. Interestingly, when the US dollar slid in 2008, foreign issuers had opted to issue their bonds in RM and did not mind incurring foreign exchange costs when converting it into US dollar. For example, in 2008, 3 foreign banks issued their bonds in RM. The State Bank of India and the Export-Import Bank of Korea issued RM500.0 million and RM1.0 billion bonds, respectively. Whereas the Industrial Bank of Korea upsized its original RM600.0 million bonds to RM1.0 billion (approximately US$320.0 million).
Recently, on 22 June 2009, Hana Bank of South Korea issued bonds of approximately US$284 million.
Growing market
While the Islamic finance market still lags behind conventional debt markets in terms of size, we are seeing increased interests among foreign issuers to explore issuing Islamic bonds in Malaysia. The Asian economies are still growing and require much needed funds to sustain their growth. But in this current environment of global credit crunch, sources of funds are harder to come by and this has resulted in companies being prepared to seek alternative cost-effective fund raising avenues such as Islamic finance.
