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Tuesday, 4 June 2013

Bringing benefit to mankind by staying true to Shariah in Islamic banking

Last week, Shariah scholars from across Asean congregated in Singapore for the annual “Muzakarah Cendekiawan Shariah Nusantara” organised by the Malaysia-based International Shariah Research Academy for Islamic Finance.

This wonderful annual event brings regional industry players, Shariah scholars and regulators together to exchange views on the practical applications of Shariah in the Islamic financial market.

I thought I should pay homage to the muzakarah in my column by discussing this year’s talking points centred on fees and charges chargeable in Islamic finance. I will focus the discussion here on the most important issue that keeps every industry player awake at night, which is the charging of an Islamic bank’s financial costs to customers.

Currently, any cost that is considered to be financial in nature is not accepted as real or actual cost of the bank, and therefore has not been allowed to be charged to customers by many learned Shariah experts.

It has been said that financial cost in the form of the forced unwinding of hedging and funding arrangements arising from the early termination or default of a fixed rate financing is not an actual cost because many see it as an opportunity loss rather than an actual loss to the bank.

Many make the assumption that every non-consummated fixed rate Islamic financing contract is replaceable with an equivalent transaction immediately. Many say that the hedge is something that the bank has to do anyway as part of prudent business undertaking, so it should not claim from customers. Many forget that the bank had to enter the hedging because the customers demanded an affordable fixed rate, long-term Islamic financing. Without the hedging, the cost of the financing to the customer would be more expensive.

Worse, many seem to have forgotten that Islamic banks do not give loans like conventional banks. An Islamic bank gives financing but it is done by way of a real trade contract. If the trade contract is unreal then it would not have attracted double stamp duty, real property gains tax or other relevant tax to the extent that the Islamic bank requires tax neutrality be provided under law by the government in every tax jurisdiction.

This blinked view of the situation caused many Islamic banks to absorb the losses suffered due to the inability to charge a break funding fee.

I guess this is the true problem statement. This makes Islamic banks totally inefficient and disadvantaged compared to conventional riba-based bank. Globally, this is one reason why Islamic banks’ return on equity is, on average, inferior to conventional banks’ with a few exceptions like Al-Rajhi Bank in Saudi Arabia and CIMB Islamic Bank Bhd in Malaysia.

Islamic banks are licensed to do banking business. Some Islamic banks in Asean do carry a universal banking licence but most are just licensed to do traditional regulated banking activities such as taking deposits and providing financing to customers.

Under such approved activities, the full set of banking business requirements have to be fulfilled by Islamic banks for them to fulfill their obligations under the licence. Any intervention that interrupts this would be detrimental to Islamic banks and causes many to fail the fundamental objective to facilitate financial inclusion and effective distribution of wealth.

Generally, financial costs are real costs of the Islamic banks in doing their function as the mobilisers of funds. Real costs in Islamic banking business can be easily equated with the real costs under non-financial businesses. Although Islamic banking business is purportedly a financial business in nature, it does carry the same financial costs as any normal trade that is non-financial in nature.

An exporter of goods may enter into a hedging contract to mitigate the risk of the sale arising from currency risk, funding risk and so on, in the event of cancellation, early payment or default of the sale contract and to provide best pricing for the buyer. They may also enter a specific funding arrangement just because of the specific purchase by the buyer.

Based on fair trade practice and a willing buyer, willing seller basis, the exporter could charge a break fee to discourage or to incentivise the buyer not to cancel, early pay or default the contract. There is no known Shariah reason to prohibit this, even from an ethics’ perspective.

Financial costs such as break funding costs caused by the unwinding of risk management tool for the trade entered by an Islamic bank are similarly very real under banking business.

Without it, customers will never get access to affordable financial solutions, which is the hallmark of banking as a public good.

We must always remember that Islamic banking with its two-part fund mobilisation system has long been approved as activities consistent with Shariah by many qualified Shariah scholars globally. As long as there is no contradiction with clear express prohibitions in the Quran and legitimate Hadith, any activity under the Islamic banking practice that is a prerequisite business requirement, should not be disallowed and continue to be disallowed.

I believe one cannot invite someone for dinner and then say he can eat the food but cannot drink, or worse, he can chew the food but cannot swallow. Such invitation is incomplete. The same incompleteness exists when allowing a licensed Islamic bank to do Islamic banking business but not allowing it to charge the consequential financial cost it has to incur to make it affordable to the customers.

Having said all of the above, many would still have difficulty accepting the need to allow an Islamic bank to charge financial cost. However, going back to basics, what right does anyone have to deny a seller of goods (in this case Islamic banks) the ability to get the full selling price that has been contracted with the buyer (ie the bank’s customer) if all conditions are met? The answer here is none. I would even go as far as saying it compromises the very basic principle of Muamalat. Of course this does not preclude the bank from giving rebate or discount.

An Islamic bank has the absolute right to the full sale price of a trade contract so the discussion on break funding cost rightly is superfluous in the first instance. However, we are forced to discuss it because people have accused Islamic banks of doing interest-based lending business.

We should never lose the plot of what Islamic banking business is all about. People need to stop this misplaced accusation against Islamic banks when fundamentally it is not and cannot do so under Shariah.

A forced lifting of the veil in the underlying transactions to supposedly expose the purported characteristics of the Islamic banking instruments will only defeat the very purpose of the original application of Shariah principle to provide traditional banking services to principally alleviate poverty among the two billion Muslims globally. If murabahah transaction is stripped off from murabahah financing for example, what is left is the outright lending with the charging of interest, which is unlawful under Shariah.

The net effect might be the same, but financing or monetisation using proper Shariah trade structure is very different from conventional riba-based financing. The former, which is trade, is encouraged under Shariah, while the latter, which is riba, is clearly prohibited.

The confusion between the two is already foreseen in the Quran.

All in all, Islamic banks undertake trade as approved banking activities under financial regulation allowing its customers to own, say a house or a car on fixed term and deferred payment basis. Islamic banks do have flexi rate financing but the issue of financial cost charges is not relevant. The financial cost arising from any hedging or funding arrangement entered to allow an Islamic bank to sell a house or a car on an affordable, fixed-term basis is typically built into the financial obligations of the customer under the underlying Shariah based contracts.

I sincerely hope my hoopla here on the issue of chargeable fees and charges in Islamic finance helps elicit a deeper thought process and brings us back to the reality of the issue. There are many things that we do not know and not sure of but if we stay true to Shariah, we will not lose sight of the ultimate objective of Shariah, which is to bring benefit to all mankind and prevent them from harm.

In the end, not allowing the charges of financial cost within the sale price under a sales contract entered by an Islamic bank with a customer brings more harm to society than good.

Just remember that Shariah has always given the right to the full sale price to a seller of goods to start with but some of us in the context of Islamic banking business seem adamant to change the rule of sale, that has stood for millennia, to the detriment of the Islamic finance industry.

(The Malaysian Reserve / 03 Jun 2013)

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