EUROPE
Response to new demographics
Most Islamic and non-Muslim countries are paying serious attention to Islamic banking. Those that are not taking urgent steps to catch the wave of growth in Islamic banking fear being left behind in attracting good inward investments and financial institutions. Much progress has been made in the UK towards launching Islamic products from high street financial institutions. This is expected to be followed by similar initiatives among 20 million Muslims in Europe, Canada and the United States. Tax implications, consumer protection act and some similar obstacles remain an issue but are solvable.
The UK has done wonders in recent years in supporting the development of Islamic banking and making allowances such as abolishing the double stamp duty on Islamic mortgages and authorising the operations of two Islamic banks. Such initiatives have encouraged the global players to set up dedicated Islamic windows within their mainstream activity. In Europe, the challenge will be to operationalise the equity considerations of the Shariah and make this mode of financing widely accepted among a constituency that transcends Muslim communities. Islamic banking has to be embraced by the wider communities to make a real commercial and practical impact and to create secondary markets in the non-Muslim countries.
The main concern is that European countries such as France and Germany have been slow to encourage the establishment of Islamic financial institutions. They are losing a lot of ground. The other main challenge is financing and creating funds to offer alternatives to the customers. Bank lending is still practised but is limited to either no-cost loans (mainly consumer loans) including overdrafts, tawarruq-basis or loans with service charges only. These types of loans bring little income to the banks; they are not that keen to engage in this activity. That leaves investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit- or loss-sharing (PLS) basis. This is the banks’ main income source and from where the investment account holders derive their profits. It is precisely the PLS scheme, however, in which the main problems arise.
SOFTWARE
How technology keeps banks in line with Shariah-compliance
With an estimated value of US$500 billion and an annual growth rate of between 15% and 20%, the global Islamic financial sector market is advancing at a rapid pace. Financial services firms and new start-ups such as retail banks, wealth management firms, investment banks and insurance comp anies have started to move into the Islamic finance market. Intense competition among these players has not only pushed up the expected service level but has also accelerated the development process of Shariah-compliant products. This has resulted in a demand for technological solutions that not only cater to the demands of day-to-day operations but also provides the financial organisation with a competitive advantage, such as reducing the time taken to create and deliver new products or by augmenting its service. Although the conventional financial industry is already supported by wellconfigured, stable financial systems, the Islamic banking and financial transactions necessitate technological solutions that fulfil the underlying principles of Shariah laws.
Banks are the pillars of a financial sector and some, known as universal banks, can provide all the products for the corporate and retail market. Consequently, these institutions are usually the first to seek technological solutions. Islamic banks operate in the context of Islamic law, whereby money acts as a store of value for tangible trade and financial risk is to be shared among investors and institutions. Rosie Kmeid, head of corporate communications and marketing for Path Solutions, says: “Some of the important goals [for Islamic finance] are socio-economic justice and equal distribution of income and wealth as well as stability in the value of money. Islamic banks that engage in business processes and products consistent with these Shariah precepts will safeguard Islamic communities from activities that are forbidden by Islam.” This means that all business processes executed by the Islamic bank, including delivery of the product, must be Shariah compliant. Jamil bin Hassan, an Islamic banking technology expert and principal consultant for the Islamic banking practice at i-flex solutions, says: “If the sequence to execute a contract [between the Islamic bank and customer] stipulates that step B comes after step A, a reversal of these two steps invalidates the contract. Shariahcompliance extends to the delivery of the Islamic product and this is a massive task for the respective institution.”
TAXATION
Western tax and Islamic finance
A company wishes to purchase a machine, to be delivered immediately, with a manufacturer’s price of $1,000. The machine will be useable for five years. If purchased with conventional finance, the customer will pay for this machine immediately, financed by a bank loan of $1,000, carrying simple interest at 5% per year, with all of the interest to be paid in full when the loan is repaid after two years.
If acquired with Islamic finance, the bank will purchase the machine from the manufacturer for $1,000 and resell it to the customer for $1,100 with immediate delivery, permitting the customer to only pay the bank the price after two years. In both scenarios, the customer has the same cash-flows, obtaining the machine for immediate use and paying out $1,100 after two years.
Tax law varies from country to country, and is usually complex. Assume a hypothetical tax system under which capital equipment, such as this machine, can be amortised for tax purposes, on a straight line basis, commencing only after the machine has been paid for. Tax relief for finance costs is given on an accruals basis over the life of the debt. The hypothetical tax system, developed in an environment of conventional finance, has no problems computing the tax deductions the customer is entitled to. The key principles underlying the tax treatment are that the customer has paid for the machine on delivery (even though financed by a bank loan) so the tax amortisation starts immediately, and the customer will be paying $100 interest to the bank, spread evenly over the two-year life of the loan. When the customer acquires the machine under Islamic finance, it is not paid for until after two years, and the legal contracts record no cost of finance. Instead there is the purchase of a machine costing $1,100, which is only paid for two years after delivery. There are two fundamentally different ways for the hypothetical tax system under consideration to look at this Islamic finance transaction.
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