Issue #9 summary

If there’s a will, there’s a way
Shariah-compliant asset management has to address a number of issues to match the sophistication of Western models, writes John A Sandwick. But the Muslim world has faced harder tasks
In 1952 the economist Harry Markowitz first published his treatise on modern portfolio theory (MPT), which later led to him winning the Nobel prize with Merton Miller. MPT is at the heart of every professional asset manager’s basic investment strategy. First and foremost among Mankowitz’s findings was the need for diversification of assets. As the saying goes, you buy a portfolio, not a security.
We now have other important tools for asset management: Sharpe’s capital asset pricing model (CAPM), and Tobin’s development of the concept of the efficiency frontier, to name two.
These models were developed in the West, using observations of changes in market prices and volumes of publicly traded securities. They are deeply embedded in the thinking behind professional asset management in nearly all the world’s markets. They underlie the basic concepts used by investment managers to create and execute their investment strategies.
By comparison, the Islamic banking community has delivered almost nothing of value to professional asset managers—whether inside or outside the Muslim world—in terms of investment products that permit the construction of modern portfolios that responsibly meet client needs. Professional Islamic wealth managers are at a loss. How do we construct an efficiency frontier? What data goes into the capital asset pricing model? Where can we go to find securities that will fit into modern portfolio theory?

European progress at crossroad
Growing Muslim communities internationally has led to the call for more Islamic banking services. In Europe the response has been mixed, but signs are favourable. Waheed Qatar gives his analysis
Most Islamic and non-Muslim countries are paying serious attention to Islamic banking. Those not taking urgent steps to catch the wave of Islamic banking growth fear being left behind in attracting good inward investments and financial institutions to their countries.
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 solvable.
The UK has done wonders in recent years in supporting the development of Islamic banking and also making allowances such as abolishing the double stamp duty on Islamic mortgages and authorising the operation 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 which 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 many European countries (such as France and Germany) are reluctant—or not interested—to encourage the establishment of Islamic financial institutions. They are losing a lot of ground.

Surplus is the policy’s ‘soul’
The ownership of surplus and its final disposition are the soul of an insurance transaction, argue Omar Clark Fisher and Khalil Ghneim, as it confirms the essential relationship among the risk-takers
If the “heart” of any insurance transaction is the risk protection element, then surplus can be labelled the “soulful” element. While there does exist a savings element in some types of insurance, typically people enter into insurance transactions to share risk exposures and minimise personal losses.
Many purchasers of insurance seem indifferent to the model of insurance on offer, either due to a lack of knowledge or a preoccupation with the end product itself­—that is, coverage protection. However, the model determines many aspects of the relationship between the insured person and the insurer, which is accepting the risk, including a final disposition of surplus. The assumption for this magazine is that a takaful model of insurance applies.
So, what is “surplus”? A typical insurance transaction consists of contributions (premiums) paid into a “risk pool” or insurance fund from which
l claims or benefits are paid out to the contract holders (policyholders) as per the terms of the contract (policy)
l administrative and management fees are charged or deducted, and
l any reinsurance or retakaful risk-sharing costs are deducted.
In cases where the takaful operator retains risk, surplus can arise at the primary and reinsurance level out of the funds that may be retroceded. In a takaful contribution there are three basic elements: risk protection or mortality risk, management fees (wakala or mudarabah); and reserves for incurred but not reported claims (IBNR).
If the contribution is linked to a savings plan, then there is a fourth element for investment purposes. That portion of the contribution as risk is designated as tabar’ru (“donation”) and accumulates in a risk pool out of which claims or other types of mutual assistance are paid to policyholders as needed.

Attacking inflation on capital
Inflation devalues money daily. ALM Abdul Gafoor discusses a method for measuring inflation
appropriate to inflation on capital, estimating and compensating the realised loss of value suffered by capital—protecting both lender and borrower transparently and equitably—and separating riba from interest, helping Muslims to keep away from riba without suffering loss to their capital
The rate of inflation is so similar to the interest rate that the bank has simply to increase it by an estimate to accommodate all parties: the bank, the depositors and the borrowers. However, as this is only an estimate and is made at the beginning of the term of the deposit (or the loan), it may well turn out to be an overestimate of the inflation rate realised during the term or an underestimate. In either case, one of the three players is going to bear the loss at the expense of another, as no corrective step is taken.
In my book, Commercial Banking in the Presence of Inflation, existing measures, such as the consumer price index, were considered inappropriate for mirroring the effect of inflation on capital. But a solution was devised in a study to determine realised inflation in the interest paid (or charged) by the bank.
The study was spurred by the special concerns of those who abhor receiving interest payments for religious or other reasons. When they reject the paid interest, they reject the little compensation for inflation contained therein, resulting in their capital losing some of its purchasing power. It is as if they are being punished for their religious (or other) conviction, and for their desire to act on it. This, too, is unfair.

Clarity and standards underpin growth
Greater transparency and standardised accounting principles constitute the two main legs of enhanced financial reporting practices necessary for Islamic finance to reach the recognition it will ultimately have, writes Anouar Hassoune
Islamic financial institutions (IFIs) operate regionally, nationally and internationally and tend not to speak the same financial language. IFIs have not adopted a single financial reporting framework, and it is difficult without microanalysis of their accounts to reconcile the information into a single comparable set.
International Financial Reporting Standards (IFRS) constitutes the only financial reporting framework adopted that has vague global recognition and could help cross-border comparability of financial reports, but IFIs have yet to adopt it across the board.
IFRS is better suited to conventional financial activities and is incapable of capturing all the subtleties and specificities of Islamic banking and translating them into a shared language.
Islamic banking and finance jargon, reflecting the specific nature of Islamic contracts, does not easily lend itself to standards that take the perspective of the economic nature of banking transactions, such as loans, investments, placements and fixed assets rather than its contractual aspect: ijara, istisna, murabaha, and musharaka.
Divergent interpretations of IFRS might also cause inconsistency across countries. Kuwait Finance House (KFH; A-/Stable/A-2) and Dubai Islamic Bank (DIB) both apply IFRS, for example. KFH, however, recognises IAS 39-related fair-value adjustments on its available-for-sale portfolio on the liability side, but not in equity, unlike conventional banks. DIB recognises these adjustments directly through its income statement, and not in equity.