Applied Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

As a predominant Muslim nation and with the government’s continuous support and laudable initiatives to develop the Malaysian Islamic capital market, the potential for the development of Shari’ah-based Islamic products is enormous.

Today, various capital market products are available for Muslims who only seek to invest and transact in the Islamic capital market. Such products include the list of the Commission’s Shari’ah Approved Securities, Islamic debt securities, Islamic and Shari’ah Indices, warrants and Islamic unit trust.

The Islamic unit trust refers to the market where the activities are carried out in ways that do not conflict with the conscience of Muslims and the religion of Islam. In other words, the Islamic unit trust represents an assertion of religious of law in the capital market transactions where the market should be free from the involvement of prohibited activities by Islam as well free from the elements such as usury (riba), gambling and ambiguity (gharar).

The Islamic unit trust is one of the components in the overall capital market in Malaysia. It plays similar important role as other unit trust in generating the economics growth of the country. The Islamic unit trust has functioned as a parallel market to the conventional unit trust for capital seeker and capital providers, and has played a complementary role to the Islamic banking system in broadening and deepening the Islamic financial market in Malaysia.

As the market becomes more complex and sophisticated, it must possess adequate infrastructure to enable the system to operate and function more efficiently and effectively.

A unit trust is a collective form of investment whereby the financial resources of individual and corporate investors are pooled for the purpose of making larger-scale investments in a selected portfolio of securities.

As an investor, one can subscribe to any units which are equal in value in a unit trust fund. He / She will not only enjoy the earning potential of a large - scale investor but his risk of investment is also spread out over the broad selection of securities. Categories of unit trust funds are as follows:

Income fund
Equity
Growth
Bond funds
Islamic funds
Cash and management funds
Small capital fund

A unit trust scheme can be illustrated as a tripartite relationship between the Manager, the Trustee and the Unit holders. This tripartite relationship is governed by the Deed.

Small amounts required for investment
A Unit Trust Fund allows an investor to participate in a professionally managed portfolio of investment without having to expose a large sum of money through direct investment in securities. The investor can reap better returns from a portfolio of investments as opposed to the limited number of securities if one were to invest individually.

Spread of risk
The investor can obtain a much wider diversification of risk through a unit trust fund which invests in a large number of securities. This spread is possible because of the combined financial resources of a large pool of investors.

If an investor were to invest directly in the stock market and put all his money into one company, he could lose all of it if the company were to go into liquidation. But with unit trust funds, the loss would be minimized because investors' money are pooled together and invested in a diversified portfolio to spread the risk.

Professional fund management
With a unit trust fund, investments are managed by professional fund managers who have access to specialized research and stock market information and analysis.

Liquidity
An investor can realize all or part of his unit holdings on any business day.

POTENTIAL RISKS

Just like any other form of investment, unit trust funds also carry some risks. Risk is the term used to describe the extent to which any form of investment may fluctuate in value.

Factors that May Affect The Value of Unit Trust

These include overall stock market condition, interest rates fluctuation, stability of local currency, general economic environment and the Unit Trust Manager's capability. And while a track record may provide some insight on future performance, it is by no means guaranteed. The prices of units may go up as well as down. Likewise, income distributions may vary from year to year depending on the performance of the fund.

Stock market risk
The value of the fund's investments is subject to the fluctuation of the stock prices it invests in and the performance of other securities.

Individual stock risk
The performance of each individual stock that a fund invests in depends upon the quality of management of the particular company and its growth potential.

Fund management risk
Poor management of the Fund may jeopardize the investment of each Unit holder. Therefore, it is important to set investment objectives, policies and appropriate strategies before any investment activities can be considered.

Currency fluctuation risk
As for unit trust funds that invest overseas, fluctuations in the denominated currencies of the foreign shares and debentures may affect the price of the units.

Country risk
The stock prices may be affected by the political and economic conditions of the country in which the stocks are listed. Careful consideration shall be given to risk factors such as liquidity, political and economic environment before any investments are made in a foreign country.

The Islamic Unit trust scheme is collective investment funds which offer investors the opportunity to invest in the diversified portfolio of Shariah-approved securities that are managed by professional managers in accordance with the Shariah. The Islamic unit trust scheme are required to appoint Shariah committee as stipulated in para 6.4.1 of “ Guidelines on Unit Trust Funds” to ensure that their operations are in accordance with Shariah principles. The schemes are available in many forms such as Islamic equity funds, Islamic bond funds, Islamic index funds and others

The primary objective lies in achieving the Islamic objectives of doing business or investing. As Islam prohibits interest and injustice in investment, our Islamic Unit Trust Investment ensures Muslims to avoid prohibited (Haram) means to earn income and depart from the traditional interest based investment and at the same time ensuring an income mean in a way which is allowed (Halal) in Islam. The secondary objectives are listed below.

To invest the fund in undervalued equities and other shari’ah consistent investments which are able to offer relatively good and safe long – term capital growth potential.

To optimize net of tax returns to its investors by ensuring the most of the gains achieved are in the form of capital appreciation rather than income distribution or fixed – income returns.

To enhance the safety of the trust and the preservation of its capital by ensuring that as much of the fund is invested in well researched blue – chip counters which are trading on the KLSE at below its estimated intrinsic value; and

To optimize the return on investment and safety of the trust by using relevant and timely economic and market research for the purposes of allocating funds in to the Malaysian capital market, such that when the KLSE is perceived to be undervalued, a greater portion of the trust will be invested in equities and vice – versa in the case of Islamic fixed-income and money markets.

To provide an easy way for those who are interested to participate in the Malaysian capital markets in Shari’ah consistent manner but do not have the time nor skills to do the fundamental research and to gather relevant information to guide their investment decisions.

To enhance the role of the Muslims in society through greater participation in the economic life of the nation. Specially to enhance the role of Muslim women who have a high level of financial independence. Consequently it will enable them to meet their financial concerns as wives, parents, as well as caring citizens.

The assets of the Trust will be invested in a diversified portfolio of Shari’ah consistent equity and equity-related securities. These may include bonds, convertible bonds and warrants as well as short-term money market instruments when Shari’ah consistency can be established. In addition, the trust may invest in unlisted securities and other forms of investments where considered consistent and relevant with the investment objectives of the Trust.

The trust has the policy of providing opportunity for all individual, private limited companies, corporate bodies, societies, co- operatives, associations and other entities to invest in the Islamic Unit Trust.

The trust has a strict policy of having well diversified investment portfolio in the Malaysian capital markets with a relatively low risk profile. This is to ensure that the investors are taken care from risky investment. Also to gain reasonable returns through both capital appreciation and income distribution on their investment over a long period of time. And finally to have access to easy liquidity I realizing their investment into cash.

If someone deposits his property as a trust with someone trust worthy person, he is duty bound to look after this property as just as he would look after and protect his own. A man who keeps someone’s property in trust is Amin, a trustworthy person. Because of his integrity, honesty, sincerity and faith in Allah (swt), he does not devour another’s wealth by false or illegal means nor does he change someone’s superior things for something inferior. The holy prophet’s life offers us the best model as even those people who had not accepted Islam because of his great qualities as a trustworthy man gave him an honorific title Al-Amin. Even on the day of Hijrah from Mecca to Madinah, he made sure and handed over all the trust property to his cousin, to return to their rightful owners.

“Allah does command you to render back your trusts to those whom they are due; and when you judge between man and man, that you judge with justice. Verily, how excellent is the teaching, which He gives you. For Allah is He who hears and sees all things.”

The trustee is charged with a great responsibility in Islam. His duty is to guard the interest of the person on whose behalf he holds the trust and to render back the property and accounts when required according to the terms of the trust. This duty of keeping trust is linked with the sanction of the Religion of Islam, which requires a higher standard than even stipulated by common law. The Qur’an says:

“And if one of you deposits in trust a thing with another, let the trustee (faithfully) discharge his trust, and let him fear his Lord.”

The Islamic concept of life is such that all our human life in this world must be lived as in the presence of Allah (swt) who sees all our actions, knows fully our thoughts and intentions. Any breach of trust or bad intentions will be accounted for, if not in this world, on the Day of Judgment. The Hadith of the prophet enumerates the signs of the hypocrite, one of which is a man who becomes dishonest in the matter of trust deposited with him:

“ The signs of the hypocrites are three: when he speaks, he lies; and when he makes a promise, he breaks it: and when he is charged with a trust, he becomes dishonest.”

The Qur’an injunction further emphasizes upon keeping the trust in the following words:

“ O ye that believe betray not the trust of Allah and the Apostle, nor misappropriate knowingly things entrusted to you.”

The trust referred to in this verse may be of various kinds: (1) property, goods, credit, etc. (2) plans, confidences, secrets, etc.; (3) knowledge, talents, opportunities, etc.; which we are expected to use for our fellow men. Men may betray the trust of Allah (swt) and his Apostle by misusing property, or abusing the confidence reposed in them or the knowledge or talents given to them.

The forth Calif, Ali (RA) is also on record as having held craftsmen and traders responsible for the loss of goods that were placed in their custody. This he considered to be for the maslahah of the people so that traders should take greater care in safeguarding people’s property.

Secondary source: Ijmak, Qiyas, Maslahah and other source that are in line with Shariah.

The general criteria adopted by the Shariah approved committee (SAC) in evaluating the status of the companies include following:

Operation based on riba (interest) such as activities of financial institutions like commercial and merchant banks and finance companies;
Operations involving gambling.
Activities involving the manufacture and/or sale of haram (forbidden) products such as liquor, pork and meat not slaughtered according to Islamic rites; and
Operation containing elements of gharar (uncertainty) such as conventional insurance business.

For companies with activities comprising both permissible and non-permissible elements, the SAC applied several additional criteria, which are:

The core activities of the company must be activities, which are not against the Shariah as outlined in the four criteria above. Furthermore, the haram element must be very small compared with the core activities.
The public perception or image of the company must be good; and
The core activities of the company have importance and maslahah (benefit in general) to the Muslim nation and the country, and the haram element is very small and involves matters such as common plight, custom and the right of the non-Muslim community, which are accepted by Islam.

The SAC also takes into account, the level of contribution of interest income received from conventional fixed deposits by the company, as part of the criteria in the analysis of the approved securities.

From the above data, we can say that the overall performances of conventional and Islamic unit trust are likely the same. Some of them doing very well and some in the other way.

We also can see that the counter for Islamic trust is nowadays more than half of the conventional unit trust. It give us picture that Islamic unit trust are getting popular in Malaysia

The Islamic private debt securities (PDS) are structured based on the specific contract of exchange of Shariah approved assets. Such contract can be made through the sale and purchase of an asset based on deferred payment, leasing of specific assets or partition in joint-venture businesses. Hence, the issuance of Islamic bonds is not an exchange of paper for money with the imposition of an interest but rather an exchange of Shariah approved asset for some financial consideration applying various Shariah principles such as bai’ bithaman ajil (BBA), murabahah, ijarah, mudarabah and musyarakah that allow the investors to earn profits from the transactions.

The issuance of Islamic PDS is regulated by the Securities Commission (SC) through the framework provided under the Guidelines on the Offering of Private Debt Securities. Hence, as stipulated in the guidelines, the structure of Islamic PDS must be confirmed and approved by a Shariah adviser who is appointed by the issuer. A Shariah adviser can be an independent Shariah adviser who has been approved by the SC or a Shariah committee attached to the financial institutions that carry out Islamic banking activities approved by the central bank.

The shari’ah advisory council resolves that the benchmark used, as a guide in price determination does not contradicts shari’ah based on siyashah iqtisodiyyah, which is an economic ruling. It acts as a reference for determining the price level in a more systematic way and consistent with prevailing market condition. And appropriate price level is an important feature of an Islamic market as underlined by the principle of istiqrar ta’amul. In general this principle emphasizes the importance of a market that operates smoothly based on mutual agreement of buyers and sellers resulting from a system that is transparent, fair and efficient, and where there is market integrity. Hence participating individuals are not ignorant of a market that facilitates trading activities, which fulfill their needs. To achieve this, Islam has defined the principle of Ghalat and prevented Gharar. With the establishment of benchmark, the uncertainty of pricing is minimized and the market is made more transparent and efficient.

The principle involved an a’qad for buying and selling asset whereby the price, which includes a profit margin, is agreed upon by both parties (the buyer and the seller). This concept is appropriate in structuring an Islamic bond, as the profit in selling the asset has been predetermined. The price of issued bond and yield to be earned will be determined based on the total buying and selling of asset and the Murabahah profit.

After the buying and selling of asset have been concluded according to Murabahah, the Islamic Debt securities can be structured and sold in the secondary market according to the principle of bai’ dayn

In the contact of Islamic bond, the Khazanah Nasional Berhad (KNB); institution for issuing the bond, will sell its asset in cash to a principle dealer and buys them back on murabahah. The murabahah price, which is paid in instalment, is a right to the debt for the principle dealer. The right is Haq maliy or the right on the asset that can be traded. The right to the debt which is in the form of shahadah dayn(debt certificate) can be used to obtain cash by redeeming it from the debtor upon maturity. This shahadah dayn complies with mail according to a majority of Islamic jurists and can be traded.

According to the Shafi’e mazhab, a debt that is to be sold to a third party must comply with several basic regulations as follows:

the debt must be the result of trading activities permissible in Islam and the ’aqd must be legal according to shari’ah.
the debt to be sold must be a debt of quality i.e. guaranteed to be safe and has a low risk of default. This is in the interest of the investors.

The Islamic bond also intended to be a benchmark for the current value for an asset and also the profit level. In this context the principle of bai’muzayadah can be applied. It refers to the action of the seller offering his product in the market followed by a demand of several buyers competing in offering a higher price, resulting in the seller selling the product to the highest bidder. The shari’ah advisory council had resolved that bai’muzayadah is permissible. This is based on the practice of the prophet (saw) himself. Imam Buhari has dedicated a specific topic that explains the permissibility of such trading.

SHARIAH APPROVED SECURITIES ON THE KLSE
Main Board/ Second Board/ MESDAQ Market	Approved Securities	Total Securities	Percentage of Approved Securities
Consumer Products	111	124	90
Industrial Products	234	247	95
Mining	4	6	67
Construction	60	63	95
Trading/Services	119	159	75
Properties	57	84	68
Plantation	34	44	77
Technology	21	21	100
Infrastructure (IPC)	6	6	100
Finance	4	63	6
Hotels	Nil	6	Nil
Trusts	2	4	50
Closed End Fund	Nil	1	Nil
TOTAL	652	828	79

The above list has been approved by Shariah Advisory Council (SAC) of the Securities Commission and will take effect from 26 April 2002, which have been classified as Shariah approved securities. The securities are listed on the Kuala Lumpur Stock Exchange (KLSE).

In classifying these securities as approved securities, the SAC has applied a standard criterion in focusing on the core activities of the companies listed on the KLSE. Hence, companies whose core activities are not contrary to the Shariah principles are classified as approved securities.

In order to expend the horizon of Islamic Finance, the main concern is addressing the various risk elements faced in the both the local and the international arena. In undertaking the transnational businesses, the Islamic institution faces the following main risks:

Forex exposure risk
Credit spread risk
Underlying base funding cost risk (interest cost risk)

The above risk elements can be illustrated by the following example; a Malaysian company raising a USD Islamic Financing Facility to invest in a project in Indonesia, that receives revenue proceeds in Japanese Yen.

How does the company mitigate it currency fluctuation problems through Islamic Finance methodologies? At present, most of these companies would have to turn to conventional solutions, of which most are not likely to be Shariah compliant.

Another situation, which may rise from the same example is, how can the company address the risk from its exposure to the vagaries of the money market funding rates (say the project financing was undertaken vide a “floating funding cost” Ijarah structure)?

At present, these areas are largely unaddressed vide the Islamic context due to the current absence of any Islamic financial instrument to meet the market’s requirement on this area and sadly even cross border transactions being done by Shariah compliant businesses are being undertaken vide conventional mode.

One of the greatest challenges for the twenty-first century would be to develop the vision of an alternative economic order which is the Islamic Economic System. It is very sad to note that the Muslim Ummah finds it very convenient and comfortable to follow the conventional economic systems which are created by non-Muslims for the purpose of their own benefit and tarnishing the Islam and its concepts of economy. The question arises as to while non-Muslims are able to implement a successful economic system, why are Muslims unable to implement their own system derived from the perfect religion, Islam? The answer is yes, we can implement it when the whole Muslim Ummah is united. Islamic economics have produced a body of knowledge which attempts to show how financial institutions can be established on an interest-free basis. Malaysia is one of the Islamic nations which try to implement this system. The Islamic Unit trust investment is one of the financial institutions established to achieve this goal and it has been successfully carried out. But still there are rooms to be improved for more success. As people’s perceptions and decisions are based on the material benefit, the institution has to financially perform well and it is to be constant. In order to achieve this goal, the management should have strategic plans to manage the fund in profitable ways and be competent with conventional unit trust investment. And finally, the public should be educated as to the benefits of investing in Unit Trust from the point of material benefits as well as the Islamic point of view.