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Islamic finance in 2021


Islamic Financial growth to meet environmental, social and corporate governance (ESG) and challenges to Islamic Finance worldwide

Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

Islamic finance has significant global growth potential in line with the growing worldwide movement towards environmental, social and corporate governance (ESG), given their commonalities.

Bursa Malaysia (Central Bank) Bhd chairman Tan Sri Abdul Wahid Omar said instruments that meet Shariah principles also meet with ESG requirements due to their common criteria, including legitimate underlying transactions, not speculative in nature and not harmful to mankind, the society and the environment.

“There are a lot of opportunities in Islamic social finance as we exit the COVID-19 pandemic.

“I don’t think Islamic Finance is competing with the ESG, it is very much complementary (in nature); and when ESG gains traction, so will Islamic Finance,” he said at the virtual 2021 APAC Summit.

Abdul Wahid said embracing ESG principles and committing to net-zero carbon emission goals are no longer an option but a must for corporates’ survival, noting that more than 130 countries are expected to commit to net-zero carbon emissions goals by 2050-2060.

With the continued efforts by the United Nation Principles for Responsible Investment, Principles for Responsible Banking and Principles for Sustainable Insurance, all businesses would eventually get on board the net-zero carbon emissions movement, he said.

“Given the neutrality of ESG, we hope the financial institutions would start to offer Shariah-compliant ESG products, which will then appeal to both Shariah funds and non-Shariah funds as well,” he said.

The global Islamic asset under management (AUM) has grown by 2.3 times over the last decade to reach US$140 billion as at end-2020.

Abdul Wahid said the increase in the scale of funds might be an indication of the flow of funds into emerging markets’ fixed-income funds, as a result of the search for yield and increased global liquidity.

He added Islamic funds continues to remain concentrated by domicile in three core markets, namely Saudi Arabia, Malaysia and Iran, constituting around 81 per cent of the total Islamic AUM.

Malaysia alone accounts for 29.3 per cent of the AUM, he said, noting that there is also a tremendous growth potential for Islamic funds in Indonesia as its economy would grow significantly in the next few years.

Abdul Wahid also added that in Malaysia, Shariah funds grew by 41.5 per cent over the past two and a half years to RM225 billion, equivalent to 24 per cent of the total AUM of RM947 billion.

However there is no formally accepted definition of Islamic finance. Islamic finance transactions are based on Islamic principles and jurisprudence (together, the Shari’ah) which are derived from the primary sources of the Qur’an and the Sunna. A fundamental principle of sharia is that a physical asset or tradable commodity should underpin each transaction. As a result, Islamic finance transactions are either asset-based or asset-backed. In contrast, conventional banking generally relies on a contractual liability to recover monies exchanged as loans and deposits, together with an interest margin for the lender.

While Islamic and conventional financing may initially appear incompatible, the structural issues involved are not insurmountable. One of the major differences between conventional and Islamic finance systems is the notion of interest, which is prohibited under the principles of sharia’s law. This, however, does not suggest that an Islamic bank acts as a charity institution. In Islamic finance, financing of industries deemed unlawful by sharia law such as alcohol, tobacco, weapons, pork and gambling are also prohibited.

Contracts in which one party is regarded as having gained unjustly at the expense of another are also considered invalid. Contracts which contain uncertainty, particularly in regard to one of the fundamental terms of the contract such as the subject matter, price or time for delivery, are also considered invalid. The test is whether something has been gained by chance rather than by productive effort. To ensure adherence to these underlying Islamic principles, most Islamic institutions are governed by a supervisory board of Muslim scholars who analyze the institution’s methods and operations.

A significant challenge affecting Islamic finance is the diversity of opinion as to whether particular practices or products are sharia compliant. This means that some products and services may be approved as being sharia compliant by some sharia scholars but not by others. On a global level, the approval of an Islamic firm’s products and services may also depend on the jurisdiction in which they are to be offered. This can add another layer of complication for regulators.

A second obstacle for Islamic finance has been the risks associated with the shortage of qualified Sharia’s scholars in the Islamic financial industry. Currently, financial advisors, Islamic financial institutions and their Sharia’s committees are grappling with how to structure Islamic finance to properly integrate with conventional finance. The end result has been the development of a cumbersome and document-heavy structure that in many respects mimics conventional financing. There is clearly opportunity for more education and training and some positive steps are now being taken, including university degrees and professional training courses in Islamic financing.For decision along with sharia scholars, banker’s legal expert and market practitioners are also needed to be part of the committee making decisions with every one having equal vote.

There is a lack of a legal and regulatory framework for dispute resolution, especially in cross-border transactions. In contracts for Islamic transactions, the enforceability of terms and conditions depends on the governing law. In the case of a dispute, it is unlikely that a court located in a commonwealth country will determine a verdict based on Sharia’s law. To mitigate this risk, contracts have to be written carefully to minimize potential disputes.

Another challenge is the lack of tax framework for Islamic products leading to uncertain tax outcomes and sometimes even double taxation, as well as the prohibition of certain Islamic products. A number of countries are revising their tax, legal, and regulatory frameworks to attract Islamic finance.

Lastly, Islamic finance presents an unusual problem because there is neither any specific legislation regulating it, nor is there sufficient relevant case law to address these issues. Sharia’s law is not a codified body of law, but rather a set of practices based on various interpretations. Furthermore, Islamic finance in some countries and their various business models have not yet been tested in a severe economic or market downturn.

Notwithstanding these challenges, many Islamic institutions are expected to undergo a positive transformation in their approach and strategy towards Islamic finance, and more importantly in their business models. With the development of Islamic financing techniques, it is clear that there are increasing opportunities for its use. Increased product sophistication and market awareness-building would also need to go hand-in-hand with the advancement of the financial and legal infrastructure in Islamic finance. Indeed, Islamic banking can incorporate lessons from the global financial crisis and emerge as a role model in the future.


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