Islamic Finance moves into the mainstream
SOURCE: CHARTERED BANKER, APRIL / MAY 2010
The use of specialist Islamic finance products within the wider investment market (both on and offshore) has increased, partly due to the recent expansion of Sharia compliant mortgage options; but also due to the slowdown in more conventional lending.
Although Islamic finance is only a relatively small part of the global industry, it has grown by around 15% in each of the last three years and has continued to grow in the face of challenging economic conditions. The more recent impetus has been provided by non-Muslim investors beginning to invest in Islamic products, attracted by the fact that funding is more readily available than conventional debt, as well as the opportunity to invest in the still relatively buoyant Middle East.
At its broadest, Islamic finance covers all financial activity that enables investments to be made in conformity with Sharia (that is, Islamic principles and jurisprudence) and involves investment techniques and structures to create arrangements that are broadly analogous to conventional finance, but which are Sharia-compliant.
Islamic finance techniques differ, but most are either asset or risk based so that a structure might rely on a transfer of underlying physical assets so that the funder will at some point acquire the assets and assume commercial risk (similar to a sale and leaseback structure). Alternatively, the funder and customer might enter into some form of joint enterprise and share in the profits and losses (the model suggested for Scottish mortgages). In practice, transactions will often combine a number of these techniques to produce the desired economic result and it is common for larger deals (such as significant infrastructure projects) to incorporate both Sharia-compliant and conventional aspects.
An area of growth is in relation to financial instruments, known as Sukuk and usually in the form of certificates, which represent an undivided ownership share in an underlying asset or interest held by the issuer. This distinguishes them from both conventional bonds (which represent debt obligations of the issuer) and conventional equities (which represent ownership interests in the issuer itself).
The basic principle is that an ownership share in the underlying asset entitles the holder to a proportionate share of the returns generated by the asset and so the overall economic effect is similar to a conventional bond. Sukuk are used in combination with other techniques to allow a Sharia-compliant return on the underlying asset (such as rent, for example).
Despite continued growth through the use of Sukuk and other structures, the Islamic industry faces a number of challenges, including the fact that there are very few qualified Sharia scholars and there is no global consensus or regulation. This, combined with a high level of innovation and low transaction volumes mean that documents for the market (and the Sukuk market in particular) tend to be tailor-made for individual transactions, leading to higher transaction costs than those for conventional alternatives.
The Government has indicated that it will continue to monitor developments and act as necessary. For example, consideration is being given to SDLT, stamp duty and capital gains tax issues relating to Sukuk and further measures are likely to be announced this year, while the FSA and Treasury are also consulting on regulatory treatment.
However, it has also made it clear that it does not intend to adopt a state-led approach to improving the standardisation of products and documentation. Some progress has been achieved already by the adoption of standards created by international Islamic finance bodies, and adapting conventional practices (including guidelines issued by the Loan Market Association), and so it is believed that the industry should continue to lead improvements in this area. Similarly, the prevailing view is that industry should lead initiatives to raise awareness of Islamic finance, with Government support where appropriate, and should take the lead in addressing any skills issues faced by the sector.
Islamic finance is here to stay and will continue to move into the wider market, both domestically and as a component of offshore transactions. As such, it is important to be aware of it and, with experience of Sharia-compliant structures allied to offshore expertise, Semple Fraser can advise on all aspects of structuring and financing Islamic deals.
AUTHOR: ALEX INNES