Issues in Islamic Finance What Insolvency Practitioners Need to Know

A fundamental tenet of the practice of law has always been that lawyers must understand the business of their clients. For insolvency lawyers, this typically has required the development of an in-depth understanding of how banks operate.
As banks increasingly give way to asset-based lenders, hedge funds, and private-equity firms as the core providers of commercial capital, insolvency lawyers have had to keep pace with the development of complex lending and recovery businesses. This trend has been spurred in part by the excess liquidity in the global marketplace over the last few years, which has allowed borrowers to become more demanding about what types of lending vehicles and products they wish to avail themselves of. Islamic finance is poised to achieve—or arguably already has achieved—this status in the Western World. This article provides insolvency practitioners with a primer on Islamic finance and the potential issues it may raise in an insolvency context.
While the practice of Islamic finance in the Muslim world dates to the Middle Ages, the first modern Islamic bank was established in Egypt in 1963. [1] Following this initial experiment, the Organization of Islamic Countries (OIC) created the Islamic Development Bank (IDB) in 1974, giving momentum to the interest-free banking system based upon Shariah (Islamic law) principles. [2] This revitalization was prompted by the increased liquidity from the first oil price shock of 1973 to 1974, in addition to increased demand by Muslim populations seeking financial services compatible with their religious beliefs. [3]
The past two decades have seen record high growth rates for Islamic banks around the world in both number and size. The entire banking systems of Iran, Pakistan, and Sudan have converted to Islamic banking, while other countries frequently have Islamic financial institutions alongside conventional banks.
Market share of these banks in Muslim countries is estimated to have risen from 2 percent in the late 1970s to 15 percent in the mid 1990s. [4] Consequently, global financial institutions, such as HSBC, Deutche Bank, and Citigroup, are capitalizing on this niche market by establishing Islamic banking subsidiaries or having extensive involvements in this field. [5] Today, 284 institutions operating in 38 Muslim and non-Muslim countries worldwide offer Islamic financial services. In addition to banks, Islamic capital markets, mutual funds, and insurance services also are developing. [6]

Modes & Methods

Islamic finance is based upon Shariah principles derived from the Holy Quran and the Sunna, and its central feature is the prohibition of payment and receipt of interest (riba). [7] Explanations proposed by Muslim scholars for this ban are that interest serves as unearned income, prevents full employment, and can lead to monetary crises. [8] Other Shariah restrictions that affect Islamic finance include those against speculation and gambling (maser), uncertainty of subject matter and contractual terms (gharar), and capital that has no social purpose beyond unfettered return. [9]
Although Shariah imposes a ban on interest, it recognizes capital as a factor of production and allows owners of capital to share in a surplus that is uncertain, as long as there is no prior claim on interest. Thus, a viable alternative to charging interest has been profit sharing with a predetermined ratio. [10]
The Western system of equity financing is probably most comparable to Islamic finance. Depositors in Islamic banks are like shareholders who earn dividends when the bank makes a profit and lose a portion of their savings if the bank suffers a loss. [11] The main restriction is that depositors are not entitled to any addition to the principal sum unless they partake in some risk. [12]
There are five basic Islamic financing methods, each of which can be understood under the framework of existing Western financial instruments. [13] They are:

• Murabaha, or cost-plus financing, is a method of asset acquisition finance. The transaction occurs when the bank purchases an asset at the request of its client and then sells it back to the client on a deferred sale basis with a markup. The markup is determined before the purchase takes place and cannot be modified during the life of the contract. Murabaha is primarily applied to trade finance but can also be used for real estate and project financing. [14]
• Ijara and Ijara wa-Iqtina are Islamic leasing arrangements that are comparable to Western operating and finance leases, respectively. Ijara is like an operating lease in that a bank rents an asset to its client for agreed payments throughout a specific period of time, but the client does not have the option of owning the asset. Similar to a finance or capital lease, Ijara wa-Iqtina allows a client to own the asset at the termination of the lease. In both cases, the leased assets must have a secure productive life and the lease payments cannot be based upon speculation. [15]
• Istinsa operates like a commissioned manufacture and often is used to finance long-term, large-scale facilities. The Islamic bank will manufacture assets, usually through a parallel contract with another institution. It then sells them to a client at a reasonable profit in exchange for taking on the risk of manufacturing the assets. [16]
• Mudaraba is similar to a Western limited partnership, whereby one party contributes capital to a business and the other party provides expertise. A profit-sharing ratio is arranged and agreed upon prior to undertaking the project. [17]
• Musharaka can be compared to a joint venture in that two parties provide capital toward the financing of a project that both may manage. Profits are shared based on a prearranged ratio, but losses are distributed in proportion to equity participation. [18]

One of the major reasons financial institutions are trying to integrate and implement Shariah-compliant systems is that it opens the opportunity to tap into the funds of Islamic investors. [19] While many Muslim countries have established Western-style stock markets, some are now attempting to apply Shariah principles to trading. Tough challenges will arise in this process, especially given the Islamic restriction against gambling (qimar). Nonetheless, Malaysia already has made great progress in this field with the establishment of Islamic brokerage houses and an Islamic stock index with 170 listings. [20]
The Islamic bond market, which was not even in existence in 2000, also has made an impressive debut, reaching $6.7 billion in 2004. The income streams from these bonds are based upon Musharaka, Murabaha, and Ijara structures, rather than an interest system. [21] As new Islamic financial products are introduced, these markets undoubtedly will become more prevalent and sophisticated in the future.

Insolvency Concerns

In theory Islamic or Shariah-based legal systems, such as those found in Pakistan, Saudi Arabia, or Sudan, can adequately address insolvency issues arising out of Shariah banking arrangements. How these legal systems attempt to do this is a complex and interesting subject that is beyond the scope of this article. Of more immediate concern to most insolvency professionals is the confluence of Shariah banking transactions with Western, particularly common-law, legal systems. The United Kingdom, for example, already has a number of high street banks offering Shariah-based financing products sanctified by local religious boards.
The introduction of these products raises a number of general policy issues for Western banks. In murabaha real estate transactions, for example, the bank effectively becomes a landlord. For most large commercial banks, this business will be relatively new to them and is fraught with risk. Moreover, a bank that chose to offer Islamic finance products to depositors (as opposed to just borrowers) would need to retain a clearly differentiated status between shareholders’ capital and clients’ deposits to ensure that profit sharing was administered in accordance with Islamic Law. This may be a difficult undertaking for a publicly traded bank that has many shareholders.
Apart from these concerns, however, is the issue of how Islamic finance transactions will be treated in cases of insolvency. Given the relative novelty of these transactions in Western countries, there is little jurisprudence on the topic. But it is not difficult to envision the types of issues that may arise in the coming years:

1. The Bank as Landlord. As described earlier, murabaha transactions can be crafted to allow for the purchase of real estate by the bank, rather than the borrower, and the creation of what is, in effect, a traditional mortgage, by way of a long-term lease with an automatic transfer of title at the end of the lease term. Upon default of a traditional mortgage, particularly in industrial situations, a bank may take steps to avoid becoming a “mortgagee in possession,” at least until it is satisfied that there are no serious environmental concerns with the property. Where a murabaha real estate transaction interacts with a typical restructuring law, however, an insolvent debtor may have the ability to disclaim the unexpired portion of the murabaha lease, thereby causing possession and control of the property to revert automatically to the de facto control of the bank/landlord. Undoubtedly, banks will erect the necessary corporate firewalls to address such risks. But at a minimum, reputational risk should be a large concern.
2. Substance Over Form. At a basic level, there is a concern as to whether the bank’s retention of title in both Ijara and Ijara wa-Iqtina transactions will be definitive in insolvency situations. Many modern personal property security laws apply to any transaction that, in substance, creates a security interest. In the past, courts therefore have disregarded retention of title clauses in leases and have determined that the transaction was in fact a financing one—requiring the interest to be perfected under the relevant personal property security regime. Absent specific carveouts for Islamic transactions in such regimes, this issue is likely to be a significant one.
3. The Bank as Controlling Mind of the Company. In typical lender-borrower relationships, banks often take scrupulous care to avoid taking steps that could result in them being deemed to be in control of their borrower. In mudaraba—and in particular, in musharaka—transactions, this may be impossible. If a court could find that a bank, particularly on the eve of a company’s insolvency, was a controlling mind of the company, there are a number of implications to consider:

Corporate Governance. The biggest area of concern is the broad playing field on which issues involving corporate governance and insolvency collide. This is especially true in jurisdictions in which modern insolvency laws impose liability on officers and directors for actions taken on the eve of insolvency. In many civil law systems, these can include business judgments made in good faith that nonetheless contribute heavily to the insolvency of a company. In many jurisdictions, regardless of the cause of the insolvency, officers and directors bear personal responsibility for particular statutory liabilities, such as employee withholdings and sales tax. Banks in musharaka transactions will have to ensure that these liabilities are met on an ongoing basis or risk exposing the bank to liability for them. Some jurisdictions impose fiduciary responsibilities on controlling minds of a corporation to ensure that lenders are not misled or wrongly induced into advancing further funds to a company. Finally, virtually every modern insolvency law imposes some level of liability on officers and directors for carrying on business (and accruing debt a company is unlikely to be able to repay) during the pre-insolvency period. Banks will have to ensure that they take adequate steps to stop such trading from taking place.
Equitable Subordination. In recent years, courts have employed the doctrine of equitable subordination (which can result in secured debt being subordinated to unsecured debt) to correct what they have seen as various forms of malfeasance by banks. It is difficult to anticipate precisely when this doctrine will be employed, but it is not difficult to see how the heavy involvement of a bank in the effective management of a business venture that becomes insolvent could result in the bank’s interest being equitably subordinated.

Undoubtedly, Western banks will attempt to mitigate these risks through the use of corporate structures, carefully crafted contracts (drawing on existing precedents within the world of Islamic finance), and even various forms of indemnities or insurance. If insolvency jurisprudence has taught anything over the last 10 years, however, it is that corporate veils can be pierced and contracts set aside when the larger interests of stakeholders demand it. Put another way, no “ring-fence” is entirely secure.
This is not to suggest that Shariah financing transactions are to be avoided or feared. In fact, there are compelling arguments that Shariah- based financing results in more efficient allocations of capital, greater stability, and larger growth. [22] Moreover, as noted earlier in this article, the depth of financial markets in many Western countries will ensure that the market responds to borrowers’ increasing demands for a diversity of lending products. Instead, lenders—and perhaps more importantly, their professional advisors—will have to be sure to understand the complexities and risks associated with these transactions and ensure that appropriate measures are in place to reduce exposure.

This article has been prepared by the authors in their respective personal capacities and not in their capacities as World Bank staff. The authors wish to gratefully acknowledge the assistance of Robert Liu, Glenn Martin, Thierno Balde, and Vijay S. Tata in the development of this article.

The findings, interpretations, and conclusions expressed in this article do not necessarily represent the views of thexecutive directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data contained in this article.

Issues in Islamic Banking

slamic banking has achieved growth rates that tremendously outpace conventional banking. While there are banking norms common to both Islamic and western financial systems, certain norms are exclusive to Islam. Some of the Islamic restrictions render certain western banking practices and transactions void.

The main prohibitions are riba and gharar. Most of the  scholars are of the view that riba includes both interest and usury. Gharar signifies ambiguity, uncertainty or lack of specificity in the terms of a financial contract.

As riba is prohibited, suppliers of capital become investors instead of creditors. Also, investment can only be made in permitted commodities and activities. For instance, one cannot deal in import and export of alcohol and narcotic substances. Similarly, money is not allowed to be invested in a casino.

A variety of Islamic banking instruments and transactions are available in different markets. These may beclassified as equity, debt or fee based services/ products. The first includes musharaka and mudaraba; the second consists of salam, istisna, istijrar, qard, murabaha, ijara, bai-bithaman-ajil, bai-al-einah, bai-al-dayn, and tawarruq; the third comprises services based on wakala and kafala.

On the validity of some of these transactions and instruments, there is a difference of opinion among Muslim scholars. There are scholars who oppose certain practices because they find hidden elements of riba and gharar in them. They claim that some products appear Islamic only in form, not substance. Tawarruq, bai-al-dayn, and bai-al-einah are among transactions either disallowed or, at best, deemed controversial by some of the prominent scholars.

Most banks conducting Islamic operations have a panel of Muslim scholars, called shariah committee or shariah board, that determines whether a product or practice complies with Islamic provisions. Certain banks have a single shariah consultant or shariah advisor. Whether it is a sole shariah adviser or a shariah board, a particular scholar hired by a bank to accredit new products can give it an edge vis-a-vis its competitors.

Shariah scholars usually receive a fee for their services. Sometimes the fee depends on a deal going ahead. In fact, there have been cases where scholars approved conventional products as Islamic for the right price. Thus, the critics of Islamic banking came up with the term rent-a-sheikh.

According to different estimates, the number of these religious experts is between 100-200. However, there are about 12 of them who are the most sought after. As reported in Financial Times, they are making millions of dollars in yearly income. There have been mutterings not only about these scholars serving on too many shariah boards, but also about their advising direct competitors. In order to address this issue, Malaysia, in 2005, restricted scholars from serving on more than one board or committee.

As shariah can be given different interpretations, the shariah committees, at times, give conflicting rulings. A product approved by one committee can be rejected by another board within the same jurisdiction. For instance, in Jordan, a prominent shariah scholar criticised the penalty imposed on a defaulting client in murabaha, and declared that it is a kind of riba. Similarly in Britain, a famous Muslim scholar advises against taking out Islamic mortgages due to the structure being interest-bearing debt in disguise. Difference may also arise and exist between countries or regions. For example, in Malaysia, Islamic financial restrictions are construed more liberally than in the Middle East.

There are bodies and organisations--- Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is one of them--- that are trying to address this lack of Islamic standardisation. However, without a consensus of religious experts there cannot be a binding, universal set of Islamic banking rules. In fact, there is a proposal to set up a supreme shariah board. Indonesia serves as a good example where a national shariah board issues rulings that are mandatory for all shariah boards in the country.

Malaysia has also proposed that a meeting be held in Kuala Lumpur for setting up global standards for Islamic banking and finance. The prime ministers of Malaysia and Qatar recently discussed this at a meeting in Doha. Such standards would eliminate confusions and resolve issues with a common approach.

Another shortcoming confronting Islamic banking is the shortage of qualified professionals at all levels. There are not many people who are equally skilled in conventional banking and Islamic law. A person well acquainted with conventional banking can easily understand any Islamic product; however, one cannot successfully develop or market such a product without knowing the rules and institutions unique to Islam.

Originating in the 70s--- Dubai Islamic Bank was the first Islamic bank established in 1975--- Islamic bankinghas developed into a global industry and has assets exceeding $900 billion. Though the share of Islamic bankingis very small in the worldwide banking industry, it is showing an impressive growth, i.e., 15-20 per cent per year. According to an estimate by Moodys, it could hit $4 trillion in five years. Islamic banks have been set up not only in Muslim countries, but also in non-Muslim jurisdictions, like England and the US that have Muslim minorities.

Islamic banks take pride in the fact that, unlike their conventional counterparts, they have emerged relatively unscathed from the global financial crisis. In fact, in England, two Islamic banks, European Finance House and Gatehouse Bank, were launched in 2008, while governments in Europe were busy bailing out their banks. And while Lehman Brothers collapsed, Islamic Bank of Britain launched an Islamic residential mortgage.

Islamic banks have avoided complex debt-based structures and have relied more on retail deposits and financed real estate, private equity, and equities. In other words, Islamic banks have never been exposed to the risks that have affected their conventional counterparts. Even now, western governments and banks are considering possible regulation instead of giving up interest based and speculative transactions. Just surviving the financial crisis does not mean that Islamic banking will influence conventional banking.

To summarise, lack of uniformity in laws and deficiency of skilled professionals are some of the main hurdles faced by Islamic banks and their clients. However, the industry has a promising future--- the Arab oil money is often claimed to be the main driving force. This is evident not only from the growing number of banks established specifically for practicing shariah compliant finance, but also from the increasing number of conventional banks--- Citibank, HSBC, RBS, Standard Chartered, UBS, etc--- engaging in shariah compliant operations.

Most importantly, Islamic banking is mainly for Muslims. Due to the prohibition of riba and gharar, Islamic bankingproducts generally tend to be less efficient than conventional ones. Islamic bankers must be careful not to blur the lines between Islamic and conventional banking in their eagerness to attract wealthy non-Muslim clients or Muslim clients that are more interested in profits than piety.