Islamic finance is available in 56 countries through 1,389 sharia-compliant companies that have total assets under management (AUM) of $2.4 trillion, according to a 2018 study from Thomson Reuters.
In 2017, the market grew 11% and while recent expansion has been slower in core markets, such as the Gulf and south-east Asia, future trends are significantly rosier.
For example, Malaysia, the world’s largest market for sukuk (Islamic bonds), is now opening up to retail investors. The growing emergence of fintech is also leading to digital-only Islamic banks, robo-advisors and digital wealth management services.
This will see the industry make in-roads into areas including leasing finance for goods such as computers, factory equipment and motor vehicles.
Impediments to growth often relate to incomplete legal and regulatory frameworks, which are needed to create the optimum environment for Islamic finance.
Recent developments in countries including Indonesia, Malaysia and Brunei have sought to address the issue, in turn paving the way towards a more flexible future.
Malaysia’s Financial Sector Blueprint 2011-2020 was augmented by a five-year Islamic fund/wealth management initiative, rolled out in 2017, and is now well established.
Indonesia’s five-year roadmap for its own domestic Islamic banking industry includes new foreign ownership rules for Islamic banks and the requirement that conventional insurers spin off their takaful (Islamic insurance) operations.
In Brunei, the Monetary Authority of Brunei Darussalam’s financial sector blueprint (2016-2025) underscores that nation’s desire to facilitate further development of its Islamic finance industry.
While Islamic financial institutions are endeavouring to provide economically viable financing alternatives to the conventional global financial system, framed within the boundaries set by Sharia principles, it is worth noting that there are no underlying restrictions to their use in leasing finance.
For example, the core mechanisms in place need to ensure contracting parties share the risks of any venture amongst themselves, so if structured correctly, Islamic law allows for asset-based financing, more specifically known as Ijara.
Literally translated as ‘to give something on rent’ or ‘providing services and goods temporarily for a wage’ Ijara is a term contained within Fiqh (Islamic jurisprudence)
In the case of automobile Ijara, for example, the customer and car owner - typically a bank, as the lion’s share of the industry (71% of AUM) is accounted for by Islamic banks - enter into a rental agreement for a period agreed at the time of the contract.
The customer makes an initial security deposit, after which (when the lease period expires), they can either take ownership of the car via a separate sale transaction or return the car and take back the security deposit.
Similar flexibility in terms of credit requirements, contractual obligations and time frames offer scope to serve the growing market for vehicle subscription models. These are similar to products being rolled out by vehicle manufacturers and service providers throughout the world, even though those are not specifically designed to be Sharia-compliant.
Islamic finance and car leasing
Car leasing is allowed because the asset is defined at the outset in terms of who owns the vehicle, what the lease will cost and what the car will be worth at the end of the contract.
Other structures permitted include Murabaha, a cost, plus sale contract with a deferred payment term.
As Kosta Georgiadis, director, financial advisory, Deloitte Middle East, points out: “Another parallel that can be drawn is with that of a timeshare scheme for real estate, which is common in various parts of the world.
“Such a scheme may be Sharia compliant if there is a fair share in risk and return amongst the scheme owners and promoters, as well as if the underlying real estate assets are operating in a Sharia compliant manner.
“Usually such schemes are funded by equity only, which in nature is a Sharia-compliant financing mechanism. Although we have not witnessed such a scheme here in the Middle East for vehicle ownership/usage, we do not foresee Sharia compliance as an issue for shared vehicle ownership.”
A case in point is Volvo Car Leasing, rolled out in Malaysia in June 2018. That initiative, while not overtly Islamic finance-based, is structured in such a way that it would be compliant for Sharia purposes.
That is because at the end of the leasing agreement, which includes insurance, road tax, maintenance costs, as well as warranty, customers can either choose a new model to drive home, buy the car at market rate or simply return it to the supplier.
With ongoing initiatives in south-east Asia aimed at boosting Islamic finance, it is inevitable that opportunities will present themselves as the ecosystem continues to develop and expand.
First movers among the Islamic banks and other financial institutions are likely to be the biggest beneficiaries.
On the basis that vehicle subscription programmes are fully compliant with Sharia law, Europe may provide a useful pointer, going forward.
Putting this in context, by 2025-26, vehicle subscription programmes could account for nearly 10% of all new vehicle sales in the US and Europe, according to Frost & Sullivan, equivalent to 16 million vehicles and creating a business opportunity worth an estimated $100 billion.
Vehicle subscription services can readily exploit car sharing, rental, leasing, and outright purchase agreements, given their flexibility in terms of allowing customers to switch programmes and swap vehicles easily. Whether this particular form of flexibility will be inserted into the Islamic financing space in a significant way remains to be seen, however.
What is certain is that the market is destined for growth.
For example, when the Indonesian government launched the National Committee for Sharia Finance (KNKS) in 2017 as part of a strategic move to make the world’s most populous Muslim nation a global hub for the Islamic finance industry, the Indonesian Islamic finance space comprised 12 general Sharia banks, 22 Sharia business units of conventional banks, 58 takaful operators and 163 Sharia people’s credit banks.
With a population of more than 260 million that is 87% Muslim, there is a significant opportunity for growth.
Islamic Finance explained
Established in 1975 with the formation of the Islamic Development Bank, modern Islamic finance is, in relative terms, at the beginning of its lifecycle. However, the underlying financial principles of the industry remain unchanged since their origin over 1,400 years ago.
The framework of an Islamic financial system is based on elements of Sharia (the law of Islam) which governs Islamic societies. Sharia originates from two principal sources: the Quran and the teaching and practices of the Prophet Muhammad.
The fundamental concept of Islamic finance is that money has no intrinsic value and should only be used as a measure of worth. Sharia compliant investments are structured on the exchange of ownership in tangible assets or services with money acting simply as the payment mechanism to affect the transfer.
The taking or receiving of interest (Riba) is strictly prohibited as, under Sharia principles, money is not valuable in itself and no charge should be made for its use. Islamic financial principles also prohibit speculation (Gharar), precluding any involvement in gambling (Maysir) or extreme uncertainty. Any risk in a transaction must be shared between at least two parties, meaning that investors and entrepreneurs alike must bear the business risk for a share in the profit.
These principles of Islamic Finance mean that methods to undertake transactions differ from conventional finance.
Common Sharia-compliant instruments include:
- Sukuk: Islamic type of bond representing the ownership by the Sukuk holders in the underlying asset.
- Murabaha: Asset purchased by the bank and sold on to the customer with an agreed mark-up.
- Ijara: Asset purchased by the bank and leased to the customer over a specified period.
- Musharaka: Investment partnership in which profit-sharing terms are agreed in advance and losses are attributable to the sum invested. Similar to a joint venture arrangement.
- Mudaraba: Partnership financing contract under which one party provides the labour whilst the other provides the capital.
- Takaful: Mutual insurance.
Strict due diligence is needed to assess the viability of a business proposal before funding is agreed and any proposed venture must be certified as Sharia compliant by an expert (Scholar) of Islamic law. Certain investments deemed non-ethical or incompatible with Sharia law (Haram) are forbidden, including business related to alcohol, pork products, conventional financial services, gambling, pornography, weapons and defence.
Conversely, investment based on the core values of promoting social justice and the economic prosperity of the whole community is encouraged.
This is an extract from UK Excellence in Islamic Finance, published by the UK's Department for International Trade, Foreign & Commonwealth Office and HM Treasury.