Setting up Offshore Jurisdiction in Islamic Finance - Dissertation Example

? Developing a Best Practice Framework for Setting up an Offshore Jurisdiction in Islamic Finance Number: Supervisor: Table of Contents 1.0 Introduction 3 1.0 Introduction Islamic finance is growing stronger to become US$ 2 trillion within a decade. The market for Islamic Financial products is at least USD 5 trillion. Modern Islamic finance and banking took off in 1960’s after Egypt launched a Social Bank. Initially, Islamic Finance was confined to Middle East; however, Pakistan and Sudan have tried to ‘Islamicise’ all their financial systems. Offshore jurisdictions that are fertile for Islamic finance include; Cayman Islands, Isle of Man, Jersey, Guernsey, Bahamas, British Virgin Islands, Bahrain, Labuan (Malaysia), Luxembourg, Dubai International Financial Centre and Dublin (Ireland). Other offshore jurisdiction favoured for investment includes Turks and Caicos Islands, Bermuda, Barbados, Cook Islands, Labua, Liechtenstein, Mauritius, Cyprus and Gibraltar (Academie de Droit and International de la Haye, 1995). Most of the offshore centres in the world are anxious to become influential financial locations. These offshore locations aggressively seek investors interested in global investment from any part of the world. Growth of global investments has caused unprecedented growth of offshore jurisdictions in the past years. Accumulation of petrodollars and increasing Muslim population as well as increase in infrastructural projects demanding huge amounts of capital drive global Islamic finance. Furthermore, active participation of investors and independence of countries in Islamic capital markets are some of the reasons of growth and development of global Islamic finance (Muhammad 2009). Wealthy people and entities put their assets in offshore jurisdiction to avoid their legal obligations in their jurisdiction. They seek lawful lowering of tax incidence upon their wealth and avoid exposure of assets to risks such as claims that might otherwise arise in the home jurisdiction and can be legally avoided by investing away from home. A report released by Ernst & Young Islamic funds & Investment department indicated that global Islamic fund assets stagnated at US$52.3 billion in 2009 from US$51.4 billion in 2008. This is minimal growth and Islamic fund managers must adapt their strategies and operational models in line with new level expectations. Shariah investable assets have experienced strong growth over the years. Director at Ernst & Young’s Islamic Financial Services Ashar Nazim said that Shariah investable pool grew by 20% from US$ 400 billion in 2008 to US$ 480 billion in 2009 (Investors Offshore n. d. ). Islamic Finance has remained strong despite the global credit crisis that shook global financial markets. This is because Islamic Finance has demonstrated promising banking behaviour over years. Trusts are normally set up to protect assets transferred to an offshore jurisdictions from the claims of creditors who might come into existence in future time but are nonexistent at the time of transfer of the assets of the offshore trusts. The transferors also aim to provide among members of their families in way that could not be done, were the forced heir ship provisions of the home jurisdiction enforced against the migrant property of the person. Offshore transfer of funds makes the transferor to have the advantage of trust provisions which are not known in the home jurisdiction. 2.0 The Research Problem Islamic Finance is becoming one of the most admirable financing products across the world. Both Muslims and non-Muslims are approaching Islamic banks and Islam based financial institutions to meet their banking and financial needs. Islamic Finance is based on the teachings of Koran (Shariah Law) and does not operate like a conventional financial institution. Therefore, it has a totally different best practice framework, which must meet the dictates of the Koran. Unlike conventional banks, Islamic banks are faced with more challenges in terms of inadequate or failed internal processes, systems, external events or people due to perceived or real Islamic religion influence. As more money is invested in Islamic financial products, there will be more challenges brought about by increasing customer base, new government legislations, religious requirements, increased competition in the sector and economic hardships. To remain stable, competitive, relevant and productive; offshore jurisdictions must develop best practice framework to set and operate Islamic Finance effectively and efficiently. According to (Investors Offshore n. d.), Rushdi Siddiqui (global Head of Islamic Finance) cited that Islamic finance lack standardization, consensus among Shariah scholars, poor connectivity between Islamic Finance Institutions across the globe and acute shortage of experienced Islamic finance professionals. Islamic finance need to innovate best practice framework /techniques if it hopes to thrive. 3.0 Research objectives i. To know the principles of operations under Islamic finance ii. To know development model adopted by current Islamic offshore jurisdictions iii. To identify attempts by national and international standard setting bodies such as IFSB, IOSCO and AAOIFI at developing standard practices/framework in establishing Islamic offshore jurisdictions. 4.0 Research Questions i. What principles govern Islamic finance operations? ii. What development model has been adopted by current Islamic offshore jurisdictions? iii. Has there been any attempt at developing standard practices/framework in establishing Islamic offshore jurisdictions by national and international standard setting bodies such as IFSB, IOSCO and AAOIFI? 5.0 Justification This research is important because no research of this nature and magnitude known to me has been done before. Therefore, it forms the basis and literature of other research of similar nature in future. It is also important to identify, develop and implement best practice framework in Islamic Finance to aid in regulation and replication of best practices in offshore jurisdictions and other parts of the world on Islamic finance. This will ensure that sanity, efficiency and stability prevail in Islamic banking and finance at all times so that the sector will have more credibility and win over the confidence of all the stakeholders. 6.0 Theory/Literature Review 6.1 Principles of Islamic Finance It is a norm for every Islamic Financial institution to set up Shariah Advisory Board. The Shariah Board provides opinions on many aspects associated with Islamic Finance and Banking. Islamic Financial products are Shariah compliant and are based on sharing risks and rewards. The investors usually agree to on a profit-sharing ratio (formula). However, losses are shared in proportion to the capital invested. Shariah Law forbids riba (interest) charging and stresses that money must be used productively. Profit from lending or investments may be earned through profit or loss sharing or mark-up pricing in business ventures. According to Venardos (2010), profit is considered lawful if entrepreneur or the bank bears the risk of loss. As a principle, Shariah compliant Islamic financial products must not invest in entities that charge interest (riba) or trade in illicit (haram) product or services. Illicit products include pork, obscene materials, alcoholic beverages, weapons, pornography, armaments, gambling and tobacco. Islamic bonds, or Sukuk, Shariah-compliant mutual fund assets, commodity murabaha trading platform, Islamic Hedge Funds and Derivatives are some of the products of Islamic Finance. 6.2 Elements of Islamic finance Murabaha (cost –plus- financing contract) is popular and is used to purchase a variety of assets. If a person wishes to buy a house using Murabaha, the buyer and the seller approach a bank. The bank will assume risks associated with the property and agree to purchase a house registered in the name of the buyer. The house will be sold back to the buyer (customer) at a higher price. Murabaha is also used to purchase cars, TV sets, refrigerators and other household appliances and finance trade. Murabaha can also issue letters of credit. Ijara (lease), bank buys an asset and leases it to customer for an agreed future time. During the lease, the buyer pay some form of rent deemed to be reflective to risk involved in the transaction. The customer will eventually own the property. Musharaka (participation) is also used in Islamic finance. Bank and customer contribute capital of the company or a project and agree on a profit or equity sharing ratio for the asset and losses are shared on similar ratios. Mudharabah contract is used to finance new business ventures. Under this, one party (rabal-maal) provides finding while the other party (the entrepreneur or mudarib) provide labour and management. Profit is shared at an agreed ratio, but if the business venture fails, the losses are borne by rabal-maal and mudarib receives nothing for his or her efforts. Financial assets (international bonds) called the sukuks are backed by assets like the pools of Ijara. Assets are leased to clients to yield the return on the sukuk backed by real assets. This ensures that sukuk could be traded in a Shariah-compliant secondary market. 6.3 Islamic Financial regulators Archer and Karim (2007) asserts that Islamic Financial Service Board (IFSB) was founded in 2002 by association between Central bank, the Islamic Development Bank and IMF to provide prudent guidelines and standards to be used to supervise Islamic Banks. IFSB standard number one prescribes guiding principles for risk management in financial institutions offering Islamic Finance Services. It is based on Basel Committee operational risk guidelines to provide direction on risk caused by inadequate or failed internal processes, systems, external events or people associated with Shariah compliance as well as risks associated with institutions and fiduciary responsibilities toward different fund providers. IFSB standard number two cover adequacy for financial institutions offering the Islamic Financial Services. It prescribes that amount of capital meant to cover for operational risk is measured using the Basic indicator Approach or Standardization approach dictated by Base II. According to the indicator approach, a bank needs to set aside a fixed 15% of its annual average gross income (averaged over three preceding years). However, under the Standardization approach, the fixed percentage may vary between 12% and 18% depending on the line of business (LOBs). Operational risks for corporate finance, trading, sales, payment and settlement is 18%, commercial banking services is 15% and retail banking as well as asset management and retail brokerage is set for 12%. Islamic Financial Services are organized according to the LOBs. However, ISFSB has proposed to Islamic Financial Services to use Basic Indicator Approach, which require setting apart a fixed percentage of average annual gross income averaged over three preceding years (Archer et al, 2007). Mohd & Shariah (2001) asserts that a well developed governance structure is important for safety, stability and soundness of Islamic Financial Institutions. Governing structure ensure that Shariah and principles are complied with. Development of Shariah governance involved domestic and international initiatives. Domestic initiatives include establishment of Shariah Committee for each IFIs. In addition, central bank ensures that centralized Shariah Advisory body, legislations and specific guidelines are set up. International initiatives include contributions by international regulatory bodies such as AAOIFI, IFSB and OIC Fiqh Academy. AAOIFI developed governance standards, Auditing standards and Ethics Standards for IFIs. IFSB developed guiding principles on corporate governance and governance systems for IIFs. OIC Fiqh Academy published guidelines for Shariah advisory roles on matters associated with Islamic Finance. Schoon (2009, p. 139) states some of the roles played by audit departments and committees to ensure that the company complies with best practices of Islamic finances. According to Bock (2010, p. 24), SPB clearly specifies duties of Shariah advisors, handling conflicting Shariah edicts as well as how to integrate Shariah compliance with new products and services introduced to Islamic Finance. On the other hand, IFSB advices on ways of setting up and running a Shariah governance system and how to handle fiduciary risk. Labuan International Business and Financial Centre (LIBFC), Dubai International Finance Centre (DIFC), Dubai Financial Services Authority (DFSA), Dubai Multi Commodities Centre Authority (DMCC), Islamic Financial Service Board (IFSB), Central Bank of Malaysia Act 2009 and Banks and Trust Companies Law 1995 are some of the regulatory bodies that have contributed immensely to growth and development of Islamic finance. 6.4 Application and development of Islamic Finance at selected offshore jurisdictions Mauritius is an offshore jurisdiction offering Islamic financial products and is regarded as one of the most active players in global Islamic finance sector (Muhammad 2009). It is experiencing ever growing demand for Shariah-complaint financial products. HSBC is one of the banks in Mauritius offering Islamic banking services. Some microfinance institutions are also offering Islamic banking Services based on Murabaha (deferred sales). Financial products and services available in Mauritius include Takafu (Islamic Insurance), Ijara (Islamic leasing), and sukuk (Islamic bonds). According to Tegally (2009), Islamic Bank License is issued by Central Bank to financial institutions with as share capital of at least MUR 200million (US$6million). In Mauritius, it is mandatory for all Islamic banks to set up Shariah Advisory Board made up of a Shariah advisor (scholar) or three members. Shariah advisor must have integrity, honesty, ethically reliable and proven experience or knowledge in Shariah rulings and issuance of scholarly opinions on issues associated with Islamic law. Comprehensive, modern and efficient regulatory framework coupled with multilingual professionals (French, Arabic, English, Hindi or Mandarin) makes Mauritius attractive to Islamic Financing. According to Offshore Incorporation (n.d.), Cayman Islands are among the most respected offshore jurisdiction with one of the largest and most efficient banking centre in the world. The islands have established best legal regimes, efficiency, lower costs and large pool of professional and experts. It has trusts and mutual funds worth $ 20 billion. Cayman Islands are respectable and have stable commercial infrastructure accompanied by flexible legislations. In addition it is able to provide asset protection and have not joined the Hague Convention. Therefore, it does not recognise foreign judgements and exclusion of forced inheritance. Cayman Islands do not have foreign exchange control and Caymanian dollar is fixed against the US dollar at the rate of CI$ 1.00 to US$ 1.20. All banks are governed by Banks and Trust Companies Law 1995. Cayman Islands offer Sukuk. In a March 2007, Dar Al-Arkan Real Estate Company was allowed to issues $ 600 million three year Sukuk Al-Ijara. Sukuk Al-Ijara was heavily oversubscribed. Even Western investors, in particular hedge funds were attracted to it due to its diversification and strong asset backing. Labuan is an offshore jurisdiction in Malaysia with a vibrant and comprehensive Islamic finance structure. Islamic Finance Sector is regulated by Central Bank of Malaysia Act 2009, Shariah Advisory Council of Central Bank of Malaysia and Labuan Islamic Financial Services and Securities Act 2010. The Labuan Islamic Financial Services and Securities Act 2010 clearly outline governance of Islamic finance institutions (Republic of Malaysia, 2010). The Act provides guidance for appointing Shariah supervisory council, fund managers and administrators and trustees/ custodians and lincensing intermediaries. It also provides the roles of and duties of Islamic and securities bank licensees, and Islamic self-regulatory organizations. It outlines the management of Sukuk, Islamic mutual funds and other financial products. The 2010 Act also indicates and registers the types of businesses that are allowed to get involved in Islamic finance. To look into the good governance of funds, Central Bank of Malaysia Act 2009 require the Islamic Finance institutions to create risk management committee, management committee board, Shariah committee and board audit committee management to look into the affairs of the institutions. In addition, the country’s constitution emphasizes the use of the court and arbitrators to settle disputes arising. 6.5 Strategies to make Islamic institutions effective and efficient There are specific actions that Islamic financial apply during their operations They develop Shariah Audit & Compliance for Islamic Banking. Shariah audit plan and audit program as well as Development of Shariah Compliance Review & Auditing for Retail Products, Corporate, and Treasury Products trade financing and hedging instruments (Islamic swaps, forwards). Islamic finance institutions also try to understand and institutionalize the objectives of Shariah (Maqasid al-Shariah). There are also Shariah principles governing risk management practice of Islamic finance as well as Shariah Internal Control System. Furthermore, Islamic finance institutions need to develop a pool of Shariah experts and scholars who will be able to understand the complexity of Islamic financial instruments. 7.0 Research Methodology This chapter focuses on the research design and the procedures and methods used to select, study, collect, analyze and present Islamic Finance facts in Seychelles. This study is descriptive in nature and relies on both primary data collected through a questionnaire and secondary data collected from various relevant publications. The primary data collected are analyzed statistically using data analysis packages such as Statistical Packages for Social Scientists (SPSS). 7.1 Data Collection Methodology Primary data collection will be done via structured questionnaires and personal interviews. Selected workers for the study will be contacted by telephone. Trained research assistants will be tasked to administer questionnaires and collect the data on Islamic financing. Research assistants will contact the respondents and reminded them of the purpose of the study, assure them of anonymity, give them written explanation of informed consent and administer questionnaires. The activity is expected to take 15-30 minutes. Research assistants will clarify issues that will be asked. 7.2 Ethical/ legal Issues Permission to conduct the research will be obtained from the road financing representative to be involved, the University and respondents. Only those representatives who will agree to offer information involuntarily will be contacted and interviewed. Before the survey commenced, respondents will be informed of the nature and purpose of research and will be thanked for volunteering information. Those who felt that they will not participate will be allowed to do so without any negative or undesirable consequences to them. All the people who participated in providing information will not be named or exposed. Finally, all the information obtained from the respondents and company records will be treated with secrecy and used only for the purpose of academics. This research will also be copyrighted in my name. 7.2 Reliability and Validity Research instruments must be valid and reliable. Reliability refers to the extent to which scores on the research instrument are free from measurement errors. Validity means that if research is meant to test an overall theme, the research instruments should be sufficient to capture the actual information as required. This will ensure that the research instrument is valid and reliable at all levels. 8.0 Research Plan The research is expected to begin on March 2011 and completed by September 2011. Table1 -Proposed Timeline Time / period March 2011 Finalise Research Proposal April/May 2011 Write up Introduction and Literature Review May/June 2011 Write up Methodology Sections, finalise Research Questionnaire/Interviews and collect Data July 2011 Analyse data and Write up Chapter on Empirical Findings August/September 2011 Write up Conclusion and Finalise and Submit Thesis 9.0 Bibliographies Academie de Droit & International de la Haye 1995, Recueil Des Cours: Collected Courses of the Hague Academy of International Law, Volume 2; Volume 252. Martinus Nijhoff Publishers Norwell, USA. Archer, S & Karim, R 2007, Islamic finance: the regulatory challenge, John Wiley and Sons, 2 Clementi Loop, Singapore. Archer, S., Ahmed, R & Karim, A 2007, Islamic finance: the regulatory challenge, John Wiley and Sons, 2 Clementi Loop, Singapore. Bock, M 2010, Governance Risk Management and Financial Product Development in Islamic Financial Institutions, GRIN Verlag, Germany. Iqbal, Z., Askari, H., Krichenne, N and Mirakhor, A 2010, The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future, John Wiley and Sons, 2 Clementi Loop, Singapore. Karim, AS 2010,The Islamic Moral Economy: A Study of Islamic Money and Financial Instruments, Universal-Publishers, Florida, USA. Kettell, B 2010, Frequently Asked Questions in Islamic Finance, John Wiley and Sons, West Sussex UK. Mohd, R & Shariah, I 2011, Governance Framework for IFIs: Raising Shariah Competency to the Next Level International Conference on Islamic Business and Finance Islamabad, Pakistan, viewed 10 March, 2011, . Muhammad , U 2009, Mauritius Shariah IFLR, viewed 10 March, 2011, . Offshore hubs lure Islamic finance business, viewed 10 March, 2011, . Offshore Incorporation, n. d., Cayman Islands: a respectable offshore and banking centre, viewed 10 March, 2011, . Oxford Business Group 2009, The Report: Malaysia 2008, Oxford Business Group, London. Republic of Malaysia 2010, LAWS OF MALAYSIA Act 705 LABUAN ISLAMIC FINANCIAL SERVICES AND SECURITIES ACT 2010, Percetakan Nasional Malaysia Berhad, Malaysia. Sameer Khalid Tegally, 2009, Mauritius: emerging Islamic Finance HUB, Conyers Dill & Pearman. Mauritius, viewed 10 March, 2011, . Schoon, N 2009, Islamic Banking and Finance, Spiramus Press Ltd, BS, London. Venardos, AM 2010, Current issues in Islamic banking and finance: resilience and stability in the present system, World Scientific, 5 Toh Tuck Link, Singapore. Venardos, MA 2010, Current issues in Islamic banking and finance: resilience and stability in the present system, World Scientific, 5 Toh Tuck Link, Singapore. Read More