Islamic Finance - The case for Malta
By Reuben M. Buttigieg

Islamic Finance may be new to most Maltese. However, there is a strong established niche market which is set for an exponential expansion over the next few years.  The annual growth of this market is of 15 percent to 20 percent per annum. The market is estimated to be approximately GBP 250 billion.

Islamic Finance comprises all aspects of banking, insurance and capital markets. Its development is due to the fact that conventional finance did not meet the strict requirements of Islam. Muslims believe that the pursuits of life, including economic activities, should be conducted in accordance with Shariah law as revealed in the Kuran and demonstrated in the practices of the prophet Muhammad.
The most rapid growth in Islamic Finance has been in banking, both in Islamic banks and in conventional banks with Islamic Windows. The Islamic capital market has seen a surge in activity with a variety of multi million pound bonds (sukuk) hitting the headlines, the most recent being Britain. Britain is planning to become the first Western government to launch Islamic bonds, or sukuk bonds, early next year.
Sukuk are seen as an important way for the Islamic Finance market to meet the funding requirements of both the Middle East and south East Asia, which are estimated at GBP 250 million to GBP 500 million in the next five years.

The growth in demand has resulted from two factors. The first is the massive accumulation of assets in banks operating in the predominantly Islamic countries that have benefited from the extraction of energy reserves.  The most obvious examples are the Gulf states, along with Brunei, Malaysia and Indonesia.

The second factor was a reaction to western practices throughout the Muslim world and a move towards comparative practices adhering to Islamic Law (sharia).

Shariah compliant Finance

There are approximately 1.5 billion Muslims around the world. Around a quarter of these live in countries with Muslim majority. Most of them currently subscribe to western financial principals but the new developments in Islamic finance may appeal to this group. It is also believed that the socio economic ethos underpinning Islamic finance may prove attractive to non Muslims. In reality, if one analysis the basic principles behind the Islamic Finance, one will find that there are various common principles with other religions such as Christianity.

Investment and trade are central to the Islamic view of wealth creation. Practicing Muslims believe that profits should not be earned simply because they have money to lend and someone is prepared to pay them to borrow it. Hence interest is forbidden under Islamic law, so government bonds for example pay profits or rent from an underlying asset with the securities representing part ownership of the asset. They believe that a lender should profit only as a result of their interaction with an investment. So an individual should only invest in projects where he will play an active role in sharing the risk if he wants to benefit. As a result, individuals or businesses wishing to borrow from those with surplus funds need to be able to trade with the financier, who can then profit from a real trade investment.

In conventional finance, if a business person needs funds he will borrow from someone else and he is charged interest on the amount borrowed depending on the duration of the loan and the perceived risk. With Islamic finance the lender and borrower do not exist but they are trading partners. The necessity for both parties to interact in a trading enterprise means that contracts play a key role in the process. They ensure that the participants benefit, however not from merely transferring or holding cash balances. The nature of these contracts is central to all aspects of Islamic Finance.

Trading contracts may be the hardest thing for the uninitiated to understand. The problem is not that each contract is derived from practices that have existed for centuries, but that they are expressed in Arabic terms. Contracts that are at the core of Islamic financial products include:

Mudarabah -  profit sharing
Musharakah  - a form of equity partnership investment
Murabahah – cost plus mark up
Ijarah – operating lease
Ijarah mintahia bi tsmleek – an alternative to hire purchase and finance lease

A range of bolt-on agreements can be included to adjust each deal in order to meet the customer’s particular requirements while still complying with Shariah principles. This for example may lead for a need to change certain EU member states legislation such as Malta.

In the UK, banks such as HSBC are offering Shariah-compliant accounts and loans. The UK Government changed the law on stamp duty to aid the growth in Islamic Mortgages. There are a huge number of international companies who are issuing types of Islamic securities.

Although there are relatively few verses in the Kuran relating to the finance industry, a company must offer products and services that are Shariah compliant in order to trade as an Islamic Financial Institution (IFI). Such compliance must permeate throughout its organisation and its activities. An IFI client can use its funding for Shariah compliant purposes only.

The issue of consistency is a big challenge for the industry. Each IFI has its own Shariah advisory board, which is an independent panel comprising experts in interpreting the Shariah principles governing product terms and conditions. These boards provide integrity by ensuring that the IFI’s policies and instruments don’t contravene the principles set under Shariah. They are seen as the most important body governing Islamic Banking and finance. All of them have the common goal of ensuring compliance, but they will differ over details such as methods of appointment, the legal status of rulings, internet supervision and so on.

The standardisation of products and services is also challenged by the fact that boards differ in how they interpret the Shariah principles. In the case of finance, South East Asia generally takes a more flexible approach than the Middle East. For example, most Gulf states allow only operating leases and not finance leases. This requires the lessor to assume responsibilities as in an operating lease until the transfer of title is executed. It also means that products deemed acceptable in South East Asia may not be adopted in the Middle East. Such differences of opinion are accepted by the Muslim Community as long as the scholars involved have used a rigorous method of interpretation (ijtihad) that can be traced back to the primary sources of the Kuran, the practices of the prophet Muhammad and juristic views in the past.

A notable development in the market is that an increasing number of non Musims are seeking out Islamic Financial products. The attraction for them seems to be the ethical basis on which financial decisions are made. When an IFI makes a trading agreement with a customer, it creates a stronger link than that of the normal lender-borrower relationship. If the venture fails, the institution suffers the loss while customers lose only the time and effort they have spent. An IFI will, therefore, conduct strict due diligence before entering a deal and also work closely with a customer to endure the success of their enterprise. Also an IFI would not wish to invest in a deal that could result in the exploitation of any party to it. Business activities should be based on mutual consent and goodwill. All the participants should feel that they are benefiting from the arrangement. In addition, ventures involving alcohol, tobacco, gambling, entertainment, weaponry and pork products are excluded.

Another indication of social responsibility is the religious levy of zakat which Muslims pay on all wealth that is capable of generating a return excluding their home, furniture, tools of trade and personal jewellery. Zakat payments are distributed to designated beneficiaries, primarily the poor and needy.

Islamic Finance and the Current Situation in Malta

The IFIs may lead to achieving the so long desired practices from various socialist groups in the European Union. The EU has managed to protect consumers to a certain extent but has possibly failed in ensuring ethics in certain aspects of finance. The commission and performance remunerated financial advisors give doubt to the valid advice given by certain European Financial Institutions. Whilst one understands the conventional banks’ way of motivating their managers and consultants in increasing the shareholders’ wealth, from a country’s perspective this may not necessarily mean economic growth and social responsibility. Business persons are possibly being misdirected by certain financial services companies and they are being directed to take loans or credit facilities beyond their means, sometimes in spite of the different advice given by their accountants.

A different way, or a new concept, of banking may also assist the country in controlling speculation which may be leading to exorbitant inflation in certain sectors. For example this may be achieved through a new home loan concept. The difference between conventional and Islamic mortgage is the underlying concepts and principles. While the former stresses on debtor/creditor relationship between the home buyer and the lender, the latter emphasises on purchasing and selling, where the lender purchases the house and sells it to the buyer at a price inclusive of profit. Another difference between conventional and the Islamic home loan is the mortgage rate. The former has a variable rate while the latter a fixed rate. For better protection against inflation, an Islamic mortgage is a better choice as the selling price is fixed at the time of contract.

In this regard, Islamic Finance may be beneficial to Malta not only from an economic perspective but also from a social perspective. In actual fact, introducing Islamic Finance to Malta may result in achieving economic results that other measures have failed to achieve. Controlling the property inflation in the aforementioned manner will render the property market more accessible by younger families and younger generations.  It will also assist the property industry as it will generate more real demand and the financial services industry will thrive through more loans.

The Opportunities

Tapping into Islamic Finance is a unique opportunity for Malta. However, Malta needs to time this appropriately to obtain maximum benefit from the underlying advantages, amongst which:

• Malta may be the first European Union member state in the Mediterranean to aggressively market itself as an Islamic Finance Centre;
• Substantial Capital inflow to Malta;
• In spite of these astonishing numbers, and hence the increasing importance of Islamic Finance, the complexities of this type of finance is not widely understood. Malta may benefit from its geo-strategic location and geo-political capabilities to work towards becoming a centre of excellence in education even in this area;
• Create alternative methods of finance available in Malta. It may be an opportunity for new access to finance for our business;
• Contribution to other industries crucial for Malta such as Tourism, the Health Sector, education and manufacturing;
• A good strategy to tap into this market may assist Malta in increasing other Financial Services target areas such as Pensions and Investments and Funds; and
• Opportunity for Maltese owned financial services companies to window in Islamic Finance and hence tap into new markets

The Challenge

There are various challenges that Malta needs to overcome in the area of Islamic Financing. One of the main challenges might be to surmount certain perceptions due to the lack of awareness of what Islamic Finance is all about.

In order to attract Islamic Finance in Malta there might be the need to certain changes in legislation, or the creation of new legislation. Whilst with respect to certain types of finance instruments such as Islamic funds there is no need for change of legislation, this is certainly not the case for areas like banking, where substantial measures need to be introduced, if not the creation of an Islamic Banking Act per se.

If Malta wants to be an International Islamic Finance Centre, there might be the need for a revision of our tax regime. Apart from the need of creating incentives to attract more Islamic Finance to Malta, as we see a shift in the way finance is looked at in Malta, Government with the current regime may have a fall of tax revenue in the short term with higher returns in the longer term.

There are various tax incentives that one may give such as tax exemption for Islamic Finance Banks and Takaful Companies and exemption from Property Final Withholding tax.

As in the case of the UK we need to review our Duty on Documents in view of the transfer of property occurring, for example in the case of home loans.

Malta needs to ensure as well that we have sufficient educated human resources in order to service the industry. Our experts in conventional finance will only partially assist in the area. They need to be Islamic Finance experts and hence substantial investment in training is necessary. Furthermore there might be the need to introduce again Arabic in our schools.

The Accountancy Profession will require substantial training in order to understand the mechanics of Islamic Finance. The profession would need to work hand in hand also with the Accounting and Auditing Organisation for Islamic Financial Institutions.

Marketing
Malta is ideally placed to tap into this market in view of its strategic location. Furthermore, this is the perfect timing to aggressively target this market. The optimal initial step to put Malta on the Islamic Finance Map is by issuing Government Bonds in compliance with Shariah law (Sukuk). Apart from attracting finance to Malta, the Islamic World would start looking at what is happening in Malta and how come a Roman Catholic Country in the European Union is issuing Sukuk. This way of marketing Islamic Finance seems to be a proven way as we may see from the case hereunder.

A Success Story
The roadshow for the first Islamic Eurobond commenced, following the confirmation by the central German state of Saxony-Anhalt on 14 July2004, which saw the first issue of a European-based and backed Islamic bond (sukuk).
The 5-Year 100-million-euro asset-backed sukuk was lead arranged by Citigroup and marketed primarily in the Gulf Cooperation Council (GCC) states; Malaysia; Turkey; and in the US and UK; and listed on the Luxembourg Stock Exchange. The transaction, according to Trowers & Hamlins, the City of London-based international law firm, which has a thriving Islamic finance business, is essentially a sale (to a special purpose company) and leaseback (to Saxony-Anhalt) of certain previously state-owned real estate assets.
Saxony-Anhalt, with a population of about 2.54 million, and whose capital is Magdeburg, is one of the poorer former East German states.
The sovereign sukuk that have been launched to date have all been lead arranged by either Citigroup or HSBC, who are both building up a considerable expertise in structuring sukuk and running the books for such transactions.
Indeed, the Ministry of Finance of Saxony-Anhalt had been working on this issue for three years, following a visit to Bahrain in 2001, where officials met both conventional and Islamic bankers. Gulf investors had already participated in one or two conventional bond issues floated by the German land, whose latest program calls for the issuance of 1 billion euros worth of fixed-rate bonds.
The Ministry of Finance of Saxony-Anhalt initially intended to issue the sukuk in 2003. But in a post 9/11 environment, there was initially some political opposition to issuing an Islamic bond. The sukuk structure itself posed no problem from a legal and regulatory point of view. The German state is also keen to broaden its investor base, to reduce its finance cost, and to attract inward foreign direct investment into Germany.
Is it indeed a reflection of the state of the global Islamic finance sector that a former East German state, which by West German standards is considered as under-developed and emerging, issued a sovereign sukuk ahead of countries such as Saudi Arabia, Iran, Turkey, Indonesia, Egypt and Oman.  It is a further reflection that a German region took precedence of many European countries such as Malta.
The governments, through their ministries of finance, are less keen to invest in doing the basic research and building up the case for sukuk, both as tools to raise funds for infrastructure development and for monetary policy management. If a small region however, made such a success one further emphasises the benefits that Malta may have in investing in this niche.
Trowers & Hamlins stresses that Islamic bonds (sukuk) are becoming more popular amongst conventional investors as they seek to diversify their holdings away from G-7 borrowers who are suffering from increased public deficits. The coupons, says Trowers & Hamlins, are also highly attractive, although as more issues occur and the sukuk market matures, pricing will certainly become finer. In fact, almost half of the $700 million Qatar Global Sukuk was subscribed by conventional institutions in the US, UK, Europe, and Southeast Asia.
The sovereign sukuk are fully guaranteed and underwritten by the issuing governments, although the actual issues are usually done through their ministries of finance, or through special purpose vehicles (SPVs) formed by them. The Saxony-Anhalt issue’s investment grade carries the same rating as the sovereign rating of the state: AA- (Standard & Poor’s); AA3 (Moody’s); and AAA (Fitch). All three ratings have a stable outlook.

Coordinating Efforts

Malta’s national efforts done in various areas may be coordinated to ensure success in attracting the appropriate attention. The project that comes immediately to mind in this aspect is the Smart City project. However, we can already benefit from the relations created in the financial services industry with certain countries such as Turkey and the relations created by various organisations in Malta; from Qatar to Dubai; from Morocco to Tunisia; from Turkey to Libya.

Our political relations with the Arab world will assist us in tapping more than any other country into such market. We need more double taxation agreements with Arab countries. These Double Taxation Agreements can be a marketing tool in themselves and they may be helpful in ensuring that the necessary tax incentives are there, without jeopardising the current government tax revenue.

Malta has various competitive advantages in providing for Islamic Finance, advantages that it does not have in other areas in the Financial Services Industry. Malta is being offered an opportunity that it cannot miss. The formula for success in the area may be based on three success factors; namely; national commitment; coordination of marketing efforts; and a credible and strong legislative structure.

About the author

Reuben Buttigieg MBA (Warwick), FCCA, MIM manages his own set-up management consulting and accounting firm, Erremme Business Advisors. Reuben has gained a wide ranging experience in the field of accounting and consulting. Such experience was gained both in Malta and abroad, mainly in Milan and Reading City. He worked with various accounting and consulting practices as well as in a number of industries. Reuben has a sound track record of company financial audit, corporate finance, management control and business planning. He is Director in various companies.