Dada Adefolami

BENEFITS, hindrance AND CHALLENGES

Benefits

Corporations, individuals and IFIs engaged in rising and issuing funding based on Islamic finance virtues may be viewed as belonging in stakeholder-type partnerships that are engaged in deriving benefits from ethical, fair business activity. The result of these partnerships is one of mutual interest, trust and co-operation. The ethical stance and fair dealing of Islamic finance virtues means that partnerships, business activity and profit creation comes from benefiting the community as a whole.

Since the virtues of Islamic finance and enterprise prohibit speculation and short-term opportunism, it encourages all parties to take a longer term view of success from the partnership. It focuses all the parties’ attention on creating a successful outcome to the venture. This should result in a more stable financial environment. hence, literature in this area suggests that had banks and other financial institutions conducted their business activity based on Islamic finance principles, the negative impact of the banking and sovereign debt financial crises would have been much reduced.

IFIs or conventional financial institutions with products based on Islamic finance principles gain access to Muslim funds across the world and provide finance for organizations and individuals who need them. As the world emerges from the global financial crisis and business activity increases, this should increase. Furthermore, access to Islamic finance is not restricted to Muslim communities only. The wider business community could have access to new sources of finance. This may be particularly attractive to corporations focused on ethical investments that Islamic finance virtues stipulate.

Hindrances and challenges
The prohibitions of riba and on speculation, IFIs may be slower to react to market demand and changes. They may lack sufficient flexibility in their product offering when compared to conventional financial institutions and may be less able to take advantage of short-term opportunities.

Moral hazard and principal-agent issues may be more pronounced between IFIs and organizations and individuals to whom they lend funds. This is because Islamic finance virtues stipulate close relationships from partnership-like arrangements. However, information asymmetry between the IFI and the borrower of funds will always exist. Therefore, costs related to increased level of due diligence and negotiating are probably higher for IFIs.

Costs related to developing new financial products may also be higher for IFIs because not only will the products have to comply with normal financial laws and regulations but also with Sharia rules. As stated above, the resources required by SBs can be considerable.

In addition to this, because these financial products need to go through stages of compliance and layers of complications before they are approved, the approval process can take time. The pace of innovation of new Islamic financial products may be considerably slower than that of conventional products. This may make the IFI less able to compete with conventional financial institutions and may make it restrict its activities to smaller, niche markets.

Some Islamic financial products may not be compatible with international financial regulation – for example, a diminishing Musharaka contract may not be an acceptable mortgage instrument in law, although it could be constructed as such. The need to ensure that such products comply with regulations may increase legal and insurance costs.

The interpretation of Sharia rulings may allow certain Islamic finance products to be acceptable in some markets, but not in others. This has led to some Islamic scholars, who are experts in Sharia and finance, to criticize a number of product offerings. For example, some Murabaha contracts have been criticized because their repayments have been based on prevailing interest rates rather than on economic or profit conditions within which the asset will be used. Some Sukuk bonds have faced similar criticisms in that their repayments have been based on prevailing interest rates, they have been credit-rated and their redemption value is based on a nominal value rather than on a market value, and thereby, perhaps, making them too close to conventional bonds and their repayments too similar to riba. On the other hand, the opposite argument could be that in order to make Islamic financial products competitive in all markets, their valuations need to be comparable. Therefore, benchmarking them using conventional means is necessary, the discussion on hindrances and challenges has focused on IFIs, as providers of Islamic finance. It is also important to consider the hindrances and challenges that corporations may face when using Islamic finance.

From the above discussion, the costs related to developing and gaining approval for Islamic financial products is likely to be passed down to customers and possibly make these products more expensive. In addition to this, access to new products and flexibility within existing products may be limited, due to the more complicated approval process that is necessary. These more expensive and less flexible sources of finance may make the corporation using them less competitive when compared to rivals who have access to cheaper, more flexible sources of finance.

The partnership nature of Islamic finance contracts may also cause agency type issues within corporations. These may be more prevalent in joint venture type situations or where the diverse range of stakeholders may make it more difficult for corporations to determine and act upon the importance of various stakeholder groups. For example, in the case of a Musharaka contract, where the IFI and the organization are both involved in the management of a project, dealing with other stakeholder groups may be more challenging.

Before the financial crisis, trading in asset backed and securitized Sukuk products, issued by corporations, has been limited a notable exception was Sukuk products .Furthermore, since the financial crisis, issuance in new Sukuk products has reduced somewhat.

Using Islamic finance may also increase the cost of capital for a corporation. For example, it may be more difficult to demonstrate that repayments for Mudaraba, Musharaka and Sukuk contracts are like debt, and therefore they may not attract a tax-shield. However, an equivalent organization which raises the same finance using conventional debt finance may be able to lower its cost of capital due to tax-shields and therefore increase the value of its investment.
finally

The increasing global interest in and use of Islamic finance means that this is an important source of finance which organizations need to consider. Its many attributes that are common to ethical investment and finance would make it an attractive source of finance particularly to organizations that place importance on ethical issues. The innovations in Islamic financial products by IFIs, such as Sukuk and diminishing Musharaka, have meant new and innovative Islamic finance products are being developed and are coming into the market. This is likely to continue as the impact of the financial crisis recedes.

However, IFIs face a number of challenges such as agency-related issues, increased costs, lack of flexibility, and difficulties with complying with Sharia rulings, and also normal regulations and law. The IFIs and the wider Islamic finance regulatory bodies need to put into place mechanisms and strategies that will help to overcome these challenges, and thereby ensure that Islamic finance-based products compete and compare with conventional riba-based financial products.

American financial service company headquartered in Southfield, Michigan. It provides home and commercial financing based on Islamic banking and finance principles for the Muslim community. UIF, is the first Islamic banking subsidiary run entirely on Shariah principles and serves the needs of the American Muslim community by offering both Shariah-compliant commercial real-estate financing and home financing through their Murabaha and Ijara programs.

Dada Suraju Adefolami, Professor of Finance, School of Business Administration. UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]: 08052043855