The Malaysian Reserve

Has the Islamic finance industry prospered with integrity?

Generic Photo (Pic: TMR)

Islamic financing instruments are not accounted differently from interest-based debt financing in companies’ financial reports, argue 2 academics


Although Islamic finance is often described as embracing ethical finance at large, there are issues and challenges in reality that stakeholders should be aware of to protect their interests.

Are stakeholders of the Islamic finance industry really aware that Islamic financing instruments are not accounted differently from interest- based debt financing in companies’ financial reports?

Islamic financing instruments have been popularly used by Malaysia’s government-linked companies including 1Malaysia Development Bhd (1MDB). According to 1MDB’s audit report that is now publicly available from the National Audit Department, 1MDB had issued Islamic medium-term notes (IMTNs) of RM5 billion to fund its initial operation in 2009.

IMTN is one of the many innovations that are described as “Islamic financial instruments” in academic literature.

Bear in mind that this innovation is a “borrowing” transaction in substance. In the case of 1MDB, this borrowing is guaranteed by the federal government of Malaysia. The audit report stated that the annual interest rate charged on this borrowing is 5.75%.

This means that Malaysians are exposed to the default risk of an Islamic loan that contains an interest element. If failing to pay the interest means a default, then the interest is clearly a source of guaranteed and fixed income (return) to investors.

It is indeed awkward to treat this as an Islamic contract, especially when the risk implicated the public alone ultimately. Islamic finance is about risk-sharing, not risk-shifting.

Contentious Contracts

1MDB’s IMTN is just one of many cases of contentious Islamic financing. In addition, findings from our research so far suggest that murabahah contracts are widely used in Islamic financing. Islamic banks often offer financing based on murabahah, rather than profit/loss/risk- sharing contracts (eg mudarabah or musharakah).

Murabahah contracts are commonly described as “cost plus sale” contracts. In theory, a murabahah-based transaction would envisage an Islamic bank to purchase an asset (eg property) and sell it onward to a consumer.

In principle, this has to be a genuine and real trading (ie buy and sell) activity, whereby the parties to the transaction will bargain on a margin of profit (or mark-up) over a known cost of the underlying asset. In the case of a credit sale (murabahah-mu’ajjal), the payment of the asset’s “cost plus the agreed mark-up” will be made by the consumer to the bank on a deferred basis.

The buyer-seller relationship in a murabahah-based trading is supposed to be distinguishable from a straightforward lender-borrower relationship that forms conventional bank financing.

In murabahah, the bank should act as a seller of a real property, not a seller of “money for money” as in the case of conventional lending. The bank could be motivated by fair profit from trading, but not interest (riba) income from lending at all.

However, if the International Financial Reporting Standards (eg IFRS 9 Financial Instruments) are adopted, profit earned by a bank under a murabahah contract could be viewed as being akin to interest, and therefore would be accounted for as interest revenue.

This “substance over form” approach dismisses the real trading notion envisaged for murabahah. It also portrays murabahah-based trading as if tantamount to interest-based lending activity.

Islamic Element

One may question whether the promised “Islamic” element of a murabahah-based financing has been fulfilled if it is legally treated as akin to an interest-based borrowing?

Despite this critical question that was also posed by learned scholars and practitioners elsewhere, the Islamic finance industry has proudly grown under an “Islamic” umbrella.

The Islamic Financial Services Board estimated that the industry grew annually at a 17% rate between 2009 and 2013. Of course, the industry would have not been that successful without the support from carefully selected, and perhaps well-paid, Shariah scholars who had gracefully approved the way they run murabahah.

That said, it is important for the Islamic finance industry to grow with integrity. A flawed or rather misleading practice, if any, is feared to reduce the practice of Islamic finance to a mere façade of conventional finance.

Promotional materials that suggest otherwise, as they often do, may not only trigger ethical concerns, but also legal actions in the future, as consumers become more sophisticated and learn about any misleading practices.

For this matter, regulators should not be facilitating or condoning a mis-leading practice. The goal of financial regulation to protect consumers from mis-selling should not be overlooked in this context.

It is unfortunate that some consumers may have “bought” blindly into Islamic slogans. While “careless” behaviour helps the industry to grow uninterruptedly, education is important to ensure stakeholders really understand the fundamental principles of Islamic finance and press the industry to “walk the talk”.

If regulators are hopeless, enlightened stakeholders and their activisms are key to steer the industry to the right direction. The challenge is whether we are ready to prioritise integrity over profitability.