Islamic finance is the fastest growing sector in the financial services industry, having grown by over 20 per cent annually in recent years, and estimates of current global Islamic banking assets under management range up to $1 trillion. Islamic finance assets are expected to grow to $2 trillion by the end of 2012.
This remarkable growth has been driven principally by ample liquidity flows from the recycling of petro- dollars, and the active role played by some jurisdictions around the world in promoting the awareness and development of Islamic financial markets in their respective countries, most notably Asia, the United Kingdom, Luxembourg and France.
Largely due to the promotion by US federal and state regulatory authorities over the past few years, Islamic finance is slowly but surely gaining a foothold in the US.
With its emphasis on risk sharing, not only on the financial but also at the societal level, the ethical and moral bases of Islamic finance are being increasingly reviewed at the current time when world leaders are calling for and effecting significant financial reforms.
Islamic financing transactions in the US are reasonably isolated from many of the evils experienced by the US mortgage market which have so eroded consumer confidence. This is due to the immaturity and small size of the US Islamic finance market, as well as the fact of a different customer base than there exists in the conventional mortgage market.
There is effectively no such thing in North America as an analogous sub-prime Islamic mortgage market. Interestingly, the largest originators of retail Islamic finance products in the US are two small banks, a somewhat larger community bank and the mortgage company.
These institutions underwrite transactions using Fannie Mae and Freddie Mac underwriting standards, not the standards of an investment bank which may seek to make more money following the trend by putting together a mortgage conduit and slicing and dicing the mortgage into an infinite number of parts.
An advantage of the Islamic finance market in the US is that it has not yet attracted the attention of financiers who feel a need to “push the envelope” for more business.
The most commonly used Islamic transaction form in the US is a musharaka transaction involving a loss-sharing arrangement with a customer that could increase the financier’s risk in an environment of decreasing home values above the level of risk faced by a conventional lender.
A musharaka, by definition, results in a very real sharing of the risk between the financier and the customer based on their respective equity shares. In a diminishing musharaka, in light of the greater likelihood of property prices increasing over time, if there is a loss to be borne it is more likely to be earlier in the transaction’s life and thus assumed in large part by the financier and not the customer.
As earlier noted, “retail” musharaka transactions have not been approved for use in the US by federal banking regulators, and thus only a non-bank entity may offer a residential musharaka at this time.
The next most popular transaction form is a murabaha. Residential murabaha transactions are available from a couple of providers in durations from 8-40 years. By its nature as a static pool of debt, a murabaha has no re-pricing risk as does a conventional ARM or other exotic variations. If a customer qualifies for a murabaha at its inception, unless the customer’s circumstances changes, the customer will be qualified at its conclusion.
The ijara structure is the third most popular transaction form used in the US. If it is done with a fixed rental rate for the duration of the transaction, it is in the same risk category as a murabaha transaction.
An ijara with an adjustable rental rate tied to an index, or an adjustable musharaka, is subject to the same repricing risks as a conventional ARM. Risk still exists in the Islamic market, but it is muted by the more conservative range of financiers comprising the market.
Where countries such as the UK and Luxembourg have standardised, scrutinised and taken advantage of the growing Islamic finance sector with appropriate regulations, the United States has not done so, perhaps in part due to certain statutory and regulatory framework provisions which may present obstacles to Islamic banking.
I would like to suggest an approach as to how the United States might take advantage of the international growth in the Islamic finance industry which I believe would ease some of the US’s financial problems and also allow the US to reach out to Muslim communities and prevent them from radicalising like some parts of the Islamic world.
Islamic finance in the US has developed along two distinct paths. First, is the development of retail Islamic finance and investment products by conventional US financial institutions and several Shari’ah-compliant non-bank financiers, and the marketing of these products to US consumers and small business.
The second is equity investment by non-US Islamic institutions (and their clients) in US assets, particularly real property, companies and leased equipment. In the case of the former, approvals from US and/or state banking regulators, as well as tax rulings from local tax authorities are required.
In addition, sponsors must consider the application to their products of various federal and state laws intended to protect consumers in their financial and investment dealings.
In contrast, the making of equity investments in US assets and, in particular, the financing of those investments by US financial institutions, raises a number of legal issues of a non-regulatory nature that typically are addressed by the parties in the structuring of the transaction documentation.
Retail financing products
The United States does not permit a deposit at a bank to be at risk, and thus the FDIC insures it up to a specified limit. However, in the Islamic banking model, the deposit account is based on a profit-loss sharing scheme, an arrangement that puts the initial deposit at risk.
Thus, the US statutory definition of “deposit” poses a potential obstacle to Islamic financing. In addition, the National Bank Act prohibits commercial banks from the purchase, holding of legal title, or possession of real estate to secure any debts to it for a period exceeding five years.
This ban would effectively restrict Islamic home finance products, such as the availability of a murabaha. In two interpretive letters, the Office of the Comptroller of the Currency concluded that particular types of murabaha and ijara transactions would be considered exceptions to the National Bank Act if they meet certain standards for functional equivalents to conventional asset financings.
The OCC and Federal Reserve, in approving these types of transactions, chose to look to the substance of the transactions rather than their form and in so doing reached the conclusion that the risks posed to the US financial institutions affording the financing to its customers were essentially credit risks of the same type as regularly managed by those institutions in their conventional banking operations.
These types of home mortgage financing with Islamic murabaha and ijara structures have now been approved not only by the Federal government, but also by the New York State Banking Department and the banking authorities of several other states.
Given a similar regulatory approval for such products offered by US banks, there remain legal issues faced by the US banks, including the significant issue of state property transfer taxes which need to be taken into consideration in any home finance product. Almost all states impose a tax on each and every transfer of real estate and/or each recording of a deed.
If a murabaha or ijara structure is used, the initial purchase of the home by the bank would be subject to one transfer tax, the payment of which will typically be shifted to the consumer or built into the resale price or lease rental payments.
When the murabaha or lease payments have been fully made and the property is to be transferred to the consumer, a second real estate transfer tax is likely to be payable, thus imposing an additional tax burden on an Islamic financing transaction.
The tax authorities in New York and a few other states have recognised the inequity of imposing this second transfer tax payment on a Shari’ah-compliant structure when the substance of the transaction is the equivalent of a conventional financing, and rulings have been issued on a case-by-case basis to eliminate this double tax burden.
In a Shari’ah-compliant murabaha or ijara home financing structure, the financial institution will inevitably become part of the “chain of title” and, as a result, US law imposes various responsibilities and liabilities on all current and prior owners of real estate, and a bank participating in a financing structured in a Shari’ah-compliant manner must recognise and mitigate those risks.
For example, in Islamic financings, the financier is subject to environmental risks to which any owner of the property are subject, but to which conventional financing banks generally are not subject. While due diligence and borrower indemnities may be utilised, these may be insufficient.
Ownership also carries with it the risk of liability for injuries occurring on the property, and strong indemnifications from borrowers are appropriate, together with insurance protecting the financing institutions against risks associated with property ownership.
A customer in a murahaba transaction for the purchase of goods or equipment will need to have the benefit of his seller’s express and implied warranties relating to the goods or equipment, and the finance institution will want to be sure that its customer looks to its supplier rather than the financial institution in the event that the customer seeks to make claims under the warranties.
It is generally possible to transfer contractually the benefit of supplier warranties from the financial institution to the customer, and this issue must be addressed in the documentation in order to avoid the warranties benefitting only the financial institution. Similarly, the financial institution will seek to eliminate any warranty claims that might be made against it by its customer, and any contract between the financial institution and its customer must boldly state an appropriate disclaimer of warranties.
In addition, a disclaimer of certain implied warranties, such as merchantability and fitness for a particular purpose, requires specific language to be enforceable. A series of laws in the U.S. aim to protect consumers by limiting interest or finance charges and prepayment penalties that may be imposed on a customer.
In these transactions, one often sees the financial institutions providing such financial products to rebate the “unearned” profit (realised as a result of early voluntary payment) to its customer so that the financial institution may avoid violating US laws concerning the receipt of usurious interest charges or what might be considered to be impermissible prepayment penalties.
The offering of retail investment products to US consumers is still a work in progress, and investment accounts of the type offered by Islamic institutions in Europe and the Middle East are not yet available in the US Depository arrangements currently targeted to the Muslim community in the US permit the customer to share in the profits of the depository bank, but not in any of the bank losses, in light of the US regulatory framework which does not permit a depository amount to be at risk, and which requires backing of deposits by federal deposit insurance up to specified limits.
It remains to be seen whether a financial institution operating in the US may seek US regulatory approval for a deposit product that would pass on the financial institution’s losses to the depositor under a UK-style “waiver approach” or some other arrangement that has the same substantive effect. One suggestion has been made to treat a profit and loss sharing depository account as an “investment security” regulated by the SEC, rather than a banking product regulated by federal and state banking regulators.
With respect to equity investments in US real estate or other assets, the foregoing regulatory issues are generally not relevant in Shari’ah-compliant acquisitions and financings. Rather, it is necessary to satisfy the following tests to declare an investment as Shariah-compliant (KMI-2008).
First, the core business of the company should be Halal (not prohibited by Islamic Law such as liquor, pork and pornography etc).
Second, liquid assets should be equal to no more than 20 per cent of total assets of the company; shares of a company merely dealing in liquid assets are not Shariah-compliant, hence IFIs cannot invest.
Third, the ratio of all interest-based debts (including preferred stock) should be less than 40 per cent of total assets of the company.
Fourth, the ratio of non-Shariah-compliant investments to total assets of the company should be less than 33 per cent.
Fifth, revenue from non-compliant investments should be less than 5 per cent of total revenue of the company, and even then Islamic lenders are required to purify their earnings by spending this non-compliant revenue as charity. Finally, market price per share should be greater than the net liquid assets value per share.
The structure that is most frequently used for acquisitions and financings of US assets is an ijara wa’iqtinah, or a lease purchase agreement. In this structure, ownership of the property is held by a special purpose entity (SPE), the shares of which are usually owned by a corporate services company.
The property being acquired from the third-party seller is transferred directly to the SPE, which at the time of acquisition enters into a lease of the property to an entity (Investor Co) established for that purpose by the Islamic financial institution sponsoring the investment. The lease documentation requires Investor Co. to make an initial payment to the SPE which payment may be treated as an initial rent payment, but which in substance represents the equity investment made by Investor Co in the property.
The SPE would enter into a conventional mortgage financing arrangement with a US bank or other lender (Lender) and the proceeds of that financing, together with the initial payment made by Investor Co, would be used by the SPE to pay the purchase price for the property. Investor Co as master lessee of the property from SPE would become the landlord in relation to the tenants physically occupying the property. Investor Co would secure its obligations under the lease documentation by assigning to the SPE Investor Co’s rights under the tenant leases as collateral and by granting a security interest in any other assets of Investor Co.
The SPE will in turn secure its obligations under the mortgage loan from Lender with an assignment of its rights under the lease with Investor Co, and a collateral assignment of the collateral received from Investor Co. Payments by Investor Co under the ijara are substantially equivalent to the debt service obligations of SPE under the mortgage loan documentation with Lender. As a result, any payment default by Investor Co is likely to result in a payment default under SPE’s mortgage loan documentation with Lender.
Moreover, Lender’s mortgage loan documentation is likely to have an explicit cross default such that defaults by Investor Co under the ijara constitute a default under the mortgage loan.
In conjunction with the ijara documentation, the SPE would typically grant to Investor Co a “call” right to purchase the property at any time or at certain specified times for an acquisition cost specified in the ijara. Investor Co would in turn typically grant to the SPE a “put” right to require Investor Co to purchase the property in the event of a default for an amount equal to the acquisition cost.
In order to satisfy Shariah requirements, the ijara will require that certain tasks associated with ownership of the property, such as major repairs and property insurance, be handled by the SPE, as legal “owner”.
In order, however, for Investor Co to be treated as the “tax owner”, the SPE will typically retain Investor Co (or its affiliate) under a separate agreement to handle the performance of those responsibilities on behalf of SPE. In order to avoid termination of the ijara in the event of a “total loss” casualty, which is required under Shariah law, this supplemental agreement also requires Investor Co to maintain insurance which in the event of a “total loss” casualty will pay proceeds equal to the total outstanding obligations of Investor Co under the ijara (which obligations are substantially identical to the SPE’s obligations under its mortgage loan from Lender).
The amount required to be paid by the SPE to Investor Co under this supplemental agreement would be factored into the rent payment obligations of Investor Co under the ijara. The final document comprising the ijara documentation would be a tax matters agreement in which Investor Co and SPE would agree on the US tax treatment of the overall transaction.
Two key legal issues presented in the foregoing structure are as follows:
First, Investor Co (and its investors) will seek to be treated as the “owner” of the property in order to obtain US federal tax benefits of property ownership. Thus, all of the benefits and burdens of property ownership must rest with Investor Co, notwithstanding that Investor Co is the lessee of the property and not the holder of legal title.
The second key legal issue relates to Lender’s recognition that while its mortgage loan is to SPE, which is the title owner of the property, its true “borrower” is Investor Co which leases the property from the SPE. Lender will want to be certain that this structure, in which an SPE is interposed between it and its true borrower, will not negatively impact Lender’s rights or its enforcement of its remedies.
As a general observation, Islamic financing operates under a number of inherent restrictions, including the following. First, IFIs can only provide financing for an activity which is permitted by Sharia, irrespective of its profitability and economic viability (eg, excluding the business of liquor, pork or pornography).
Second, IFIs cannot lend any amount in cash to pay interest; consequently, certain financial needs of some sections of the society are ignored in financing, including personal loans and working capital requirements of non-for-profit organisations.
Third, when Islamic financing is provided under “profit and loss sharing”, although profit can be shared in accordance with an agreement between the parties involved, loss generally must be shared according to capital contribution/ownership.
IFIs cannot claim interest on their balances with other banks or on mandatory cash reserves maintained with a central bank; cannot invest in government securities or interest-based bonds; cannot claim time value of money from defaulters; they bear real economic risks in sale and lease transactions and can only invest in Shariah-compliant securities and not in all available equities; and they have to compete with conventional banks in deposit-servicing, as well as in financing.
Two features of the Islamic financial system are worth mentioning, however. First is the required linkage between the financial and the real asset sector, as IFIs cannot extend credit without having support from the tangible economic sector. Financings are either made through sharing risk and reward, or must be asset-backed.
Second, a unique feature of Islamic financing is in the form of Mudaraba which can play the role of catalyst for bringing prosperity to society by extending capital to skilful persons lacking capital.
Under the Mudaraba mode of financing, a partnership between capital and skill is formed which can be used to provide self-employment to jobless skilled persons. Islamic banking is not a mere copy of conventional banks as perceived by certain Muslims. It has its own way of doing business and all operations are duly certified by qualified Shari experts.
Generally, and with particular reference to the US, in light of its statutory and regulatory hurdles, both to the establishment of a national Islamic bank and the expansion of Islamically-structured Shari’ah-compliant acquisition, investment and other financial products, it is necessary to overcome the impasse that is currently preventing Islamic banking from flourishing in the United States.
An education initiative needs to occur with US regulators, foreign investors and domestic consumers to make them aware of the advantages of Islamic finance. Foreign and state regulators must put aside views that Islamic finance is linked to terrorism, and must develop new ways to eliminate regulatory barriers to Islamic banking in the US Foreign investors must also be educated as to the banking, securities and tax regimes in the United States, both on the federal and state levels.
Finally, Islamic financial institutions should continue marketing and educating consumers in the United States about the importance of interest-free Islamic financial products. There is no reason why the United States should not actively become a major hub for Islamic finance.
A second-tier approach would be to simplify the regulatory regime in the US and adopt some of the British financial reforms including, in particular, the consolidation and coordination of financial regulatory agencies.
At the same time as certain states are seeking to impose anti-Shari’ah statutes, Americans should be seeking a change in financial regulations, particularly given the ineffective response of the current regulatory scheme to deal with bank failures, the sub-prime mortgage crisis and the credit crunch.
Thus, there is a potential broad base of support from voting constituents for the advent of a single, integrated financial regulator that would effect a broadening of the capital markets and be more effective in preventing financial crises and attracting foreign investments.
Under this regime, there may well be room for further financial innovation, such as government-issued sukuk to provide long-term financing for infrastructure projects, for example, that could spur growth in the US and elsewhere, including the growth of future of future financial markets in such areas as takaful, Shari’ah-compliant pension schemes, Shari’ah-compliant open and closed-end funds and real estate investment trusts.