Islamic finance

1. Center in Islamic
Finance for Africa

2. Connecting Africa to the world of Islamic finance
Islamic finance offers alternative solutions to conventional finance that comply
with the principles of Shari’ah1
. Islamic jurisprudence strives to promote moral
and ethical values in establishing an economic system that outlaws the payment
and receipt of interest, excessive uncertainty in business transactions and
investment in prohibited industries2
.
Initially, the operations of Islamic banks were underpinned by the principle of
a two-tier Mudaraba3
. In this model, funds were acquired from investors on a
profit and loss sharing basis (tier one). These funds were then channeled to an
entrepreneur to invest in productive activity (tier two). Any profits generated
from the business venture would be shared in a pre-agreed ratio between
all parties, whereas losses would be incurred by the investors alone. This
principal-agent relationship, however, proved to be slightly problematic in that
considerable discretionary power was provided to the entrepreneur to invest
funds. The separation between management and ownership at times resulted in
the best interest of the venture and the investor not being considered. The return
provided to participants is also dependent on the profitability of the venture, and
inadequate oversight and decision-making increased the risk of financial loss.
This principle had limited use in practice, as Islamic banks undertook liability for
losses incurred by depositors. Another drawback with this system was that the
return provided to depositors proved to be volatile.
As financial systems became more complex, Islamic finance structures began
developing further. The two-tier Mudaraba3
model was gradually phased out as
the industry moved toward Murabaha4
modes of financing. These were contracts
entered into between banks and clients at a price incorporating an agreed-
upon profit margin. Murabaha has become one of the most frequently used
modes of financing among Islamic financial institutions globally. Over the past
few decades, Islamic finance has progressed significantly, and many different
products have been introduced.
Currently, the industry comprises three sectors: Islamic banking, Takaful5
and the
Islamic capital market. There remains huge potential for growth as the industry
remains untapped locally and within Africa, and the challenge lies in exploring
new avenues to tackle existing problems.
Islamic finance can act as the catalyst in mobilizing funding into Africa, thereby
resulting in economic growth and sustainable development. As per the African
Economic Outlook6
, the continent’s growth is expected to progress to up to 6% in
the upcoming year. This is driven by increased domestic demand, developments
in the private sector and strong trade relations with developed economies.
Although the Islamic financial services industry in Africa is currently dominated
by the banking and Sukuk segments, growth potential remains in the asset
management and Takaful spheres. Globally, the Islamic finance
sector is expected to surpass the US$2 trillion mark
by the end of 2015.

3. 1. Islamic law based on the teachings of the Qur’an and Prophet Muhammad (May Peace Be Upon Him).
2. Including the gambling, alcohol, entertainment, arms manufacturing, tobacco and certain food manufacturing industries.
3. Contract in which an investor (Rabb-ul-Mal) provides capital and an individual or institution (Mudarib) manages the capital
on behalf of the investor.
4. Form of trade financing in which commodities are sold at cost plus an agreed-upon profit margin.
5. Joint guarantee based on the underlying principle of mutual cooperation and solidarity – an Islamic alternative to
conventional insurance.
6. Report published by the African Development Bank in collaboration with the United Nations Development Program and the
Organisation for Economic Co-operation and Development.
Islamic Finance Growth Drivers in Africa
Islamic finance mitigates the risks posed by unsecured lending and contributes
toward a more stable economic system. In developing Islamic finance further, a
key factor would be the alignment of existing regulations to conform to Shari’ah
structures. Locally, efforts have been made in amending legislation to provide
leniency to institutions offering interest-free financing. Human capital investment
is also crucial in establishing visionary policies and initiatives.
Product innovation and diversification would provide solutions to satisfy existing
and emerging needs. This will go beyond tweaking existing contracts and, rather,
focus on newer and more imaginative ways of delivering in line with market
demand. The growth of Islamic finance into new territories and jurisdictions will
necessitate harmonization of Shari’ah and regulatory rules. This will ensure that
the industry remains efficient and competitive, and will require extensive collabo-
ration and cooperation.
Prospects for Islamic finance remain positive as interest in the field continues
to grow. Islamic finance is steadily merging into the mainstream conventional
finance and is here to stay. This creates extensive opportunity for advisory orga-
nizations to provide guidance to institutions willing to tap into this field. EY has a
Center in Islamic Finance for Africa that provides a support structure for clients
and will play a key role in developing Islamic finance on the continent.
Economic Growth
Stronger growth supported by improving
fundamentals, domestic demand and
stronger regional integration.
Demographics
A continent of 1 billion people. Africa’s
middle-class population is expected to
increase and this will boost demand for
retail banking, takaful and Islamic funds.
Infrastructure funding gaps
Significant wealth investment needed in
the medium-run, with the funding gap
estimated at USD48 bln a year, mostly in
the power sector.
Increasing awareness
Improving financial literacy across the
continent, including on Shariah-compliant
products amid policymakers’ renewed
interest in the sector as a means of
supporting financial inclusion.
Islamic Finance in Africa: Growth Drivers
Source: KFH Research Limited

4. Regulatory impact of Basel III
on Islamic institutions
Although the structures underlying Islamic
finance transactions differ to those for
conventional institutions, Basel III makes
no clear distinction between Islamic banks
and conventional banks. It requires banks to
strengthen their capital positions by improving
the quality of capital held. This would result
in reduced dependency on debt instruments
and would provide further insulation in times
of financial difficulty. This move is consistent
with the business model of Islamic banks. The
definition of capital has also been revised under
Basel III. Tier 1 capital comprises of common
equity, preferred stocks and hybrid securities;
Tier 2 capital comprises of subordinated debt
and loans; and and Tier 3 has been revoked.
Islamic financial institutions may be better
suited to meet the enhanced capital
requirements of Basel III, but these banks would
also be subject to regulation of the Islamic
Financial Services Board, which proposes more
stringent criteria in defining capital (or other
local regulators, depending on jurisdiction).
For Islamic financial institutions, Tier 1 capital
would include common equities, as well as
other Shari’ah-compliant instruments that have
a high degree of loss absorbency. Tier 2 capital
would include hybrid instruments that are
convertible into equities in addition to general
provisions and reserves held for future losses.
Islamic banks obtain deposits primarily through
a profit sharing investment account (PSIA)7
that, whether restricted or unrestricted, is not
guaranteed by the Islamic bank. The PSIA is
merely used as a mechanism for liquidity risk
management, hence excluded from regulatory
capital. Reserves such as a profit equalization
reserve (PER)8
and an investment risk reserve
(IRR)9
would not form part of an Islamic
institution’s capital as defined. The IRR and a
component of the PER are also excluded, as
they comprise equity of the investment holders
and not that of the Islamic institution.
Basel III also requires banks to hold more
liquid, low-yielding assets to meet short-term
funding needs, but this may have an adverse
impact on profitability. Islamic banks may also
face challenges in managing liquidity, as there
are constraints on borrowing that may limit
access to liquid funding. In addition, surplus
liquidity cannot be transferred to conventional
banks. There is also a need to further develop
Shari’ah-compliant liquid instruments, as many
of the instruments currently available are not
accessible to Islamic institutions due to the
interest prohibition.
In comparison with conventional banks, Islamic
banks seem to be slightly less impacted by
Basel III, as the business model of an Islamic
bank is more conservative. These institutions
are better capitalized compared with their
conventional counterparts; however, challenges
do remain, as existing risk management and
corporate governance practices may need to be
improved. Uniform application across different
jurisdictions is also key in ensuring stability
within the overall financial system. Islamic
banks should ensure that they are actively
engaging with Basel III to position themselves
strategically in a competitive market.
7. As deposit accounts within Islamic banks are not interest bearing,
a PSIA is used instead. This account is based on the principles of
Mudarabah (partnership) or Wakalah (agency).
8. This is a reserve created by an Islamic bank by appropriating a
certain portion of the Mudarabah income (income resulting from a
venture in which one party provided capital and another provided a
service) before allocating a share to the Mudarib (service provider).
The profit equalization reserve provides a mechanism to control the
rates of return on investment.
9.This is a reserve created by an Islamic bank by appropriating a share
of the income of the investment account after payment to the
Mudarib (service provider). This reserve is held as a buffer against
future losses that may be incurred by the account holders.
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This material has been prepared for general informational
purposes only and is not intended to be relied upon as
accounting, tax, or other professional advice.
Please refer to your advisors for specific advice.
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Naseeha Mahomed
Naseeha Mahomed is a
Manager in Financial Accounting
and Advisory Services and is
responsible for the Center in
Islamic Finance for Africa.
cifa@za.ey.com
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