Institutions offering Islamic financial services began appearing in the market in the 1960s and in isolation, Islamic banking and finance gaining momentum around 1975 with the establishment of the Islamic Development Bank in Jeddah and the Dubai Islamic Bank.
Liquidity management
Understandably, in contrast to their conventional counterparts, Islamic banking and finance are still in their infancy, striving to find competitive Shariah compliant financial products. The sub-prime mortgage crisis and the credit crunch that followed heavily crippled the conventional financial markets, especially the mortgage-backed securities sector. This has to a considerable extent left Islamic financial institutions (IFIs) intact as the industry remains very liquid, mostly due to the upward scale in oil prices that at times reached record highs, benefiting of course the oil producing countries, particularly in the GCC region.
While this has placed the vast majority of IFIs enjoying high levels of liquidity, Shariah compliant liquidity management remains a thorny issue for them as they cannot convert their liquid assets into treasury bills, repos and other financial instruments as their conventional counterparts normally do to maximize liquidity. This is because it would entail, among others, the earning of interest, which is explicitly prohibited in Shariah law.
Shipping an attractive investment vehicle
As progress and know-how in structuring Shariah compliant financial products evolves, industries such as shipping have not gone unnoticed by IFIs. The boom that ‘hit’ the shipping industry prior to the credit crunch era, mostly due to, among others, China’s entry into the World Trade Organization and India’s development pace, has made shipping a very attractive investment vehicle for IFIs.
But although IFIs are currently at an advantage when compared to their conventional counterparts, there is still a long way to go for them in providing financial products that are both attractive and practical to shipping players. A few years ago, clients in the Middle East were cash buyers of vessels, mostly due to their inability to find attractive financing terms from both conventional and Islamic financiers. Lately however, the tide has turned and IFIs are rushing to attract clients by offering what their western counterparts now cannot do anymore.
One thorny issue that still has to be tackled relates to the “parasitical” costs associated with Islamic financing structures such as legal and accountancy fees, as Ijarah and Istisna contracts, for example, are highly complicated, often requiring the setting up of many special purpose vehicles in order to materialize a deal. Naturally, these costs fall upon the entity seeking the finance.
Western financing enthusiasm
Putting aside the credit crunch issues that naturally affect the size of their lending portfolios, Western financial institutions’ interest in the GCC shipping industry has grown substantially. A notable factor making the local shipping players in the area an eye turning investment alternative is none other than their success in tying up ship-owning and chartering in their ocean venture strategies.
This is particularly the case in the “wet” sector of the industry as many oil majors are investing in ship owning and vice versa, thus maximizing economies of scale while at the same time securing employment of their vessels and timely delivery of cargoes. Hence, any bank would feel much more secure lending money for the purchase of a vessel knowing that the vessel’s employment is pretty much guaranteed.
Although not yet mandated by local shipping players, Shariah compliance of any financial product has not been a prerequisite for doing business with a western financial institution or any financial institution for that matter. Problems may arise however when, say, a number of vessels belonging to the fleet of the same potential borrower have been financed under Shariah compliant financial structures. Legally, the western bank offering a conventional financial product may find it difficult to bridge the two financing structures, especially in the case when cross collateral security is sought.
Another factor that may be hampering western financing enthusiasm is the sanctions imposed by the United Nations (UN) on Iran. Beneficial ownership, proposed trade routes, ports of call and of course charterers come under intense scrutiny by western banks when it comes to financing a shipping project.
Interest from shipping companies outside the Middle East in obtaining financing from IFIs is still in its infancy. When it comes to traditional debt financing, western shipping companies have long-standing relationships with western banks and as a result are offered attractive financial packages.
Additionally, cash-rich owners would not find it practical or pertinent to switch from a financial package they have been acquainted with for years to one that may be attractive at face value yet still is a relatively unknown product in the shipping sector.
Added to that is the strong relationship between lender and borrower that took years to build which in some instances can prove to be more important than a discount on a few basis points an IFI may counter offer.
What western shipping companies are quite keen on, however, is attracting large cash flows from Middle Eastern investors to set up shipping funds, with themselves acting as managers. Greek ship owners have already set the trend in going public in either New York or London, accumulating sizeable sums. Some shipping companies are now eyeing the Gulf as an equal if not better alternative for similar cash raising transactions which need not necessarily involve being listed in the local stock markets.
Practicality is the key
Islamic finance has adapted itself to the shipping industry, as evidenced by the deals that are announced regularly where second hand tonnage and new builds change hands with the use of Islamic finance products. Some people misconstrue Islamic finance as being obstructive in nature to such deals. This is far from the commercial reality.
For example, an Ijarah wa Iqtina or a finance lease is not a lot different from a typical lease-purchase financing supported by a Barecon charter party that some western financial consultancies frequently offer nowadays. So, flexibility is not the issue; the attainment of practicality however is.
Justice and fair play are the raison d’être of Islamic thought, finance and the economic system in general. This is hardly the case with western economic systems. Also, making money from money is strictly prohibited. That leads us to the prohibition of interest. That is not to say however that when one approaches an IFI for finance, one will be granted finance without paying a price for it.
On the contrary, while a western bank will charge interest on the amount lent, the Islamic bank will charge a fee. There is similarity in the amounts to be paid by the borrower as both banks usually benchmark the amounts on the London Interbank Offered Rate or Euro Interbank Offered Rate plus some basis points above them.
A notable difference between the two systems is that a western bank never owns the asset for which finance is sought whereas that is usually the case, albeit indirectly, in most of the Islamic financing structures.
Co-dependency
While in the past it was Arab banks that were importing conventional financial products from either Europe or the US, now conventional banks are keen on improvising Shariah compliant products to not only please existing Arab clients but, more significantly, also the ever growing Muslim population in Europe. Arab banking dependency on conventional banking has been replaced by co-dependency, as the two have had to converge in order to offer products attractive to Muslims and non-Muslims alike.
London has for some time now been at the forefront in providing Shariah compliant financial products to its customers. The importance placed by London on Islamic finance can be evidenced by the listing of the Islamic Bank of Britain and the European Islamic Bank on the Alternative Investments Market, with Islamic finance in general being regulated by the Financial Services Authority and the Bank of England. Sukuk issuance has also gained popularity.
On a retail level, HSBC Amanah and Lloyds TSB offer Shariah compliant current accounts mostly structured on a Wakalah or Murabahah basis. House financing is also evident across Europe and more specifically in London where banks have been providing Shariah compliant housing loans to Muslims since 1988. Following the abolition of the double stamp duty in 2004, Shariah compliant house financing in the UK gained even greater momentum.
Istisna and Murabahah
Our shipping department has advised shipping companies whose new building orders were financed under an Istisna contractual structure. Understandably, parallel Istisna contracts are also pertinent in any such transaction in order to safeguard the parties involved. On the second hand tonnage level, we recently advised a shipping company on the acquisition of two dry bulk vessels, their financing being under Murabahah structures.
The prohibition of conventional interest does not in any sense denote that money provided under a Shariah compliant financial product is cost-free. The prohibition is aimed at encouraging equity financing and rewarding entrepreneurial spirit by sharing risk and reward. This means both the financier and the customer share the fruits of success and the vicissitudes of an unsuccessful commercial venture.
Murabahah
This structure may be more appealing to IFIs as the element of risk is much more limited compared to the Musharakah structure. A bank’s concern that a client may not eventually take delivery of the goods as per the agreement can be alleviated by the use of an agency agreement where the client takes delivery of the goods from the seller as the acting as the agent of the bank.
Gharar
When it comes to shipping transactions, or ship financing, agreements have to be bona fide and subject to full disclosure between the parties concerned, as matters that are left unsaid, or subject to improbable contingencies, may render an agreement void under Islamic law.
Thus, any type of transaction where the subject matter, the price or both are not determined and fixed in advance may be viewed with suspicion under Shariah law and tainted by gharar.
Forward freight agreements (FFAs) will most probably be considered void under Shariah law for two reasons — the excessive risk involved in these derivative products and the fact that they are not asset-backed securities such as Sukuk for example, FFAs being mere paper derivatives lacking any form of direct tangible security.
Shariah boards
One of the main features of modern Islamic banking is the role of the Shariah board that form an integral part of an Islamic bank. The Shariah board monitors the transactions of the Islamic bank and whenever a deal raises doubt from a Shariah standpoint, the board has the ultimate say as to whether the transaction is compliant or not.
These boards comprise highly educated and esteemed scholars. In addition, the International Association of Islamic Bankers, an independent body, supervises the workings of individual Shariah boards while its Supreme Religious Board studies the fatwas of the Shariah boards of member banks to determine Shariah compliance.
However, what hampers the system is the fact that the Shariah is open to interpretation, hence lacking a unified and codified system of law. This gives rise to divergent views as to whether a financial product is compliant. In this regard, there is no practical guide as to what constitutes an acceptable financial instrument since one Shariah board may approve it while another may not.
Ijarah Sukuk
Islamic bond issuances for financing shipping projects have gained momentum. Under an Ijarah contract, the usufruct of a particular property is transferred from the owner to another party, usually to the issuer of the Sukuk, in exchange for lease payments.
Ijarah certificates or securities represent a proportionate ownership claim over the asset being leased under the Ijarah contract and therefore holders of the certificates or bonds have ownership responsibilities and benefits which terminate only upon maturity or upon their sale to another party.
Lease payments are in turn passed on to the Sukuk investors. The most noteworthy Sukuk issued so far was the Qatar Global Sukuk valued at US$700 million. I am sure that many in the shipping industry may find this way of financing an attractive form of financing, especially in these times of financial crisis.
Islamic finance shall surely gain the momentum it deserves in the years to come. However, a lot of hard work is still needed, especially in resolving the problems that arise in interpreting the Shariah. There needs to be an agreement among Shariah boards as to what is compliant and what is not, and reaching such an agreement will be far from easy.
Managing partner
Alexiou & Co
43 Mavromateon Street
Athens 104 34 Greece
Email:
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Website:
www.alexiouco.com