European Journal of Islamic Finance – N.1 Dec. 2014 / Page 1-10

University of Turin, Italy, paolo.biancone@unito.it

University of Turin, Italy, maha.radwan@unito.it

Abstract

Islamic Finance have been a flourishing phenomenon recently with a very high growth rates and countries worldwide are exerting efforts to introduce it as an alternative financial system especially after proving its stability in the last financial crisis. Introducing the Islamic finance in Italy would be very important step with high potential opportunities due to the creation of investment opportunities, increase of liquidity, accessing Arab sovereign funds, and promoting integration policies for immigrants. Understanding the current nature of the Italian companies in particular the Small and Medium Enterprises (SMEs) and by testing their eligibility of being Sharia compliant in this paper; which is a fundamental step for exploring the feasibility of adapting them to the Islamic financial system and therefore the possibility for financing them through Islamic financial instruments; had proved its validity with an optimal results whether on the screening process or the performance and profitability measures.

Keywords; Islamic finance, Sharia Compliant, SMEs, Sharia Indices, Sharia Compliant Screening.

I. RESEARCH PROBLEM AND OBJECTIVES

Small and Medium Enterprises (SMEs) are the basic stones in most of the economies. They contribute heavily to the economic growth worldwide. Most of the countries always try hardly to encourage development of SMEs as it contributes a lot not only to economic growth, capital accumulation but also through the employment opportunities that they create. This research aims to explore the feasibility of adapting Italian SMEs to the Islamic financial system and verify the possibility of financing them through Islamic financial instruments which requires certain aspects to be fulfilled. Applying this would require that the Italian SMEs to be a Sharia compliant. Objectives of the research are: – To test the Italian SMEs for Sharia compliant screening – To determine the eligibility of Italian SMEs to the Islamic finance – To evaluate the problematic criteria‟s that could prevent the SMEs from being eligible – Figuring out what are the suitable tools that Islamic finance could offer to SMEs

II. INTRODUCTION AND LITERATURE REVIEW

Islamic finance is, indeed, a growing sector with its diversity in different segments in various parts of the world. Although the Islamic finance industry started to flourish recently, Islamic theories of economics have existed for more than a millennium. However, only in the 20th century Muslim scholars and academics seriously started to revisit these topics; and this had been the beginning for the modern Islamic finance industry to emerge in the 1970s (Iqbal & Mirakhor 2011) [13]. Islamic finance has not taken root solely in Muslim countries but has also spread to non-Muslim countries. It is not serving only religious Muslims in Muslim‟s societies and Muslims in Western countries but also it started really to flourish as an ethical non risky attractive financial instrument for NonMuslim population. Islamic finance is a system for all financial transactions that are conducted according to Sharia which is the legislative framework that regulates all aspects of lifxe for Muslims; it governs all their public and private life. Sharia is derived directly from four main sources:

1) The Holy Quran; which is the Holy book that contains the words of Allah “God”.

2) Sunna; which refers to Hadith “sayings”, actions, of Prophet Mohamad “Messenger of Allah”.

3) Ijma; which is the consensus of all Muslim scholars on a specific issue.

4) Qiyas; means “Analogy” and this for the issues that were not explicitly mentioned either in Quran or in Sunna and consequently in this case it is declared by qualified scholars who evaluate a measurement through studying rules applied for similar issues. Islamic finance from an economic point of view refers to a system which identifies and promotes economic and financial orders that are consistent with the principles of Sharia [7].

These principles differentiate Islamic finance from the conventional finance. Specifically, Islamic principles require that Muslims earnings must come from permissible means, and must also be spent on acceptable categories of expenditure that are Sharia Compliant “adhering completely to Sharia principles”. Consequently, Islam prohibits investing in businesses that are considered unethical or contrary to the Islamic ethical teachings and values. Islamic economics is mainly concerned about the distribution of wealth as a mean for achieving justice, equality, fairness, and economic equilibrium among the society. Muslims are encouraged to maximize their wealth as long as they do not create a situation that is creating a social distortion or violating the norms of Islamic justice [4]. As a result the need for financial institutions, products and services, instruments and contracts that is compliant with Sharia and within the constraints of Islamic ethical principles. Sharia compliant institutions are similar to conventional financial intermediaries in that they are profit maximizing institutions and offer traditional banking services, but differ in some of the principles under which they operate [9]. Research from the International Monetary Fund (IMF) indicates that Islamic banking appears to be a complement to conventional banks, rather than a substitute. A core concept of finance in Islam is that Allah “God” is the owner of all wealth in the whole world, however at the same time; Muslims have the right to enjoy whatever wealth they acquire and spend it in Sharia compliant ways. The most important principles of Islamic finance include a prohibition for Riba “Usary”, prohibition of Gharar “uncertainty/speculation”, prohibition of Maysir “Gambling” and prohibition on investment in Non- Halal that is equivalent to Haram “unethical” businesses products or services (such as alcohol, tobacco, pork, adult entertainment, and weapons). Sharia compliant products must be backed by or based on an identifiable and tangible underlying asset; it is also important that the investor and investee adhere to the concept of profit and loss sharing which is in other terms sharing the risk of all financial transactions. Islamic Financial products, while they are derived from Islamic ethical laws, are not limited to Muslims population only but they are available to everybody. It is a technical financial system that is operating on an ethical basis that is very similar to the social responsibility investments that promotes for an ethical finance. Islamic Finance is considered to be the fastest growing sector of finance in the world. The Islamic finance industry has experienced in recent years (estimated at 10%-20% annual growth) [3]. Industry experts estimate that assets held under Islamic finance management doubled between 2007 and 2010 to each around $1 trillion [10]. A survey of the top 500 Islamic financial institutions shows that Sharia compliant assets in these institutions rose from $822 billion in 2009 to $895 billion in 2010.

III. FUNDAMENTALS AND FINANCIAL INSTRUMENTS OF ISLAMIC FINANCE

Islamic finance institutions operate with reference to principles of Sharia. Those principles have got specific characteristics and prohibitions that regulate it which are different from the traditional conventional financial institutions features.

1. Prohibition of Riba “Usury or Interest”: From a Sharia prospective, riba “interest” is considered to be usurious and is prohibited. Riba refers to the premium that must be paid by the borrower to the lender along with the principle amount as a condition for taking the loan. Scholars have classified riba into two types that could be seen in;  Inequality of quantity or weight and dissimilarity of quality exchanged between parties  The extension of the repayment period of a loan for additional amount of money. It makes no difference whether the loan is for consumption, or business purposes, or whether the return is a fixed or a variable percentage of the principal. It also makes no difference whether an absolute amount to be paid in advance or on maturity, or received in the form of a gift or a service if stipulated as a condition in the loan contract or an extension in its maturity” [2].

2. Prohibition of Gharar “Uncertainty or Speculation”: Gharar “uncertainty” in Arabic refers to excessive risk, uncertainty and hazard. Gharar can be seen into two types: gharar in the object of the contract and gharar in the terms of the contract. The rationale behind the prohibition of gharar is that to ensure the full consent of all parties in a contract.

3. Prohibition of Maysir “Gambling”: Maysir in Arabic means gambling which is hazard game of chance and it is considered as an extreme form of gharar. It refers to all transactions that have the element of gambling i.e. based merely on chance. The logic behind the prohibition of maysir is that the unjustified gains and increase of wealth through games of pure chance is a transfer of wealth from one to another and this kind of transfer is done on the expense of the society.

4. Principle of Profit and Loss Sharing (PLS): The Islamic ethics and Sharia has encouraged the increase of wealth however this increment should be done with reference to a very important principle which is Profit and Loss Sharing (PLS). This principle specifically refers to an equitable sharing of risks and profits between the parties involved in a financial transaction. Earnings of profits or returns from assets are permitted as long as the business risks are shared by the lender and borrower.

5. Prohibition of Haram “Unethical” Versus Halal “Ethical Investments”: Sharia has prohibited Haram “unethical activities”. Haram unethical activities are represented not only in the riba, gharar, maysir but also for specific businesses and industries that are forbidden in socially and ethically manner that do not work in the direction of benefiting the society. These include, for example, pornography, alcohol, weapons, pork based products…etc. It is also not allowed to acquire the shares of the companies providing financial services or business that is not Sharia compliant.

6. Necessity of Underlying Tangible Asset: Sharia defined that each financial transaction must be tied to a “tangible, identifiable underlying asset,” i.e. real estate or commodities, etc. Money is recognized in Islam as a means of exchange, but not as a commodity because it is not capable of fulfilling human needs unless converted into a commodity. Sukuk which are Islamic financial instrument that are similar to those of conventional bonds but a key difference is that they are backed with underlying asset.

7. Obligation of Zakah “Purification”: Zakah is one of the five pillars of Islam and is a religious duty for Muslim as a charitable activity for the needy and poor. Zakah has a strong rationale behind being an obligation as for its great benefit for the society and the reinforcement of the social responsibility towards the poor and needy.

IV. FINANCING MECHANISM AND ISLAMIC FINANCIAL CONTRACTS

The previously mentioned fundamental principles in Sharia concerning the financial transactions and operations should be transformed into a set of rules and contracts or financial instruments to be practically used. A. Equity-Based Financing Mechanism The most widely used contracts in the Equity-based modes are the Musharaka “Joint Venture or Partnership of Equity Participation” and Mudaraba “Partnership”. They are mainly based on the modes of profit and loss sharing, where the profitability of Islamic institutions is directly linked to their physical investments. This constructs the main difference between the Islamic banks and the conventional banks that get the return in the form of interest on the loans provided to the customers regardless the fact that they invested this loan and whether it generated any profit or not [8]. B. Debt-Based Financing Mechanism The debt-based financing is a mechanism that depends on the idea of a fixed return on investment. In order to achieve this concept with a Sharia compliant way without breaking the rule of prohibition of Riba “interest” it must be done in a particular mechanism. This mechanism is done by mark up cost plus concept and this can be used in contracts that are based on sale with a deferred payments or purchase or that are based on leasing. Most well known contracts are Murabaha “cost plus mark up”, Ijara “leasing”, Salam and Istisna.

V. SHARIA COMPLIANT SCREENING METHODOLOGY

Investments should be always a Sharia compliant, which requires screening for its eligibility for qualitative and quantitative criteria. The qualitative criteria are mainly related to the business activity of the company and it permissibility according to Sharia. Regarding the quantitative criteria they are a set of financial ratios and levels that had to be examined and their results should not exceed specific threshold. 1. Qualitative Screening Criteria Companies must have their activities within the permitted activities which are named Halal and avoid all non permitted activities which are referred as Haram activities. Activities should of course include all of the production and sales of the company‟s products. Screening for those activities in the companies is considered a fundamental step and crucial phase. This step represents the classification of the core business of each company. Passing this initial qualitative screening phase means moving towards a quantitative financial screening.

Non permissible activities are those:

•  Alcohol
•  Pork related products
•  Pornography
•  Tobacco
•  Gambling
•  Interest bearing financial services (i.e. conventional banks and insurance companies)
•  Weapons and defense
•  Biological human and animal genetic engineering (ex: cloning)
•  Media and advertising companies with exception to news channels, newspapers, and sports 2.

Quantitative Screening Criteria The second phase is the quantitative screening in which the financial ratios of the companies are tested for not exceeding specific threshold that are different among the different global indices. The three main aspects that should be tested are the leverage level (debt level ratio), interest ratio, and the liquidity ratio (cash and account receivables), and finally the portion of revenue that is generated from non compliant operation.

Level of Debt: Any interest based debt is not permitted according to Sharia principles and this ratio verifies that the interest based debt is not exceeding the specified threshold.

 Interest Ratio: The second ratio is the interest one which tests practically the investment in interest bearing securities and assuring that the income generated is not considered riba.

 Liquidity Ratio: The third ratio is the liquidity ratio that is mainly focused on testing the liquid assets in the company (i.e. cash and accounts receivables).

 Non Permissible Income: There is a final criteria of financial ratio to be verified as well which is the level of non permissible income ratio. There is a minimum level of tolerance to accept some income that is generated from impermissible operations as long as the business sector is Sharia compliant. …

(… next week for the 2nd part…)

Paolo Biancone – Maha Radwan / European Journal of Islamic Finance  ©2014-2017

Courtesy of  The European Research Center of Islamic Finance ,(Università di Torino)

You can  free download the original paper at: file:///C:/Users/User/Downloads/908-3276-2-PB.pdf