SUSTAINABLE DEVELOPMENT

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M . K A B I R H A S S A N

B A N K I N D O N E S I A P L E N A R Y S E S S I O N D E C E M B E R 1 3 , 2 0 1 8

S U R A B A Y A , I N D O N E S I A

SUSTAINABLE DEVELOPMENT GOALS AND ISLAMIC

FINANCE

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Global Challenges

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836 million people still live in extreme poverty

Globally, one in nine people in the world today

(795 million) are undernourished More than six million

children still die before their fifth birthday each year

103 million youth worldwide lack basic literacy skills Water scarcity affects more

than 40 per cent of the global population and is projected to rise

One in five people still lacks access to modern electricity

828 million people live in slums today and the number keeps rising

Source: UN Sustainable Development Goals Webpage

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Islam And Poverty Eradication

■ Islamic principles of poverty alleviation are based on the Islamic views of social justice and the belief in Allah Almighty

■ Islamic approach involves a holistic approach with set of anti-poverty measures:

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Poverty Eradication Scheme of Islam

Positive Measures

Preventive Measures Corrective Measures Income Growth

Functional Distribution of Income

Equal Opportunity

Control of Ownership

Prevention of Malpractice

Compulsory Transfer:

Zakah

Recommended Transfer:

Charity State Responsibility

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Core Characteristics of Impact Investing

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Investments intended to create positive impact beyond financial return

Provides capital Business designed with intent

To generate measurable and

positive social and/or environmental impact

Expect financial return on

investment

►Sustainable development, Impact investing and Islamic finance

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Islamic Finance vs Impact Investing

Claims: “doing good and avoiding harm to others”:

 Approach to business-society relations: advancing human wellbeing.

 Financial inclusion: integrating people that are directly/indirectly kept out of the formal financial sectors.

The two financing methods resemble each other in many ways:

 First of all, both Islamic finance and impact investing share the same objective: doing good and avoiding harm principle.

 Second, both sectors seek investments that are compatible with the investor’s ethics and expect their investments to promote social- welfare.

 Third, both sectors provide access to finance for the poor and unserved that are kept out of the formal financial sectors.

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Islamic Finance vs Impact Investing

Islamic finance and impact investing are not only compatible but can create synergies through their rigorous moral, social criteria and emphasis on business-society relations.

There is also much that one can learn from the other:

 Shari’ah compliant funds are extremely efficient at screening out negative firms, but Shari’ah compliance is not Impact Investing,

 It is only one step away from considering positive social or environmental changes to turn it into Impact Investing.

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@ M. Kabir Hassan et al. 2017 CIIT Conference, Lahore Islamic Business Scorecard

Main Findings

Qualitative + Quantitative Screening

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Motivation Empirical Work Conclusions

 More than two-thirds of the companies (69.5%) comply with the qualitative requirements, whereas only one-third (32.5%) comply with the quantitative screen (Previous table).

 The introduction of EII and CSR dimensions into Shari’ah compliance does not significantly reduce the Shari’ah compliant investment universe, since about 70% of the companies are still Shari’ah compliant. This should help boost investors’ confidence.

 The majority of the companies, however, have been screened out because of the quantitative (financial) screens.

 After adopting a more restrictive format by adding three quantitative screens to the

qualitative screen, this study reports only 19% compliance. Similar percentage was reported by Pok (2012).

No of

companies⁺ Threshold No of compliant

companies %

Qualitative screening 200 >13^* 139 69.5

Qualitative + liquidity 139 <33% 80 40

Qualitative + liquidity + interest 80 <33% 58 29

Qualitative + liquidity + interest + debt 58 <33% 38 19

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Islamic Finance: A comprehensive system

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Corporate

Islamic Financial Institutions,

SME’s High Net Worth

Individuals Affluent Individuals Upper Middle Class Middle Middle Class

Lower Middlie Class

Hard-core Poor Islamic social finance: Zakat& Awqaf Sadaqa and Qard Hassan Microfinance and Microtakaful

Islamic Financial Services Ecosystem

Reducing GAP

Sukuk Investment

Equity Funding Mobilizing

Resources

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Islamic Social Business Model

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Islamic Finance is a Non-traditional Source for SDG Financing

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Global assets estimated to reach $3.2 trillion USD in 2020.

Emphasis on risk-sharing.

linkages to real economic activities.

Partnership-based.

Wide geographic reach (Asia and the Middle East) with expected rapid expansion of global assets in Muslim and non-Muslim countries.

Islamic Financing will be instrumental in the successful implementation of SDG policies

Major Principles:

 Financial stability

 Financial inclusion

 Shared prosperity

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Comprehensive Islamic Finance Solutions in Supporting SDGs

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Category Number of SDGs Islamic Finance Mechanism

Infrastructure Development and Capacity Building

8 SDGs (SDG 4, SDG 7, SDG 9, SDG 11, SDG 13, SDG 14, SDG 15, SDG 17)

Raising wholesale funding mainly from

1. Sukuk program

2. Islamic Syndicated financing

Social Development

6 SDGs (SDG 1, SDG 2, SDG 3, SDG 5, SDG 8, SDG 10)

Islamic Social and Financial Inclusion.

1. Zakat 2. Waqf

3. Islamic Microfinance (including Microtakaful)

Promoting Innovation to Achieve Efficiency

6 SDGs (SDG 6, SDG 7, SDG 8, SDG 13, SDG 14, SDG 15)

Equity based structure is more suitable in promoting innovation such as

1. Islamic Private Equity.

2. Islamic Venture Capital 3. Equity Funds

4. Crowdfunding

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Are All Sukuk Shariah Endorsed?

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 Of 1599 unique corporate sukuk issues between January 1996 to November 2018, 678 issues were considered

Shariah non-compliant by AAOIFI

 Only 383 issues were considered Shariah compliant as per AAOIFI, while the remaining 538 issues totally lacked

AAOIFI endorsements

 Only 24% sukuk are shariah compliant, the same as

claimed by Justice Taqi Usmani in 2007 which brought

turbulance in the sukuk market then

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EVOLUTION OF SUKUK STRUCTURE DEVELOPMENT

No. Sukuk features Asset backed Asset based Asset light 1. Presence of right

to sukuk asset Present Absent, as recourse to the guarantor

Absent, as recourse to the guarantor 2. Risk and return

Deriving from the real asset performance

Based on the guarantor’s performance

Based on the guarantor’s performance 3. Presence of true

sale transaction Present Absent Absent

4. Presence of

guarantee Absent Present Present

5. Asset

composition

Highly dominated by

real assets

Highly dominated by real assets/with mixture of financial

assets

Highly dominated by financial assets Source: Reviewed from Jobst (2006), Howladar (2009), Haneef (2009), Ahmed (2010),Nazar (2015)

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ESHAM: A TURKISH LEGACY

• Esham (plural of sehm) means shares

• They were utilized probably for the first time in Islamic financial history by the Ottoman government

• Defeated by the armies of Imperial Russia in 1774,

Ottomans had to pay a huge war indemnity within a year

• Since the borrowing had to be done by the government of the Caliph, it had to be Shari`ah based.

• Esham successfully raised about one third of the war indemnity within less than a year and then came to

dominate Ottoman public finances for the next century or so [Cizaka, 2011]

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Esham vs Sukuk

Sukuk Esham

Underlying Asset Physical asset Physical asset

Revenue Stream

Fixed Annuities generated by income of leasing back the underlying asset to its operator

Fixed Annuities as a percentage of income generated by the underlying asset

Redemption At maturity

No maturity, the borrower can redeem the Esham certificates when it is convenient

Principal repayment At maturity No principal repayment required

Transaction Costs High transaction costs

because of the SPV Low transaction costs

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Esham Application

In practice, Esham instruments have been recently used. However, they are being referred to as Sukuk.

Malaysian Airlines (2012) Abu Dhabi Islamic Bank (2012) RM 2.5 Billion was raised through

Sukuk.

No maturity date : like Esham No 3

^rd

party guarantee

No fixed annuities

No obligation of principal repayment

Raised USD1 Billion through perpetual sukuk

Redemption possible (if ADIB should chose so) after 2018

Issued to meet Basel III Tier 1 capital requirements

This sukuk is considered equity and does not negatively affect the issuer’s gearing ratio.

Expected to pay 6.9% of profits semi annually.

Private Banks allocated 60% of the Sukuk while the public was allocated 40%.

Inclusion of the growing middle class

through this instrument.

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Foundational Principles of Islamic Finance

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Rooted in Divine Law Economic Justice Circulation of Wealth

Commoditization Risk Sharing

Prohibition of harmful transactions

Economic justice for all humanity

Interests concentrates wealth

Backed-by real assets for real growth

Does not transfer risks to

the borrower

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Foundational Principles of Islamic Finance

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Lending (in a debt based economy)

Win-Lose Framework

Creates Debt

Risk Transferred

Unfair gains from profits and losses

Investing in an ethical equity based economy

Win-Win Framework

Invests in Real Assets

Risk is Shared

Just and fair profits and loss sharing

Rich gets richer

Poor gets poorer Justice and Equity

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Fictional financial economy is over 26 times larger than everything else produced

on earth.

Perpetual

Risk A Systemic

Problem

An Economy of Bubbles & Bursts

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Global GDP , in 2010 is $63

Trillion

Value of Shares and Bonds traded $87 Trilliom

Value of financial derivatives traded

$601 Trillion

Total Volume of Foreign Currency Transactions $955 Trillion

Data sources: April 2010 figures from IMF, BIS and WFE

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Challenges Facing IF

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Challenges

Developing appropriate legal,

regulatory,

supervisory, Shariah framework

Managing the liquidity in Islamic financial institutions

Continuing development of financial products that have positive impact on

the economy Development of Islamic

Microfinance for Poverty Alleviation

Commitment to apply Shariah, Accounting

and Supervisory Standards issued by Specialized Institutions

Encouragement of financing income generation Awqaf

project and the capacity building of

Waqf institutions

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Challenges Facing IF

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Communication Gap: Misconceptions,

misunderstandings and misplaced notions about Islamic Finance must be removed through

awareness and advocacy program.

Communication Gap

Trust Gap

Innovation Gap Talent Gap

Innovation Gap: Balance between Macro and micro maqasid should be maintained, the so called form versus substance (financial engineering).

Trust gap: Social Business and Impact

Investing should be emphasized to remove tensions among the stakeholders of the Islamic finance industry.

Talent Gap:

A new brand of scholars who are well versed in Islamic jurisprudence and secular financing techniques and mechanisms must be nurtured.

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Islamic Finance | Value-Based Finance

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Acknowledgement

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