Islamic finance in Sri Lanka needs good corporate governance, regulatory and legislative measures

By Riyazi Farook

The Islamic finance is certainly the fastest growing industry in the world, worth over US$ 1 trillion to date- a 28% increase from last year, which clearly demonstrates the industry’s potential despite the global financial crisis and the consequent economy downturn. Interestingly, industry is already catering to as much as 15% non-Muslim customer base throughout the world.

The Sri Lankan financial sector remained comparatively insulated from the global financial crisis, despite the fact, similar to the island’s conventional finance sector Islamic finance has also witnessed the insolvency before even the industry kicked off.

Institutions offering Islamic financial services in Sri Lanka cannot undermine the corporate governance practice, which should be on top of its strategic agenda to credibly protect particularly depositors' and shareholders' resources in the investment pools. Regulatory measures should also ensure Islamic financial service ventures are not just merely attracted to quick profit from the emerging industry but to aim at what global Islamic finance industry being achieved over the last three decades.

Industry Overview

In March 2005, CBSL issued an ordinance to include provisions for Islamic finance in which Sri Lanka became one of the few countries to have specific legislation for Shari’ah-compliant financial operations. The amendment also provided flexibility for conventional financial institutions to establish windows to offer Islamic banking and finance products and services.

According to Islamic Finance News Malaysia Islamic banking sector in Sri Lanka is estimated around US$900 million. Sri Lanka has number Islamic financial services providers including market leader Amana Investments Limited, Muslim Commercial Bank (MCB), People’s Leasing Company - Islamic Financial Services Unit, First Global Group, and ABC Investments (Baraka Islamic Financial Services). Amana Takaful Limited (ATL), the only takaful provider in the country, was introduced in 2002 and ATL was listed on the Colombo Stock Exchange (CSE) in late 2006. Amana Securities Limited (ASL), a subsidiary of Amana Investments Limited, is a trading member of the CSE and is one of just 20 stock-broking companies licensed to operate on the CSE.

The country’s largest bank, Bank of Ceylon, was planning to launch an Islamic banking unit in early 2008, but the bank decided to delay due to the global financial crisis.

In a remarkable development, Amana Investments Limited was recently issued a Letter of Provisional Approval by CBSL. Presently AIL is in the process of fulfilling certain condition listed in the Letter of provisional Approval such as raising of a minimum capital of Rs. 2.5 billion to establish island’s first ever full-fledged Islamic licensed commercial bank named Amana Bank Limited under Section 5 of the banking Act No. 30 of 1988 to carry out Islamic banking business in Sri Lanka aiming to deliver retail, business, and private banking facilities including wealth management, infrastructure financing, bonds, corporate treasury placement and many other financial products and services in the country to attract Shari’ah compliant investment funds from the Middle East and the Far East.

The ‘DJIM Amana Sri Lanka Index' launched in collaboration with Dow Jones Indexes, USA, The DJIM Amana Sri Lanka Index is the only Islamic Index in Sri Lanka, provides access to investors who seeks investment opportunities in Sri Lanka stocks that comply with Shari’ah requirements.

Country’s first ever planned Sukuk issuance attempt to raise approximately Rs. 500 million (US$ 4.5mn) by the Islamic Financial Services Unit, window of the People Leasing Company Co. LTD. - a fully owned subsidiary of People’s Bank (100% State-owned bank) was postponed primarily due to procedural delays and with regard to regulatory authorities, and consequences of the global financial meltdown. However, the company sources said that it is now rescheduling to launch the Sukuk once the investors sentiment and market condition become more favourable.

Corporate Governance PRACTICE

The Corporate Governance, including risk management staged to rigorous debate as corporate scandals and failures around the world shook the financial industry, and indeed Islamic finance industry is not immune to scrutiny. Sri Lanka has also been experiencing increased scams and failures in conventional including Islamic financial industry for last few years, which resulted CBSL to issue a voluntary code of corporate governance practice to financial institutions but, corporate governance code yet to be made mandatory for financial institutions to prevent such scandals and failures in future.

Generally, corporate governance in Islamic finance institutions is quite similar to a combination of both Combined Code and Sarbanes-Oxley, because the corporate governance of an Islamic financial institutions distinguish in many forms to that of its conventional counterparts, most importantly Islamic finance institutions need to ensure that they comply with the Shariah (Islamic law) meaning that unlike secular governance practices Shariah would first examine at the transactional structure to find whether the process involves any activities or elements that contradict the profits generation. Also Islamic financial institutions must invite customers to contribute an active role in the governance process.

For instance, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Financial Accounting standards 11 provides clear principles and guidelines for Islamic financial institutions to disclose the share of the actual profits and of the funds from the returns they receive and emphasise the their disclosure in the financial statements and annual reports. The CBSL, as frontline regulator should regulate corporate governance practice by improving the levels of disclosure, compelling transparency, reporting standards, risk management and accountability to protect investors and maintain the integrity of this emerging financial industry competitive.

In the absence of sufficient legal and regulatory framework the emerging market unable to remain and perform competitive in the financial industry. A good example, in the UK or USA Islamic finance services industry subject to higher standards of corporate governance requirements and making them attractive for investment. To improve viability of the island’s Islamic finance and get greater benefit from this fastest growing industry, Corporate Governance should be enforced at the core of the Islamic financial institutions in Sri Lanka.

REGULATORY AND LEGISLATIVE ISSUES

The country’s Islamic finance institutions and experts will continue advising the CBSL on the development of new laws and regulations to facilitate the Islamic finance industry. Particularly, Amana Investments Limited has not only established itself as the pioneer of Sri Lanka’s Islamic financial services industry, but in the forefront lobbying the CBSL for relevant changes in the Islamic finance legal framework.

The Islamic finance directive issued by the CBSL supervision department defines Islamic banking and two of its fundamental elements clearly in the legislation. Receiving money for the investment in a commercial venture agreed based on the profit and loss sharing principles including Mudaraba and Musharaka contracts. Second, a contract based on buy and sale transaction agreement based on deferred payment option such as Murabaha.

Islamic Finance Focus Group (IFFG) was recently set up by Islamic finance industry experts and interest groups, including KPMG Sri Lanka. The main objective of IFFG is to advise and lobby the Sri Lankan government, relevant regulatory bodies and parties to allow Islamic finance to compete on a level playing field with conventional financial institutions. IFFG continues to play a pivotal role in the development of new tax legislation and regulations in Sri Lanka to facilitate Islamic finance. In order to achieve this development there are few areas of anomalies in the Sri Lanka’s tax system that required to be addressed carefully for urgent reform and restructure to accommodate all forms of Islamic finance transaction in Sri Lanka.

Some Shari’ah compliant transactions are more affected by the Value Added Tax (VAT) than conventional finance, but this area of legislation is difficult to modify, as it quite similar to the EU tax system. However, it is significant to note that the Sri Lankan tax regime is not as complicated and extensive as the EU, UK or US tax system.

IFFG also working closely with CBSL and regulatory bodies to enable new legislation to be drafted to allow Islamic financial institutions to offer comprehensive range of Shari’ah compliant products without occurring the adverse direct tax consequences. Sri Lankan government should aim these measures to promote the island as a leading centre for Islamic finance in the South Asian region.

Growth Potential

The stable foundations for the future development of Islamic finance in Sri Lanka have yet to be laid firmly. Although future growth cannot be precisely forecasted due to lack of research on the island's Islamic financial market, there is a clear scope for expansion.

With mega post-war development projects in the pipeline such as infrastructure and economy development, the majority in the road sector would that have a positive impact on the construction industry, sovereign sukuk (Bond) issuance will potentially attract widespread international and local investors’ interest. Islamic finance institutions and experts realise the importance of encourage the Sri Lankan government to issue sovereign sukuk as an alternative to government bonds in the future.

On the aspect of development and challenges of Sri Lanka’s Islamic finance industry, Managing Director of the island’s market leader Amana Investments Limited, Faizal Salieh added, “Having completed twelve years of strong presence in country’s financial industry, we are continuously lobbying for regulatory and fiscal legislation to ensure innovation and growth; we are happy that CBSL has introduced promising changes in regulatory framework to support Islamic banking and Insurance Board of Sri Lanka has also licensed Takaful operators. Islamic finance has been supported by the tax authority applying substantial reform so far, but now we need progressive tax neutrality for Islamic financial products. At this stage Islamic finance industry imposing tremendous challenges for market players to ensure good corporate governance, risk management, transparency and Shariah compliance practices.”

The Sri Lankan government has allowed enough avenues in the fiscal and regulatory policy framework to facilitate Islamic finance since 2005. Furthermore, positive support and a favourable financial regulatory environment are encouraging for Islamic financial institutions to set up operations and for local and international investors to participate in taking the country’s Islamic finance industry to new growth.

Riyazi Farook can be contacted for further enquiries at riyazif@islamicfinanceandbanking.com