Financing for Development: The Role of Islamic Finance M. Kabir Hassan SESRIC, Istanbul November 23, 2018

Source: UN Sustainable Development Goals Webpage Global Challenges 828 million people live in slums today and the number keeps rising One in five people still lacks access to modern electricity Water scarcity affects more than 40 per cent of the global population and is projected to rise 836 million people still live in extreme poverty More than six million children still die before their fifth birthday each year Globally, one in nine people in the world today (795 million) are undernourished 103 million youth worldwide lack basic literacy skills Source: UN Sustainable Development Goals Webpage

Sustainable Development Goals The development goals include measures for the present but also for future development. Sustainable development targets three broad goals for the society (Sachs,2015, p.219) : Economic development, Social inclusion, Environmental sustainability, One aim is to preserve and efficiently use natural resources. They will join both science and morality to save humanity in the long run.

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.

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.

No of compliant companies Main Findings 2/16/2019 Motivation Empirical Work Conclusions Qualitative + Quantitative Screening   No of companies+ Threshold No of compliant companies % Qualitative screening 200 >13* 139 69.5 Qualitative + liquidity <33% 80 40 Qualitative + liquidity + interest 58 29 Qualitative + liquidity + interest + debt 38 19 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).

Islamic Finance: A comprehensive system Islamic Financial Services Ecosystem Mobilizing Resources Corporate Islamic Financial Institutions, SME’s Sukuk Investment High Net Worth Individuals Reducing GAP Affluent Individuals Equity Funding Upper Middle Class Middle Middle Class Lower Middlie Class Microfinance and Microtakaful Hard-core Poor Islamic social finance: Zakat& Awqaf Sadaqa and Qard Hassan

Islamic Social Business Model

Islamic Finance is a Non-traditional Source for SDG Financing 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

Comprehensive Islamic Finance Solutions in Supporting SDGs 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

Are All Sukuk Shariah Endorsed? 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

Evolution of Sukuk Structure Development Sukuk features Asset backed Asset based Asset light 1. Presence of right to sukuk asset Present Absent, as recourse to the guarantor 2. Risk and return Deriving from the real asset performance Based on the guarantor’s performance 3. Presence of true sale transaction Absent 4. Presence of guarantee 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)

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]

Esham vs Sukuk Sukuk Esham Underlying 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 No principal repayment required Transaction Costs High transaction costs because of the SPV Low transaction costs

Esham Application In practice, Esham instruments have been recently used. However, the 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 3rd 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.

Acknowledgement I acknowledge writings of various authors over the years from which I have benefitted immensely and whose ideas I mingled with mine in this presentation.