The economic shutdown resulting from the COVID-19 pandemic across countries, has caused a huge impact on various industries which are cutting down production and jobs due to diminishing demand and cash flow constraints. The Islamic finance industry is not spared. Before the pandemic, there has been a steady growth in demand for Shariah-compliant products and services and the industry’s total assets reached US$2.5 trillion globally in 2019. Now, given the global recession and outlook, the Islamic finance industry, together with the rest of the world, is staring at a long road to recovery ahead; facing challenges that are unprecedented.
Following the Global Financial Crisis, Islamic finance has proven to be a resilient alternative to conventional financing. Islamic social finance solutions like waqf, zakat, Islamic microfinance helps and provides liquidity access to SME and micro-businesses for them to scale up their productivity. Whereas, instruments like sovereign Sukuk can raise funds for governments for various development and infrastructure projects. Islamic finance products and instruments, backed by actual assets, provide a solution which not only balances the fund-raising needs of end-users but also afford sufficient protection and security for the financial institutions. This is one of reasons why Islamic finance came out relatively unscathed from the Global Financial Crisis.
The Issues Faced
Now in response to the threat of COVID-19, many jurisdictions, governments and regulators have announced various types of payment moratoriums, deferments and suspensions. For instance in Singapore COVID-19 (Temporary Measures) Act 2020, provide various temporary relief to businesses and individuals who are unable to perform their contractual obligations because of COVID-19 including moratorium on legal action.
This also impacts Islamic finance transactions. Islamic finance is an interest-free system built on principles based on responsible, ethical and sustainable financing. Islamic finance transactions would typically include a profit component payable to the Islamic finance institutions amortised over the course of the repayment period.
Take for instance the following:
- Customer B has an outstanding repayment of S$50mil to Islamic Bank A pursuant to a Commodity Murabaha Islamic finance facility,
- S$50mil comprises of S$40mil cost price and profit of S$10mil
- Repayment is to be made over 5 years at S$10mil per year
- On 3rd year, COVID-19 legislation passed and moratorium is in place for a year.
In the light of such COVID-19 legislation, how should Islamic financial institutions treat transactions in which there is a moratorium on repayment obligations which are imposed by the legislation? As there are strict principles governing Islamic financial transactions against usury / interest, if a contractual repayment obligation period is extended, can the remaining amount of deferred profit still be claimed? And what about a claim for an increase in profit, due to the extension of the repayment period? Is this allowed?
The Response and Solutions
These are the issues that the industry is grappling with given the new normal. The COVID-19 outbreak has not only underlined the urgency of research to find a vaccine, but it has also highlighted the need for clarity and solutions for Islamic finance transactions. Recently on 22 May 2020, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has published a statement “Accounting implications of the impact of COVID-19 pandemic”. AAOIFI is a leading international body responsible for the development and issuance of standards for the global Islamic finance industry. The objective of the statement is to provide clarifications to Islamic financial institutions for the application of AAOIFI financial accounting standards (FASs) and the AAOIFI’s Conceptual Framework considering certain pertinent issues arising due to economic factors and regulatory interventions in the wake of the COVID-19 pandemic.
AAOIFI acknowledged and classified the various payment moratorium legislations by the different jurisdictions into the following categories of impact on Islamic finance transactions:
- extending the contractual period of the transaction, without increasing the profit / return on the Islamic finance transaction (Scenario A below)
- suspending the payments for the time being, without increasing the contractual period of the transaction, and the total profit on the transaction remains the same (Scenario B below); and
- modifying the contractual terms and conditions whereby the contractual period of the transaction is increased with increase in the profit/return (where acceptable in line with Shariah principles and rules)
Practically speaking, what is recognised is that (i) the contractual repayment period can be extended without an increase in profit (Scenario A), (ii) the remaining amount of deferred profit can be amortised over the extended period (Scenario B); and (iii) if there is to be an increase in profit and contractual term (i.e. neither Scenario A nor B), then this must be done not only by agreement of parties, but also in a manner that is ultimately Shariah-compliant, for which you will need to seek separate legal advice.
Further, AAOIFI clarifies that the expected contractual period in respect of an Islamic finance transaction is considered to be modified (extended) only in the following cases:
- there is a mandatory payment moratorium by the regulator, as and when such regulatory decision is enacted; or
- if there is an optional payment moratorium by the regulator, as and when the counter party submits its consent for application of payment moratorium in line with regulatory instructions.
Potential Pitfalls
It is important to note that as per paragraph 5/7 of AAOIFI Shariah standard (SS)8 “Murabaha” it is not permissible to extend the date of payment of debt in exchange of additional payments in case of rescheduling, irrespective of whether the debtor is solvent or insolvent. Accordingly, there is no intrinsic right of increase in profit in such situations.
Hence, if you have any doubts or queries in relation to the re-financing of your Islamic finance facility or disputes arising out of the moratorium on repayment issues, you should seek professional legal advice. It is hoped that we can all adapt to the new legislative and regulatory framework and the industry will be able to demonstrate the same resilience it had shown during the Global Financial Crisis.
