Islamic Finance

INTRODUCTION TO ISLAMIC FINANCE

Concept of Islamic finance can be traced back about 1,400 years, its recent history can be dated to the 1970s when
Islamic banks in Saudi Arabia and the United Arab Emirates were launched. Bahrain and Malaysia emerged as Centers of
excellence in the 1990s. It is now estimated that worldwide around US
$1 trillion of assets are managed under the rules of Islamic finance.

Islamic finance rests on the application of Islamic law, or Shariah, whose primary sources are the Qur'an and the sayings
of the Prophet Muhammad. Shariah, and very much in the context of Islamic finance, emphasizes justice and
partnership.

The main principles of Islamic finance are that:

• Wealth must be generated from legitimate trade and asset-based investment
(The use of money for the purposes of making money (Interest) is expressly forbidden).
• Investment should also have a social and an ethical benefit to wider society beyond pure return.
• Risk should be shared.
• All harmful activities (haram) should be avoided.

The prohibitions
The following activities are prohibited:

• Riba (Charging and receiving interest). The idea of a lender making a straight Interest charge, irrespective of how the
underlying assets price, violates the concept of risk sharing, partnership and justice. It represents the money itself being
used to make money. It also prohibits investment in companies that have too much borrowing (typically defined as
having debt totaling more than 33% of the firm’s stock market value over the last 12 months).

• Haram business Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or anything else
that the Shariah considers unlawful or undesirable (haram).

• Gambling (betting on uncertainty), where transactions involve speculation, or extreme risk. This is seen as being
similar to gambling. This prohibition, for example, would rule out speculating on the futures and options markets.
Mutual insurance (which relates to uncertainty) is permitted if it is related to reasonable, unavoidable business risk. It is
based upon the principle of shared responsibility for shared financial security, and that members contribute to a mutual
fund, not for profit, but in case one of the members suffers misfortune.

• Short sales, Complex derivatives, Margin Selling. Uncertainty about the subject matter and terms of contracts –
this includes a prohibition on selling something that one does not own. There are two financial techniques available for
contracting to manufacture a product for a customer. This is necessary because the product does not exist, and
therefore cannot be owned, before it is made. A manufacturer can promise to produce a specific product under certain
agreed specifications at a determined price and on a fixed date. Specifically, in this case, the risk taken is by a bank which
would commission the manufacture and sell the goods on to a customer at a reasonable profit for undertaking this risk.
Once again the bank is exposed to considerable risk. Avoiding contractual risk in this way means that

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transactions have to be explicitly defined from the outset. Therefore, complex derivative instruments and conventional
short sales or sales on margin are prohibited under Islamic finance.

The permitted
Because of the restriction on interest-earning investments, Islamic banks must obtain their earnings through profit-
sharing investments or fee-based returns. When loans are given for business purposes, the lender, to make a legitimate
gain under the Shariah, should take part in the risk. If a lender does not take part in the risk, the receipt of any gain over
the amount loaned is regarded as interest.

There are a number of Islamic financial instruments under Shariah-compliant finance:

• Murabaha (An Islamic form of credit sale) is a form of trade credit for asset acquisition that avoids the
payment of interest. Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price
that includes an agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased, even if the client
does not take the goods within the time agreed in the contract. Payment can be made by installments. The bank is thus
exposed to business risk because if its customer does not take the goods, no increase in the markup is allowed and the
goods, belonging to the bank, might fall in value.

1. Deliver goods today

Seller Buyer
2. Pay for goods later

• Ijara (An Islamic form of lease) is a lease finance agreement whereby the bank buys an item for a customer
and then leases it back over a specific period at an agreed amount. Ownership of the asset remains with the lessor bank,
which will seek to recover the capital cost of the equipment plus a profit margin out of the rentals payable.
Emirates Airlines regularly uses Ijara to finance its expansion. Another example of the Ijara structure is seen in Islamic
mortgages. In 2003, HSBC was the first UK clearing bank to offer mortgages in the UK designed to comply with Shariah.
HSBC’s Islamic mortgage involves the bank purchasing a house and then leasing it out to the customer. The customer’s
payments include a contribution to the purchase price, a rent for use of the property and insurance charges. At the end
of the finance term, when all the payments have been made, customers can exercise a right to have the property
transferred into their name. The UK Islamic mortgage market is now undergoing significant growth.

Longterm Ijara (similar to finance lease)

1. Provide asset
2. Pay rentals for use of asset
Lessor 3. Pay asset value with rentals Lessee

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Shorterm Ijara (similar to operating lease)

1. Provide asset
Lessor 2. Pay rentals for use of asset Lessee
Lessee
3. Return asset

• Musharaka (An Islamic form of equity) is a joint venture or investment partnership between two parties who
both provide capital towards the financing of new or established projects. Both parties share the profits on a pre-agreed
ratio, allowing managerial skills to be remunerated, with losses being shared on the basis of equity participation. As both
parties take on project risk, it is relatively rare for banks to participate in Musharaka transactions.

General Partner
General (Musharik)
Partner General Partner
General (Musharik)
Partner
(Musharik) (Musharik)

Capital & expertise Capital & expertise

Profit & Loss Investment (Project)

Investment Profit & Loss
(Project)

• Mudaraba (An Islamic partnership contract) is essentially like equity finance in which the bank and the
customer share any profits. One party, the bank, provides the capital and the other party provides expertise to invest
the capital, manages the investment project and may provide labor. Profits generated are distributed according to
predetermined ratio, but like the capital itself, cannot be guaranteed. Losses accrued are, therefore, borne by the
provider of capital, who has no control over the management of the project. In practice, most Islamic banks use this is as
a form of investment product on the liability side of their statement of financial position, whereby the investor or
customer (as provider of capital) deposits funds with the bank, and it is the bank that acts as an investment manager
(managing the funds).

Funds provider (Rab al Mal) Business Partner (Mudarib)

Capital Expertise

Profit & Loss Investment (Project) Profit only

• Sukuk (An Islamic form of bond or debenture) is debt finance. A conventional, non-Islamic bond or
debenture is a simple debt and the bondholder’s return for providing capital to the bond issuer takes the form of
interest. Islamic bonds, or sukuk, cannot bear interest. So that the sukuk are Shariah-compliant, the sukuk holders must
have a proprietary interest in the assets which are being financed. The sukukholders’ return for providing finance is a
share of the income generated by the assets. Most sukuk, are ‘asset-based’, not ‘asset-backed’, giving investors
ownership of the cash flows but not of the assets themselves. Asset-based is obviously more risky than asset backed in
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the event of a default. There are a number of ways of structuring sukuk, the most common of which are partnership
(Musharaka) or lease (Ijara) structures. Typically, an issuer of the sukukwould acquire property and the property will
generally be leased to tenants to generate income. The sukuk, or certificates, are issued by the issuer to the
sukukholders, who thereby acquire a proprietary interest in the assets of the issuer. The issuer collects the income and
distributes it to the sukuk holders. This entitlement to a share of the income generated by the assets can make the
arrangement Shariah-compliant.

The cash flows under some of the approaches described above might be the same as they would have been for the
standard western practice paying of interest on loan finance. However, the key difference is that the rate of return is
based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not
necessarily on the financial impact. In Islamic finance the intention is to avoid injustice, asymmetric risk and moral
hazard (where the party who causes a problem does not suffer its consequences), and unfair enrichment at the expense
of another party.

Advocates of Islamic finance claim that it avoided much of the recent financial turmoil because of its prohibitions on
speculation and uncertainty, and its emphasis on risk sharing and justice. That does not mean, of course, that the system
is free from all risk (nothing is), but if you are more exposed to a risk you are likely to behave more prudently.

The Shariah board

The Shariah board is a key part of an Islamic financial institution. It has the responsibility for ensuring that all products
and services offered by that institution are compliant with the principles of Shariah law. Boards are made up of a
committee of Islamic scholars and different institutions can have different boards. An institution’s Shariah board will
review and oversee all new product offerings before they are launched. It can also be asked to deliver judgments on
individual cases referred to it, such as whether a specific customer’s business proposals are Shariah-compliant.

The demand for Shariah-compliant financial services is growing rapidly and the Shariah board can also play an important
role in helping to develop new financial instruments and products to help the institution to adapt to new developments,
industry trends, and customers’ requirements. The ability of scholars to make valid judgments using their own expertise
and based on Shariah, highlights the fact that Islamic finance remains innovative and able to evolve, while crucially
remaining within the bounds of core principles.

Developments
Perhaps the main current problem is the absence of a single, worldwide body to set standards for Shariah compliance,
meaning that there is no ultimate authority for Shariah compliance. Each Islamic bank’s adherence to the principles of
Shariah law is governed by its own Shariah board. Some financial aspects of Shariah law, interpretation, with the result
that some Islamic banks may agree transactions that would be rejected by other banks. Therefore, a contract might
unexpectedly be declared incompatible with Shariah law and thus be invalid.

In Malaysia, the world’s biggest market for sukuk, the Shariah advisory council, ensures consistency to help creating
certainty across the market. Some industry bodies, notably the Accounting and Auditing Organisation for Islamic
Financial Institutions (AAOIFI) in Bahrain, have also been working towards common standards. To quote the AAOFI

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website: ‘AAOIFI is supported by institutional members (200 members from 45 countries, so far) including central banks,
Islamic financial institutions, and other participants from the international Islamic banking and finance industry,
worldwide. AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the
Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria. The relevant
authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines
that are based on AAOIFI’s standards and pronouncements.’

However, despite these movements towards consistency, some differences between national jurisdictions are likely to
remain.

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