10 Key Points about Islamic Finance

The turbulence in the global financial market has caused an alternative system of financial intermediation to receive increased prominence in recent years – that of Islamic banking and finance. Islamic banks are said to be less directly impacted by the recent credit crunch because they didn’t get into securitisation activity or mortgage-backed securities. Here we look at ten concepts in Islamic finance to give you a taster of what the subject’s all about.

Islamic financial institutions are organisations that are based, in their objectives and operations, on the rulings of Islamic law: known as Sharia law.

Understanding what the Qur’an is

The name Qur’an derives from the word qara’a, which means ‘to read’. For Muslims, the Qur’an holy Scriptures are proof of the prophecy of Mohammed, the most authoritative guide for Muslims and the first source of the Sharia on which Sharia law is based.

The Qur’an contains 114 suras (chapters) and 6,235 ayat (verses) and consists of manifest revelation, which is defined as communication from God to the Prophet Mohammed.

‘So how does this relate to finance?’, you ask. Well, the Qur’an is based on Sharia law and Sharia law is what dictates the laws of Islamic finance. For example, Sharia law prohibits Muslims entering into interest-bearing loans.

Looking at Sharia

Sharia means the ‘path to be followed’. Not only is it the path that leads to Allah (the Arabic term for God), but Muslims also believe that it’s the path shown by Allah (which is the main reason why Muslims are obliged to strive for the implementation of that path and no other).

Although every Muslim who’s able to give a sound opinion on matters of Sharia is entitled to interpret the law of Allah when necessary, where an explicit command of Allah or His Prophet already exists, no Muslim leader, legislature or religious scholar can form an independent judgement; not even every Muslim in the world, put together, has any right to make any alterations to Sharia.

The laws of Islam are firmly based upon the Sharia and are deemed to be in the interests of the people as a whole. For finance, the consequence of this is that many of the traditional areas of corporate finance (such as bank loans and leasing transactions) found in Westernised banks are, in fact, much different in Islamic finance, simply because organisations governed by Islamic finance are not allowed to make money from money.

Establishing the meaning of Murabaha

The term murabaha refers to a form of trade credit or loan in which the Islamic bank takes constructive or physical ownership of the asset. The asset is then subsequently sold on to a buyer for a profit and that person is allowed to pay the bank over a set number of payments.

Keeping in line with the law: Sukuk

One way of raising debt finance for a company working within the Western finance tradition is to issue bonds. In this situation, the bondholder receives interest and this interest is always paid before dividends are paid to the shareholders.

Under Islamic law, however, this method of raising finance isn’t allowed, because interest-bearing finance is strictly prohibited. Instead, Islamic bonds (known as sukuk) are linked to an underlying asset, which is structured so that the sukuk holder is a partial owner of the underlying asset. Profit is linked to the performance of that underlying asset.

However, the Islamic finance industry has been shaken by defaults and restructurings appearing in the sukuk market. For example, a Texas-based East Cameron Gas Company went bust in autumn 2012 that had issued a $167 million Islamic securitisation back in 2006. At the time of writing, a court in Louisiana was deciding what rights (if any) the loan note holders had because there is uncertainty as to whether the issuer of the notes is bankruptcy-remote and whether a true sale of the assets had taken place.

Running through the term Riba

The word riba in Islamic law means an addition over and above principal. So riba is the addition in the amount of the principal amount of a loan according to the time for which it’s loaned and the amount of the loan. In other words, it’s the equivalent of interest, but financial systems based on Sharia law strive to eliminate the payment and receipt of interest in all forms.

A range of modern interpretations apply as to why riba is forbidden, although they’re strictly secondary to the religious underpinnings.

Pinning principles on Islamic banks

Islamic banks must conform to Sharia law and, as a result, to the following six principles:

  • They must not allow predetermined loan repayments to become interest (riba) – the receipt and payment of interest is strictly prohibited.

  • The sharing of profits and losses must be at the heart of the Islamic banking system.

  • All financial transactions must be asset-backed. In other words, making money out of money isn’t acceptable in Islamic finance.

  • Speculative behaviour is forbidden (and so options and futures are prohibited in Islamic finance).

  • Only contracts approved by Sharia are acceptable.

  • An emphasis is placed on the holiness and sacredness of contracts.

Islamic laws strictly prohibit investments connected with gambling, liquor or tobacco, too.

Making sense of Hawala

In a legal sense, a hawala can be a bill of exchange, cheque, draft or promissory note. Hawala is a mechanism that can be used in order to set up international accounts by book transfer. To a large extent, this approach removes the need to transfer physical cash.

Technically, debtors pass on the responsibility of payment of their debt to a third party who owes the former a debt; hence, the responsibility of payment is shifted to a third party. This arrangement is unique because no form of financial instrument is exchanged; the transaction takes place entirely on the honour system (a system based on trust, honour and honesty). Trust and the extensive use of connections such as family relations are the components that make it completely different from other remittance systems.

Making money within Sharia law

In the Western tradition, banks make money by charging interest on loans. A simple example is a house mortgage: the bank lends you money to buy a house and you pay this amount back with interest. The interest element is essentially the bank’s profit.

Islamic banks are strictly forbidden to charge interest. Instead, the concept of profit and loss sharing comes into play. Islamic banks don’t charge interest but instead participate in the yield that results in the use of funds. Depositors also share in the bank’s profits, which are determined in accordance with an agreed ratio. Hence, a partnership exists between the Islamic bank and its depositors and also between the bank and its investment clients.

Islamic banks can’t make money with money, because under Sharia law money is only a medium of exchange – a way of defining the value of something – and it has no value in itself. Therefore, money isn’t allowed to generate more money by being put in a bank or lent to someone else.

Under Islamic finance laws, Muslims are encouraged to spend and/or invest in productive investments as opposed to keep their money idle.

Running the risk with risk

When a Western bank or finance house invests in a project, the investor (the bank or finance house) is assured of a predetermined rate of interest and the investee bears all risk. The investor receives a predetermined return regardless of whether the project succeeds or fails.

This situation doesn’t apply in Islamic banking, which promotes risk-sharing between an investor and an investee: the unjust distribution of risk that occurs in Western banking is prohibited. In Islamic banking, the investor and the investee share the results of the project in an equitable way. Where a project makes a profit, both parties share in this profit in predetermined proportions. On the flip side, if a project makes a loss, the investor bears the loss by way of no repayments, with the investee bearing the loss by receiving no wage or salary.

Looking at leasing issues

In the West, companies often lease assets to use in their business. The leasing agreement usually makes provisions for the lessee (the company leasing the equipment) to pay the lessor (the owner of the equipment) periodic payments, which contain the capital element and the interest element. Islamic finance prohibits interest-bearing finance and has its own the equivalent of lease finance.

Ijara is a form of leasing involving a transfer of ownership of a service for a specified period of time for an agreed lawful consideration. Instead of making provisions for the payment of capital amounts and interest, this arrangement allows the financial institution to earn profits by charging rent on the asset leased to the customer.

During the period of the lease the leasing company still owns the asset but the lessee has the right to use it. When the leasing agreement expires, the right to use the asset goes back to the lessor.

An Islamic lease often looks like an operating lease (where the risks and rewards of ownership remain with the leasing company). But the redemption features of an Islamic lease can be structured in such a way to make it look like a finance lease (where the risks and rewards of ownership of the leased asset pass to the lessee).

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