EXPLAINATION OF ISLAMIC BANKING

OVERVIEW OF ISLAMIC BANKING

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Understanding Islamic finance
23 May 2008

Anzal Mohammed

Partner, United Arab Emirates

Hooman Sabeti-Rahmati

Consultant, Singapore

With an estimated global worth in the hundreds of billions of dollars and an anticipated growth rate of 15-25 per cent per annum over the next five years, the market for Islamic financial products has garnered considerable attention from the international financial community.
From consumer products tailored for individuals to large-scale financings with embedded derivative products targeting global investors, the range of genuinely Shari'a-compatible financial products has broadened significantly in the last few years. In addition, the reach of the market, in terms of new institutions, jurisdictions and consumers, continues to grow at a dramatic pace, with new frontiers reached on a regular basis.

The last two years in particular have witnessed a substantial upsurge in the market as the petro-economies in the Middle East continued to see rapid growth and both regional and international investors grew increasingly comfortable with Shari'a-compliant financial products.

Moody's estimates that there are currently 250 Islamic mutual funds operating with US$300 billion of assets, 300 Islamic financial institutions holding US$250 billion of assets and nearly US$200 billion of assets held in 'Islamic windows' (ie, Shari'a-compliant subsets of conventional banks) and McKinsey predicts that Islamic banking assets and assets under management will reach US$1 trillion by 2010.

As this developing sector will continue to play an important role in capital markets transactions, there is an increasing demand for market professionals to understand how Islamic financial products function. This article discusses the primary principles and financing techniques that shape the Islamic financial markets.

Shari'a principles

In contrast with most other religions, Islamic law, or Shari'a, governs social, political and economic relationships and institutions. Shari'a is not a codified body of law but a principles-based legal system that is capable of development and subject to interpretation. The legal principles underlying Islamic law are derived from a series of primary and secondary sources.

The primary sources for Shari'a are the Qur'an (scripture), Sunnah (practices and traditions of the Prophet Muhammad) and Ahadith (accounts of the sayings and deeds of the Prophet Muhammad). The secondary sources of Islamic law are, essentially, a series of methods (eg, analogical reasoning, or consensus of scholars) that allow further rules to be extracted from the primary sources and applied to a modern context.

There are five classical schools of thought (called madhab) within Shari'a, each named after its founding jurist and associated with a particular geographic region. These schools are more similar than they are different, but their differences account for some of the variation in financing techniques deemed permissible by scholars. For instance, the Hanbali school, prevalent in the Arabian peninsula, recognises an arbun contract, a sort of down payment with option to purchase, while the other schools are less receptive to it.

Islamic finance refers to the network of financial institutions and commercial activities that conform to the core Shari'a principles which govern commercial dealings, namely the prohibitions on: (i) receipt and payment of interest, (ii) uncertainty and (iii) specific forbidden activities.

Riba (interest)

The most familiar Shari'a principle is the prohibition on interest (it is not a prohibition of usury, in the sense of excessive interest, but a prohibition of any interest at all). Interest here is in the sense of a predetermined return on money lent or advanced, as opposed to a return that reflects exposure to the commercial activity to which the financing provided is applied.

The roots of this prohibition probably lie in certain pre-Islamic lending arrangements prevalent in Arabia which were viewed as particularly onerous and unfair. In general, the Islamic philosophy of commercial activity favours trade and the sharing of commercial risk, including by financiers, and so is not disposed to the provision of financing against a predetermined return without acceptance of commercial risk.

Gharar (uncertainty)

The Shari'a prohibition of uncertainty in contracts is an area of subtle distinctions. Shari'a does not recognise the validity of a contract if its principal terms are uncertain. For example, a sale contract where the existence, price, quantity or material characteristics of the asset are unknown or unspecified would not be recognised. This is of course not very different from the position in secular legal systems. In Shari'a, whether some particular uncertainty is forbidden is often a question of degree.

One aspect of uncertainty is uncertainty in outcome, for instance in a game of chance, and so Shari'a forbids gambling or speculation (maisir) in contracts. Accordingly, conventional contracts of insurance and particular futures and options contracts are viewed as akin to gambling and are therefore proscribed. In the case of derivatives, this is reminiscent of the struggle that some secular legal systems have had with whether derivatives contracts fall within gambling prohibitions.

Haram (forbidden activities)

Because of its specificity, the simplest Shari'a prohibition to understand is the prohibition on involvement in certain forbidden activities, businesses or items. These include gambling, weapons, pornography, alcohol and pork.

The application of this principle allows for de minimis variation. For example, as alcohol is haram, financing a brewery would clearly be prohibited, but financing a hotel or airline that incidentally generates income from alcohol sales may, depending on the relative portion, be permissible.

Shari'a-compliant financing techniques

Over time, Shari'a has developed certain canonical forms of commercial contract which are acceptable. Complex transactions may be structured by assembling a number of these contracts together to produce the desired commercial arrangement. Not surprisingly, these forms of contract are quite similar to basic contracts that exist in conventional finance, since commerce requires the same basic building blocks everywhere. Thus, Shari'a sanctions contracts of sale (eg, murabaha, istisna'a), contracts of lease (ijara) and joint enterprise arrangements (eg, musharaka, mudaraba), each with its own parameters.

Some of the more popular varieties of these contracts are described below:

Murabaha (cost-plus financing)

A murabaha is a tri-lateral sale arrangement whereby a financier-intermediary purchases goods from a supplier and sells them to an end-user at a deferred price that is marked-up to include the intermediary's profit margin. This profit margin is deemed justified since the intermediary takes title to the goods, albeit possibly only briefly, and hence accepts the commercial risk of their ownership.

Often, the intermediary appoints the end-user as its agent to purchase the goods from the supplier on its behalf. The intermediary must bear the risk of ownership after the end-user, acting as its agent, purchases the goods and before the intermediary sells the goods to the end-user.

Owing to their flexibility, murabaha contracts are a popular financing technique, accounting for perhaps three-quarters of all Islamic financings. They form the basis of a number of innovative derivative products.

Istisna'a (custom manufacturing)

An istisna'a is a sales contract for custom-manufactured goods, whereby the seller agrees to manufacture and deliver a specified thing that does not exist at the time the istisna'a is formed. The contract must specify the nature and quality of the goods. While the sale price must be fixed in advance, payments can be made in one lump sum or in instalments and at any time up to or after the time of delivery.

The seller bears the risk of ownership up to and until the purchaser takes possession of the goods and also bears the risk of any increase in cost during the manufacturing process after the purchase price has been agreed.

The contract is irrevocable after manufacturing has commenced, though the delivered goods may be rejected if they do not satisfy the contracted terms.
In an istisna'a, the concept of 'manufacture' is rather broadly understood, so that, for instance, an extracted mineral can be a manufactured item on account of the processing it must undergo to be transformed into commercial goods. This contract lends itself naturally to project or property financings.

Ijara (lease)

An ijara is a contract whereby, much like a conventional lease, a specified asset or its usufruct is made available in exchange for rental payments. The leased asset must have some value and continue to exist throughout the term of the lease. If the leased asset ceases to exist or its economic value is totally destroyed, the ijara must terminate; hence, a conventional hell-or-highwater lease is not permissible as an ijara.

The risks of ownership of the subject asset must remain with the lessor in an ijara. Accordingly, the lessor is normally responsible for major maintenance and for insurance arrangements for the leased assets, although it is possible for the lessor to contractually appoint the lessee as its agent to undertake these.

The rental amount or the method for determining the rental amount for each rental period must be specified, although the parties may specify a method which produces variable results. For instance, the parties may agree to determine periodic rental payments by reference to the London Inter-Bank Offered Rate (LIBOR).

Musharaka (partnership)

A musharaka is a partnership arrangement in which each partner shares in the profits or losses of a specified venture. While partners may allocate profits according to an agreed formula, rather than simply in proportion to their capital contributions, they may not be entitled to a pre-determined, fixed profit.
However, unlike a conventional partnership, the allocation of losses is not subject to contract; the partners are required to share losses in proportion to their capital contributions. Absent negligence or breach, no partner can contract out of this business risk.

Each partner has the right to participate in managing the venture, although they may delegate management duties to other partners or third parties.

Mudaraba (investment agency)

In a mudaraba contract, one or more investors (rabb al-mal) provide capital to an investment agent (mudarib), who then uses his expertise to apply the capital to some enterprise. The investors and the mudarib may agree to any arrangement for the sharing of profits. However, only the investors bear the risk of loss, although the investors may allocate this risk among themselves.
The mudarib may also make capital contributions to the enterprise and share in the profits. A mudaraba is more flexible than musharaka as a mudarib may use the capital contributions to invest in a contractually specified enterprise or to make discretionary investments.

Other commercial law concepts

Shari'a recognises many of the fundamental legal concepts that are used in conventional finance. For instance, concepts of agency and delegation are recognised, custodial and bailment arrangements exist, security may be provided for an obligation, a guarantor may stand behind another's obligation and certain unilateral promises may be enforceable.

The sukuk product

The foregoing financing techniques may be used in a variety of ways to structure Shari'a-compliant products whose economic profile mimics conventional instruments (although their risk profile may be subtly different). The complexities of structural innovations in, and market potential for, the sukuk product exemplify this point.

Sukuk are medium to long-term, Shari'a-compatible trust certificates, representing a beneficial interest in certain approved assets, usufructs or services, whose performance mimics conventional fixed-income securities. Typically, the issuer of a sukuk is a special purpose financing vehicle which uses the proceeds of the issuance of the sukuk to purchase or gain an interest in tangible assets and income-generating contracts relating to those assets. The issuer then declares a trust over its assets for the benefit of the sukuk holders, who then receive periodic distributions from the income of the trust.
Sukuk are not categorised as debt under conventional capital markets terminology. Rather, they represent a profit and risk-sharing partnership between the issuer and the investor where the underlying investment is limited to specific types of assets.

Essentially, sukuk investors purchase an ownership interest in a tangible asset and contracts that generate income from that asset, where risks and rewards are tied to the performance of the underlying asset. In order to conform to the Shari'a prohibition against interest (riba), sukuk returns must be formally linked to the performance of the underlying asset otherwise the return would amount to unlawful interest. A properly structured sukuk will satisfy the relevant Shari'a restrictions while having the economic behaviour of a conventional fixed-income instrument.

The assets underlying a sukuk must be sufficiently determined so that the investment is void of uncertainty (gharar). Furthermore, since Shari'a forbids the trading of pure receivables except at par, in order for sukuk to be freely tradeable like conventional bonds, a certain minimum (usually one-third by value) of the underlying assets are required to be tangible.

Although sukuk are asset-based securities, they are not always asset-backed securities in the conventional sense of that term. Sukuk are often structured so that investors economically face the credit risk of a corporate or sovereign entity and depend on that entity's performance for their return. The credit ratings on such sukuk reflect the rating of this entity.

On the other hand, conventional asset-backed securities are structured so that investors have exposure and recourse strictly to the underlying assets, not to any entity. Of course, sukuk lend themselves particularly well to securitisation of (Shari'a-eligible) assets, and the true asset-backed sukuk market has seen some notable recent advances including the 2007 securitisation by Tamweel PJSC, a leading UAE home finance provider, of a portfolio of Shari'a-compatible home financings.

Sukuk can be structured in a variety of ways and the Accounting and Auditing Organisation of Islamic Financial Institutions has recognised 14 different types. The most common structures so far have been ijara, musharaka and istisna'a-based sukuk.

An example: the Tabreed sukuk