DEFINATION OF ISLAMIC FINANACING
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What is Islamic Finance?
The notion of Islamic Finance has been dismissed by some as a financial system that is essentially interest free, and that is the end of it. This generalization is not entirely accurate as, although the basis of Islamic Finance denounces usury, termed as riba (which is the lending of money at exorbitant rates), there is more to it than just this. The concept is more accurately that money has no intrinsic value – it is only a measure of value, and since money has no value itself, there should be no charge for its use. Therefore, Islamic Finance is said to be asset based as opposed to currency based whereby an investment is structured on exchange or ownership of assets, and money is simply the payment mechanism to effect the transaction. The basic framework of an Islamic Financial System is based on elements of Shariah, which governs Islamic societies. Shariah, the law of Islam, originates from two principal sources: the Quran, the Holy Book of the Muslims and it practices; and Sunnah, the way of life prescribed as normative in Islam, based on the teachings and practices of Prophet Muhammad.
When did Islamic Finance originate?
Islamic Finance is almost as old as the religion itself, and the base principles that govern what we currently understand it to be have been used throughout the last 1500 odd years across the modern Muslim world and beyond. Modern Islamic finance really originated in the 1960s, escalating with the petro-dollar boom of the 1970s when in 1975, the Islamic Development Bank was formed to promote acceptable financial practices according to Islam. While many banks originating in the Middle East strictly follow these principles, many also follow Western practices of finance, with a number following both practices to cater for both markets. Interestingly, many of the internationals larger banks (with HSBC, UBS and Citigroup as notable examples) all have Islamic banking arms either in Middle East or the West.
What are the main principles of Islamic Finance?
The main principles of Islamic Finance include:
- The prohibition or taking or receiving interest at exorbitant rates (Riba), but this does not preclude a rate of return on investment.
- Risk in any transaction must be shared between at least two parties so that the provider of capital and the entrepreneur share the business risk in return for a share in profit.
- The prohibition of speculative behaviour (Gharar) is not allowed, meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited and thus contractual obligations and disclosure of information are a sacred duty. This also restricts traditional derivatives.
- Money is seen as potential capital and thus only takes the form of actual capital when it is used in a productive capacity. Other investment guidelines restrict the following:
- Investment in companies whose total debt divided by trailing 12 month average market capital is greater than 33%
- Investment in companies whose sum of cash and interest-bearing activities divided by trailing 12 month average market capital is greater than 33%
- Investment in companies whose account receivables divided by total assets are greater than 33% (sometimes 45%)
- Investments that violate the rules of Shariah, advised against by Shariah boards, and are generally non-ethical meaning that investment in businesses related to alcohol, pork related products, conventional financial services, entertainment (gambling and casinos, hotels, cinema, pornography, music). In addition, some Shariah boards recommend against tobacco, weapons and defense. An example of index restriction can be seen on Page 5 of The Dow Jones Islamic Market Index Rulebook.
Why are the reasons for the recent growth in Islamic Finance?
The IMF estimated that there are now more than 300 Islamic financial institutions operating in more than 75 countries at the end of 2005, and the industry sector has maintained a growth rate of 15% per annum over the last 10 years. It is predicted that this growth will continue or speed up in the coming years, dependant on different regulatory practices. The main reason for the growth stems from a number of sources: Muslims worldwide are starting to opt for Shariah compliant products that were not previously available to them; the increase in oil wealth is being channeled more into such products; and due to their increasing competitiveness and ethical focus, Islamic products are attracting both Muslims and non- Muslims. With Islam as the fastest growing religion in the world, and being the second largest religious group in the UK, USA and France, Islamic Finance is certainly not about to go away any time soon.
What are the more common instruments offered by Islamic Finance?
With the prohibitions dictated by Islamic Finance, the method to undertake transactions differs, in concept, to Western philosophies. The main instruments are:
Shariah compliant Current and Saving Accounts – In the absence of interest, there needs to be some incentive to gain a customer and this is done through a profit sharing exercise whereby at the end of the year, banks allocate profit to the account holders, which may be equivalent to, but not the same as, a conventional saving rate. Also, since an overdraft facility would amount to charging interest, banks may offer interest free loans (Quard- Hassan) to customers on specific request.
Murabaha (Cost-plus sale) – Murabaha essentially is undertaking a trade with a markup and is used for short-term financing, similar in form to purchase finance. An example would be a bank purchasing a tangible asset of some sort from a supplier with the resale based on the cost plus an agreed markup. This is most often used to finance property, since the bank would not be allowed to charge interest on any loan. Once such a debt covenant is in place between a bank and the customer, repayments can begin until a completion point where the asset is transferred to the customer. There is no interest rate risk which is essentially covered within the markup percentage, identified at the outset.
Ijara (Leasing) – Ijara is a leasing contract whereby one party leases an asset for a specific amount of time and cost from another party, usually a bank. The bank would bear all the risk and a portion of the installment payment goes towards the final purchase of the asset at the time of transfer of asset. This can also be set up as a lease-purchase contract for the term of the asset’s specified lifetime.
Musharaka (Equity Participation) – There is very little difference between this and a joint venture agreement. The parties involved contribute in varying degrees of assets, technical expertise etc. and agree to a percentage of the returns as well as the risk. All parties must invest a certain amount of capital. In the case of purchasing a property under this sort of arrangement, it is purchased by both the bank and the customer together, and the repayments made are partly rent and partly a buyback.
Mudaraba (Partnership Financing) - Mudaraba is very similar to Musharaka and is a trustee type finance contract under which one party provides the labour while the other provides the capital.
Istinaa (Commissioned Manufacture) - Istinaa is the solution for manufacture of goods since speculation prevents the selling of something that one does not yet own. With a promise to produce a specific product that can be made under certain agreed specifications at a determined price and on a fixed date, an Istinaa contract is established. Specifically, in this case, the risk taken is by a bank who would commission the manufacture and sell it on to a customer at a reasonable profit for undertaking this risk.
What exactly is the difference between Islamic Finance and Western thought Finance?
If we took the example of purchasing a property again, it could be done in three possible ways – Musharaka, Murabaha and Ijara. The payments might be the same for all these processes as well as for the standard western practice of payment of interest used commonly for mortgages. The 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. Some consider this as just a play on words but to Muslims there is an inherent difference in the way the transaction is carried out, and all based upon the previously mentioned prohibition of Riba. The intention is to avoid injustice and unfair enrichment at the expense of another party.
Does this mean that equities, bonds and insurance are unacceptable under Islamic Finance principles?
Equity investing is permissible, so long as the company being invested in does not engage in the prohibited practices mentioned previously. Conventional bonds are considered as Riba and thus not allowed. Instead there exists Sukuk (Islamic Note), which is an Islamic type of bond. In general terms, the transaction is structured on an asset base, and so, if a series of payments arise from an asset based transaction, these can be traded at a market price. Also, even though conventional insurance may be considered Gharar (uncertainty), this is not applicable to reasonable unavoidable business risk. The issue with insurance is, again, its interest based nature. Instead, Takaful (mutual insurance) is based upon the notion of shared responsibility provides for shared financial security, so that, in theory, members contribute to a pot, not for the result of profit, but in case one of the members suffers misfortune in their investments. Takaful is thus not based on gaining interest, but really to insure against any losses incurred.
Are there any notable examples of use of Islamic Finance?
The most recent example of Islamic Finance was the funding of the Dubai Ports World takeover of P&O which, at USD11.4bn was the largest Sukuk in the world. Emirates Airline regularly uses Ijara to finance its fleet expansion. Also, banks such as HSBC and Lloyds are reputable high street banks offering Islamic mortgages in the UK. Also, in 2005 Dolphin Energy signed the largest Sharia compliant financing Istinaa arrangement of USD1bn with a large number of banks. And in the UAE, this week, is the official launch of the first Sharia compliant National Bond scheme. Furthermore, Amlak and Tamweel the two largest home property finance houses in the UAE offer Sharia compliant financing.
What is a Shariah Board?
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