The basis of Islamic Finance prohibits usury, termed as Riba (which is the lending of money at exorbitant rates) but it doesn’t stop just there. 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 its practices; and the Sunnah, the way of life prescribed as normative in Islam, based on the teachings and practices of Prophet Muhammad (pbuh).
What exactly is the difference between Islamic Finance and Conventional 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. In addition, the expectation will be for the source of funds will be Shariah compliant.
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 secured on assets and not debt. 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.
The issue with conventional insurance is its interest based nature, the uncertainty of returns and removal of risk from one party to another. Instead, Takaful (mutual insurance) is based upon the notion of shared responsibility and 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.
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 which is agreed up front by both parties contracting. In most cases, the references to interest rates by Islamic financial institutions are to help benchmark the return on investment to offer transparency. This does not imply interest is being used in the transaction.
- 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), meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited and thus contractual obligations and disclosure of information are a sacred duty.
- 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, pornography, weapons and defense. An example of index restriction can be seen on Page 5 of the Dow Jones Islamic Market Index Rulebook.
Bai’ al ‘inah (sale and buy-back agreement)
Bai’ al inah is a financing facility with the underlying buy and sell transactions between the financier and the customer. The financier buys an asset from the customer on spot basis.
The price paid by the financier constitutes the disbursement under the facility. Subsequently the asset is sold to the customer on a deferred-payment basis and the price is payable in installments.
The second sale serves to create the obligation on the part of the customer under the facility. There are differences of opinion amongst the scholars on the permissibility of Bai’ al ‘inah, however this is practised in Malaysia and the like jurisdictions.
Bai’ bithaman ajil (deferred payment sale)
This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties.
Like Bai’ al ‘inah, this concept is also used under an Islamic financing facility. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan.
The problem here is that this includes linking two transactions in one which is forbidden in Islam. The common perception is that this is simply straightforward charging of interest disguised as a sale.
Bai’ muajjal (credit sale)
Literally bai’ muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal.
It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed.
The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.
Bai’ muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed.
“Mudarabah” is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise.
The capital investment comes from the first partner, who is called the “rabb-ul-mal”, while the management and work is the exclusive responsibility of the other party, who is called the “mudarib”.
The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialized knowledge to invest the capital and manage the investment project.
Profits generated are shared between the parties according to a pre-agreed ratio. If there is a loss, the first partner “rabb-ul-mal” will lose his capital, and the other party “mudarib” will lose the time and effort invested in the project
Main article: Murabahah
This concept refers to the sale of goods at a price. This includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement.
The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin.
The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled.
This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores.
Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process.
This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.
Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract.
It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.
Basic features and conditions of Salam
- The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.
- Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain.
- It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned.
- It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa.
- The exact date and place of delivery must be specified in the contract.
- Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari’ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.
- This is the most preferred financing structure and carries higher order Shariah compliance.
This is a token given voluntarily by a debtor to a debitor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a ‘gift’ on savings account balances, representing a portion of the profit made by using those savings account balances in other activities.
It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank’s discretion, and cannot be ‘guaranteed’(akin to Dividends earned by Shares, however it is not time bound but is at the bank’s discretion).
However, the opportunity of receiving high Hibah will draw in customers’ savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.
It is important to note that although this indeed again, no matter how many different ways we re-word this, does in fact, sound like interest, it is not, because it is Hibah.
Istisna (Manufacturing Finance) is a process where payments are made in stages to facilitate step wise progress in the Manufacturing / processing / construction works. Istisna enables any construction company get finance to construct slabs / sections of a building by availing finances in installments for each slab.
Istisna also helps manufacturers to avail finance for manufacturing / processing cost for any large order for goods supposed to supply in stages. Istisna helps use of limited funds to develop higher value goods/assets in different stages / contracts.
Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage.
Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.
Ijarah thumma al bai’ (hire purchase)
Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is aBai that triggers a sale or purchase once the term of the Ijarah is complete.
For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price.
The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term.
The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church’s prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.
A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee.
The undertaking or the ome an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.
Musharakah (joint venture)
Musharakah is a relationship between two parties or more that contribute capital to a business and divide the net profit and loss pro rata. This is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assess an imputed rent and will share it as agreed in advance.
All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans).
Qard hassan/ Qardul hassan (good loan/benevolent loan)
القرض الحسن This is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed.
However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan.
Some Muslims consider this to be the only type of loan that does not violate the prohibition on ‘riba, for it alone is a loan that truly does not compensate the creditor for the time value of money.
Sukuk (Islamic bonds)
Main article: Sukuk
Sukuk, plural of صك Sakk, is the Arabic name for financial certificates that are the Islamic equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.
Takaful (Islamic insurance)
Main article: Takaful
Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.
In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank’s discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.
Wakalah (power of attorney)
This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney.
What is a Shariah Supervisory Committee or Shariah Board?
A Shariah board can be thought of as a committee of a minimum of 3 Muslim Scholars, acting as an advisory board which issues a ruling as to whether a particular undertaking is in accordance with prescribed principles.
What essentially this means is that the board look into specific investments and decide if the investment or process follows Shariah guidelines or is halal (permissible, as opposed to haram meaning forbidden).
Some think of it as a sort of due diligence for the customer. Others consider the board to be similar to compliance officers so that they do not have to worry that the investment follows the guidelines of Islamic Finance.
Shariah Boards for different companies will usually have different Scholars. However, the Shariah board consists of those that are knowledgeable in Shariah principles, either from economic, legal or religious standpoints and when working in the finance field, they will usually have Fiqh-al-Muamalat knowledge and experience.
They will also usually be members of either AAOIFI (Accounting and Auditing of Islamic Financial Institutions who are based in Saudi Arabia) or IFSB (Islamic Financial Services Board who are based in Malaysia).
Why would non-Muslims use Islamic Finance?
It would seem obvious why Muslims would use Islamic Finance, but realistically, Muslims are only now being able to get the opportunity to do so, and while not all Muslims would necessarily shift, there is growing popularity.
What is surprising is the growing number of non-Muslims taking up Islamic Finance. In the UK, Salaam Insurance, the UK’s first Takaful company, has a significant part of their customer base made up from non-Muslims.
This is in large part due to the conventional pricing of the product range but also due to the ethical nature of Islamic Finance itself. If products are developed using Islamic principles along with a Western approach, Islamic Finance could become an even more significant market over the coming years. After the impact of the excesses and greed by conventional banks in the run up to the credit crunch, the public, governments and financial institutions are all looking for a better way of managing money and a fairer way of wealth distribution – Islamic finance is one such way as long as it can stay true to its principles.
(Live Trading News / 17 Oct 2013)
Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com