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Saturday, 13 December 2014

The Basics of Islamic Finance

Trade Financing Matters welcomes this guest post by Gohar Jawahir Bilal, Managing Partner North Sea Capital, UK focusing on raising and structuring Asset Backed and Structured Trade Finance
I call Islamic finance “alternative finance” as its’ fundamental principles are based on Islamic law. What got my attention is that the fundamental rules of Islamic law prohibit taking /giving interest (usury). As a finance professional the first question that came to my mind was “if there is no interest, how does one make money?” This one question made me eventually quit my investment banking job in 1998. I chose to go to Harvard Law School as a Visiting Scholar to research Islamic law governing Islamic finance. Also the answers that I was getting for “how” and “why” were not satisfactory.
The Basics
Finance essentially revolves around three building blocks i.e. Money, Debt and Equity and these are fundamentally viewed differently in conventional (interest based) vs. Islamic (non interest base) finance.

The conventional view is money is a tangible asset. You can loan money and charge interest. In Islamic finance money is only a “measure of value” (a benchmark or a yardstick). Rule 1: One can lend this yardstick but “cannot charge for lending the yardstick ” = Interest = disallowed.

Debt in conventional finance is of high importance. Regulations for banks are largely built around debt which can be sold at par, premium or discount. Under Islamic law, in finance debt can only emerge as a consequence of sale and that this debt cannot be sold, it can only be transferred at par (not at a discount or premium). Rule 2: In a sale transaction payer can defer payment for an agreed time. This becomes a debt (obligation) of the payer to the payee. Because asset sale price is agreed between buyer and seller at the time of sale, if the payment is deferred, the obligation (debt) is only this sale value. Hence when debt is transferred to another party it can only be at par.

Compared to conventional finance, equity or “ownership” is the absolute nucleus of Islamic Finance. Rule 3: The fundamental principle is “profit in a commercial transaction belongs to those that take the ownership risk”.

Interestingly one realizes that Islamic laws for finance fundamentally promote trade which can be of tangible or intangible assets as money is only a yardstick.
Tangible asset e.g. commodities
I own a bag of sugar worth $100. I can sell this to David for $120 = $100 (principal) + $20 (profit). He and I can agree that he pays this $120 in 30 days and becomes an obligation (debt) on David. Now Jane (3rd party) agrees that she’ll pay me $120. Hence David’s debt is transferred as he will now owe Jane the $120 (on a period that they will agree amongst them). As the $120 debt resulted only because the payment of sale value of sugar bag was deferred this value cannot change. Also, remember ownership of the sugar bag (asset) transferred from me to David, who can now sell it at any price. Another Rule emerges here is: what I do not possess, I cannot sell.

Intangible asset e.g. I own a car and “sell the use” = intangible asset of this car.
As most of us know this “sale of use” (intangible asset) of a car (tangible asset) is called lease or renting. Because I own the car, I call sell its “use” to David for any value say $100. David can agree to pay $100 in 30 days. Now Jane can pay me $100 and then David will owe Jane this amount. Note, the ownership of the tangible asset did not transfer from me – only ownership of its “use” transferred. Hence, after 30 days, I can sell this “use” for $200 to Brain. Because I own the asset, I can charge anything for its use.

A Thomson Reuters report estimated the Global Islamic economy including food, consumer goods, pharmaceuticals, travel and media to be $1.62 trill in 2012 and projected to reach $2.5 trill by 2018. Islamic finance is more popular in Saudi Arabia, UAE, Qatar, Bahrain, Kuwait, Oman, Malaysia and Indonesia. While it is not main stream in the west, regulators in most developed countries are aware of this alternative finance. For example there are three FCA regulated Islamic Banks in the UK. Most popular Islamic products are Islamic bonds (called Sukuk) and an Islamic structure called “Commodity Murabaha” used for Islamic deposits and Islamic financing.

(Trade Financing Matters / 12 December 2014)
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