Tag: Islamic Laws

What is Islamic Finance?

Islamic finance simply put is a method of conducting financial transactions, banking, and managing money with moral principles that respect Islamic law or Sharia. Islamic finance includes activities like saving, investing, and borrowing money either for business or personal transactions that are permissible under Sharia and that comply with Islamic Laws. The concept of Islamic finance also refers to the type of investments that are permissible under Sharia.

Sharia or Islamic Law constitutes a broad set of rules that guide an individual on leading an ethical life. These rules and guidelines are derived from the Qur’an and the sayings and practices of the Prophet Muhammad. The word Sharia in Arabic means “the way,” thus showing an individual the ideal way to live. In the context of Islamic finance, the rules and guidelines place an emphasises on justice and partnership. Hence, you may hear Islamic financial services often described as “Islamic finance” or “Shari’ah-compliant”.

Principle of Islamic Banking

The Islamic law or Sharia recognises money only as a medium of exchange which has no value in itself. Therefore, as per Sharia law money cannot generate more money. The Islamic law prohibits the income earned through the medium of interest generated. This interest can be defined as interest generated through lending money, or interest earned by money simply sitting in an account.

Islamic finance is principally based on trading with emphasises on justice and partnership. The use of money for the purposes of making money is explicitly forbidden.

The main principles of Islamic finance are:

• Wealth must be generated from lawful trade and asset-based investment
• Each transaction must be related to a real underlying economic transaction.
• Investment should have a social as well as an ethical benefit to wider society beyond pure return
• Profit/Loss and Risks should be shared
• All harmful activities (haram) should be avoided

Therefore, banks can make a profit from the buying and selling of Shari’ah-compliant goods and services. When a customer deposits money according to Islamic law, the bank needs to select a Shari’ah-compliant investment for the purpose of that deposit. The profits and risks that come with the investment are shared equally with the bank. The practices of Islamic banking have some clear ethical advantages over more traditional banking systems, which can be seen as unprincipled.

Things Prohibited in Islamic Finance

In order to comply with the Shari’ah, certain activities are prohibited in Islamic finance.

The following activities are strictly prohibited in Islamic finance:

Charging and receiving interest (riba):

• A lender charging a straight interest, irrespective of how the underlying assets fare disobeys the concept of risk sharing, partnership, and justice. Thus, representing money being used to make more money. Investment in companies that conduct borrowing excessively is also prohibited.

Investments in unethical businesses (haram):

• Investing in businesses that deal with activities like alcohol, gambling, drugs, pork, pornography, or anything else that Shariah considers unlawful or undesirable is prohibited.

Investments in transactions that involve speculation, uncertainty, or extreme risk (gharar):

• This type of investment is considered gambling, which is prohibited (haram). For example, investing or speculating on the futures and options markets is prohibited. Mutual insurance (which relates to uncertainty) is permitted if it is related to a reasonable and unavoidable business risk.

Uncertainty about the subject matter and terms of contracts:

• Selling something that one does not own is prohibited. Investing in special financial techniques that is available for contracting to manufacture a product for a customer is considered as investing in a product which one doesn’t own, as the product hasn’t been made yet. A manufacturer can promise to manufacture the product under certain agreed specifications at a determined price and on a fixed date and in this case, the risk taken is by a bank that would commission the manufacturer and sell the goods on to a customer at a reasonable profit for undertaking this risk. Thus, the bank is exposed to considerable risk. Avoiding contractual risk in this way means that transactions have to be explicitly defined from the outset. Hence, complex derivative instruments and conventional short sales or sales on margin are prohibited under Islamic finance.

Things Permitted in Islamic Finance

As mentioned above, the receipt of interest is not prohibited in Islamic finance. Hence, when Islamic banks provide finance, they have to find other means to earn their profits. This can be done through the profit share relating to the assets in which the finance is invested or can be via the fee that is earned by the bank for the service provided. The essential feature of Islamic law is that when commercial loans are made, the lender must have a share in the risk. If this is not so, then any amount received over the principal of the loan will be regarded as interest.

The following activities are permissible financing instruments in Islamic finance:

Profit and Loss Sharing Contracts (Mudarabah):

• The Islamic bank pools together investors’ money and accepts a share of the profits and losses, as agreed upon with the depositors beforehand. The bank invests in a group of mutual funds screened for Sharia compliance. These investments are then filtered to determine whether any sources of income to the business are prohibited. Companies that hold a lot of debt or are engaged in forbidden lines of business are excluded. In addition to actively managed mutual funds, passive funds also exist. They are based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Declining Balance Shared Equity

• Commonly used to finance a home purchase, declining balance shared equity calls for the bank and the investor to purchase the home jointly. The bank will then gradually transfer its equity in the house to the individual homeowner, whose payments comprise the homeowner’s equity.

Lease to Own

• This arrangement is akin to the declining balance shared equity. The financial institution or bank puts up most of the money for the house and agrees to sell the house to the eventual homeowner at the end of a pre-decided fixed term. A portion of every payment goes toward the lease and the balance goes towards the home’s purchase price.

Instalment Sale (Murabaha)

• An instalment sale starts with an intermediary buying the home with a free and clear title to it, which is then sold to a prospective buyer on an agreed upon sale price. This price includes some amount of profit. This purchase can be made either outright (lump sum) or through a series of deferred (instalment) payments. This credit sale should not be confused with an interest-bearing loan as it is an acceptable form of finance.

Leasing (Ijarah)

• Leasing or Ijarah involves selling the right to use an object for a specific time. The condition followed must be that the lessor should own the leased object for the duration of the lease. A variation on the lease, ‘ijarah wa ‘iqtina, provides for a lease to be written where the lessor agrees to sell the leased object at the lease’s end at a predetermined residual value. This promise binds only the lessor and the lessee is not obligated to purchase the item.

Islamic Forwards (Salam and Istisna):

• These are used for certain types of business and are not that common. The price for the item is paid in advance and the item is delivered at a definite point in the future. The help of an Islamic legal advisor is usually required as there is a host of conditions to be met to render such contracts valid.

Some permissible Basic Investment Vehicles are:

Equities

• Sharia law allows investment in company shares (common stock) as long as those companies do not engage in any forbidden activities (haram). Investment in companies can be in form of shares or by direct investment (private equity).

Fixed-Income

• Retirees who want their investments to comply with the principles of Islamic finance face a dilemma in that fixed-income investments include riba, which is forbidden. Hence, specific types of investment in real estate provide steady retirement income while not running afoul of Sharia law. These investments can be direct or securitized, such as a diversified real estate fund.

Basic Insurance Vehicles

• As traditional insurance is not permitted as a means of risk management in Islamic law, a possible Sharia-compliant alternative is cooperative (mutual) insurance. Investors contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed amongst the policyholders.

Who makes the rules for Islamic Finance?

Islamic finance offers products and services that comply with Islamic law (Sharia) and often the question that comes up is of who decides what is and is not sharia-compliant? Also, what mechanisms are existing to enforce those judgments?

There are several options a bank can utilise to keep check of these rules

Sharia Supervisory Boards:

• Generally, each Islamic finance institution has a sharia supervisory board (SSB). This board is composed of at least three jurists. These jurists although are paid by the bank, act as independent consultants and are involved in both consultative and regulatory aspects. They verify operations, answer the staff’s questions, advise on charity contributions (zakat), and certify products.
• The Sharia Supervisory Boards decide what is allowed (halal) or forbidden (haram) based on the two main sources of Islamic law; the Quran and the Sunnah; or what Prophet Muhammad reportedly said and did during his lifetime. Board decisions are taken by a majority vote and are binding on the bank.
• These SSB members are religious scholars who specialise in Islamic jurisprudence. It is not necessary for them to be Muslims only. In countries like the UK, there are also non-Muslims experts who have studied and specialised in this matter extensively.
• Over the past decade, Islamic finance has rapidly expanded across the world and finding qualified people to sit on SSBs has become challenging. In the world of Islamic finance, reputation is important and sharia non-compliance can be extremely fatal to a bank.

Sharia-Compliance Consultancy: A Juicy Business

• With the increasing popularity of Islamic finance, a number of private firms have emerged over the past few years offering sharia compliance services or consultancies. Their clients are not only Islamic banks but also conventional lenders and companies who wish to develop products or acquire certifications that will allow them to tap into the Islamic market.
• These consulting firms employ a group of Islamic scholars who function like an externalised sharia board, providing guidance and issuing Islamic rulings (fatwas) in exchange for a fee.

International Standards and Central Banks

• At the international level, two supervisory bodies are created for Islamic finance. They are the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Malaysian Islamic Financial Services Board (IFSB).
• These bodies collaborate with institutions such as the IMF or the World Bank to promote sharia compliance globally. The AAOIFI sets basic standards for the Islamic finance industry while the IFSB issues recommendations based on risk assessment.
• In Bahrain and the United Arab Emirates, AAOIFI standards are mandatory but, in most countries, their standards and recommendations are not binding. If a bank doesn’t comply, there are no sanctions. It is up to each independent country government to enforce certain rules through their central banks who impose those rules on sharia boards.
• In all countries except for Sudan and Iran Islamic finance exists alongside conventional banking. For Islamic banks, this means navigating a dual regulatory framework. This means the country follows the country’s laws and regulations as well as sharia compliance.

Growth of Islamic Finance

The concept of Islamic finance can be traced back to about 1,400 years ago when the concept came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance related to the banking sector came into being only in the 20^th century. In recent history, it can be traced to as recent as the 1970s, when Islamic banks in Saudi Arabia and the United Arab Emirates were launched. The concept has since grown with Bahrain and Malaysia emerging as centres of excellence in the 1990s.

Shari’ah-compliant financing (SCF) or Islamic finance is recognised as one of the fastest-growing segments in the global financial system. Since 2009, the estimated compound annual growth rate has been 17%, proving the significance of Islamic finance in the global economy. The Islamic finance sector has had a significant expansion since, with a growth rate of at least 15%-25% per year. As of 2015, the industry’s global assets had reached up to $1.6 trillion in value. In today’s date and time, it is estimated that worldwide Islamic financial institutions oversee assets valued at over $2.5 trillion with hundreds of specialised institutions located in more than 80 countries, which are managed under the rules of Sharia.

Understanding the importance Islamic finance plays in the global economy, the popularity of Islamic finance is reaching systemic significance in a number of countries in Asia. Islamic finance has achieved at least a 15% market share in the domestic banking sector in countries like Brunei, Bangladesh, and Malaysia. The expansion of Islamic finance can also be seen in developing member countries (DMCs) within Central West Asia, South Asia, and Southeast Asia. Here Islamic finance has been expanding to new jurisdictions and maintaining momentum where it already has a strong established presence. The DMCs have begun implementing legislative and regulatory initiatives to establish themselves as Islamic financial hubs.

Islamic finance is gaining popularity not only in countries having predominantly Muslim populations but also in European and African countries. Luxembourg, Hong Kong, China, the United Kingdom, and South Africa have debuted sovereign Sukuks (Islamic trust certificates, similar to conventional bonds), with all issuances being at least twice oversubscribed, demonstrating strong demand for Islamic finance globally. According to a State of Global Islamic Economy report in 2019, the total sharia-compliant assets are expected to grow to at least $3.5 trillion by the year 2024. Islamic finance is proving to be an increasingly relevant sector as can be derived from the increasing market share of Islamic finance in the domestic banking sectors around the world.

The Bottom Line

Islamic finance is a century-old practise that is gaining recognition throughout the world. Islamic banks are by far the biggest players in the Islamic finance industry, accounting for almost $1.75 trillion or 70% of the total assets. In 2019, Islamic finance represented about 1% of global financial assets with an 11.4 % growth rate. Islamic finance is expanding quicker than conventional finance, however with COVID 19 that growth is expected to slow down but remain positive. In some geographies like the Gulf Cooperation Council (GCC) or Sub-Saharan Africa, Islamic banks are now competing directly with the Western banks to attract more Muslim clients and given the increasing development of Muslim nations, this field is expected to undergo even more rapid evolution. Islamic finance will continue to address these challenges of resolving Islamic investment policy and modern portfolio theory.