Islamic Finance What Is Islamic Term Paper

  • Length: 9 pages
  • Sources: 3
  • Subject: Economics
  • Type: Term Paper
  • Paper: #92767843

Excerpt from Term Paper :

Sometimes there is lack of sufficient money available to fund important projects and the price of loanable funds is normally high, showing the paucity of savings. In low-income economies, it is hardly a surprise that savings rates are small, as most disposable income is needed to be used for making purchases of necessities of daily living, and a lot of families just cannot bear to make financial provisioning for the future, although this makes them insecure and helpless. In this backdrop, the Middle East is unlike other developing regions. Even though individual countries experience shortages, however for the region as a whole the revenue generated from oil exports gave a great deal of surplus during the 1970s and also major portion of the 1980s. Even though the circumstances transformed with the fall in oil prices, the infusion of finance of course benefited not just the leading oil-exporting nations, but also through govt.-to-govt. transfers and remittances, it also helped the poorer nations of the region. Even though, by 1990s there was a reduction of the surpluses, the oil price rise of 1973-74 and 1979 brought unprecedented increase to capital formation across the region, and as a consequence gave beneficial improvements in infrastructure. Thus as against majority of the areas of the Third World, the Middle East is well bestowed with financial as well as physical capital. (Wilson, 1995)

How does Islamic Finance work: the types of investments available and how they work?:

Working principles of Islamic Finance:

There has been a steady growth of Islamic finance in recent decades and various standard products have been formulated to fulfill the financing requirements of trade and projects. Some of them are founded directly on strictures enshrined in the Quran while others are achievements of financial engineering, amalgamating various allowable financial instruments to arrive at a product which combines acceptable returns with financially acceptable risks. Concurrently, Islamic Banks experienced difficulties expanding their lending business with the pace of their deposit base, generally due to the limits in their risk management capacity. Consequently, in international trade and project finance, Islamic financers have generally depended on bank credit limits, for instance, to get a credit line, an importer is required to give a guarantee from a local bank. International banks take such local bank guarantees only till a certain level. (UNCTAD Secretariat, 2006)

However, in conventional finance, several structured finance techniques have been developed to tide over this constraint and therefore such techniques can also be very appropriate to Islamic finance. The number of banks offering Islamic finance instruments has risen rapidly since the initial part of 1970s and the market has presently attained a volume of more than U.S.$200 billion. This is in part due to the supply going up to fulfill the demand for Islamic finance; in part this growth is propelled by the pressure of funds seeking for 'halal' which implies lawful or clean investments. To put it differently, banks or trading companies who are able to suggest Islamic finance to their clients can get a competitive edge, and individuals who are able to tap into Islamic financing markets are able to get comparatively low-cost capital. (UNCTAD Secretariat, 2006)

Concurrently, banks handling Islamic finance can understand from the structures and techniques formulated by their structured finance peers and acclimatize them for their independent purposes. Since banks are not permissible to charge interest, they must earn income through fees and other fixed commissions that could be clearly associated to the interest payments which a more conventional bank would charge. The working principles of Islamic finance are that depositors are not paid an interest on their savings, however they share in the profits of the operations which their money assists in financing, or they are handed optional 'gifts', prices or financial or non-financial bonuses by their banks. Islamic finance is a flexible type of financing, with sufficient scope for banks as well as other financiers to make good for the absence of interest rates. (UNCTAD Secretariat, 2006)

Nevertheless, a lot of Islamic financers plan to keep their risks levels low, concentrate nearly solely on the most fundamental "mark-up" types of Islamic finance instead of much more pioneering "profit sharing" forms; and practically, for international finance such banks sometimes depend on bank-to-bank credit lines. Structured finance has spawned to a lot of means to tackle with the risks in which banks-to-bank credit lines are not present or inadequate, and in developed country capital markets securitization methods have developed to draw even traditional investors into new forms of finance. Islamic finance over the years has been very much open to innovation, equipped with well-established methods to introduce novel techniques into mainstream financing practices. Islamic FIs normally have their own Sharia boards who review proposed transaction structures in detail, to find out if they are Sharia complaint or not. Under Islamic financing, the primary forms of trade finance are murabaha contract which is just like a buyer's credit, salam - bearing resemblance to a pre-financing, and some uses of istasna that permits banks to provide pre-export finance for goods for which there is confirmed orders. A general idea of the application of Islamic financing instruments for trade and project financing purposes, and their 'conventional finance' counterparts is stated in Exhibit -I. (UNCTAD Secretariat, 2006)

Generally murabaha is used in association with LCs and normal documentary credit collections. One more form of Islamic finance applied in trade is Bai al Salam which in principle is just a pre-paid forward sale. It is different from the narrow recourse prepayments usually found in the Western world, made through business companies, wherein it is the bank, not the trader who is making the prepayment. Musharaka is regarded by some as the complete form of Islamic finance that has close resemblance to joint-venture while at times the activity somewhat appears like venture capital to compensate the high risks it is taking. Istisna is similar to salam to the extent that it comprises of a simple pre-paid forward sale. Whereas salam is used for commodity trade, istisna is applies to goods which is required to be manufactured. In case of salam, full upfront payment is needed, however, in istisna payment can be made at different stages of the process. (UNCTAD Secretariat, 2006)

Types of Investment available and how they work:

Under Islamic Finance, Muslims are allowed to invest directly in Sharia compliant legitimate business. Nevertheless, it is essential to concentrate on comparatively passive investment avenues such as equities, mutual funds etc. As also 'fixed-income' options to debarred interest-based instruments like bonds and money-market funds. Muslims are allowed to hold common shares of companies running lawful business. As common stocks of Sharia compliant companies might be bought or sold, it is also possible to create mutual funds in such stocks. In certain Islamic nations, some "Islamic mutual funds" even calculate and pay the suitable zakah on shares. Within the Sharia compliant permitted selection of companies agreed for trading by the Sharia boards, a myriad of funds might be created such as technology, high growth, blue chip, regional etc. (El-Gamal, 2000)

Majority of these "Islamic funds" of this category have recorded an unabated spree of outperforming the market in majority of the categories. Even the Dow Jones has a Dow Jones Islamic Index -- DJII which is Sharia compliant. The rules adopted by the DJII board are almost similar to those approved in the earlier years by other fund management company Sharia boards in Islamic nations. Under fixed income funds, majority of retirees with lower risk appetite seek income generating vehicles with minimal risk. Naturally parking funds in common stock carried considerably greater risk and thus a component of their investment is required to be put in for "fixed income" investments. But unfortunately, the teeming majority of conventional fixed income investments for instance CDs, government bonds, money market accounts etc. include forbidden riba. The option for the retirees in this case lies in procurement of some real estate which is able to produce income in the shape of rent. With inflation the rent will go up with rise in the value of real estate, thus giving a reasonable inflation hedge and assisting the investor retain the real value of his wealth and at the same time generate an income on which to sustain. (El-Gamal, 2000)

Under Islamic Banking, the risk management assumes a challenge because of its odd risk features and the need for compliance to Sharia principles, While the Basel II initiatives on the credit identification, market and operational threats can be incorporated into Islamic Banking, the initiatives is required to be harmonized with consideration of the added proportion of risks which are present on Islamic financial dealings. The risk management infrastructure in Islamic financial institutions are required to find out, measure, control and check all the specific threats in the Islamic financial transactions and instruments. (Aziz, 2006)

Institutions offering Islamic Finance products; etc.:

It is rather of a truism to refer to the symbiotic relationship…

Online Sources Used in Document:

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