Islamic Finance What Is Islamic

Islamic Finance

What is Islamic Finance?

The Sharia or 'Islamic Law' unlike conventional Western Banking prohibits making money from money, like charging interest known as Riba which is usury. The law stipulates that wealth must be 'generated' solely through valid trade and investment in assets taking care that no investment is done in companies involved in alcohol, gambling, tobacco and pornography. Hence the bedrock of Islamic Finance is that all forms of interest are considered forbidden known as haram and its financial model works on the basis of risk sharing. Under Islamic Banking, the customer and the bank agree to share the risk of any investment and divide the profits between them. The primary categories within the Islamic Finance are Ijara, Ijaa-va-Iqtina, Mudraba, Murabaha and Mushraka. Ijara is a leasing agreement wherein the bank purchases an item on behalf of a customer and subsequently leases it back for a specific period of time. Ijaa-va-Iqtina is an analogous arrangement, with the exception that the customer is permitted to purchase the item at the end of the contract. ("Q&a: Islamic Finance," 2005)

The feature of Mudraba is that it gives specialist investment by a financial expert wherein the Bank and the customer share any profits. The customer agrees to bear the risk in the event the investment turns out to be a failure, even though the Bank will refrain from charging any handling fee unless it makes a profit. Murabaha is a type of credit that facilitates customer to make purchases in the absence of having to take out an interest bearing loan. The Bank purchases an item and thereafter sells the same to the customer on a deferred basis. Musharaka is an investment partnership wherein the profit sharing conditions are agreed beforehand and the losses are attached to the amount investment. Presently, all the conventional retail banking services expected from established frontline banks can be obtained in a Sharia compliant format for followers of the Muslim community. ("Q&a: Islamic Finance," 2005)

Islamic Finance was practiced largely in the Muslim world right through the middle ages, promoting business activities. It is argued that a lot of ideas, methods and tools of Islamic finance were subsequently adopted by European financers and businessmen. The renewal of Islamic banking matched with the global celebration of the arrival of the 15th century of Islamic calendar called Hijra in 1976. Concurrently, financial resources of Muslims especially the oil producing nations, got an impetus because of the rationalization of the oil prices, that were earlier been the reserve of the overseas oil Corporations. These happenings resulted in Muslims' to struggle to align their lives compliant to the ethics and philosophy of Islam. Islamic banking is a tool for the development of an Islamic economic system. ("Islamic Banking: What is Islamic Banking?," n. d.)

The Islamic financial system applies the notion of participation in the business, through making use of the funds at risk on a profit and loss sharing basis which does not mean that the investments with Financial Institutions -- FIs are essentially speculative in nature. Speculation can be minimized through a careful investment policy, risk diversification and prudent management through Islamic FIs. It is probable that investment in Islamic FIs can deliver potential profits in proportion to the risk taken to fulfill the various demands of participants in the present environment and within the procedure of the Sharia. Islamic Banks are ordered to keep a distinctly differentiated position among shareholders' capital and deposit of the clients' so as to guarantee appropriate profit-sharing according to Sharia. ("Islamic Banking: What is Islamic Banking?," n. d.)

Riba has rarely been acknowledged as applicable beyond the Islamic world, but a lot of its guiding principles have been. Much of these principles are founded on simple morality and common sense which is the underlying wisdom of a lot of religions inclusive of Islam. Even non-Muslim literature, prohibits usury, if Old and the New Testaments are any indication. 19th century literature inclusive of writings by Shakespeare also criticized the practice of usury. Majority of the moral principles advocated by Victorian writers like Charles Dickens ranging from equal distribution of wealth right through a person's basic right to work is distinctly available in modern Islamic society. Even though the western media often points out that Islamic Banking in its current shape is a new occurrence, in reality, the fundamental practices and principles can be traced back to the initial part of the seventh century where it was practiced. ("Islamic Banking: What is Islamic Banking?," n. d.)

Islamic finance is beginning to assume strategic proportions in the Islamic world and has started to play a major role in the West both in its extent as well as influence. Islamic contracts, as understood and explained by the Sharia, are no more intelligible nor disregarded by the Western scholars. Modern Islamic writers and law makers have attempted to build a structured Islamic law of contract identical to the Western law, but benefiting from the adaptability of the general principles stated in Sharia. This apart, and as a constituent of the same trend, attempts are continuing to set up a comprehensive 'Islamic' economic principles, containing modern ideas and business practices like insurance, presented as an substitute to available economic systems. (Khorshid, 2004)

How is Islamic finance different from regular finance, and why:

The most marked difference between Islamic financing and available equivalent product is in the prohibition of interest. This is based on the context that it is improper in and of itself for money to go up in value by just being lent to another person. Hence, financial products like conventional deposit accounts and loans which either result in payment or receipt of interest are outside the realm of Sharia law. Nevertheless, it is important at the same time to note that Sharia law does not debar the making of a return on capital employed when the provider of the capital consents to share in the risks of a productive business enterprise. Therefore profit and loss sharing systems can be acceptable when there is an element of risk sharing. (Timms, 2005) detailed analysis of the different products under Islamic Finance reveals the difference between Islamic Finance and conventional finance. For instance there are a lot of differences between Islamic home buying known as murabaha and conventional mortgage. While under a conventional mortgage, one borrows money to buy a house and pay the money back over a certain number of years along with interest which is against Sharia. Under Islamic Home Financing, one has to identify the property which one desires to buy and the bank purchases the same on behalf of the buyer from the seller. The bank in turn will sell the same property back to the buyer inclusive of the bank's profit margin. The buyer will be placed under a deferred payment plan which implies that the buyer pays the bank in equal monthly installments over the agreed period of the plan. ("Manzili Home Finance," n. d.)

Similarly taking the case of Ijara Financing, the Bank will buy the property from the seller. In place of selling the property to the buyer, it will lease the same to the buyer for an agreed period. Concurrently, the Bank agrees to hand over the property as a gift to the buyer till he meets all the terms and conditions stated in the lease agreement. The difference between conventional finance and Islamic finance on this aspect is that the assets stay as the property of the bank. Over the period of the finance, the bank becomes the landlord and the buyer plays the role of a tenant. During this period, the buyer makes monthly payments that comprise of contribution towards the purchase price of the property i.e. capital and rental payments. Till the time, the buyer has made sufficient 'capital' contributions to fulfill the original purchase price; the property is transferred to the buyer. ("Manzili Home Finance," n. d.)

In terms of the Arab world also, the growth of modern Islamic banking since the 1970s has posed an impasse in case of the governments since doubts were raised regarding whether the people responsible for the situation also had a political plan. Nevertheless, there was also a consciousness that the Islamic finance could possibly contribute to formation of capital and economic development. Because of this, some of the Arab governments were vehemently opposed to Islamic banks, while Syria, Iraq, Libya and Algeria disallowing such institutions to operate, other governments, especially Jordan, Tunisia and Sudan viewed Islamic finance as a means to tap an opportunity and also as a means of drawing capital inflows from the oil rich countries of the Gulf in which there was highest eagerness for this novel type of banking devoid of interest. Not amazingly, taking into account the government resentment, Islamic economic concepts and the Islamic finance movement have put a restricted influence on the economies of the Arab world. (Roberson, 2003)

It is a fact that finance is considered as a huge restraint on development in major regions of the Third World. 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)