Islamic finance in its modern form is a little over 30 years old, yet, it is a rapidly growing part of the financial sector, and has survived the recent global banking crisis almost untouched. The size of the market is huge, and demand for Islamic financial services exists wherever there is a significant Muslim community.
It is reckoned that over 500 financial institutions in more than 50 countries practice some kind of Islamic finance. And the market has been growing at around 15% per annum. Recent estimates place total assets at around US$1 trillion. The main attraction of Islamic finance is that it offers banking that is compliant to the laws of Islam to its clients. It is underpinned by pure principles, with integrity at the forefront and a genuine sharing of profit and loss as its credo. This has all been achieved with remarkable speed and the sector’s popularity continues unabated.
Islamic finance is based on the ‘Shariah’, an Arabic term which is translated as ‘Islamic Law’. The Shariah provides guidelines to Muslims in all aspects of their lives which include religious beliefs and practices, politics, economics, banking, business and law. Shariah compliant financing constitutes financial practices that conform to Islamic Law.
One of the major principles of the Islamic law which is applicable to finance, and differs from conventional finance is the ‘Ban on interest’. In conventional finance, a distinction is made between acceptable and usurious interest. In contrast, under Islamic law, any level of interest is considered to be usurious and is prohibited.
People, who are not conversant with the principles of Shariah and its economic philosophy, sometimes believe that abolishing interest from the banks and financial institution would make them charitable rather than commercial.
This however, is totally a wrong assumption. According to Islamic law, interest free loans are meant for cooperative and charitable activities, and not normally for commercial transactions, except in a very limited range. So far as commercial financing is concerned, the Islamic Shariah has a different ‘setup’ for that purpose. The principle is that the person extending money to another person must decide whether he wishes to help the opposite party or he wants to share his profits. If he wants to help the borrower, he must rescind from any claim to any additional amount. His principal will be secured and guaranteed, but no return over and above the principal amount is legitimate.
However, if he is advancing money to share profits earned by the other party, he can claim a stipulated proportion of profit actually earned by him, and must also share his loss if he suffers a loss. It is thus obvious that exclusion of interest from financial activities does not mean that the financier cannot earn a profit. If financing is meant for a commercial purpose, it can be based on the concept of profit and loss sharing, for which specific modes of Islamic financing have been designed since the very inception of the Islamic commercial law.
Other major principles of Islamic finance that differ from conventional finance are:-
٠ Ban on uncertainty: Uncertainty in contractual terms and conditions is not allowed, unless all of the terms and conditions of the risk are clearly understood by all parties to a financial transaction.
٠Risk sharing and profit sharing: Parties involved in a financial transaction must share both the associated risks and profits.
٠ Capital must have a social and ethical purpose .
٠Investments in businesses dealing with alcohol, gambling, drugs or anything else that the Shariah (Islamic law) considers unlawful are deemed undesirable and prohibited.
٠Transactions involving speculation and gambling are prohibited.
٠Financing must be ‘asset-backed’: Each financial transaction must be tied to a ‘tangible, identifiable underlying asset.
Based on the fact that Islamic finance has to be ‘asset-backed’, in the sense that one cannot collect or pay interest on ‘rented money’, as done in conventional banking, different forms of transactions are used in Islamic finance which are ‘secured lending’. Some of these are:-
٠ Buy-sell back arrangements given the classical name of ‘Murabaha’. Under this transaction, the bank obtains a promise that its customer will purchase the property on credit at an agreed-upon ‘make-up’. The bank then proceeds to buy the property and subsequently sells it to the customer.
٠Lease-to-purchase or diminishing partnership arrangements under the Arabic names of ‘Ijara’ or ‘Musharaka Mutanaqisa’. A typical structure (of this) requires the bank to create a special purpose vehicle (SPV) to purchase and hold title to the financed property. The SPV then leases the property to the customer, who makes monthly payments that are part-rent and part principal. Rents are calculated based on market rates, allowing monthly payments to follow a conventional amortization table.
Islamic finance also provides alternatives for corporate and Government bonds. Some of these are based on profit and loss sharing, and others guarantee the principal but do not guarantee a fixed rate of return. In a similar manner, alternatives to investment in corporate equity (conventional) are also offered in Islamic finance through the means of Islamic Mutual Funds and Islamic Private Equity.
Islamic finance also offers the system of ‘Takaful’ (Islamic Insurance) as an alternative to the conventional insurance which is based on interest.
In this way, Islamic banking and finance offers almost all the facilities and services that are extended by conventional banking. It is free from interest, but yet, brings about a handsome return to investors. In this way, it aspires to create an equitable economy, help reduce poverty and correct the defects which are present in conventional finance.
By: Mufti Waseem Khan
M.A Islamic Studies (Karachi, Pakistan)
Post Graduate Diploma – Islamic Banking & Finance (UK)
Master Diploma – Islamic Finance (UK)
Certified Islamic Finance Expert (UK)
Certified Takaful (Islamic Insurance) Professional (UK)