Islamic finance: principles and types of products
We continue our discussion on Islam in the month of Ramadan. Today’s discussion is first of two on Islamic Financing.
Islamic finance is a type of financing activities that must comply with Sharia (Islamic Law). The concept can also refer to the investments that are permissible under Sharia.
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The common practices of Islamic finance and banking came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance occurred only in the 20th century. Nowadays, the Islamic finance sector grows at 15 per cent - 25 per cent per year.
The main difference between conventional and Islamic finance is that some of the practices and principles that are used in the conventional finance are strictly prohibited under Sharia.
Sharia law sets out five categories of actions that guide a Muslim’s actions. These are acts that are:
a. Obligatory
b. Meritorious
c. Commendable
d. Reprehensible; and
e. Forbidden.
Principles of islamic finance
Islamic finance strictly complies with Sharia law. Contemporary Islamic finance is based on a number of prohibitions that are not always illegal in the countries where Islamic financial institutions are operating:
a. Paying or charging an interest: Islam considers lending with interest payments as an exploitative practice that favours the lender at the expense of the borrower. According to Sharia law, interest is usury (riba), which is strictly prohibited.
b. Investing in businesses involved in prohibited activities: Islam prohibits industries that it considers harmful to society and a threat to social responsibility. These industries include alcohol, prostitution, pornography, weapons of mass destruction, pork, tobacco and illegal drugs. By prohibiting certain industries, Islam also prohibits profiting from them in any way. Therefore, an Islamic financial institution cannot finance a project or asset that is prohibited and a Muslim investor cannot put money into a mutual fund or other equity product that funnels money to a company that participates in a prohibited industry.
c. Speculation (maisir): Sharia strictly prohibits any form of speculation or gambling which is called maisir. Thus, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.
d. Uncertainty and risk (gharar): The rules of Islamic finance ban participation in contracts with the excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertain in nature investments. Gharar is observed with derivative contracts and short-selling, which are forbidden in Islamic finance.
e. Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.
f. Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the other party.
Types of financing arrangements
Islamic financial products are based on specific types of contracts. These Sharia-compliant contracts support productive economic activities without betraying key Islamic principles as some conventional financial products do. Sharia-compliant contracts cannot create debt, cannot involve the payment of interest, and must provide for a sharing of risk and responsibility between the involved parties.
Commonly used contracts in Islamic finance:
Profit and loss sharing financing
a. Mudarabah (Profit-and-loss sharing partnership): A mudarabah or mudharabah contract is a profit sharing partnership in a commercial enterprise. One partner, rabb-ul-mal, is a silent or sleeping partner who provides money/capital. The other partner, mudarib, provides expertise and management. The arrangement is similar to venture capital in conventional finance in which a venture capitalist finances an entrepreneur who provides management and labor.
Profits are shared between the parties according to a pre-agreed ratio, usually either 50 per cent–50 per cent, or 60 per cent for the mudarib and 40 per cent for rabb-ul-mal. If there is a loss, the rabb-ul-mal loses the invested capital, and the mudarib loses the invested time and effort. The sharing of risk reflects the view of Islamic banking proponents that under Islam, the user of capital — labour and management — should not bear all the risk of failure. Sharing of risk, according to proponents, results in a balanced distribution of income, and prevents financiers from dominating the economy.
b. Musharakah (Profit-and-loss sharing joint venture): This contract creates a joint venture in which both parties provide investment capital, entrepreneurial skills, and labor; both share the profit and/or loss of the activity. The major types of these joint ventures are:
Diminishing partnership: This type of venture is commonly used to acquire properties. The bank and investor jointly purchase a property. Subsequently, the bank gradually transfers its portion of equity in the property to the investor in exchange for payments.
Permanent musharkah: This type of joint venture does not have a specific end date and continues operating as long as the participating parties agree to continue operations. Generally, it is used to finance long-term projects.
Asset-backed financing:
Asset-backed or debt-type instruments (also called contracts of exchange) are sales contracts that allow for the transfer of one commodity for another commodity, the transfer of a commodity for money or the transfer of money for money.
c. Murabaha (Credit Sale): Murabahah (or murabaha) is an Islamic contract for a sale where the buyer and seller agree on the markup (profit) or "cost-plus" price for the item(s) being sold. In Islamic banking it has become a term for both a marked-up price and deferred payment — a way of financing a good (home, car, business supplies, etc.) whereby the bank buys the good and resells it to the customer at higher price (informing the customer of the price increase), and offering to take payment in installments or in a lump sum. Murabahah has also come to be "the most prevalent" or "default" type of Islamic finance. It is effectively a form of credit sale, where the customer receives the goods but pays for them later on a fixed date. However, instead of charging interest, a fixed price is agreed before deliver – the mark-up effectively including the time value of money.
d. Sukuk (Bonds): This is equivalent to debt finance (Islamic bonds). Sukuk must have an underlying tangible asset, and the holders of the Sukuk certificates have ownership of a proportional share of the asset, sharing revenues from the asset but also sharing the ownership of risk.
An example may be where the financial institution purchases a property financed by Sukuk certificates and rents it out at fixed rent. The certificate holders receive a share of the rent (instead of interest) and a share of the eventual sale proceeds.
The Sukuk manager is responsible for managing the assets on behalf of the Sukuk holders (and can charge a fee). The Sukuk holders have the right to dismiss the manager.
e. Musawamah (Bargaining): A Musawamah contract is used if the exact cost of the item(s) sold to the bank/financier either cannot be or is not ascertained. Musawamah differs from Murabahah in that the "seller is not under the obligation to reveal his cost or purchase price". Musawamah is the "most common" type of "trading negotiation" seen in Islamic commerce.
f. Istisna: This type of forward sale contract allows an Islamic financial institution to buy a project (on behalf of the buyer) that is under construction and will be completed and delivered on a future date. It is a customised contract where immediate payment is made for goods in the future — goods not yet manufactured, built, or harvested. Istisna contracts (literally, a request to manufacture something) are limited by Islamic fiqh to use for manufacturing, processing, or construction.
g. Salam: In this forward contract, the buyer (or an Islamic financial institution on behalf of the buyer) pays for goods in full in advance, and the goods are delivered in the future. Salam contracts predate istisna and were designed to fulfill the needs of small farmers and traders. A salam contract cannot be cancelled unilaterally, the full price must be paid in advance, and the time of delivery must be specified — restrictions that do not apply to istisna. In a istisna contract, the financer/bank can make payments in stages, to finance raw materials (in the case of manufacturing), or construction materials (in the case of the construction project). When the product/structure is finished and sold, the bank can be repaid
h. Ijarah (Leasing): Ijarah is a leasing or renting contract. In traditional Islamic jurisprudence (fiqh), it means a contract for the hiring of persons, services, or the "usufruct" of a property, generally for a fixed period and price.
In this type of financing arrangement, the lessee pays rent to the lessor to use the asset. Depending on the agreement, at the end of the rental period, the lessor might take back the asset (effectively an operating lease) or might sell it to the lessee (effectively a finance lease – Ijara-wa-Iqtina).
Whatever the agreement, the lessor remains the owner of the asset and is responsible for maintenance and insurance, thus incurring the risk of ownership.
The writer is the Head, Research Unit at the Institute of Chartered Accountants (Ghana)
Email: [email protected] / [email protected]
