Islamic Finance: Basics

Table of Contents

1. Introduction
1.1 Islamic Finance Today

2 Principals of Islamic Finance

3 Instruments of Islamic Finance
3.1 Murabaha (Cost-Plus Sale)
3.2 Mudaraba (Partnership Financing)
3.3 Musharaka (Equity Participation)
3.4 Ijara (Leasing)

4 Difference between Islamic and Conventional Banking

5 The Governing Body of Shariah Board
5.1 Accounting and Auditing of Islamic Financial Institutions

6 Future Challenges of Islamic Finance

7 Conclusion Summary

Bibliography

1. Introduction

The present term paper is dedicated to the topic “Islamic Finance”. In order to understand its importance, in the first stage today’s challenges for the Islamic Financial Instruments are pointed out. In the next stage the principals of Islamic Finance are defined, and differentiated with conventional finance system as those build the basis on which this paper is written.

Islamic Financial activities is consistent s with the principles of shariah law and its practical application through the development of Islamic economics. Shariah prohibits the fixed or floating payment or acceptance of specific interest or fees (known as riba, or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also haraam ("sinful and prohibited")¹

The concept is more accurately that money has no intrinsic value - it is only a measure of value, and since money has no value itself, there should be no charge for its use. Therefore, Islamic Finance is said to be asset based as opposed to currency based whereby an investment is structured on exchange or ownership of assets, and money is simply the payment mechanism to effect the transaction. The basic framework of an Islamic Financial System is based on elements of Shariah, which governs Islamic societies.²

The return on savings and investment accounts are variable, and dependent on the Bank's performance and the profits from Halal business transactions only. While these profits are not necessarily guaranteed and are subject to a degree of risk, these are managed professionally to ensure better returns than many other conventional alternatives.

1.1 Islamic Finance today

Islamic Finance principals have been applied in varying degrees by historical Islamic economies. As mentioned, the basis of Islamic Finance is from the Shariah, so the concepts of Islamic Finance have been around since the origination of Islam itself. The practices of what we see today have been used throughout the last 1500 odd years across the modern Muslim world and beyond. The modern Islamic finance really originated in the 1960s, escalating with the petro-dollar boom of the 1970s when in 1975, the Islamic Development Bank was formed to promote acceptable financial practices according to Islam. While many banks originating in the Middle East strictly follow these principles, many also follow Western practices of finance, with a number following both practices to cater for both markets. Interestingly, many of the internationals larger banks (with HSBC, UBS and Citigroup as notable examples) all have Islamic banking arms, both in the Middle East and the West.

2 Principals of Islamic Finance

Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital. But that is not the sole purpose either. Adherence to Islamic law and ensuring fair play is also at the core of Islamic banking. Because Islam forbids simply lending out money at interest (riba), Islamic rules on transactions have been created to prevent this evil. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk- transfer.

The main principles include :-

- The prohibition of taking or receiving interest as Islam vies money is not an asset that should earn a surplus on and of itself.
- Financial provider must share the risk with the entrepreneur and not only the profits.
- Capital must have a social and ethical purpose beyond pure and unfettered return Islam upholds contractual obligation Islam upholds contractual obligation and the disclosure of information as a sacred duty. This feature reduces the risk of asymmetric information and moral hazard.
- Only business activities that do not violate the rules of Islamic law qualify for investment, for example business dealing with gambling, pornography and casinos would be prohibited.³

3 Instruments of Islamic Finance.

It is important to appreciate that Islamic finance is more than just financial contracts. In principle, a great deal of emphasis is placed on responsible investments; client relationships; capitalism with a moral focus; and eliminating excessive uncertainty within the markets. These ideals are clearly stipulated within Islamic law. Islamic banking introduces concepts such as profit sharing (Mudharabah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar).

3.1 Murabaha (Cost-Plus Sale)

Murabaha essentially is undertaking a trade with a markup and is used for short-term financing, similar in form to purchase finance. An example would be a bank purchasing a tangible asset of some sort from a supplier with the resale based on the cost plus an agreed markup. This is most often used to finance property, since the bank would not be allowed to charge interest on any loan. Once such a debt covenant is in place between a bank and the customer, repayments can begin until a completion point where the asset is transferred to the customer. There is no exposure to variations in interest rates as there is a fixed markup percentage, identified at the outset.

3.2 Mudaraba (Partnership Financing)

Mudaraba is very similar to Musharaka and is a trustee type finance contract under which one party provides the labour while the other provides the capital. Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar to the function of an asset manager or employed manager of a company.

As the profits are shared with the manager and the capital provider but the losses are beared only by the capital provider this mode is also named profit sharing - loss bearing. Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.

3.3 Musharaka (Equity Participation)

There is very little difference between this and a joint venture agreement. The parties involved contribute in varying degrees of assets, technical expertise etc. and agree to a percentage of the returns as well as the risk. All parties must invest a certain amount of capital. In the case of purchasing a property under this sort of arrangement, it is purchased by both the bank and the customer together, and the repayments made are partly rent and partly a buyback.

It is about contributing capital to a company, project, or any kind of asset transaction. The profit and the losses needs to be shared. This method is recommended by Muslim economists as being the most fair and just method.

In a Musharaka contract all parties may take part in the management or some parties may not take part in the management (silent partnership). Losses need to be born proportionately to the capital provided by each party (pro rata). Regarding the profits there is a disagreement between the schools whether other than pro rata distribution is permissible.

3.4 Ijara (Leasing)

Ijara is a leasing contract whereby one party leases an asset for a specific amount of time and cost from another party, usually a bank. The bank would bear all the risk and a portion of the installment payment goes towards the final purchase of the asset at the time of transfer of asset. This can also be set up as a lease-purchase contract for the term of the asset’s specified lifetime.

The conditions of an Ijarah contract are basically the transfer of a valuable use (usufruct) while the ownership remains with the lessor with all its liabilities involved. The period of the lease needs to be clarified in the contract and during this period the payment of rent can be negotiated freely. A forward lease is unlike in sales contracts permissible. Subleases are permissible with consent of the lessor or if similar usage could be expected.

In Islamic law it would not be possible to bind two contracts such as rent and sales in one. Each needs to be clarified precisely. Further a sales contract cannot defer the transfer of ownership and the payment for it in the future. The solution is again a promiss of the lessor, binding only to him, to sell the asset to the client at a certain price in future. Also it is possible to structure a gift in the end of the period, so that the ownership is transferred without payment.

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¹ Wiki Reference

² World Islamic Banker Data Base

³ Wiki Finance