Islamic Finance

Islamic Finance is now a multi-billion dollar global industry, with over 270 institutions operating in 48 countries and holding more than US$300 billion in assets. As Sharia’a compliant products become more sophisticated they are growing in popularity. ‘Non-traditional’ Islamic funds have grown from just 12 in 2001 to over 100, and there are currently over 120 Islamic equity funds in existence globally totalling US$16bn in assets under management. Western majors are joining the fray by launching similar Islamic equity products.

For those of you who are still in the dark, here is a bite-size guide to the fundamentals of Islamic financing:

Basic Tenets
Islamic banking refers to a system of banking or banking activity that is consistent with Fiqh al-Muamalat (Islamic rules on transactions).

Islamic law prohibits riba, the collection and payment of interest. It also prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as pornography). There is an emphasis on ethical investment. While Islamic law prohibits the collection of interest, it does allow a seller to resell an item at a higher price than it was bought for, as long as there are clearly two transactions.

Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).

Fixed-income, interest-bearing bonds are not permissible in Islam. Sukuk are securities that comply with the Islamic law. Total global issues of sukuk – Sharia’a compliant asset-backed securities - are expected to reach US$27 billion this year.

It is generally accepted by Muslim jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah. They argue that it involves the elements of uncertainty (Al-gharar) in the contract of insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and interest (Al-riba). Takaful - Sharia’a compliant insurance – is currently growing by approximately 20% per year. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

Participatory arrangements between capital and labor reflect the Islamic view that
the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy.

Islamic banks employ advisory consultants to ensure that the operations and activities of the bank comply with Sharia’a principles.

How it works
For example, in an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that it is profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabaha. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

Objections
Many Muslims and non Muslims have opposed Islamic finance, claiming that it deals in interest but conceals it through legal innovations. Islamic finance bears a striking resemblance to “contractum trinius”, a method devised by European bankers and merchants during the Middle Ages designed to circumvent the Church’s prohibition of fixed interest payments. A set of three separate contracts were presented to someone seeking a loan: an investment, a sale of profit and an insurance contract. Each of these contracts were permissible under Church law, but together replicated the effect of an interest-bearing loan. In early sixteenth century Europe, it was realized that the complete prohibition of lending for profit impeded economic development. This was especially true for the merchants, traders, and industrialists who needed extra capital to expand their commercial enterprises. In the end, Henry the VIII – amongst other things – overturned the ban on interest-bearing loans. "The Act Against Usury" was passed by the English Parliament in 1545, providing for an interest rate ceiling of up to "ten in the hundredth" (ten percent). This became the foundation of English usury law.