Islamic Banking

The roots of Islamic banking goes to the time of the establishment of the Islamic Arab empire – the Caliphate which conquered vast areas in Middle Central Asia, North Africa and parts of Europe in the 7th Century, where systems of payments and finance were required which included Qardan Hasannah (interest free loan), Hawallah (promissory notes/ bills of exchange), a currency (Dinar), Waqf (trusts), to facilitate trade and mercantilism and pay the employees of the Islamic state. However, this dissertation shall focus on modern Islamic banking, which is based on the following concepts (Definitions adapted from FAS 1 issued by AAOIFI[1]:-

Mudarabha – A partnership in profit between capital and labour. It may be conducted between investment account holders as providers of funds and the Islamic bank as a mudarib. The Islamic bank announces its willingness to accept the funds of investment amount holders, the sharing of profits being as agreed between the two parties, and the losses being borne by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic bank. In the latter cases, such losses would be borne by the Islamic bank. A Mudarabha contract may also be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on behalf of investment account holders, and business owners and craftsmen.

Salam : – Purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions or sale of a commodity for deferred delivery in exchange for immediate payment.

Murabaha : –  Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale is of two types. In the first type, the Islamic bank purchases the goods and makes it available for sale without any prior promise from a customer to purchase it. In the second type, the Islamic bank purchases the goods ordered by a customer from a third party and then sells these goods to the same customer. In the latter case, the Islamic bank purchases the goods only after a customer has made a promise to purchase them from the bank.

Musharaka : – A form of partnership between the Islamic bank and its clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. However, losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.

Istisna’a : – A contract whereby the purchaser asks the seller to manufacture a specifically defined product using the seller’s raw materials at a given price. The contractual agreement of Istisna’ has characteristic similar to that of Salam in that it provides for the sale of a product not available at the time of sale. It also has a characteristic similar to the ordinary sale in that the price may be paid on credit; however, unlike Salam, the price in the Istisna’ contract is not paid when the deal is concluded.

Ijarah and Ijarah Wa Iktana:- A lease agreement (similar to a hire purchase agreement) whereby instead of lending money and earning interest, the Islamic bank purchases the asset and rents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renter agrees to buy the asset at a nominal price at the end of the contract, in ijarah there is no such agreement to purchase the asset.

Islamic Insurance – Takaful

Takaful is an Arabic word meaning guaranteeing each other. An Islamic insurance (Takaful) industry observing the rules and regulations of Islamic Sharia law has developed in recent years, which in common with Islamic banking avoids interest, excessive uncertainty and gambling. However this concept has been practiced in various forms for over 1400 years based on shared responsibility in the system of aquila as practiced between Muslims of Mecca and Medina, which laid the foundation of mutual assistance insurance – Takaful based on risk pooling and sharing today. Although some Muslim scholars consider any form of insurance to be against the concept that Muslims believe in God, who is the provider and sustainer of all and is based on the following verse from the Holy Quran “Who, when a misfortune overtakes them, say: ‘Surely we belong to Allah and to Him shall we return’.”.   (Sura Al-Baqara, Verse 156)

Takaful is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may inflict upon any of them, out of the fund they donate collectively. The Takaful contract so agreed usually involves the concepts of Mudarabah (partnership in profit), Tabarru´ (to donate for benefit of others) and Ta-Awun (mutual assistance or sharing of losses) with the overall objective of eliminating the element of uncertainty.  Even though all Muslims believe in the will of Allah who is the owner of everything and we are merely his stewards, the steward had a duty to protect the assets given to him in trust by the owner, hence justification for a Sharia compliant Islamic alternative Takaful to conventional insurance. This view point for Takaful is justified based on the following Islamic jurisprudence sources[2].

Basis of Co-operation Help one another in al-Birr and in al-Taqwa (virtue, righteousness and piety): but do not help one another in sin and transgression. (Holy Quran Surah Al-Maidah, Verse 2) and Allah will always help His servant for as long as he helps others. (Hadith Narrated by Imam Ahmad bin Hanbal and Imam Abu Daud)

Basis of Responsibility The place of relationships and feelings of people with faith, between each other, is just like the body; when one of its parts is afflicted with pain, then the rest of the body will be affected. (Narrated by Imam al-Bukhari and Imam Muslim)

One true Muslim (Mu’min) and another true Muslim (Mu’min) is just like a building whereby every part in it strengthens the other part. (Narrated by Imam al-Bukhari and Imam Muslim)

Basis of Mutual Protection: – By my life, which is in Allah’s Power, nobody will enter Paradise if he does not protect his neighbor who is in distress. (Narrated by Imam Ahmad bin Hanbal)

Key Elements of Takaful

Mutual Guarantee: Loss covered by contribution  of members in fund which pays out losses.

Ownership of Fund: Contributors are owners of fund, hence entitled to the profit after pay off of covered events.

Elimination of uncertainty: Contributions are voluntary and no pre-determined benefits.

Management of Takaful Fund: Operator uses either Mudaraba (Partnership) or Wakala (Principal Agent relationship ) contract to manage funds, which are Sharia compliant.

Investments Conditions: Avoids interest and haram (prohibited) activities for investment.

 

Islamic capital markets

There are two major components of Islamic capital markets namely Sukuk’s (Sharia compliant bonds) and Islamic investment funds. Using the double entry sheet terminology the Sukuk sits on the credit side of the balance sheet hence is a liability, while Islamic investment funds sit on the debit side of the balance sheet hence an asset. Both the capital market instruments are market traded on organised stock exchanges, with some restrictions on the tradability of debt instruments.

Sukuk is the Arabic word for financial certificate, commonly analogous to a bond (promise to pay) in conventional finance. It is asset based rather than asset backed to comply with sharia requirements. The beauty of the Sukuk lies in asset securitisation, whereby future cash flows emanating from an asset are converted into present cash flow. A sukuk can be created on an existing asset and also on a future asset which is being created. The sukuk can be structured as Sukuk Murabaha which constitutes partial ownership in a debt,  Sukuk Al Ijara  which is asset backed, Sukuk Al Istisna which is  project backed,  Sukuk Al Musharaka which is business backed or Sukuk Al Istithmar which is an investment. From a strict sharia perspective debt certificates are not tradable at a price other than at par or face value, as any money generated from holding money is considered interest which is prohibited, hence most sukuk instruments are held to maturity. Therefore the secondary market although in exists but has limited trades.

An Islamic investment fund is a Sharia compliant fund which invests in halal activites, avoids excessive uncertainty, avoid interest and is not overly speculative (gamble). These  can be structured as a mutual fund, a hedge fund or electronic traded fund (ETF).

The common types of investment funds are commodity funds, equity funds, murabaha funds and Ijara funds.

Commodities funds generate profits by buying and reselling commodities. Due to the restrictions on the use of derivatives, commodities fund make use of two types of contracts:

  1. Istina’a- It’s a contract where the buyer of an item funds upfront the production of the item. A detailed specification of the item as to be agreed before production starts and the cost of production has to be paid in full when the contract is agreed.
  2. Bay al-salam which is similar to a forward contract where the buyer pays in advance for the delivery of raw materials or tangible goods at a later date.

Equity funds invest in equity shares of companies engaged in halal business activities. These are similar to ethical investing funds.

Murabaha funds are similar to development funds, and use the ‘cost-plus’ financing model, where a fund will buy goods and sell them to a third party at a given price. The price is made of the cost of goods plus a profit margin.

Ijara Funds acquire and keep ownership of an asset (real estate, machinery, vehicles or equipment) and then makes profits by leasing it out in return of a rental payment. The fund is responsible for the management of the assets and will earns a management fee. This is similar to Real Estate Investments Trusts (REITs) and Energy Royalty Trusts (common in Canada).

Differences between Islamic Finance and Conventional Finance instruments

Sukuk and Bonds

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines a sukuk as being: “Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity”.

Hence, it is a mezzanine financial instrument that is neither debt nor equity, created by a process of securitization of cash flow and ownership of an asset or project. The sukuk holder shares in the cash flow generated by the asset and the disposition proceed of the assets. A bond on the other hand is a contractually obligation to pay to bondholders, on certain specified dates, interest and principal.

Takaful and Insurance

Takaful is based on the principles on mutual assistance and voluntary contribution in a pool of funds to be shared among those in the group afflicted by perils or calamities, without guarantees that the fund will be adequate of expectation that the operator will earn a profit.

In conventional insurance the insurer collects premium from the insured to cover expected payout and profit, this is akin to speculation (Maysir) which is forbidden in Islamic Finance. The insurer pays premiums to be covered for risks that may or may not materialize, this is uncertainty (Gharar), which is also forbidden in Islamic Finance. Lastly, the premiums collected are invested to earn interest (usury) which is forbidden in Islamic Finance.

Conclusion

The basic principles underlying the Islamic Finance concept are very similar to ethical investing, co-operative arrangements, and mutual principles, very closely aligned to conventional financial products but avoiding interest, excessive uncertainty and speculation.

[1] Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) http://www.aaoifi.com/aaoifi/Definitions/tabid/209/language/en-US/Default.aspx (accessed 14 March 2011)

[2] http://en.wikipedia.org/wiki/Takaful (accessed on 14 March 2011)

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