Islamic Finance – An introduction

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Having completed his Masters in economics, Rizwan Rahman worked at the World Bank in Bangladesh, acting as a researcher for the Senior Economist. After returning to the UK, Rizwan pursued his legal studies while concurrently working at leading law firms. In 2008, he was introduced to Islamic finance through undertaking an internship at European Finance House (now Qatar Islamic Bank). Rizwan has since worked at the Islamic Finance Council and BMB Islamic. At Edbiz Consulting, he is jointly responsible for product development, drafting of legal documentation to ensure legal and Shari’a / Shariah compliance and conducting market research and analysis. He is also senior editor for Edbiz Consulting Publications.

 

For the uninitiated the attraction of Islamic finance lies precisely in the word Islamic. It confers the idea that Islamic financial products have validity from the divine. Indeed, Islamic finance products are typically vetted by Shariah scholars – those jurists with an understanding of Islamic law – so there is a connection between the transcendent and the mundane.

However, it is perhaps a mistaken belief that Islamic law is God’s law. Rather it is what man thinks God’s law is in any given situation based on principles and precedents derived from the religious texts, the Quran and the sayings of the Prophet. With that in mind, invoking the rules and regulations of 7th century market for the 21st century appears anachronistic.

Perhaps. But Islamic finance is founded on two powerful pillars; the prohibition of interest and attenuation of uncertainty (or in other words, no speculation and gambling). Ironically, if one could pinpoint the causes of the financial crisis, interest and speculation would be preeminent.

Shah'ria laws prohibit interest in Islamic finance
Shah’ria laws prohibit interest in Islamic finance

 What’s more is that the foundations of the contemporary financial system are interest ( the banking system relies on the fractional reserve system and interest bearing debt to survive) and speculation ( walk into an investment bank and ponder what’s happening when a trader invests).

So really the fundamentals of Islamic finance calls for a complete overhaul of the conventional financial architecture. However, Islamic finance has not managed to achieve this. While Islamic economic thinking has called for such a move, the connection between theory and practice has been tenuous at best.

The difficulty of removing interest and speculation was a concern even in the post prophetic period. It was easy to fall into the trap. Thus, the Muslims came up with some ingenious ways of trading without interest. Primarily, focus was placed upon equity models known as shirkah. To summarize the different permutations of shirkah, profits and losses of a transaction would be shared between the investor of funds and the agent undertaking a project.

These business transactions were obviously quite primitive, but the models created and the laws that underpinned them gave contemporary Islamic finance scholars the bedrock to formulate a uniquely Islamic system. There were two distinct hurdles. Firstly, the models were mostly trade based. They are not finance based models; and secondly, most were used for single and terminal transactions. One could not say there was a wide scale system of financing as there is today.

Nevertheless, contemporary Islamic scholars have translated these trade based models into wide scale financial ones. The starting point was the institutions in the conventional system. From what was present, scholars formulated an Islamic alternative.

For instance, conventional retail banks rely on financial intermediation and maturity transformation to derive revenue. Here depositors place funds in a bank for a small return of interest – essentially they loan to the bank and are considered the banks liability. The bank then accumulates a pool and loans a percentage of the pool to borrowers on the asset side. Here they charge a higher interest and therefore make profits from the spread. Short term liabilities (deposits) and transformed into long term assets (loans).

Islamic finance banks have employed a few models to replicate this. One popular model is known as two tier mudaraba. A mudaraba involves an investor (known as the rab ul mal) providing funds to an agent (known as the mudarib) to undertake a commercial transaction. In Islamic finance banks, a two tier mudaraba starts with the depositors placing their funds with a bank. The bank, as agent, invests (not loans) funds on the asset side. The return is then shared between the bank and the depositor.

One does not speak of a system of loans and interest with Islamic banks. Rather, they are either investments that accrue profits or placement of funds from which banks give gifts (hiba) to depositors.

However essentially the process is the same; but the legal underpinnings are different and to some extent, so are the risks. On the asset side, banks are limited as to what they can do with the funds. Liquidity tools for banks remain limited although there are concerted efforts by the industry to create more “Shariah compliant tools.” This means instruments that follow the Shariah law.

On the asset side, banks finance through investment or through trade based models. One popular tool has been the murabaha. Previously, the murabaha involved one merchant buying a good at its market price and selling it to another merchant at its cost price plus a profit rate, both of which would be known to the buying merchant. Today, high expense transactions such as buying a house, would involve the bank buying the property at market price and selling it to the customer over a period of time but at a higher price. This model of house buying was popular in the earlier days of Islamic finance. Today, the most common model is known as diminishing musharaka. Here, the bank buys a share of the property while the buyer buys a share. Over a period, the buyer buys out the banks share, thereby decreasing its ownership. During this period the buyer also pays a rent (known as ijara) for the benefits derived from banks share share.

The concepts of mudaraba and musharaka along with murabaha and ijara underpin the Islamic financial system on the retail side. There is typically some derivation of these models. The key point to take from these models is the concerted effort to avoid the lender-borrower model and the charging of interest. While there is a resemblance in the financial profile, the products are different. One can analogise with two shops, one selling alcohol and the other selling juice. To compete they both sell at about the same price. However, the former is a forbidden good. Islamic finance looks at interest based financial products as forbidden goods like alcohol or pork.

7 thoughts on “Islamic Finance – An introduction

  1. An informative post on this topic and a good introduction for the uninitiated.
    I have been reading and wondering about “Islamic finance” for a while, it strikes me as a little odd that there is such a hoopla about finance but little noise about the underlying economy. Afterall, it is the economy that is supposed to be served by finance and not the other way round. Seems to me that the problem is not just the financial model, it is the whole economic model, the political economy, if you will, that is to be overhauled.
    I wonder if there could be a contribution about the topic of “The Islamic Political Economy”.

  2. From what I understood, the concepts of mudaraba, murabaha etc are essentially the same as the traditional practices in non Islamic banks. For example, I don’t really see any difference in the murabaha and the conventional practice of mortgages and loans. Also, the ‘hiba’ in mudaraba is like the interest a depositor receives and the ‘ijara’ is the interest a borrower pays. The distinction, however, may lie in the terms and conditions in the legal contract. But either way, I don’t think it makes any difference to the borrower or depositor.

    1. My apologies. There has been some confusion. With regards to the sentence “One does not speak of a system of loans and interest with Islamic banks. Rather, they are either investments that accrue profits or placement of funds from which banks give gifts (hiba) to depositors”, investments that accrue profits refers to the mudaraba model I mention. As for the placement of funds, this could either be as a interest free loan (Qard Hasana) or as a trust (Wadiah). From the Qard and Wadiah, the banks could give gifts (hiba)

      1. Thanks, it’s clearer now. By the way, great article. First time I’ve read about Islamic Finance and I already know so much!

  3. Very nice write up . I got some basic ideas about Islamic Finance. I really like the diminishing Musharaka model. However, many questions are there in my mind. I would like to know more about it.

    1. Is Murabaha a substitute of LC ? How it will work and is there any Islamic Substitute of back to back LC?

    2. How the diminishing Musharaka model works? For example, if a bank buys 80% of the house for me . Is there any fixed maturity of it to buy back the remaining 80% which is purchased by the bank? If bank wants to make a profit from the deal then the bank have to forecast the future value of the house, inflation etc.. But is forecasting a speculation in the eyes of Islamic scholars? Though I feel its an educated guess or expectation. Is there any fixed EMI ( Ijara + Installment for buying back)to settle the buy back procedure?

    3. What are the mechanisms to mitigate depositors’ risks?

    It will be very helpful if I get to know some of your Islamic Banking products and their features.

    1. 1.) LCs are related to trade finance. Islamic banks do use the murabaha model for LCs, but in the case described, there is no LC situation arising.

      2.) there is usually a fixed time period in which to buy the share. Islamic banks are just as, if not more so, scrupulous about receiving payment. Hence, deposits can be quite high and the ultimate payment could be higher than a conventional mortgage. This may be mitigated over time as economies of scale grow. Forecasting is not considered speculation., and it is as you said educated guess. The ijara rate itself will be floating. The share itself will be fixed although this will be incorporated in the banks sale price.

      3.) To mitigate depositors risk, islamic banks follow the same sort of regulations regarding capital adequacy as conventional banks. Basel III will be as important to Islamic banks as conventional banks. A big issue is liquidity as the inter-bank markets are problematic of Islamic banks. So there is a quest to create the right tools for liquidity.

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