Introduction to Islamic Finance

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The five pillars of Islam

The foundation of Islamic Finance is based on the five major tenets (pilars) of Islam:

1. Shahada or creed, which translates as to know or believe without suspicion, as if witnessed. This idea is synonymous with western ideas of faith, which is to believe without absolute confirmation.
2. Salats, the daily prayers made by the faithful Muslims
3. Swam, which is the period of religious fasting during the month of Ramadhan
4. Zakat, almsgiving to the poor
5. Hajj, religious pilgrimate taken to Mecca, Islam holy land

Four basic principles govern at least 80% of all islamic transactions:

• Riba – free transactions

The Arabic word riba refers to “increase” or “addition” and in commercial context refers to any incremental increase, above the original lent or exchanged amount. While riba is of many types, the most common kind is ordinary commercial interest, where the borrower compensates the lender with an interest payment for the right to use a sum of capital over a period of time.

Often riba is translated as usury, and because in modern times usury normally refers to exorbitant rates of interest, in reality, however, riba refers to any increment above the principal amount, whether it is a soft, development loan charged at 1% annually or a usurious consumption loan charged at 10% monthly. So riba includes both usury and commercial interest.

• Risk sharing

The concept of risk sharing is common to all islamic finance transactions, whether equity, trade or lease based. A few additional conditions make Islamic finance transactions even more equitable in many cases: such as the ruling that silent partners receive profit no more than is proportionate to their investment, while they may receive less and that working partners may enjoy more pre – agreed profit than is proportionate to their investment, reflecting an emphasis on reward for work rather than reward for merely processing capital. The distribution of risk is itself an equity – based principle. Such seemingly insignificant conditions are often lost in contractual minutiae, and often confuse the layman into thinking that there is no difference between a given Islamic product and its conventional counterpart, but when things go wrong, the details in an Islamic contract place particular emphasis on the equitable distribution of risk.

• Asset and service backing

Because Islam restricts the treatment of money as a commodity by declaring unlawful any profits earned from the exchange of like currencies, regardless of the time value of money, transactions are backed by an assets or a service. Assets and service backing ensures that real assets and inventories are created, rather tha pyramidic money – lending schemes where money simply creates money and market volatility increases unchecked. Even monetary losses due to inflation are overcome by denominating the exchange of money into an asset with intrinsic utility, such as gold.

• Contractual Certainty

Contract play a central role in Islam. The uncertainty of whether a contractual condition will be fulfilled or not is unacceptable in shariah and creates gharar (ambiguity or uncertainty leading to dispute), conventional insurance, interest, futures and options all contain an element of contractual uncertainty. This is distint from commercial uncertainty, such as whether a business will be profitable or not, which is acceptable because there is an asset (such as prosperity, plant and equipment) or service (such as labor) underpinning the risk.

Nine hundred years ago, Imam Al – Ghazali, a celebrated Muslim Thinker and Philosopher wrote: “Riba (interest) is prohibited because it prevents people from undertaking real economic activities. This is because when a person having money is allowed to earn money on the basis of interest, either in spot or in deffered transactions,  it becomes easy for him to earn without bordering himself to take pains in real economic activities. This leads to hampering the real interest of humanity, because the interest of humanity can not be safequarded without real trade skills, industry and construction.

Islamic finance also treats risk differently: speculation or maysir (the same word used for gambling) and uncertainty (gharar) are considered haram. These prohibitions tend to rule out derivatives, options and future, all of which have been deemed to require excessive speculation about future events. Islamic principles of risk – sharing rule out conventional insurance, because it tends to be offered by companies for the benefits of shareholders rather than the insured. In Takaful, or Islamic Insurance, rather than paying premiums to a company, the insured contribute to a pooled fund overseen by a manager, and they receive any profits from the fund’s investment. 

Evolution of institutions and instruments:

Phase one: Conceptualization

Spurred by the writings of muslim scholars towards the end of colonial rule, in the sixties and the early seventies books, articles and publications were written on the need for an alternative to the interest – based economic system.

Phase two: The evolution of the Islamic banking

The second half of the seventies saw the rise of Islamic banks. These early islamic banks evolved around the concepts of Musharakah (partnership financing), Mudarabah (special partnership) and the social role of Islamic banks.

Phase three: The evolution of Islamic financing and Investment vehicles.

The eighties saw the Islamic banks involve themselves in economic activities. During this phase, various form of financing and investment vehicles were developed. There are :

-          Islamic financing methods:

o   Murabaha: installment sale

o   Ijarah: leasing

o   Salaam and Istina: pre – production finance

-          Islamic investment methods:

o   Musharakah (partnership)

o   Mudarabah (special partneship)

o   Quasi

Phase four: Development of product and standards

The late eighties and the nineties saw the evolution of and development of:

New financial products

Standardization in issues relating to shariah (islamic jurisprudence)

Accounting and audit standards with the establishment of Accounting and Audit organization of islamic financial institutions

More specialized form of islamic financial institutions started to evolve particularly in the areas of investment management and investment banking

As theoretical framework, the following guidelines should be followed when conducting transactions considered as Islamic Finance:

• Do not lie to sell your products
• Do not deceive others
• Do not boast about your products
• Do not sell products that have negative influence on young people and society as a whole
• Uphold justice in all your dealings with yours transactions with both friends and enemies
• Gambling and other risk – related purely activities based on pure luck are prohibited activities.

Features of Islamic Finance:

• Riba
• Gharar (uncertainty)
• Maisir (speculation)
• Assured profit
• Unethical Investment
• Money is a mean of exchange only
• Money is not a commodity
• Money can only be exchanged for the same par value 

In accordance with Islamic law (sharia) Islamic Financial products are based on specific types of contracts. Sharia – complian contract support productive economic activities without betraying key islamic principles. The service or assets described in the contract generally must exist when the contract is being created, must be owned by the seller and must be deliverable. Some of the most commonly used contracts in Islamic finance:

• Contract of partnership à allow two or more parties to develop wealth by sharing both risk and return, example: mudaraba, musyaraka
• Contract of exchange à allow the transfer of a commodity for another commodity, the transfer of a commodity for money or the transfer of money for money, example: murabaha, salam, istina
• Contract of safety and security à these contracts help individual and business customers keep their funds safe, example: wadia, hiwala, kafala and rahn.

Islamic financial institutions are those that are based in their objectives and operations on Qur’anic principles like:

• Quest for justice
• Avoidance of Riba (interest)
• Avoidance of ‘gharar’ (speculation)
• Focus on religiously permissible operations
• Other ethical goals

Main principle of Islamic finance:

• Prohibition of riba (interest), no receipt of interest
• Prohibition of activities with elements of gharar (uncertainty): excessive speculation is prohibited, gambling and derivatives
• Prohibition to invest in certain sectors “haram” items: Alcohol/drugs, Weapon/defense, Adult entertainment, Pig related industry and Conventional financial services (bank, insurance)
• Transactions should be backed by a tangible assets

Islamic economic philosophy aims at eliminating interest and establishing distributive justice free from all sort of exploitation. Many times has the islamic economic system been equated to an Interest – free system although it is just one aspect of the systems.

In an Islamic mortgage, rather than lending a customer money to buy a house, the bank will buy the house itself. The customer can than either  buy the house back from the bank at an agreed – upon, above market value paid in installments (this is called murabahah) or he can make monthly payments comprising a rental fee and a piece of the purchase price until he owns the home outright (Ijara). 

The basic difference:

Traditional banks (broadly speaking) operate by taking deposits and lending it again to others.  The profits come from the different in interest (take deposits for low interest, lending to others for a higher interest) However, in Islamic finance, this would constitute as riba. Thus, the islamic bank should instead be seen as an asset manager and not a financial intermediary. The depositors are not really depositors, but rather investors.

The islamic bank operates by “profit – loss sharing” the depositors agree to a fund management deal with the bank and the profit from the deal with the bank and the profits from that deal are shared by the bank and the depositor (including a management fee from the bank).  

Islamic banks operate in accordance with sharia and has been providing superior products that conform to the sharia. However, there are still many customers who are in doubt of its professionalism and service quality. There are a lot of critisms associated with service quality of islamic banks, especially regarding the application of profit – sharing system.

Time Value of Money:

Islamic principles differ from the capitalist theory as money and commodity have different characteristics, for instance money has no intrinsic value but is only a measure of value or a medium of exchange, it is not capable of fulfilling human needs by itself, unless converted into a commodity.

Trading in Stocks:

As long as the company’s business and financial position are acceptable, there is no reason to believe that trading in the company’s shares is not permissible.

Legal status of loans in Islamic law:

Loans are charitable contract

Glossary:

Islamic Banking and Finance

Term in Arabic	Meaning
Reba	Interest
Al - Wadiah	Safe keeping
Bai’muajjal	Defferred – payment sale
Bai’salam	Pre – paid purchase
Zakat	Islamic tax
Halal	Lawful
Haram	Unlawful
Ijara	Leasing
Mudaraba	Profit – sharing
Mudarib	Entrepreneur – borrower
Murabaha	Cost – plus or mark – up
Musharaka	Equity participation
Qard Hasan	Benevolent Loan (Interest free)
Gharar	Uncertainty or chance
Sukuk	Islamic bond
Qirad	Mudaraba
Rabbul - Mal	Owner of Capital
Shariah	Islamic Law
Shirka	Musharaka

Sources:

 Islamic Finance, Farmida Bi Partner, Norton Rose Fullbright LLP, 2013

Islamic banks in the United Kingdom, by: Christofer Engzell, 2008,pp.9, Research Paper

“why Islamic Financial Products are Catching on Outside the Muslim World”, www.economist.com”

Philosophy and Practice of Islamic Economic and Finance, by: Shaikh A.Hamid, Associate Professor of Finance Southern New Hampshire University.

Effect of Service Quality, Customer Trust and Customer satisfaction and Loyalty of Islamic Banks in East Java

Introduction to Islamic Finance Its Concept, Models, Growth and Opportunities, by: Serene Shtayyeh, Win Piot, Oct 2008

Islamic banking and finance by Prof.Dr. Hans – Peter Burghof with Ahmad Abu – Alkheil and Ulli Spankowski

In Your Interest by Ethica Institute of Islamic Finance, www.ethicainstitute.com