Principles of Economics

(HS19H020)
TERM PAPER

ISLAMIC FINANCE

Submitted by: Group 4

Lakshmi P (HS19H020)
Yatin Vinayak (HS19H046)
 Aryan Sarvate (HS19H051)

The Basics of Islamic Finance

Islamic Finance is a way of doing financial transactions and banking while respecting
Islamic law or Sharia. Its history dates from the 9th century A.D and develops several
concepts like Zakat (giving religious alms), Gharar (uncertainty) and riba (which means the
interest charged).[1]

Usury in Islam

The most important rule in Islamic finance is the ban on usury. This means lenders and
borrowers are forbidden from charging or paying interest or riba. Sharia-compliant banks do
not issue interest- free loans.

Instead of charging interest, Islamic banks make money by buying the product (such as a car,
or house) and re-sell it on an instalment to the clients at a higher fixed price than the initial
market price. They instead propose an equal sharing of the profits of the transaction with the
customer and use the customer's money in order to acquire assets such as property or
businesses, and profit whenever a loan is successfully repaid.

As banks operate under Islamic law, all illicit activities contrary to Sharia (such as alcohol,
pork) are forbidden.[1]

Principles

To be consistent with Sharia, the law prohibits a variety of activities such as:

• Charging interest or riba – Islamic rules on transactions (Muamalat) have been

created to prevent the use of interest.
• Investing in forbidden business activities (haraam) - Includes selling alcohol or
pork.
• Extra charging for late payment (murabahah)
• Maisir or Qimar (gambling), and
 • Gharar (uncertainty or ambiguity), which means excessive risks in transactions
which may result in people conducting illegal activities.[3]

Industry framework

Islamic financial institutions take different forms. They are:

• Full-fledged institutions such as Islami Bank in Pakistan

• Sharia-compliant units which act as Islamic windows (such as Riyadh Bank,
Commercial Bank of Saudi Arabia)
• Subsidiaries
• Non-Banking Financial Institutions (NBFC)[2]

Central Banking

The nature of the relationship between Islamic banks and central banks differed from one
country to another. In contemporary times, even though charging of interest is frowned upon,
the banks allow temporary facilities to deal with monetary policy when there are no interest
rates. They offer refinance facilities in order to deal with inflation or deflation.[4]
Products, services and contracts
Banking makes up most of the Islamic finance industry.

Banking products are often classified in one of three broad categories[5]:

 Profit and loss sharing modes — musharakah and mudarabah — where financier
and the user of finance share profits and losses, are based on "contracts of
partnership".[15] These have been called the "real and ideal" modes of Islamic
finance[6] as Islam calls for sharing of rewards and losses by all who contribute
capital to a commercial enterprise.
 "Asset-backed financing", "debt-like instruments" such as mark-up (murabaha),
leasing (ijara), cash advances for the purchase of agricultural produce (salam), and
cash advances for the manufacture of assets (istisna').[7] These are based on
"contracts of exchange", and involve the "purchase and hire of goods/assets and
services on a fixed-return basis".
 Modes based on contracts of safety and security, which includes safe-keeping
contracts (wadi’ah) for current deposits.

Profit and loss sharing

Mudarabah (trust financing)

Mudharabad is formally an agreement between two parties to cooperate in a transaction and

share the benefits/losses from the transaction.[9] Under a modaraba/mudarabah contract, an
Islamic financial institution provides the capital to finance a project while an entrepreneur
provides management skills. In financing a project, the institution does not employ its own
funds—only the funds of its investors. After paying for management skills, the financial
institution deducts its fee from the enterprise's profits, for managing its investor's funds.
Remaining profits are distributed to investors.[8]

The terms for the sharing of the profits/losses are clearly outlined before the transaction is
completed, so there is no uncertainty on either side concerning their role in the sharing of risk
from the transaction: this is acceptable because it is acknowledged that those with money
may not have the time or skills for all business transactions, and those with the time and skills
may not have the money. This type of arrangement allows both parties to benefit from the
effort and services the other can bring to the table. Since there is no guaranteed return on the
investment of the money, it does not violate the prohibition of riba.[9]

Musharakah (joint venture)

This contract is similar to a modaraba, except that the partners are not confined to distinct
roles as either financier or manager. Instead, the provision of capital and management of the
enterprise are shared.[8] Profits are shared among all partners according to predetermined
terms.[9]

Asset-backed financing

Asset-backed or debt-type instruments (also called contracts of exchange) are sales contracts
that allow for the transfer of one commodity for another commodity, the transfer of a
commodity for money, or the transfer of money for money. They include Murabaha, Salam,
and Istisna’a.

Murabahah (cost-plus financing)

In a Murabaha contract, the buyer must detail all of the costs he/she has incurred in obtaining
the object(s) to be sold. Then the Islamic financial institution purchases the object(s) at that
price and then resells it to a customer at a later date for a predetermined price. The customer
may opt for either immediate payment or deferred payment. The institution's profit is the
difference between the price paid for the object(s) and the price paid by its customer.[8]

Such contracts tend to come under fire for violating the prohibition of predetermined profit
but are justified by the fact that the client is not compelled to repurchase the goods from the
institution. This structure creates a certain degree of risk on the part of the institution, and its
profits are directly derived from that risk.[8]

Murabaha, with its fixed margin, provides lenders (i.e. banks) a predictable income stream
and profit from lending money.[9]
Istisna and Bai Salam
Istisna and Bai Salam (also Bai us salam or just salam) are "forward contracts" — customized
contracts where immediate payment is made for goods in the future — goods not yet
manufactured, built or harvested.[6]

A salam (forward purchase) contract is an agreement in which the investor/institution directly

pays the manufacturer for a commodity to be produced and delivered on a fixed date. The
possibility of the lack of a market at that future date incorporates the element of risk for the
lender, rendering such transactions legal. Payment is made at the time the contract is signed.

In an istisna' (commissioned manufacture) contract, one party agrees to buy goods made by a
second party with payments occurring at some future date/dates. The primary distinction
between an istisna' and salam is that the former is used for goods that otherwise would not
exist.[8]

Ijarah

Under an ijara contract, an Islamic institution purchases an asset and then leases it for a rate
that is periodically reviewed and possibly adjusted. The profits from the lease are justified
because the financial institution owns the asset in question and, therefore, assumes risk for its
performance. While the option for the lessor to purchase the asset at the end of the lease
period is deemed illegal (due to the uncertainty inherent in options), there are versions of ijara
contracts where the client agrees up-front to purchase the asset at the end of the lease period.
[8]

Deposit side of Islamic banking

Wadiah
The word Wadiah refers to "safe-keeping", and it generally used in conjunction with banks. A
bank holds funds for individuals (deposits) and the bank guarantees that the individual will
get the entire amount back, or any portion thereof, on-demand. The depositor may also be
rewarded with a form of appreciation for the use of funds to make a profit in operations by
the bank; as a result, the depositor is also participating in the profitable operations of the
bank.[9]

Exhibit 6 Modes of Financing by Islamic Banks: 1994-1997

1994 1995 1996 1997

M oraba ha 4 1 .5 % 4 5 .6 % 4 0 .3 % 3 7 .0 %
M os harak a 8 .2 8 .7 7 .2 1 9 .0
M od a ra b a 1 2 .6 1 5 .3 1 2 .7 6 .0
Ija r a 8 .7 9 .7 1 1 .5 9 .0
O th e rs 2 9 .0 2 1 .1 2 8 .3 2 9 .0
T ota l 100% 100% 100% 100%

Source: "Directory of Islamic Banks and Financial Institutions - 1997," The International Association of Islamic Banks, Jeddah.

The above figure shows the degree to which Islamic financial institutions employ these
instruments. In recent years, mosharaka contracts have gained significant popularity as a
mode of financing, while modaraba and murabaha have experienced slight declines.[8]
Challenges
a. Greater risk of defaulters
Institutions lend to borrowers on a profit/loss basis rather than charging interest, and
hence there is no incentive for potential defaulters to utilize it efficiently or even
return the money. According to Ibrahim Warde, [10]

“… various forms of penalties and late fees have been established, only to
be outlawed or considered unenforceable. Late fees in particular have been
assimilated to riba.”

b. Lack of safety nets

Islamic Banking suffers from maturity mismatch because it has more short-term
liabilities than long-term ones. Venardos [11] asserts that this makes it vulnerable to
liquidity risks. Very few countries with Islamic Banking have a Shari’ah compliant
inter-bank lending system or lenders-of-last-resort for liquidity problems – only 6 out
of 24 surveyed regions in IFSB 2014[12] did.

c. Lack of skilled personnel

There is a shortage of qualified professionals at all levels: there are few with adequate
training in maqasid of Shari’ah as well as economics and conventional banking.[13]
This means that the few scholars and supervisors who are work for many institutions
– Abdul Karim Abu Ghuddah sits in 85 boards[14] of Islamic Finance Institutions.
Malaysia’s ruling that one individual can sit in only one board was a welcome breath
of fresh air in such environments.[15]

d. Reliance on information efficiency

Islamic finance needs informational efficiency more than conventional banking does,
and as a result, withholding information about the outcome of a transaction is
forbidden. Sources of uncertainty have to be disclosed and investors. Shari’ah
compliant transactions are always transparent.[16] Participatory financing fails when
there is an asymmetry of information between the financer and borrower.
e. Un-Islamic Instruments
Many scholars have criticized Islamic Banking and Finance as merely imitating
conventional banking. M. A. Khan[17] said that it had devised “ruses and subterfuges
to conceal interest”. This imitation is because scholars receive a fee for their services
that depends on deals. Because scholars have to depend on firms for their incomes,
there have been cases when scholars approved products that involved gharar and riba
for a price or ‘Fatwa Shopping.’[19]

f. Lack of interpretive consistency

There is no standardization of what Islamic instruments are legal by Shari’ah. Though
Fiqh Academy of the OIC and IFSB [19] have both issued guidelines for compliance,
there is no obligation on institutions to follow them. For firms conducting cross-
border transactions, products/services deemed lawful by one committee may not be so
by another. This hampers transactions and injects uncertainty.[5]

g. Lack of accounting standards

There are no true accounting standards for financial reporting in most countries. Since
they are supposed to be independent supervisory bodies, Shari’ah boards are not
obligated to follow standards. Some countries like Indonesia, Malaysia and Pakistan
do have centralized boards whose rulings are mandatorily enforced on all boards
within the country.[20]

h. Different norms across countries

In Pakistan, Iran and Sudan, the entire financial system is aligned to Shari’ah
principles. Some countries like UAE, Turkey and Malaysia support dual banking
systems, while Saudi Arabia does not distinguish ‘Islamic finance’ in charters [8]
because it believes this declaration will brand conventional finance as implicitly ‘non-
Islamic.’ [21] Further still, some countries have broader financial instruments.
Malaysian Islamic Finance, which produced 26% of the world’s Shari’ah compliant
assets by 2017[22], contains tools like Bai al Dayn and Bai al Einah, not accepted by
scholars in the MENA regions.

Bai-al-Dayn: selling a debt that arises from trade where payment is deferred.
The customer sells the bank this debt at a discounted rate. This allows
customers to receive payment before sale is wholly realized.[23]

Bia-al-Inah, the lender sells an asset to the borrower on credit for a fixed
practice plus a profit element. The lender immediately repurchases the asset in
cash for a fixed price. Now, the lender owns the asset, the borrower gets cash
and is obliged to pay purchase price + profit in instalments.[24]
References

1. Domat, Chloe, and Pham Binh. “What Is Islamic Finance And How Does It Work?”
Global Finance Magazine, 28 June 2018, www.gfmag.com/topics/blogs/islamic-
finance-faq-what-islamic-finance-and-how-does-it-work.
2. “Islamic Finance - Principles and Types of Islamic Finance.” Corporate Finance
Institute, corporatefinanceinstitute.com/resources/knowledge/finance/islamic-finance/.
3. “Islamic Finance and the Role of IMF.” The IMF and Islamic Finance, Feb. 2017,
www.imf.org/external/themes/islamicfinance/.
4. “Relationship with Central Banks.” Financial Islam - Islamic Finance,
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5. Towe, Christopher; Kammer, Alfred; Norat, Mohamed; Piñón, Marco; Prasad,
Ananthakrishnan; Zeidane, Zeine (April 2015). Islamic Finance: Opportunities,
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sk=42816.0). IMF. p. 9.
6. Usmani, Introduction to Islamic Finance, 1998: p.12
7. Curtis (3 July 2012). "Islamic Banking: A Brief Introduction". Oman Law Blog.
Curtis, Mallet-Prevost, Colt & Mosle LLP.
8. Esty, Benjamin C., Fuaad Qureshi, and Mathew M Millett. "Introduction to Islamic
Finance, An." Harvard Business School Background Note 200-002, August 1999.
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10. Warde, Ibrahim, Islamic finance in the global economy. Edinburgh University Press.
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finance: The role of Shariah experts.” 7th Harvard Forum on Islamic Finance,
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14. Unal, Murat. "The small world of Islamic finance: Shari'ah scholars and governance -
A network analytic perspective." Funds@Work, 2010. p. 6
15. Jamaldeen, Faleel, “Islamic Finance For Dummies.” John Wiley & Sons. 2012
16. [Obaidullah, Mohammed, “Ethics and Efficiency in Islamic Stock Markets.”
International Journal of Islamic Financial Services, Volume 3, No. 2, 2001. p. 2-3
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Present State and Future Agenda.” Edward Elgar Publishing, 2013, p. xvi
18. Farooq, Mohammad Omar, “The Riba-Interest Equation and Islam: Re-examination
of the Traditional Arguments.” Upper Iowa University Press, 2005. p 21
19. Khan, Feisal. Islamic Banking in Pakistan: Shariah-Compliant Finance and the Quest
to Make Pakistan More Islamic. Routledge. 2015
20. Askari, Hossein, Zamir Iqbal Mirakhor. 2010. Globalization and Islamic finance:
Convergence, prospects and challenges. Singapore: John Wiley & Sons (Asia), 2010.
21. Grais, Wafik and Matteo Pellegrini. 2006. Corporate governance and Shari'ah
compliance in institutions offering Islamic financial services. Policy research working
paper 4054, November. Washington, DC: World Bank., p.12
22. Bank Negara Malaysia, “Islamic Finance In Asia: Reaching New Heights.” BNM,
ICD-PS, 2018.
23. Thani, N. N.; Abdullah, M. R. M.; Hassan, M. H., “The Law and Practice of Islamic
Banking and Finance”, Sweet & Maxwell Asia, 2003.
24. Ibid.