You are on page 1of 8

Business Environment Assignment Topic - Islamic Finance

Submitted byRimsha TY-B 3104

Meaning of Islamic Financing

Islamic Financing or Islamic Banking is banking based on Islamic law (Shariah). It follows the Shariah, called fiqh muamalat (Islamic rules on transactions).These rules and practices came from the Quran and the Sunnah, and other secondary sources of Islamic law such as opinions collectively agreed among Shariah scholars, analogy and personal reasoning.

As such, a more correct term for 'Islamic banking' is 'Sharia compliant finance'. The basis of Islamic Finance denounces usury, termed as Riba which is the lending of money at exorbitant rates. The concept is more accurately that money has no intrinsic value it is only a measure of value, and since money has no value itself, there should be no charge for its use. Therefore, Islamic Finance is said to be asset based as opposed to currency based whereby an investment is structured on exchange or ownership of assets, and money is simply the payment mechanism to effect the transaction. Investing in businesses that provide goods or services considered contrary to Islamic principles is also haraam ("sinful and prohibited").

The History of Islamic Financing

The basis of Islamic Finance is from the Shariah, so the concepts of Islamic Finance have been around since the origination of Islam itself. The practices of what we see today have been used throughout the last 1500 odd years across the modern Muslim world and beyond. The modern Islamic finance really originated in the 1960s, escalating with the petro-dollar boom of the 1970s when in 1975, the Islamic Development Bank was formed to promote acceptable financial practices according to Islam. While many banks originating in the Middle East strictly follow these principles, many also follow Western practices of finance, with a number following both practices to cater for both markets. Interestingly, many of the internationals larger banks (with HSBC, UBS and Citigroup as notable examples) all have Islamic banking arms, both in the Middle East and the West.

Main Principles of Islamic Financing

Islamic banking has the same purpose as conventional banking: To make money for the banking institute by lending out capital. But that is not the sole purpose either. Adherence to Islamic law and ensuring fair play is also at the core of Islamic banking. Because Islam forbids simply lending out money at interest, Islamic rules on transactions have been created to prevent it.

1. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which is seen in conventional banking. Islamic banking introduces concepts such as profit sharing, safekeeping, joint venture, cost plus, and leasing. 2. In an Islamic mortgage transaction, instead of lending 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 bank's 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 Murabahah. 3. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. 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). 4. An innovative approach applied by some banks for home loans, called Musharaka alMutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.

5. There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such 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 the lender to monopolize the economy.

6. Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. The Islamic Banking and Finance Database provides more information on the subject.

7. The prohibition of speculative behaviour (Gharar), meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited and thus contractual obligations and disclosure of information are a sacred duty.

The Common Instruments offered by Islamic Finance

Shariah compliant Current and Saving Accounts - In the absence of interest, there needs to be some incentive to gain a customer and this is done through a profit sharing exercise whereby at the end of the year, banks allocate profit to the account holders, which may be equivalent to, but not the same as, a conventional saving rate. Since an overdraft facility would amount to charging interest, banks may offer interest free loans (Qard- Hassan) in certain cases. This is not obligatory on the bank as it has to ensure it keeps a commercial viewpoint on its trading operations.

Murabaha (Cost-plus sale) - Murabaha essentially is undertaking a trade with a markup and is used for short-term financing. This is most often used to finance property, since the bank would not be allowed to charge interest on any loan. Once such a debt covenant is in place between a bank and the customer, repayments can begin until a completion point where the asset is transferred to the customer.

Ijara (Leasing) - Ijara is a leasing contract whereby one party leases an asset for a specific amount of time and cost from another party, usually a bank. The bank would bear all the risk and a portion of the installment payment goes towards the final purchase of the asset at the time of transfer of asset.

Musharaka (Equity Participation) - The parties involved contribute in varying degrees of assets, technical expertise etc. and agree to a percentage of the returns as well as the risk. All parties must invest a certain amount of capital. In the case of purchasing a property under this sort of arrangement, it is purchased by both the bank and the customer together, and the repayments made are partly rent and partly a buyback.

Istinaa (Commissioned Manufacture) - Istinaa is the solution for manufacture of goods since speculation prevents the selling of something that one does not yet own. With a promise to produce a specific product at a determined price and on a fixed date, an Istinaa contract is established. Specifically, in this case, the risk taken is by a bank that would commission the manufacture and sell it on to a customer at a reasonable profit for undertaking this risk.

Difference between Islamic Finance and Conventional Finance

If we take the example of purchasing a property again, it could be done in three possible ways Musharaka, Murabaha and Ijara. The payments might be the same for all these processes as well as for the standard western practice of payment of interest used commonly for mortgages. The difference is that the rate of return is based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not necessarily on the financial impact. Some consider this as just a play on words but to Muslims there is an inherent difference in the way the transaction is carried out, and all based upon the previously mentioned prohibition of Riba. The intention is to avoid injustice and unfair enrichment at the expense of another party.

Meaning of a Shariah Board

A Shariah board can be thought of as a committee of a minimum of 3 Muslim Scholars, acting as an advisory board which issues a ruling as to whether a particular undertaking is in accordance with prescribed principles. What essentially this means is that the board look into specific investments and decide if the investment or process follows Shariah guidelines or is halal (permissible, as opposed to haram meaning forbidden). Some think of it as a sort of due diligence for the customer. Others consider the board to be similar to compliance officers so that they do not have to worry that the investment follows the guidelines of Islamic Finance. Shariah Boards for different companies will usually have different Scholars. However, the Shariah board consists of those that are knowledgeable in Shariah principles, either from economic, legal or religious standpoints and when working in the finance field, they will usually have Fiqh-alMuamalat knowledge and experience. They will also usually be members of either AAOIFI (Accounting and Auditing of Islamic Financial Institutions who are based in Saudi Arabia) or IFSB (Islamic Financial Services Board who are based in Malaysia).

The Reasons for the growth in Islamic Finance

The IMF published an article in 2008 which estimated that there are now more than 300 Islamic financial institutions operating in more than 75 countries at the end of 2007. With the industry sector maintaining a growth rate of 15% per annum over the last 10 years, it is predicted that this growth will continue or speed up in the coming years, dependant on different regulatory practices. The main reason for the growth stems from a number of sources:

Muslims worldwide are starting to opt for Shariah compliant products that were not previously available to them; The increase in oil wealth of the Muslim nations in the Middle East and their decision to opt for Shariah compliant structured investments is making the western governments and conventional financial institutions consider using Islamic Finance Due to their increasing competitiveness and ethical focus, Islamic products are attracting both Muslims and non-Muslims. With Islam as the fastest growing religion in the world, and being the second largest religious group in the UK, USA and France, Islamic Finance is certainly not about to go away any time soon.

References

Institute of Islamic Banking and Insurance by Ibn Rushd (2011) www.en.wikipedia.org/wiki/Islamic_banking www.bankinginfo.com.my/_system/media/.../islamic_banking.pdf Islamic Banking and Finance Journals ( Volume-3 ); www.wdibf.com/journals.html

Conclusion

The preceding information makes it clear that Islamic banking is not a negligible or merely temporary phenomenon. Islamic banks are here to stay and there are signs that they will continue to grow and expand. Even if one does not subscribe to the Islamic injunction against the institution of interest, one may find in Islamic banking some innovative ideas which could add more variety to the existing financial network. According to me, one of the main selling points of Islamic banking is that unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. Therefore I feel Islamic banks are more enterprising than their conventional counterparts. It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses that will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic bank. Many Muslims find it more convenient to deal with conventional banks and have no qualms about shifting their deposits between Islamic banks and conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic 'counters' or 'windows', subject to strict compliance with the Shariah rules. The prospects of Islamic banking and finance will depend extensively on the ability of Islamic banks to continue facing challenges with resourcefulness and creativity, in addition to being worthy of trust and understanding. I believe that competition, if allowed and maintained, not only within Islamic banks, but also between all banks whether Islamic or traditional, would insure a promising future for the banking industry as a whole.

You might also like