Contents Introduction ................................................................................................................................................... 3 The main rules for Islamic finance ............................................................................................................... 5 How do the banking arrangements work for customers? .............................................................................. 7 Is the arrangements and practice similar to ethical banking, then? ............................................................. 14 What choices do people have? .................................................................................................................... 15 The function of Fiat Money in Islamic Banking. .................................................................................... 15 Conclusion .................................................................................................................................................. 16 Reference .................................................................................................................................................... 18
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Introduction How is Islamic nance different from conventional nance? It looks the same. The result is often the same. Whats the difference? Well, the best way to nd out is with a simple, real-world comparison. Lets take $10,000, for instance. And let's compare what a conventional bank can do with this $10,000 and what an Islamic bank can do. First, the conventional bank.The conventional bank nds a credit worthy customer and lends at 5% interest. The bank is not particularly concerned about what happens to this money other than that it gets repaid. The customer, on the other hand, has already found a borrower willing to pay 7%. This borrower runs a small credit co-op for students and lends at 10%. One of these students is enterprising enough to lend to his unemployed brother at 15%. Who has just discovered the power of compounding interest and now lends to street vendors at 25%. We could go on. But you get the idea. As we speak, there are poor people paying upwards of 40%...per month! Now obviously we cant blame conventional banks for everything that happens after theyve made the initial loan. But we can blame the power of compounded interest.Interest, and the fact that you dont need actual cash to lend money means that the original $10,000 could keep passing hands until we pump out over $100,000 of articial wealth. Articial is right.How much actual cash is there? Only $10,000. With interest, we managed to turn $10,000 into much more. Now what happens if the street vendors go out of business? Or the unemployed brother doesnt nd his job? Or the credit co-op goes bankrupt?Thats right. Loans dont get repaid. And if enough people cant repay their loans, lenders get into all sorts of trouble. This vicious cycle sets off a domino effect of defaults.And imagine that instead of a $10,000 personal loan, its a million dollar business loan, or a billion dollar World Bank loan. Compounding interest grows so fast that borrowers are often unable to repay. People, economies, and the environment pay the price as we grow more desperate to meet rising debts.So are we surprised when billions of dollars vanish into thin air? Lets take the example of the Islamic bank. With this $10,000 the Islamic bank only invests in actual assets and services. It might buy machinery, lease out a car, or invest in a small business. But, throughout, the transaction is always tied to a real asset or service. And this is the central point: we
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cant simply compound assets and services like we can compound interest-based loans. An asset or service can only have one buyer and one seller at any given time. Interest, on the other hand, allows cash to circulate and grow into enormous sums.Thats the difference between Islamic nance and conventional nance: the difference between buying and selling something real and borrowing and lending something eeting.In recent years weve witnessed the most dramatic global nancial downturn seen in decades. What began as a housing bubble soon became a sub-prime credit crisis. And what many thought would remain a credit crisis soon spread into a global nancial meltdown. It devastated every corner of the world.And while these events affected most of us negatively, there was one silver lining: people nallygave a serious look at alternative forms of nance. And many people stopped believing that interest could solve all problems.
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The main rules for Islamic finance Figure 1 Source of Shariah
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The rules governing Islamic Finance are derived from the Shari'ah. The Shari'ah is a framework of Islamic Jurisprudence derived from the primary sources: The Qur'an and the teachings of the Prophet Muhammad (pbuh) known as the Sunnah. In addition to which there is a dynamic secondary source of common law rulings and scholarly interpretations referred to as Fatwa's. These fatwas are the results of human interpretation of the Shari' ah, of its texts, or its principles, or a combination of the two; they are not the word of God. Islamic law, it must be remembered, is more a process than a code, and the results of legal deliberations may differ when different methods are employed. Several fatwas are indicative of an acceptance on the part of Shari'ah Supervisory Boards of new realities in the marketplace and of their willingness to understand and work with these to the extent that Islamic religious and legal principles will allow. Such an attitude has ever characterized the best in Islamic legal thought. The originators of modern banking based their system on interest-oriented investments and earnings which are clearly prohibited in the Shari'ah of Islam. Therefore, modern banking institutions, which gradually became essential to the commercial activity of the entire world, were totally antithetical to the guidance revealed to humankind through the Qur'an and the Sunnah of the Prophet Muhammad (pbuh).Many Muslims, believing in the prohibition of interest, remained aloof from this modern system of banking, and those who did enter the field restricted themselves to the routine work necessary for their employment. This was done because they had reservations about interest-based transactions and also because, owing to their political decline, they were unable to control the wheel of international commercial transactions.
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How do the banking arrangements work for customers? There are several Islamic financial instruments Ijarah = leasing Alternative spelling = Ijara A lease agreement whereby a bank or financier buys an item for a customer and then leases it to him over a specific period, thus earning profits for the bank by charging rental.
The duration of the lease and the fee are set in advance. During the period of the lease, the asset remains in the ownership of the lessor (the bank), but the lessee has the right to use it. After the expiry of the lease agreement, this right reverts back to the lessor. This is a classic Islamic financial product. Ijarah Thumma Bai = leasing to purchase The principle governing an Ijarah contract at the end of the lease period, when the lessee buys the asset for an agreed price through a purchase contract. Ijarah wa Iqtina = buy-back leasing A hire and purchase mode of financing where an Islamic bank finances equipment, a building or other facility for the client against an agreed rental, together with an undertaking from the client
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to repurchase the facility at the end of the contract. The rental and the purchase price are fixed so that the bank gets back its principal sum along with some predetermined profit. Ijtehad = effort, exertion, industry A faqhis endeavor to formulate a rule on the basis of evidence found in the Islamic sources. Inan = financial partnership Istijrar = recurring sale Different quantities are bought from a single seller over a period of time. Sometimes it is also referred to transactions whereby seller delivers different quantities in different installments to complete the full purchase. Some divergence among the scholars in terms of the timing of fixation and pricing. Istisnah = advance purchase of goods or buildings Alternative spellings = Istisna, Istisnaa, Istisnaah A contract of acquisition of goods by specification or order, where the price is paid in advance, or progressively in accordance with the progress of a job. For example, to purchase a yet to be constructed house, payments would be made to the builder according to the stage of work completed. This type of financing, along with Salam, is used as a purchasing mechanism, and Murabahah and Bai Bithaman Ajil are for financing sales.
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Mudarabah = trust financing, profit sharing Alternative spellings = Mudaraba, Modaraba, Modarabah An investment partnership, whereby the investor (the rab al maal ) provides capital to the entrepreneur (the mudarib ) in order to undertake a business or investment activity. While profits are shared on a pre-agreed ratio, losses are born by the investor alone. The mudarib loses only his share of the expected income. The investor has no right to interfere in the management of the business, but he can specify conditions that would ensure better management of his money. In this way Mudarabah is sometimes referred to as a sleeping partnership. A joint Mudarabah can exist between investors and a bank on a continuing basis. The investors keep their funds in a special fund and share the profits before the liquidation of those financing operations that have not yet reached the stage of final settlement. Many Islamic investment funds operate on the basis of joint Mudarabah. Mudarib = entrepreneur in a Mudarabah contract The entrepreneur or investment manager in a Mudarabah who puts the investors funds in a project or portfolio in exchange for a share of the profits. A Mudarabah is similar to a diversified pool of assets held in a discretionary asset management portfolio.
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Mufawadah = equal, unlimited partnership
Murabahah = cost-plus financing Alternative spellings = Morabaha, Morabahah, Murabaha A form of credit that enables customers to make a purchase without having to take out an interest-bearing loan. The bank buys an item and sells it to the customer on a deferred basis. The price includes a profit margin agreed by both parties. Repayment, usually in installments, is specified in the contract. The legality of this financing technique has been questioned because of its similarity to riba. However, the modern Murabahah has become the most popular financing technique among Islamic banks, used widely for consumer finance, real estate, the purchase of machinery and for financing short-term trade. . Musharakah = joint venture, profit and loss sharing Alternative spelling = Musharaka An investment partnership in which all partners are entitled to a share in the profits of a project in a mutually agreed ratio. L osses are shared in proportion to the amount invested. All partners to a Musharakah contribute funds and have the right to exercise executive powers in that project,
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similar to a conventional partnership structure and the holding of voting stock in a limited company. This equity financing arrangement is widely regarded as the purest form of Islamic financing. The two main forms of Musharakah are: Permanent Musharakah: an Islamic bank participates in the equity of a project and receives a share of the profit on a pro rata basis. The length of contract is unspecified, making it suitable for financing projects where funds are committed over a long period. Diminishing Musharakah: this allows equity participation and sharing of profits on a pro rata basis, and provides a method through which the bank keeps on reducing its equity in the project, ultimately transferring ownership of the asset to the participants. The contract provides for payment over and above the banks share in the profit for the equity held by the bank. Simultaneously the entrepreneur purchases some of the banks equity, progressively reducing it until the bank has no equity and thus ceases to be a partner. Muzaraa = agricultural contract A contract in which one person works the land of another person in return for a share in the produce of the land.
Qard = loan Qard Hasan = benevolent loan
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Alternative spelling = Qard Hassan A loan contract between two parties for social welfare or for short-term bridging finance. Repayment is for the same amount as the amount borrowed. The borrower can pay more than the amount borrowed so long as it is not stated by contract. Most Islamic banks provide interest-free loans to customers who are in need. The Islamic view of loans (qard) is that there is a moral duty to give them to borrowers free of charge, as a person seeks a loan only if he is in need of it. Some Islamic banks give interest-free loans only to the holders of investment accounts with them; some extend them to all bank clients; some restrict them to needy students and other economically weaker sections of society; and some provide interest-free loans to small producers, farmers and entrepreneurs who cannot get finance from other sources. Riba = interest An increase, addition, unjust return, or advantage obtained by the lender as a condition of a loan. Any risk-free or guaranteed rate of return on a loan or investment is riba. Riba in all its forms is prohibited in Islam.
In conventional terms, riba and interest are used interchangeably, although the legal notion extends beyond mere interest.
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Riba al Diyun = usury of debt Also known as usury of delay (riba al nasia).
The usury of debt was an established practice amongst Arabs during the pre-Islamic period. It can occur as an excess increment on top of the principal, which is incorporated as an obligatory condition of the giving of a loan.
Alternatively, an excess amount is imposed on top of the principal if the borrower fails to repay on the due date. More time is permitted for repayment in return for an additional amount. If the borrower fails to pay again, a further excess amount is imposed, etc.
Ruqa = payment order A payment order to draw money from the bank; used in the early Muslim period.
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Tabarru = Takaful donation A contract where a participant agrees to donate a pre-determined percentage of his contribution (to a Takaful fund) to provide assistance to fellow participants. In this way he fills his obligation of joint guarantee and mutual help should another participant suffer a loss. This concept eliminates the element of gharar from the Takaful contract. Takaful = Islamic insurance Based on the principle of mutual assistance, Takaful provides mutual protection of assets and property and offers joint risk-sharing in the event of a loss by one of the participants. Takaful is similar to mutual insurance in that members are the insurers as well as the insured.Conventional insurance is prohibited in Islam because its dealings contain several haram elements, such as gharar and riba.
Is the arrangements and practice similar to ethical banking, then? There is some common ground. Some of the tenets of Islamic banking will appeal to anyone, Muslim or otherwise, who agrees with the underlying principles of equitable distribution for everyone, the ideals of fair trading, spending of wealth judiciously, and well-being of the community as a whole. These principles result in an exacting ethical stance relating to investment.
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What choices do people have? The 1.8 million plus Muslims living in the UK can now manage their money on a day-to-day basis without compromising their deeply held convictions. Lloyds TSB offers a current account, as does HSBC through its Amanah Finance division, together with a home-financing scheme. However, although money is held separately to that managed by the rest of the organisation, these are large institutions that are not wholly compliant with sharia principles.
The Islamic Bank of Britain, which opened in 2004, operates entirely in accordance with sharia law. It has branches in London, Leicester, Birmingham and Manchester and offers a range of savings accounts, a current account and financing deals.Homebuying products, credit or charge cards and other services will be available later this year. The managing director, Michael Hanlon, says its products are competitively priced and "equivalent to those available in a conventional bank".The Ahli United Bank specialises in home-financing schemes. As well as helping Muslims buy a property to live in, it now offers sharia-compliant funding for buy-to-let property investments.
The function of Fiat Money in Islamic Banking. In the new modern world, Muslims interact with financial institutions which act as intermediaries between the capital providers or depositors and the individuals, or businesses which need the capital to buy premises, automobiles and for business operations. In return, the
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financial institutions charge interest on the loans given to the individuals and businesses and pay fixed interest to the depositors. One of the reasons that the financial institution charge fixed interest is because the fiat money deposited and lent out are subject to inflation. In other words, RM10,000 today is not the same as RM10,000 five years from now as the value of paper money is always fluctuating. Dr Umer Chapra mentions in his paper titled "Monetary Policy in an Islamic Economy" that one of the important goals Islam emphasis in realizing the socio economic is stability in the value of money (p. 31). Dr Hakimi Ibrahim in his article "The Meaning of Islamic Currency" mentioned that some people says that there is no riba if we borrow RM1,000 from a friend and we return the same amount after ten years. We could say that it has no elements of riba because it is the same in quantity. However 10 years from today the same amount will not have the same value or purchasing power. Maybe the value is lesser than the value of RM50 today. If this happens then the instability causes concerns even though it is not riba (Dr Hakimi,1998). Conclusion All banking products can largely be divided into the following 4 categories: 1. Equity 2. Trading 3. Leasing, and 4. Debt Equity refers to direct ownership, trading refers to buying and selling, leasing refers to giving an asset or service out on rent, and debt refers to providing an interest-based loan. Simply put,
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Islamic nance permits equity, trade, and lease-based transactions, but forbids debt. And in many ways were already familiar with these kinds of transactions. Heres most of Islamic nance in a nutshell: Mudarabah, Musharakah, and Sukuk are all equity based Murabaha, Salam, and Istisna are trade based And Ijarahs are lease based Some of the basic principles that guide Islamic banks. These are that transactions must: 1. Be interest free 2. Have risk sharing and asset and service backing 3. Have contractual certainty 4. And that all the elements of the transaction must, in and of themselves, be ethical
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