What is Islamic Finance?
Programme Development Coordinator, Institute of Islamic Banking and Insurance
Post date: Tuesday, 19th July 2011
Islamic finance is similar to conventional finance in the sense it refers to facilitating pooling of financial resources and their investments, except that all the activities are undertaken in compliance with Shari’ah – commonly referred to as Islamic law. Shari’ah, literally means ‘path’ or ‘way’ to water source.
In Islamic jurisprudence, Shari’ah refers to the laws contained in, or derived from, The Qur’an and the Sunnah (sayings and practices of Prophet Muhammad). The Qur’an and the Sunnah are the fundamental sources of Islamic economics providing guidelines for economic behaviour and a blueprint of how the economic system of a society should be organised.
For Muslims, Shari’ah is the guide for human conduct which encompasses every aspect of life – spiritual, individual, social, political, cultural, and economic. Shari’ah principles are the foundation for the practice of Islamic finance.
Islamic finance allows Muslims to meet their financial needs without compromising their religious beliefs. It is an ethical and equitable alternative to the conventional system and facilitates engagement with non- Muslims who share similar ethical principles.
Riba (interest), Gharar (uncertainty in a contract), Maysir (gambling) and investment in any activity considered immoral or harmful to the society or environment are the main prohibitions in the Islamic economic framework.
Riba literally means ‘to increase’ or ‘to gain’ in Arabic. Although Riba is often translated as interest, it has a much wider meaning which encompasses any excess in a deal without offering an equivalent counter value. In Islamic finance, it refers to any ‘interest’, whatever type or rate, charged or paid by a creditor or bank on capital. The charging of interest may sound innocent enough but it has been condemned throughout the ages. Aristotle understood that "Money exists not by nature but by law. For money was intended to be used in exchange but not to increase at interest”. The primary reason for the prohibition of Riba in Islam is the obstacle it poses to the realisation of the overall objective of the Shari’ah, which calls for socio-economic justice in society.
Shari’ah requires that returns on capital must be linked to the outcome of a transaction rather than emanating from the mere act of lending money.
Gharar simply means ‘hazard’ and refers to ‘uncertainty’ where the parties involved in a contract do not know about the subject matter or the outcome (risky or ambiguous sales). Business activities have an inherent risk element as no one can predict precisely the future level of sales or costs or changes in the economic environment. However, the risk which is prohibited is not the one which arises in the normal course of business operations or business activity – it is something that will make a business transaction doubtful, uncertain or suspicious.
Maysir refers to all games of chance that involve any element of gambling where a person gains at the cost of others, where the amount of money at risk might bring huge sums of money or might be lost; the risks that are prohibited are those that are not part of every day life and are unnecessary, games of chance such as lotteries represent a good example. There are investors in the conventional banking world who are concerned about investing in unethical forms of business or in industries that are harmful to, or simply do not benefit, society. This is seen as socially responsible or ethical banking or investing. Islamic finance, by its very nature, is very clear regarding these issues and therefore, it has much in common with ethical banking.
Complying with the Shari’ah requirements
Islamic finance differs from conventional finance in that it regulated by a moral code that reflects a set of guiding principles laid down in the Shari’ah. Every financial institution is required to appoint an independent supervisory board comprising of well-qualified Shari’ah experts or scholars. The role of the Shari’ah supervisory board is to provide rulings for the compliance of financial products with the Shari’ah principles and to also ensure that the rulings are being correctly implemented.
Key contracts in Islamic finance
Just like conventional finance, Islamic finance has broadly two types of contracts; equity and debt-based contracts. Equitybased contracts are Musharakah (joint venture or co-ownership financing) and Mudarabah (trust/participation financing). Islamic finance mainly has four debt based contracts of Murabaha (cost-plus mark-up financing), Ijarah (lease), Salam (forward sale) and Istisna’a (construction or manufacturing financing). Islamic finance products are structured using standalone or combination of the above mentioned contracts along with ancillary contact of Wa’ad (promise) and Walaka (agency).
Development of the modern Islamic finance industry
Although the first modern Islamic banking ‘experiment’ started in Mit Ghamr, Egypt, in the 1960s, it is the Middle East that was central in laying the foundations for Shari’ah-compliant finance as we know it today. Despite the fact that the Mit Ghamr project had made a good start, it was abandoned for political reasons.
Nevertheless, it was the first experiment to show that commercial banking activity could be organised on the basis of Islamic principles respecting the prohibition against riba and not indulging in interest. Dubai Islamic Bank, the first commercial bank to operate in compliance with Shari’ah principles, was established in the UAE in 1975 – a take-off point for modern Islamic finance. Later the same year, another Islamic financial institution – Islamic Development Bank (IDB), a multilateral development financing institution – was launched in neighbouring Saudi Arabia, in the city of Jeddah. The theoretical ideas of banking according to Shari’ah had been turned into practice. Other GCC (Gulf Cooperation Council) countries followed, including Kuwait, with the opening of Kuwait Finance House in 1977, and the Kingdom of Bahrain with Bahrain Islamic Bank, launched in 1979. Today, over three decades later, the world is experiencing ever increasing demand for Shari’ah-compliant finance, and its influence has long since spread beyond the Middle East.
One institution that has an important place in the evolution of Islamic finance is The Pilgrims’ Management and Fund Board of Malaysia, which is popularly known as Tabung Haji. It was established in 1963 so that money spent on the pilgrimage could be untainted by riba and this was not possible when money was deposited at ordinary commercial banks. The fund enables Muslims to invest, according to Islamic principles, to provide for the protection and welfare of Muslims on the Hajj (pilgrimage to Mecca in Saudi Arabia).
With the growth of Islamic finance, a number of standard setting bodies and agencies were brought to the fore in order to harmonise and standardise the practices; the most important ones are Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI); Islamic Financial Services Board (IFSB); International Islamic Financial Market (IIFM); Liquidity Management Centre (LMC) and International Islamic Ratings Agency (IIRA).
Global presence of Islamic finance
In a short span of over three decades, Islamic finance has become a global industry with presence in almost all the key financial markets. South East Asia, namely Malaysia, is currently a strong global Islamic finance hub, and other Asian states are also expressing keen interest in this type of industry. The UK is a leading centre of Islamic finance with five fully-fledged Islamic banks and a number of conventional banks, such as HSBC and Lloyds TSB offering Islamic products and services through window operations, and more importantly London is well-established as a gateway for Islamic finance in Europe with one of the largest concentrations of specialist legal and advisory expertise in the world. Singapore established the first Islamic bank in the country, Islamic Bank of Asia, in 2007 and has announced a strategy to become the region’s leading centre for Shari’ah-compliant finance. Indonesia, Thailand, and even Japan, have embarked on various Islamic finance projects. And further afield, a number of other European and North American countries have also taken up the issue of Islamic finance at the highest government levels.
Islamic finance and the global financial crisis
The Islamic finance industry is estimated to be worth US$1 trillion (£0.62 trillion) and clearly this reflects its tiny size as compared to its conventional counterpart. Although the Islamic finance industry was less affected by the recent financial crisis, initially, as compared to conventional finance, nonetheless it is not immune from the financial troubles and is facing many challenges. Some of the key issues relate to standardisation of products and practices, concentration in few asset classes and the lack of risk management tools, and transparency of Shari’ah governance mechanisms. Islamic banks’ risk management techniques are insufficient, they have heavy exposure to few sectors, in particular in some GCC countries to real estate and there have been major deficits in the implementation of accounting, auditing and reporting standards developed by Islamic finance standard setting bodies such as AAOIFI and IFSB. The size of Islamic banks is relatively small and they have limited financing capacity especially for large infrastructure projects; therefore, they usually become part of a syndicate with other Islamic or conventional banks.
With Muslims representing about one-quarter of the growing world population coupled with the appeal of Islamic finance products and services to ethical investors, the size and volume of Islamic finance transactions, especially the cross-border deals, is likely to increase in years to come. The challenging issues are being addressed by national financial regulators as well as international standard setting bodies and will help the Islamic finance industry to have a firm foothold in the global financial system.
This article first appeared in the Global Trader Guide to Near & Middle Eastern Markets 2011. To read the eBook, click here.