UK: Introduction To The Principles Of Islamic Finance

Last Updated: 22 November 2006
Article by Benjamin Macfarlane

In the last few years, Britain has become a hub for new Islamic financial products and services. With the market set for certain expansion, it is imperative that the City broadens its understanding of what Islamic Finance entails.

Conventional banking has always relied on a system that is interest-based. In the Muslim world, however, where the payment of interest is expressly forbidden, Islamic jurists have looked at other ways of managing their banking system on an interest-free basis.

While this remains a fundamental difference, the deeply ethical nature of Islamic finance chimes with a modern western trend. On the face of it "green" investment funds and Islamic Finance are a natural fit.

Background

The Islamic economic system is based on Islamic law, known as Shariah, which governs secular as well as religious activity. Shariah derives from the rules dictated by the Quran and the practice and explanation of those rules as revealed by the Prophet Mohammad (p.b.u.h), known as Sunnah.

The basic objective of Shariah is to bring about the conditions for a system of socio-economic justice that will benefit the entire community. One of the main aims of Islamic economics is that wealth, instead of becoming concentrated in the hands of a few, should be allowed to spread through society as widely as possible, so that the gap between rich and poor is reduced as far as is natural and practicable.

The principles of Islamic finance are built on the premise that money itself has no intrinsic value; it is simply a medium of exchange. Each unit is 100% equal in value to another unit of the same denomination; no profit may be made out of a cash transaction and no Muslim is allowed to benefit from the loan or receipt of money. Since the earning of interest (riba) is not permitted, interest may not be paid on Islamic savings or current accounts nor applied to Islamic mortgages.

Development and Growth

Two important developments in the Muslim world, the rise of pan-Islamism and the oil boom marked the emergence of modern Islamic finance in the early 1970s. The start of the Organisation of the Islamic Countries movement ("OIC") in 1970 led to the idea of updating traditional Islamic banking.

Research institutes focusing on Islamic economics and finance were set up throughout the Muslim world. In 1974, the OIC summit in Lahore voted, after oil prices quadrupled, to create the inter-governmental Islamic Development Bank ("IDB"). IDB was based in Jeddah and became the foundation of a new banking system inspired by religious principles. In 1975, the Dubai Islamic Bank, the first modern, non-governmental Islamic bank was opened. In 1979, Pakistan became the first country to embark on a full Islamisation of its banking sector; and Sudan and Iran followed suit in 1983. The first model of modern Islamic banking was established in those years.

More than three decades later, the industry’s build-up continues apace. The growth rates for assets compliant with Sharia have been increasing over the past decade. This has led Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world.

The growth and development of Islamic Finance has encouraged conventional banks to open Islamic branches, create Sharia-compliant subsidiaries, or undergo complete conversions to become fully Sharia-compliant.

The size of global Sharia-compliant assets is estimated today at about $400 billion, whereas Standard & Poor’s Ratings Services believes the potential market for Islamic financial services to be closer to $4 trillion, meaning that Islamic finance currently has only a 10% market share among the Muslim community globally and still has a long way to go.1

Principles

The basic principles of Islamic finance can be summarized as follows:

Prohibition of interest: Prohibition of riba, a term literally meaning ‘an excess’ and interpreted as ‘any unjustifiable increase of capital whether in loans or sale’ is the guiding rule of the system. Any positive, fixed, predetermined rate tied to the maturity and the amount of principal is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest as widely practised.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest. This is because, according to Islam, profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Further, social justice demands both that borrowers and lenders should share rewards as well as losses in an equitable fashion, and that the process of wealth accumulation and distribution in the economy should be fair and representative of true productivity.

Risk sharing: The suppliers of funds, under the Islamic economic system, become investors instead of creditors because interest is prohibited. Therefore, the provider of financial capital and the entrepreneur share business risks in return for shares of the profits.

Money as ‘potential’ capital: the Islamic financial system treats money as ‘potential’ capital. Therefore, money becomes ‘actual’ capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is ‘potential’ capital.

Prohibition on gharar: An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties (gharar). In a contract of sale, gharar often refers to uncertainty and ignorance of one or both of the parties over the substance or attributes of the object of sale, or of doubt over its existence at the time the contract is made..

For gharar to have legal consequences, it must fulfill four conditions. The first of these is that it must be excessive, not trivial. A slight gharar, such as gharar in the sale of similar items, which are not identical at one and the same price, is held to be negligible. Secondly, it must occur in the context of commutative contracts. Thirdly, it must affect the subject matter of contract directly, as opposed to what may be attached to it (for example, if a cow is the subject matter, it must affect the cow, not the unborn calf). The fourth condition that must be fulfilled is that the public are not in need of the contract in question. In case of a public need, gharar, even if excessive, will be ignored. This is because satisfying the people’s need takes priority by virtue of the Koranic principle of removal of hardship.

Prohibition on speculative behaviour: There is a prohibition on all transactions involving masir (gambling and speculation). Masir is derived from yusr in Arabic meaning ‘ease’. Gambling both fails to qualify as work and provides an opportunity to gain a pecuniary advantage at the expense of others. On the same basis an investment entered into for purely speculative reasons would be deemed unacceptable.

Shariah-approved activities: Only those business activities that do not violate the rules of shariah qualify for investment. For this reason, businesses that deal with alcohol, gambling and casinos would be forbidden to an investor.

Islamic Financial Instruments

Islamic markets offer different instruments to satisfy providers and users of funds in various activities, such as : sales, trade financing and investment. The basic instruments include cost-plus financing (murabaha), profit-sharing (mudaraba), leasing (ijara), partnership (musharaka), and forward sale (bay’salam).

The important elements of these instruments may be explained in the following way :

Trade with markup or cost-plus sale (murabaha): One of the most widely used instruments for short-term financing is based on the traditional notion of purchase finance. The investor undertakes to supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin. It involves a contract between the bank and its client. The bank, as a partner, provides the finance for purchasing goods for a share of the profit once the goods are sold. The bank may or may not share in any losses incurred. Repayment may be made either in lump sum or in instalments. Around 75 % of Islamic financial transactions are cost-plus sales.

Leasing (ijara): Another important instrument, accounting for about 10 % of Islamic financial transactions, is leasing. Leasing is designed for financing vehicles, machinery, equipment, and aircraft. The bank purchases a piece of equipment and rents it to the business. Alternatively, with hire purchase contracts, the business partly purchases and partly rents the equipment. Different forms of leasing are permissible, including leases where a portion of the instalment payment goes toward the final purchase (with the transfer of ownership to the lessee).

Profit-sharing agreement (mudaraba): This is identical to an investment fund in which managers handle a pool of funds. The agent-manager has relatively limited liability while having sufficient incentives to perform. The bank acts as a partner, providing cash to the borrower and sharing in the net profits and net losses of the business. The loan is for an undetermined period, although the contract may be rescinded by either party.

Equity participation (musharaka): This is analogous to the classic joint venture. Both entrepreneur and investor contribute to the capital (assets, technical and managerial expertise, working capital, etc.) of the operation in varying degrees and agree to share the returns (as well as the risks) in proportion to their involvement. Traditionally, this form of transaction has been used for financing fixed assets and working capital of medium and long-term duration. The bank provides part of the equity and part of the working capital for the business, and shares in profits and/or losses.

Other contractual arrangements

Sales contracts: Deferred-payment sale and deferred-delivery sale contracts, in addition to spot sales, are used for conducting credit sales. In a deferred-payment sale, delivery of the product is taken on the spot but delivery of the payment is delayed for an agreed period. Payment can be made in a lump sum or in instalments, provided there is no extra charge for the delay. A deferred-delivery sale is similar to a forward contract where delivery of the product is in the future in exchange for payment on the spot market.

Commissioned manufacture (Istisna’a): IDB defines Istisna’a as ‘a contract whereby a party undertakes to produce a specific thing that is possible to be made according to certain agreed specifications at a determined price and for a fixed date of delivery’. In such a transaction, a financier may undertake to manufacture an asset and sell it on receipt of instalment payments. The buyer is charged by the bank for the price it pays the manufacturer plus a reasonable profit. In this scenario the bank takes on the risk of the manufacture of the asset.

Recent Developments

The importance of Islamic finance continues to grow. Analysts estimate that the sector is now worth around $500 billion, up from $200 billion two years ago.2 Islamic retail banks and investment funds now number in the hundreds and financial institutions in non-Muslim countries, including Citigroup, Deutsche Bank, HSBC, Lloyds TSB and UBS, are increasingly choosing to offer products that are compatible with Sharia law alongside traditional ones.

In 2003, HSBC was the first conventional bank to offer mortgages in the UK that comply with Islamic financial principles using the ijara structure. This was followed by United National Bank Limited ("UNB") offering its first Islamic product in the UK based on the ijara model. This has come to be known as the UNB Islamic mortgage.

In May 2005, the IDB began the Trust Certificate Issuance Programme for the issue of Islamic bonds (sukuks).

Japan will be the first major industrialized country to issue Islamic bonds if the Japan Bank for International Cooperation goes ahead with a plan aimed at attracting money from oil-rich Muslim countries.

A new qualification, the first of its kind in the world, covering all aspects of Islamic finance was launched in the UK in a joint British-Lebanese initiative in October 2006. The Islamic Finance Qualification ("IFQ") was developed by the British industry body, the Securities and Investment Institute ("SII") and the Lebanese business school Ecole Superieure des Affaires, with support from Lebanon’s central bank and the British government.

Announced at an event held at Mansion House in London in the presence of the Economic Secretary to the Treasury, Ed Balls, and Lebanese Central Bank Governor, Riad Salame, this qualification is aimed at ensuring Britain’s position at the forefront of the rapidly expanding global Islamic sector The IFQ covers both technical and religious aspects of products that are compliant with Islamic principles.

Conclusion

Islamic Finance is no longer the domain of the specialist practitioner with strong ties to the Middle East. It has now come into the mainstream retail sector in the UK and elsewhere. As Gordon Brown, the Chancellor of the Exchequer’, commented in June 2006 such strong foundations can help ‘to make Britain the gateway to Islamic finance and trade’3.

Footnotes

1. www.businessweek.com/investor/content/oct2006

2.http://english.aljazeera.net

3. Islamic Finance and Trade Conference, London, 13-14th June 2006

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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