Dada Adefolami

By Dada Adefolami

What is Islamic finance?

Islamic finance is a financial system that operates according to Islamic law (which is called sharia) and is, therefore, sharia-compliant. Just like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies.

Islamic virtues and tenets specify the need for ethical behaviour and fair treatment. Within a business context, this means that organizations should maintain high ethical standards in all business dealings, specifically business and enterprise should be conducted with honesty and integrity, maintaining truthfulness and morality in all dealings. In particular, such business and enterprise should not capitalize on the misfortune of others or take unfair advantage. For example, higher prices should not be charged to an individual because they lack knowledge and information about the fair price of a product that they are purchasing. Profit creation should be the result of business activity that benefits society at large. Within this context, the Islamic finance framework is based on certain prohibitions. In particular, money and money substitute products such as gold and silver should not be viewed as commodities, but rather as means of exchange.

Therefore, interest or riba cannot be paid or received on loans, although it is fully acceptable to engage in profitable business activities, such business should be ethical. In particular dealing in alcohol, pork-related products, armaments, gambling and other socially detrimental activities is not acceptable. Engaging in activities involving speculation is also not allowed, limiting the use of derivative instruments and money markets, which are based on interest.

OPERATIONALISING ISLAMIC FINANCE
Organizations need access to short-term and long-term sources of finance. The basic, fundamental function of banks is to provide a channel that enables the flow of financial resources from investors to borrowers, and thereby provides a source of finance for organizations. Investors invest their excess funds to earn interest, and borrowers use the funds in business activity to generate profits, some of which are then used to pay interest on the borrowings. Among other sources of finance that involve the payment and receipt of interest are corporate and government bonds, how could finance flow between investors and borrowers without involving interest. The answer provided by Islamic finance, in its basic form, is through profit-sharing arrangements or partnerships.

In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channeled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.

Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and Musharaka equity-type contracts through multi-partnership contracts. Here, investors known as rub-ul-mal would invest funds with the IFI known as the mudareb or investment manager. The funds are then pooled and used in profit-making projects while also keeping within Sharia rules. Therefore, the IFI would effectively become the rub-ul-mal and the corporation that uses the funds for investment purposes becomes the mudareb. In each case, the emphasis is on partnerships, and the profits earned are shared between the corporation, the bank and the investors. It is possible that all three parties share the losses as well, if the business venture is not successful.

However, with corporations requiring different modes of finance and IFIs keen on providing these, different types of Islamic financial products have been developed. The challenge for IFIs is to ensure that the products comply with Sharia rulings, as well as normal financial regulations and law.

The term “Islamic banking” refers to a system of banking or banking activity that is consistent with Islamic law principles and guided by Islamic economics. The contemporary movement of Islamic finance is based on the belief that “all forms of interest are riba and hence prohibited”. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam. Furthermore, the Shariah prohibits what is called “Maysir” and “Gharar”. Maysir is involved in contracts …

COMMON ISLAMIC FINANCIAL PRODUCTS

IFIs offer two broad categories of financial products: equity-based and fixed income-based.

Equity-based
Equity-based financial products consist of Mudaraba and Musharaka contracts. With these contracts, the investor or IFI (rub-ul-mal) and the investment manager or corporation (mudareb) share the profits from the business venture, in which the funds are invested, in a pre-arranged agreement. The key differences between the two contracts are two-fold.

With a Mudaraba contract:
1. All losses are borne solely by the investor (IFI), although provisions can be set up to carry forward these losses against future profits, and
2. Themudareb, as the expert in the business venture takes the sole responsibility for running the business.

With a Musharaka contract:
1. losses are shared between the two parties in proportion to their monetary investment or investment-in-kind, and
2. Both parties would participate in managing and running the venture jointly.
Diminishing Musharaka contracts are a recent innovation where not only are the profits shared between rub-ul-mal and the mudareb, but the mudareb would pay greater amounts to the rub-ul-mal. In this way the mudareb owns greater and greater proportion of the asset, until eventually the ownership of the asset is passed to the mudareb entirely.

Fixed-income based
With Murabaha contracts, the IFI purchases the asset and then sells it to the business or individual at cost plus a fair profit. The business or individual pays for the asset in pre-agreed instalments and over a pre-agreed time period.

Ijara contracts are similar to operating leases where the IFI purchases an asset for the business or individual to use. The lease payments, the lease period and payment terms are agreed at the start of the contract. The lessor is responsible for the maintenance and insurance of the asset. Provisions can be made to allow the lessee to purchase the asset for a nominal fee at the end of the contract.

Sukuk bonds have been based on underlying securitised Islamic contracts such as Ijara and Mudaraba, as well on individual or groups of physical assets. Some Sukuk bonds have been based on securitisedMurabaha contracts, but there is some debate on whether these comply with Sharia rulings, as they may be viewed as debt on debt and therefore attracting riba. Some Sharia rulings have allowed minor proportions of Murabaha and Istisna contracts within the securitised asset portfolio, used as the underlying asset portfolio.

Salam contracts are similar to forward contracts, where a commodity or service is sold today for future delivery. Cash is received immediately from the IFI and the quantity, quality, and the future date and time of delivery are determined immediately. The sale will probably be at a discount so that the IFI can make a profit. In turn, the IFI would probably sell the contract to another buyer for immediate cash and profit, in a parallel Salam arrangement. Salam contracts are prohibited for commodities such as gold, silver and other money-type assets.

Istisna contracts are often used for long-term, large construction projects of property and machinery. Here, the IFI funds the construction project for a client that is delivered on completion to the IFI’s client. The client pays an initial deposit, followed by instalments, to the IFI, the amount and frequency of which are determined at the start of the contract.

SHARIA BOARDS

Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant with the principles of Sharia rules. They review and oversee all new product offerings made by the IFI and make judgments on an individual case-by-case basis, regarding their acceptability with Sharia rulings. Additionally, SBs often oversee Sharia compliant training programmes for an IFI’s employees and participate in the preparation and approval of the IFI’s annual reports.

SBs are normally made up of a mixture of Islamic scholars and finance experts to ensure that fair and reasonable judgments are made. Where necessary, the finance experts can explain the products to the Islamic scholars. The Islamic scholars often sit on several SBs of a number of different IFIs. SBs are in-turn supervised by the International Association of Islamic Bankers (IAIB).

SBs face several challenges when making judgments. Sharia law can be open to different interpretations, leading to different outcomes on the acceptability of the same products by different SBs and Islamic scholars. Therefore, precedents set by SBs are not binding, and changes in SB’s personnel over time may shift the balance of the SB’s collective opinions and judgments on the acceptability of existing and new products.

SBs need considerable resources to operate effectively, especially where Sukuk finance is concerned. IFIs need to ensure that their SB members are well informed about the developments and trends in global financial markets.