Business/Finance

Introduction to Islamic Finance

Islamic banking and finance are areas which affect everyday decisions of Muslims today, both in the UK and abroad.

Why bother with Islamic Finance as opposed to pursuing other non-Islamic financial systems?

For Muslims, living in a manner that is financially Islamic would ensure an equitable distribution of wealth and income for its participants, preventing financial injustice and loss. Islamic Finance should be conducted in a way that is consistent with Islamic principles outlined in Islamic law, shariat, which would ensure maximum socio-economic benefit for all.

What are the principle tenants that separate Islamic Finance from other financial systems?

The two main principles are the prohibition of Riba and Gharar. The former, Riba, is the main point of distinction between Islamic and non-Islamic financial means. Riba refers to a creditor exploiting a transaction for unfair gain, for example, paying too little for an item or repaying significantly less of a loan than its original value. Very commonly it can occur through applying interest or usury (extortionately high rates of interest) in his/her transactions. This is expressly forbidden in Islam. The latter, Gharar, is the selling of items which have an uncertain existence or uncertain characteristics making the transaction risky and similar to gambling.

Islamic banking is also based upon a central principle of profit/loss sharing between financer and entrepreneur. This is designed to ensure equitable trade for all parties involved and to prevent the exploitation of either party due to shortfalls or unfortunate circumstances on one of their behalves. Thus, if a lender lends money to a business, then under Islamic law he is not justified in earning a fixed rate of profit or limiting his losses, rather both parties share the risks and benefits of the deal in an equitable manner that is socio-economically positive for society.

Let us look at cases of Islamic banking from two perspectives:
Personal - Mortgages:

Muslims are reluctant to use financial facilities that use interest in their mechanism. This comes to the fore, particularly when Muslims seek their first or a further mortgage in the purchase of properties and is relevant for business when they purchase commercial properties.

What is the solution to this? – One possible solution has been outlined as the ‘Murabaha’ scheme of Islamic mortgage.

1) A customer (Muslim in this case) chooses a property he wished to purchase. He agrees to this purchase for a certain price from the owner of the property.
2) A bank buys the property for the Muslim as the agreed price.
3) The customer signs an agreement with the bank for payment of the property, with the lease for the property (held by the bank) being up to 25 years long (Note that the bank is the owner of the property until the lease has expired)
4) At the end of the lease, when the customer has paid the bank the sum of money for the property (including administrative fees charged by the bank on top of the sale price), the bank formally hands the property over to the customer.

So what are the problems with this method?

1) Financial Service authorities view these lease agreements as quite risky and therefore give lease agreements (like that outlined above) a 100% risk weighting. This effectively means that the price of lease agreements may end up significantly higher than the price of a traditional mortgage along the interest based payment method. For Islamic finance to work, the lease agreements must be viewed with a ‘risk weighting’ similar to that of a traditional mortgage – making it financially viable.
2) Under current UK taxation laws 2 sets of stamp duty are incurred firstly when the bank buys the house form the seller, and secondly when the bank sells the house to the actual buyer. This makes the stamp duty a significant factor in the price and would render the Murabaha scheme unattractive to all potential consumers. The financial authorities are currently looking into exempting one of the stamp duty’s in order to better the proposition.
3) Finally, to make the Murabaha scheme viable, the law society would need to decrease fees for this kind of transaction to levels similar to those involved in the handling of mortgage agreements.

Some important changes have been made to this system under the Manzil Ijara scheme which makes Islamic home financing more viable for banks. It is based on the structure above however. To see the Manzil Ijara scheme click here.

Business (and personal) - Insurance:

Insurance is not a new issue within Islam, rather it has been around for a long time. The principle of a person protecting himself against loss or misfortune is even described in the Qur’an through stories of some of the prophets (pbut). In Arabic this concept is known as ‘takaful’. In the modern world the issue of insurance is a tricky one for Muslims to deal with because it touches upon the very foundations of Islamic Finance.

What are the problems with conventional insurance for Muslims today?

1) The issue of insurance involves a lot of uncertainty due to its very nature. Conventional insurance companies agree to pay money to the insured under a vast range of varying conditions and amounts for pay out can be vague and extremely unpredictable. This leaves conventional insurance open to the charge of engaging in Gharar which could arguably deemed similar to gambling because of the vast uncertainty a Muslim faces when he invests in conventional insurance.
2) Most conventional insurance companies usually engage in the practice of interest, riba, which contravenes a basic tenet of shariat law.

So what are the alternatives to conventional insurance then?

The alternative to conventional insurance is Islamic insurance or ‘takaful’. Although not widely available here, takaful schemes are becoming are widely available in places such as Malaysia and Bahrain where the range of Islamic financial products is much greater.

How does it work?

1) Takaful works on the basis that a pact is formed amongst a group of members who jointly agree to guarantee themselves against loss of damage incurred by any of them, as agreed in the initial pact.
2) If a member of the pact suffers a loss or misfortune, then they would be paid a sum of money from the collective fund, as defined in the pact, as compensation for the loss or misfortune.
3) What is crucial here and different from conventional insurance is that through takaful, the members are not dealing in a buy-sell contract. Islamically, a buy-sell contract is prohibited when selling or purchasing goods or services which are non-existence; selling or purchasing goods or services which are in existence but cannot be delivered to the buyer but its form, value and timing of delivery cannot be determined and known at the time when the contract was made.
4) A defined sum of money is paid out from a defined fund, for a defined misfortune or loss.
5) The aim in this respect is to eliminate the uncertainty (Gharar) that exists in conventional insurance contracts.
6) Currently, many Muslims who get themselves insured have no idea as to what compensation level they are entitled to and what the source of this compensation is. Thus, Islamic insurance seeks to deal with these problematic issues.
7) Ultimately then, Takaful buttresses the concept of solidarity and brotherhood that underpins Islam and Islamic social justice.

For more information on Islamic insurance in particular, visit a great introduction from Takaful Malaysia.

Issues of Contention within Islamic Banking and Finance today:

- The extent to which current Islamic financial means are truly ‘Islamic’, pursuing Islamic goals and Islamic ends
- Taking out insurance policies with conventional insurance policies
- Buying shares in capital assets and sharing profits without interfering in the administration
- Buying shares in companies that engage in Riba directly or indirectly
- Buying products from ‘Kaafir’ countries, where does ‘legitimate Islamic banking’ begin or end when considering the globalised inter-dependent nature of the current world

Some statistics about Islamic Banking and Finance today:

- Today, more than two hundred and fifty Islamic financial institutions are operating world-wide
- Today, Islamic banking is estimated to be managing funds up to the value of US$ 250 billion, a 40 fold increase from 1982.
- The annual growth of Islamic financial institutions (IFI’s) has been estimated 15% worldwide over the past 10 years and is expected to accelerate in the foreseeable future.

To view the presentation used in Imaad's 'Introduction to Islamic Finance' Seminar, please click here.

Links to some resources on Islamic Banking and finance on the Internet:

http://www.islamic-banking.com/
http://www.islamicbankingnetwork.com
http://www.iibu.com
http://www.alahli.com/islamic_banking
http://www.failaka.com
http://www.cyberfatwa.com/
http://www.takaful-malaysia.com
http://www.loans.net
http://www.zakat.co.nz

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