Islamic finance: A panacea for our times?

By Shamil Samsul Mueen

1. Introduction

The global financial crisis has raised imperative issues concerning the stability and reliability of existing financial systems. This has driven an extensive global re-examination on the competence of the existing financial architecture and the search for a more enduring solution. As a result an increasing interest in Islamic finance is evident.

During the global financial crisis Islamic finance proved to be more resilient, relatively unscathed and experienced a double digit growth rate with worldwide assets close to US$ 1 trillion.1

The inherent features of Islamic finance have the potential to serve as a basis to address

several issues and challenges that have surfaced in the conventional financial system during the crisis.

Thus, Islamic Finance is now emerging as one of the fastest growing segments in the international financial system.

2. Analysis of principles

According to Islamic jurisprudence there are two kinds of rulings, the worship ruling which governs the relationship between man and Allah, and mutual dealing rulings which govern the relationship among mankind. The general principle of mutual dealing rulings is that, everything is permitted unless clearly prohibited. This is referred to as the Doctrine of universal permissibility. In addition to the Doctrine of universal permissibility, Islam permits the contracting parties to agree on any conditions as long as they do not violate any Shariah ruling.

It is argued that the purposes of some prohibitions are to provide a level playing field to protect the interests of weaker parties, to ensure justice and fairness to ensure mutual benefit for the parties as well as society at large; and to promote social harmony.2

The principles of Islamic finance are based on three main factors which are mentioned in the Quran and are an important aspect of Shariah3 and Islamic jurisprudence. These factors are Interest (Riba), speculation (Gharar) and uncertainty (Maysir), which are explained in detail below.

2.1 Interest (Riba)

 Islam does not allow acceptance or payment of any interest on transactions involving money. This prohibition essentially implies that the fixing in advance of a positive return on a loan as a reward for waiting is not permitted by Shariah. This prohibition is not confined to Islam.4 In its basic meaning, Riba can be defined as anything (big or small), pecuniary or non-pecuniary, in excess of the principal in a loan that must be paid by the borrower to the lender along with the principal as a condition, (stipulated or by custom), of the loan or for an extension in its maturity.5 According to a consensus of Islamic jurists it has the same meaning and import as the contemporary concept of interest.6

2.2 Gharar

Translated directly from Arabic, it simply means uncertainty or risk. Gharar is as important as Riba in Islamic finance. Compared to Riba, Gharar is more difficult to be defined in relation to financial transactions.

To prevent Gharar in a transaction, the full implications of the transaction must be clearly known to the contracting parties. In other words, there must not be “asymmetric information” between parties because it breaches the principles of Islamic law. Elgamal7 states that, Gharar is conceptually translated as “trading in risk, which cannot be defined”. Naked options, financial futures, and derivatives that are not backed by tangible and verifiable assets are few examples provided by Elagmal in that regard.

2.3 Maysir

Maysir is closely related to Gharar. Even though these two principles have been used interchangeably in some papers on Islamic Finance, there is a notable difference between these two principles. The main focus in Gharar is on uncertainty. On the other hand, Maysir, translated as “gambling” from Arabic, focuses on and prohibits transactions that are based on one side’s gain at the cost of the other.8

2.4 Other rules/concepts

However, In addition to these three principles there are some general rules in Islamic finance under which financial transactions become void. These could be contracts which involve immorality, or illegality against public policy, or whose foundation or substance is unlawful or illegal, or any other contract or agreement which are, directly or indirectly, in contrary to the divine principles of Shariah. Further transactions should not only be based on pure economical interest in transactions but contribution to social harmony

3. Islamic finance products

A large number of products are available in Islamic finance, and the number is growing as demand for more Islamic compliant products are growing throughout the world. Islamic commercial law is rooted on three modes which serve as the building blocks for other complex financial products. The three modes are partnership based, trade based, and rental based modes of financing.9

3.1 Partnership based mode of financing

Partnership based mode suggests an equitable sharing of risks and profits between the parties involved in a financial transaction, and includes Mudarabah, Musharakah and other hybrid products.10

3.1.1Mudarabah

Mudarabah is an agreement between a lender (bank), who acts as an investor, and a borrower, whereby the borrower can mobilise the borrowed amount for his business activity. If profits are made they will be shared between the lender and borrower according to mutually agreed ratios. In the case of loss the lender shares the loss in proportion to his contribution.

3.1.2 Musharakah

Musharakah, in its basic, is a business partnership or joint venture between two parties where one party could be a bank and the other party its customer. It is effected for a particular period such as few months, a year or more than a year. Both parties agree on their share of the profit in advance. The profit of the bank must not exceed the percentage of its investment in the Musharakah. The losses, if incurred, will be divided based on strict proportion to the equity participation ratio.11 Musharakah is used by financial institutions for asset and/or real estate financing, working capital financing, etc.

Both Mudarabah and Musharakah are closely related products. Mudarabah differs from Musharakah in that the bank is the only investor in Mudarabah, which is not the case in Musharakah where all parties invest in the project.12

3.2 Trade based modes of financing

Trade based modes of financing became available in the market much later than partnership based modes, but its products gained dominance among other products very quickly. This is because it targeted a much larger group of investors, both private and business customers, and is safer for both parties in terms of the investment.

3.2.1 Murabaha Finance

Murabaha is an agreement between a bank and its customer. The customer requests the bank to purchase or import commodities on his/her behalf, with a promise to buy them from the bank at purchase price plus profit margin of the bank, where the payment will be made on instalments.

3.3 Rental based modes of financing

The main idea of this mode is that the financial institution purchases an asset for its customer and then hands it over to him/her on a rental basis.13 This can be an operational asset, where the Islamic financial institutions act as a warrantor of the asset, and the customer deals directly with the supplier. The ownership remains with the Islamic Financial Institution until it is transferred to the customer. The two mostly used products in rental based mode of financing are Ijarah and Diminishing Musharakah.

3.3.1 Ijarah finance

Ijarah is very much similar to a leasing agreement in the conventional financial system. The only difference is that Ijarah does not involve interest bearing contracts which should be Shariah-compliant. Translated from Arabic, Ijarah means to provide something on rent.14

Ijarah have generally been used by private customers for financing consumer goods such as houses and automobiles. But recently it has gained popularity among business customers in relation to project and transportation financing. Ijarah is used for almost everything that could be leased, but some certain items that are prohibited in Shariah and a few others like fuel, food etc. are not included in Ijarah.

3.3.2 Diminishing Musharakah finance

Diminishing Musharakah is a contract between a financier (the bank) and a beneficiary in which the two agree to enter into a partnership to own an asset, but on condition that the financier will gradually sell his share to the beneficiary at an agreed price, and in accordance with an agreed schedule.15

Diminishing Musharakah is increasingly used in sectors like housing and real estate, project finance, and construction. Diminishing Musharakah takes different shapes according to the shape of the transaction.

4. Global challenge

The prospects of Islamic finance remain high at the global finance system. The latest development in the international arena is that, several countries are accessing the Sharia Compliant financial bond (Sukuk) market to finance major investment projects. United Kingdom, Japan, Turkey and Russia are some countries who seek to tap into the massive liquidity that exists in Asia and the Gulf Cooperation Council via Sharia compliant investment products.

Most countries have left Islamic finance under the legislative umbrella of their current banking laws, but have required that the industry comply with standards and guidance coming from groups such as the International Islamic Academy of Fiqh of the Organisation of Islamic Conference (OIC) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

The industry needs to improve transparency and foster credibility by harmonising standards and practices, not least, the variety of Shariah interpretation between regions and even institutions. Regulatory oversight needs to be sharpened as well. These measures could be critical in broadening the appeal of Islamic Finance.

Most importantly, there is a high shortage of suitable skilled employees working within the industry. Hence the demand for the Islamic finance professionals is increasing globally.

Thus, effort to enlarge the human capital pool is vital to keep pace with the rapid growth of Islamic finance. Investments in human capital development through specialised training and educational institutions are important to support the global development of Islamic financial services industry. Talent development and educational institutions specialising in Islamic finance that have been established in several jurisdictions should be encouraged to forge strategic alliances across borders.

5. Sri Lankan perspective

Islamic finance was first introduced to Sri Lanka as early as in 1997. However, the landmark development was the amendment made to the Banking Act No. 30 of 1988 in 200516 which permitted licensed commercial banks and licensed specialised banks to offer selected financial instruments such as Murabaha and Mushakraka. Islamic finance has garnered an increased interest in the last few years and has the potential to develop the capital markets of Sri Lanka and assist the development of infrastructure.

At present many licensed commercial banks operate Islamic finance windows with many other potential players on the verge of venturing into the market. Sri Lanka has witnessed an important milestone in that the Central Bank of Sri Lanka has permitted the operation of a fully-fledged Islamic Finance Bank and recently an Islamic Fund was launched facilitating investment in listed securities. It has to be noted that the competitive advantage of the country’s strategic geographic location provides the potential to become the Islamic banking hub for the South Asian region.

6. Conclusion

Islamic finance is becoming a pivotal part of the international financial system and it presents unique opportunities and challenges. Islamic finance needs to further strengthen its resilience to endure all possible challenges. It has to portray on its intrinsic strengths to set its position towards attaining greater robustness of the overall system.

In the context of Sri Lanka, most importantly, a strategic framework on Islamic finance needs to be developed. This should address the variety of concerns of diverse stakeholders. Hence, it is vital to include policy makers, regulators, and professional experts in Islamic finance on developing such a strategic framework for Islamic finance in Sri Lanka.



(The writer is a Passed Finalist – Chartered Institute of Management Accountants, United Kingdom, and final year undergraduate, Faculty of Law, University of Colombo. He can be reached via [email protected])



Footnotes:

 1Andreas A. Jobst and Juan Sole, ‘Operative Principles of Islamic Derivatives –Towards a Coherent Theory’ International Monetary Fund Working Paper March 2012, available at: http://www.imf.org/external/pubs/cat/longres.aspx?sk=25752.0 accessed on 8th May 2012

2 M Iqbal and P. Molyneux ‘Thirty Years of Islamic Banking: History, Performance and Prospects’, [Palgrave Macmillan, New York. 2005] p.7.

3 Shariah- the Islamic code of law and behavior based on the Quran, the sunnah, which incorporates the sayings, practices, and teachings of the Prophet Mohammed, and jurisprudence, which extends the application of the sharia, through comparative analogy and the consensus view of the religious scholars, to issues that are not directly addressed in the primary sources.

4 H. Visser, ‘Islamic Finance: Principles and Practice’, [Edward Elgar Publishing, United Kingdom, 2009] p. 39. According to Visser, based on passages from the Bible, the Christian Church at various times took a strong stand against demanding and paying interest.

5 M Iqbal and P. Molyneux ‘Thirty Years of Islamic Banking: History, Performance and Prospects’, [Palgrave Macmillan, New York. 2005] p.9

6 Ibid

7 A. El-Gamal, Mahmoud ‘Islamic Finance: Law, Economics, and Practice’ [Cambridge University Press, New York.2006] p. 58

8 Conventional banking products such as life insurance are prohibited in Islamic finance as it comes under Maysir. When gambling, the player pays a certain amount of money in the hope that he will gain much larger amount, similarly the conventional life insurance policy where the assured hopes for a chance to make a gain.

9 Nearly all Islamic finance products come under these three modes. The use of each mode is dependent on the purpose and size of transactions, but all of them are based on principle of Riba prohibition.

10 Theoretically, Mudarabah and Musharakah are the most desirable forms of Islamic financing.

11 i.e. to the capital contributed by each party. All parties, including the bank, have the right to participate in the management of the project, but equally, all parties have the option to waive such right. All parties agree through negotiation on the ratio of distribution of the profits generated from the project, if any. This ratio need not coincide with the ratio of participation in the financing of the project.

12 Further, In Mudarabah management is the prerogative of the investor, whereas in Musharakah all partners can manage the project based on a pre-specified agreement. And finally, in Mudarabah the customer does not bear losses if incurred, whereas in Musharakah profits and losses are shared based on the percentage of the investment.

13 Rental based modes of financing have existed since the beginning of Islam. It was used mostly in relation with agricultural products. Ijarah have been the only type used in this mode, but with time and the development of new products financial institutions have added other more complicated products under this mode.

14 Venardos ‘Current issues in Islamic banking and finance : resilience and stability in the present system’, [World Scientific Publishing, Singapore 2006] p. 170

15 M Iqbal and P. Molyneux ‘Thirty Years of Islamic Banking: History, Performance and Prospects’, [Palgrave Macmillan, New York. 2005] p. 22.

16 The current legislation governing Banking in Sri Lanka is the Banking Act No.30 of 1988 with its subsequent amendments. The recent amendment (Act No. 02 of 2005) that was passed on the 10th December 2005 is the 4th amendment to the Banking Act that introduces some major changes to the law relating to Banks and their regulation. With this amendment, Islamic Banking has been included to their lists of permissible businesses under schedule II and IV. Hence both Licensed Commercial Banks (LCB) and Licensed Specialised Banks (LSB) are permitted to offer Islamic Banking products.



References

A. El-Gamal, Mahmoud ‘Islamic Finance: Law, Economics, and Practice’ [Cambridge University Press, New York.2006]

Bennett, Michael, ‘Islamic Finance as a Structured Products Business Line’ [Journal of Law and Financial Management, Vol. 10, No. 1, 2011]

H. Visser, ‘Islamic Finance: Principles and Practice’, [Edward Elgar Publishing, United Kingdom, 2009]

M Iqbal and P. Molyneux ‘Thirty Years of Islamic Banking: History, Performance and Prospects’, [Palgrave Macmillan, New York. 2005]

M K Hassan. and M Choudhury ’Islamic banking regulations in light of Basel II’ [paper presented at the Sixth Harvard University Forum in Islamic Finance, 2004]

Venardos ‘Current issues in Islamic banking and finance : resilience and stability in the present system’, [World Scientific Publishing, Singapore 2006]