Sunday, 18 August 2013

A basic introduction to Islamic Finance and some of the issues surrounding it.

I never really followed Islamic Banking much. The concept of an "interest free" system sounded absurd. But when the Indian Government/RBI cleared it in Kerala, I became a bit more curious. Here is some of my research on Islamic banking. It's a vast topic and ever growing field. It's obvious that I have missed out on several other topics and anyone who wants to add to the article, please do so in the comments section.

Islamic finance started as a small cottage industry in some Arab countries in the late 1970s. It distinguishes itself from conventional finance in its ostensible compliance with principles of Islamic law, or Sharia. Its growth has been accelerating ever since, in terms of the number of countries in which it operates, as well as the areas of finance in which it has ventured. Islamic Bank assets are expected to hit $1.8 Trillion by the end of 2013.

Islamic finance is principally implemented to comply with the main tenets of Sharia law. The main sources of Sharia are the Holy Quran, Hadith, Sunna, Ijma, Qiyas and Ijtihad.

From a vantage point (ideally), we understand that Islamic financial firms are types of financial intermediaries that employ Sharia principles. Sharia commands adjustment of all aspects of Muslims’ lives and enforces a moral system. The conventional financial system focuses on the capitalistic features of economic and financial processes but, Islamic finance aims to make an equitable distribution in resources and social fairness in society.

Some of its general principles are as follows:

1. -The prohibition of Riba (Usury or Interest is translated to mean Riba which literally means an excess or addition above the principle lent) and the removal of debt-based financing from the economy. Riba leads to money being made from money: an unacceptable practice in Islamic finance.

2. -The prohibition of Gharar (translated as risk, hazard or uncertainty), i.e. the full disclosure of information and removal of any irregularities in a contract. (in simple terms, to avoid cases where the purchaser does not know what he has bought and/or the seller does not know what he has sold). Example from a Hadith - the purchase of an unborn animal in its mother’s womb is forbidden

3. -The exclusion of financing and dealing in activities and commodities which involve Maysir and other sinful activities – Example: Gambling, production of alcohol etc.

4. -The provider of financial funds and the entrepreneur share business risk in return for shares of profits and losses. Example: The Mudarabah and Musarakah.

5. -A financial transaction should not lead to the exploitation of any party to the transaction.

Other Islamic financial instruments are Zakah (payments to the poor) and Takaful (Islamic insurance). Islam makes it mandatory for the rich to support the poor and needy, hence Zakah is obligatory for all Muslims with wealth. Takaful is like a mutual self-help scheme between those who wish to support each other in difficult times. It can be established with a pool of funds by a group of people whose aim is not to obtain profit from the pool, but they may invest its funds in permissible activities in Islam to increase the fund’s wealth. In turn, the Takaful provides members with financial help in the instance of specific events.

An Islamic bank is a deposit-taking banking institution whose scope of activities includes all currently known banking activities, excluding borrowing and lending on the basis of interest. On the liabilities side, it mobilizes funds on the basis of Mudarabah contract. It can also accept demand deposits which are treated as interest-free loans from the clients to the bank, and which are guaranteed. On the assets side, it advances funds on a profit-and-loss sharing or a debt-creating basis, in accordance with the principles of the Sharia. It plays the role of an investment manager for the owners of time deposits called investment deposits. In addition, equity holding as well as commodity and asset trading constitute an integral part of Islamic banking operations. An Islamic bank shares its net earnings with its depositors in a way that depends on the size and date-to-maturity of each deposit. Depositors are informed beforehand of the formula used for sharing the net earning with the bank. There are different kinds of Islamic banking such as Islamic social banks, development banks, commercial banks and holding banks. Most modern Islamic banks are examples of commercial banks that offer deposit accounts and financing instruments derived from Islamic principles.

Some of the principal instruments of Islamic finance methods as practiced by Islamic banks and other financial institutions are:

1. Mudarabah, the provision of capital in a partial-equity partnership - Profits are then shared between the two parties (rabb-al-mal and mudarib) according to some pre-agreed ratio in the contract. If there are losses the investor bears all financial losses and the entrepreneur the operating losses; principally the opportunity cost of their own efforts. The majority of Islamic jurists and scholars hold the view that Mudarabah contracts are only really suitable for commercial activities.

2. Musharakah, full equity partnerships – It is most suited for financing private or public companies and project financing. Musharakah is described as a joint venture between an Islamic bank and a customer or business firm for certain operations. There are 2 kinds of contracts: First one where a permanent contract which ensures its parties (the investor, bank and entrepreneur)have an equitable share in the annual profit/loss on pre-agreed terms. Second one is a diminishing contract preferred by bankers as it allows the bank to reduce its share of equity each year and receive periodic profits based on the reducing equity balance. In this form, the equity share of the customer in the capital of enterprise increases over time until he or she becomes the sole owner of the enterprise.

3. Murabaha, an instrument used for financing the purchase of goods – it is a two-party buying and selling contract between bank and customer involving no financial inter-mediation or financing. Under the Murabaha contract, the customer provides the bank with the specifications and prices of the goods to be purchased or imported. The bank studies the application and collects information about the specifications and prices of the goods, focusing especially on the price and conditions for payment. When the bank and its client agree on the terms of the deal, the bank purchases the goods or commodities and resells them to the customer. The profit that accrues to the bank is mutually agreed upon as a profit margin (mark-up) on the cost of purchase.

4. Bai muajjall, deferred payments on products – this allows business or individuals to receive products now and pay for their value in the future.

5. Bai Salam, advance sale contracts - is a sale contract in which the price is paid in advance at the time of contracting against delivery of the purchased goods/services at a specified future date. It’s permissible only when it satisfies conditions like (i) the commodities sold should not be available at the time of contracting; (ii) the quality and quantity of goods must be known; (iii) the date and place of delivery for these commodities should be defined; and (iv) the purchase cost price should be paid completely at the time of the contract.

6. Istisna, or manufacturing contracts – this allows one party to obtain industrial goods with either an upfront cash payment and deferred delivery or deferred payment and delivery. here individuals or firms request their bank to facilitate a contract of production for a good, and the bank concludes an Istisna contract with a third party (the manufacturer) to produce and deliver the specific item under particular requirements

7. Ijarah, lease financing - is the reward or recompense that proceeds from a rental contract between two parties, where the lessor (the owner of the asset) leases capital asset to the lessee (the user of the asset).

8. Quard Hassan - a system of benevolent loans without interest to assist the needy in an attempt to alleviate hardship. The amount paid by the lender is considered an interest-free loan from the time of payment until the date of the settlement. The borrower’s payment of any amount over and above the principal to the lender is permissible so long as it is at the borrower’s discretion.

What concerns most of us it the Islamic deposit accounts. There are three main types-

1. Islamic current accounts are a service offered to depositors to process bank transfers and pay cheques through existing transfer and settlement systems. These accounts are payable on demand and no interest or profits are paid to depositors. Current accounts can also be held in a foreign currency to facilitate international trade.

2. As with comparable products offered by conventional banks, Islamic savings accounts offer flexible deposits, withdrawal on demand and a guarantee of capital. However, unlike conventional bank savings accounts, interest is forbidden on account balances. Depositors can, however, obtain benefits in the form of ‘prizes’ that depend, in part, on the value of the deposit and the bank’s profitability. These services are also often offered fee-free to depositors.

3. Islamic investment deposit accounts are designed for customers who wish to invest their funds using profit/loss sharing principles. Investment accounts are usually administrated under the principles of Mudarabah and Musharakah that establish the bank as the entrepreneur or a participant and the depositor as an investor or a participant.

Outside retail services, Islamic banks offer many similar services to conventional banks in the form of performance bonds, letters of guarantee, letters of credit, travellers’ cheques, money transfers, foreign exchange transactions and safe deposits. In these situations, the Islamic bank can collect a service or administration fee corresponding to the expense incurred on the service rendered under Sharia.

If we took the example of purchasing a property again, it could be done in three possible ways – Musharaka, Murabaha and Ijara. The payments might be the same for all these processes as well as for the standard conventional practice of payment of interest used commonly for mortgages. The difference is that the rate of return is based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not necessarily on the financial impact. There is an inherent difference in the way the transaction is carried out, and all based upon the previously mentioned prohibition of Riba. The intention is to avoid injustice and unfair enrichment at the expense of another party.

There are some concerns with Islamic banking with regards to the transparency in Zakat transactions. For example- Al Qaeda operates under a veil of legitimacy including businesses created by Bin Laden in Sudan, as well as honey traders in Yemen that the U.S. recently identified as part of Al Qaeda’s financial network. It also earns money through criminal enterprises ranging from the heroin trade to smuggling, fraud, and theft. Some of the money trails were connected to Islamic banks. It's important that these banks fortify their financial activities and maintain transparency. Other problems involve the draconian aspects of Sharia law and it's inflexible religious diktats. We cannot allow religious overtones in laws passed by a secular state.

Like Conventional banking, Islamic banking too has several loopholes. According to experts, there have been significant changes in it's financial system and a constant evolution in the working mechanisms. I leave it to the policymakers to decide if this can coexist along side the current Global Financial System. Perhaps, a better alternative would be to incorporate the desired aspects of Islamic banking into our finance system without the religious context.

For more detailed information on Islamic Finance :

2) IMF working paper on Islamic Finance by Olga Krasicka and Sylwia Nowak

3) Terrorist Financing- UC-Berkeley paper (2005)

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