ISLAMIC FINANCE

Introduction

Under the principles of Islamic law, wealth must be generated from legitimate trade and
asset based investment. Also, investments must have social and ethical benefit.
Speculative investments are not allowed and investment in such areas as alcohol and
gambling are forbidden.

Riba

As a consequence, the laws regarding the generation of wealth, it is strictly forbidden to

use money for the purpose of making money. I.e. it is forbidden to charge interest (riba).
Financial institutions cannot therefore make money by charging interest but instead
provide services for a fee or enter into a form of agreement with the client in which the
risk and the profits or losses are shared between the institution and the client.

Islamic Financial Instruments

The most commonly used tools to offer suitable sharia compliant financial services
include:

a) Mudaraba – a partnership contract

b) Musharaka – a form of equity where a partnership exists and profits and losses
are shared
c) Mudaraba – a form of credit sale
d) Ijara – a form of lease finance
e) Sukuk – similar to a bond

These instruments provide have varied forms and are applied to offer services
comparable to those offered by conventional banks. However, unlike conventional
banking where a division exist between the lender of the funds and the risk and actions
of the person using the funds, Islamic finance will require that an active role is played in
the use of the asset by the fund provider and the risk and rewards be shared.

Mudaraba Contract
Mudaraba transaction is a partnership transaction where only one party (rab al mal)
contributes capital and the other (Mudarib) contributes skills and expertise. The investor
has no right to interfere in the day to day operations of the business. Due to the fact that
one partner is running the business and the other partner contributes the capital, the
investor has to heavily rely on mudarib, his ability to manage the business and his
honesty when it comes to profit share payments.
Profits are shared between the parties according to the ratios agreed in the original
contract. Any losses are solely attributable to the investor due to the fact that he is the
sole provider of capital to the entire project. In this case the business manager, mudarib
does not receive his share of compensation for his efforts. However, in the event of
negligence by mudarib, he becomes liable for the total loss. This relationship is similar
to equity finance on the stock exchange or clients depositing money with the bank.

Musharaka Contract
This is similar to a partnership but both parties provide capital and expertise. Profits are
shared between the parties according to whatever ratio is agreed in the contract but
losses are shared in proportion to capital contributions. Although profits can be
distributed in any proportion by mutual consent, it is not permissible to fix lump sum
profits on one partner. This transaction is similar to venture capital where both parties
contribute capital and expertise.

Murabaha Contract
This is effectively a form of credit sale, where the customer receives the goods but pays
for them later on a fixed date. However, instead of charging interest, a fixed price is
agreed before delivery – the mark up effectively including the time value of money.
Sharia prescribes certain conditions for a sales contract (which includes murabaha
contracts)
 The object of the contract must exist and be owned by the seller
 The object is offered for a price and both object and price are accepted (price
should be within fair market range)
 The object must have value
 The object and its exchange must not be prohibited by sharia
 The buyer in the contract has a right to demand that the object is of suitable
quality and is not defective.

The difference between Murabaha sale and a loan of money

i. The goods for which the financing is being arranged must effectively be owned
by the financing company.
ii. Penalty should not be charged for late repayment which would profit the lender.
(Extensions are permissible but not for additional fees or charges)
iii. To avoid the appearance of paying interest the goods should not be sold back to
the seller at a different price.

Murabaha is equivalent to loan/ trade credit financing in conventional banking.

Ijara contract
This is effectively a lease, where the lessee pays rent to the lessor to use the asset. The
two types of leasing exist, operating and finance lease. The only difference between the
two types of leasing is the presence or absence of purchase undertaking from the
lessee to buy the asset at the end of the lease term. In a finance lease, the purchase
undertaking is provided at the start of the contract. The lessor cannot stipulate they will
only lease the asset if the lessee signs a purchase undertaking.

The main difference between the Ijara and conventional lease financing is that the
lessor will be responsible for major maintenance and insurance of the asset as he is still
the owner of the asset. The lessee bears the responsibility of wear and tear and day to
day maintenance.

Sukuk – Islamic Bond Market

This is equivalent to debt finance (Islamic bonds). Sukuk must have an underlying
tangible asset. The holders of the sukuk certificates have ownership of a proportional
share of the asset, sharing revenues from the asset but also sharing the ownership risk.
This gives Sukuks characteristics of equity and bonds. Sukus currently have a shorter
term than conventional bonds and are typically three to five years.

An example may be where the financial institution purchases property financed by

Sukuk certificate and rents it out at fixed rent. The certificate holders receive a share of
the rent (instead of interest) and a share of the eventual sale proceeds.

The sukuk manager sells the asset to the investors to raise capital but is responsible for
managing the assets on behalf of the sukuk holders (and can charge a fee). The sukuk
holders have a right to dismiss the manager if they feel appropriate.

Although there can be secondary market as with conventional debt, the purchase and
sale of certificates on the stock exchange, it is currently very small. Most Sukuk are
bought and held. Virtually any trading is done by institutions.