CHAPTER 10

FUNDAMENTALS OF ISLAMIC FINANCE

Introduction

Islamic finance, despite its name, is not a religious product. It is however a growing series offinancial

products developed to meet the requirements of a specific group of people. Developments in Islamic

finance have arisen to allow Muslims to invest savings and raise finance in a way that does not

compromise their religious or ethical beliefs.

Islamic finance is a term that reflects financial business that is not contradictory to the principles

of Shariah.

Conventional finance, particularly conventional banking business, relies on taking deposits from,

and providing loans to, the public. Therefore, the banker-customer relationship is always a

debtor‑creditor relationship. A key aspect of conventional banking is the giving or receiving of

interest, which is specifically prohibited by Shari‘ah.

PRINCIPLES OF ISLAMIC BANKING

What is an Islamic Bank?

An Islamic bank is an institution that mobilizes financial resources and invests them in an attempt

to achieve predetermined Islamically-acceptable social and financial objectives. Both

mobilization and investment of funds should be conducted in accordance with the principles of

Islamic Sharia".

1. Prohibition of Interest or Usury

2. Ethical Standards

3. Moral and Social Values

1- Prohibition of Interest or Usury

The first and most important concept is that both the charging and the receiving of interest is

strictly forbidden. This is commonly known as Riba or Usury.

Money, on its own, may not generate profits. When Riba infects an entire economy, it jeopardizes

the well-being of everyoneliving in that society. When investors are more concerned with rates of

interest and guaranteed returns than they are with the uses to which money is put, the results can

only be negative.

2- Ethical Standards

The second guiding principle concerns ethical standards. When Muslims invest their money in

something, it is their religious duty to ensure that what they invest in is good and wholesome.

It is for this reason that Islamic investing includes serious consideration of the business to be

invested in, its policies, the products it produces, the services it provides, and the impact that these

have on society and the environment.

3- Moral and Social Values

The third guiding principle concerns moral and social values. The Qur'an calls on all its

adherents to care for and support the poor and destitute. Islamic financial institutions are expected

to provide special services to those in need. This is not confined to mere charitable donations but

has also been institutionalized in the industry in the form of profit-free loans or AlQuard Al

Hasan.

4- Liability and Business Risk

The final principle concerns the overarching concept of fairness, the idea that all parties concerned

should both share in the risk and profit of any endeavor.

To be entitled to a return, a provider of finance must either accept business risk or provide some
service such as supplying an asset, otherwise the financier is, from a Sharia point of view, not only

an economic parasite but also a sinner.

THE SALIENT FEATURES OF ISLAMIC FINANCE

As mentioned above, Islamic finance, especially Islamic banking, enjoys certain peculiar features

that are not found in conventional banking. These features are as follows:

1. Interest free

Islamic banking is interest‑ free, meaning that all banking business and activities must prima facie

be free from any element of interest.

Modern banking is based on the lending of money for a premium – interest. Islamic banks must

eliminate interest in all its forms, be it in cash or kind. Interest, be it in cash or in kind is not

permissible.

2. The need for underlying assets

Islamic finance requires that all banking businesses based on sale or lease must have an underlying

asset. As the Islamic bank either acts as a seller or a service or usufruct vendor, or a lessor, the

asset or service is of paramount importance. The absence of an underlying asset will render the

contract void ‗ab initio‘. This is in contrast to conventional banking where the asset element is

not a necessary requirement. Its importance lies only in terms of collateral security in the sense

that the asset purchased using the loan money may be charged or assigned as security in favour of

the bank. The asset was never part of the loan transaction.

3. The avoidance of uncertainty or gambling

All transactions made by Islamic financial institutions (IFIs) must be free from elements of

uncertainty (Gharar) and gambling (Maisir).

from misrepresentation and fraud. Gamblingis seen as an action that always enriches one party at

the expense of the other; a zero-sum-game.

4. Profit and loss sharing

Profit and loss sharing is possible in some Islamic banking activities. The bank will share the profit

made with its customers either on a proportionate basis or on an agreed profit-sharing ratio.

In the case of a loss, the loss will be borne by the bank under a Mudarabah contract or by both

parties proportionately in the case of a Musharakah contract.

5. Rights and liabilities of banks and customers

The rights and liabilities of both banks and their customers are well documented not only in

conventional banking laws but also the legislation of many countries including Contracts Acts, the

Sale of Goods Acts, Consumer Protection Acts and the Hire Purchase Acts.

An important andsignificant feature of Islamic banking is the new perspective it gives to this

relationship. This has pushed Islamic banking beyond normal and conventional ‗banking

business‘. An Islamic bank is neither a lender nor a borrower, but can instead become a bona-fide

trader licensed under banking law.

6 .Shari’ah compliance

The central focus of Islamic finance is Shari‘ah compliance. To ensure compliance a distinctive

feature of Islamic finance is the establishment of a Shari‘ah advisory or supervisory board to

advise IFIs, Islamic insurance companies, Islamic funds and any other providers which offer

Islamic financial products. The establishment of a board, the opinions of which are binding on all

IFIs, is required to guide the institutions towards Shari‘ah compliance. An institution cannot claim

to be doing Islamic financial business until and unless it sets up a Shari‘ah board or committee
consisting of qualified scholars.

6. Unlawful goods or services

Another equally important feature is that Islamic finance must not be involved in any activities

pertaining to unlawful goods and services. These prohibited goods and services include, among

others, non‑ halal foods such as pork, non-slaughtered animals or animals which were not

slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography,

tobacco‑ related products and weapons. Non‑ involvement is not only limited to buying or selling

but also includes all chains of production and distribution, such as the packaging, transportation,

warehousing and marketing of these prohibited goods and services.

7. Overriding principles of Islamic law

Islamic finance essentially refers to Shari‘ah compliant financial activities. In addition to

observing the above‑ mentioned features, Islamic financial products and services must not contain

any principles, terms and conditions which are contradictory to established legal maximsor legal

principles.

RIBA AND GHARAR

As a key to understanding Islamic finance it is important to further explain the meaning of two

terms or concepts that must be avoided by Islamic finance in all circumstances: Riba and Gharar.

The avoidance of these two elements is a basic requirement of all Islamic financial activities.

Riba

Riba is simply translated into English as usury or interest. Any premium charged on money

borrowed is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an

advantage to one party at the expense of another for no appropriate consideration. Islamic
 commercial law addresses the issue of this unjustified advantage from two possible transactions,

namely in a loan or currency exchange contract as well as in a barter trading contract.

2. Gharar

Gharar is another element that is to be avoided in any transaction. Gharar simply refers to a lack

of knowledge or uncertainty that could result in an outcome detrimental to one party. This lack

of knowledge, as well as a lack of control of the outcome of any transaction, may stem from

misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of

the parties to the contract.

SOURCES OF FINANCE IN ISLAMIC FINANCING

Islamic banks cannot charge interest on lending, therefore, they have to find other ways of financing

entrepreneurs who are not ‘borrowers’ as the case with traditional banks but basically stand as partners

to the bank. Hence Islamic banks use the term ‘investments’ to denote their ‘borrowing’ activities.

These are done in basically Islamic investment instruments which fall in two groups:

a) Sharing money with the investor (participating financing and thereby sharing in the profit s or

losses). This includes the contracts of Musharaka and Murabaha.

b) Acting as intermediaries through a variety of sales and rental contracts. Islamic banks acquire

or ‘own’ the goods they acquire on behalf of would­be partners before re­selling them or renting (at a

higher margin).

MURABAHA

Means trade with mark -up or cost-plus sale. It is one of the most widely used instruments for

short-term financing is based on the traditional notion of purchase finance. The investor undertakes to

supply specific goods or commodities, incorporating a mutually agreed contract for resale to the client
and a mutually negotiated margin.

Murabaha was originally an exchange transaction in which a trader purchases items required by an end

user. The trader then sells those items to the end-user at a price that is calculated using an agreed profit

margin over the costs incurred by the trader.

SUKUK

Similar characteristics to that of a conventional bond with the difference being that they are asset

backed, a Sukuk represents proportionate beneficial ownership in the underlying asset. The asset will

be leased to the client to yield the return on the Sukuk.

Since fixed-income, interest-bearing bonds are not permissible in Islam, Sukuk securities are structured

to comply with the Islamic law and its investment principles, which prohibit the charging of and/or

paying interest. This is generally done by involving a tangible asset in the investment. For example,

giving partial ownership of a property built by the investment company to the bond owner accomplishes

this purpose, since the bond owner is then able to collect his profit as rent, which is allowed under

Islamic law.

MUSHARAKA

It is a partnership where profits are shared as per an agreed ratio whereas the losses are shared in

proportion to the capital/investment of each partner. In a Musharaka, all partners to a business

undertaking contribute funds and have the right, but not the obligation, to exercise executive powers in

that project, which is similar to a conventional partnership structure and the holding of voting stock in

a limited company. This equity financing arrangement is widely regarded as the purest form of Islamic

financing.

MUDARABA

This is identical to an investment fund in which managers handle a pool of funds. The agent manager

has relatively limited liability while having sufficient incentives to perform. The capital is invested in
broadly defined activities, and the terms of profit and risk sharing are customized for each investment.

The maturity structure ranges from short to medium-term and is more suitable for trade activities.

IJARAH

Ijarah means leasing. In this fund the subscription amounts are used to purchase assets like real estate,

motor vehicles, or other equipment for the purpose of leasing them out to their ultimate users.

SAFEKEEPING-WADIAH

Wadiah is safekeeping of a deposit. Such a deposit is hold in trust ( Amanah). If the depositor pays for

this favor, the depositary needs to replace it in case of lost. The usage of the deposit is subject to

permission of the depositor.

In practical terms the bank client accepts the usage of the deposit by the bank but is not entitled to

participate in the profits or losses. The deposit is guaranteed.

TAKAFUL (Islamic insurance)

With regards to Islamic insurance, better known as Takaful, the insurer, that is the insurance

company, is prohibited from providing indemnity to the insured, that is, the policyholders, as this is

not acceptable to Shari‘ah principles. This is because both the premium paid by policyholders and the

indemnity paid by the insurer are uncertain and therefore not permissible as they contain the element

of uncertainty or Gharar.

Conventional life insurance companies are profit seeking entities and need to allow for things like

average life expectancy and high risk customers when setting their premiums in order to ensure that it

profits from offering life insurance to its customers.

Takaful introduces the contract of donation among the participants/policyholders as a substitute for

the contract of sale of indemnity for a premium as practiced in conventional insurance.

This is to make uncertainty irrelevant because in Islamic terms uncertainty is only tolerable in gratuity

or in a unilateral contract such as a donation. The presence of the element of uncertainty in a donation
contract, which is unilateral in character, does not render it invalid. A donation contract can accept

and tolerate any uncertainty because the purpose of any unilateral contract is not a commercial gain.

KEY ISSUES

1.0 PROHIBITED TRADING ITEMS

In addition to avoiding interest (usury) and profit earned from uncertainty, Islamic finance should not

be invested in activities involving, amongst other things,

• armaments (military weapons),

• the consumption of pork, intoxicants,

• entertainment,

• games of chance or

• pornography

This prohibition includes the entire economic chain of activities relating to these activities, including

their production, storage, transportation, marketing and advertising.

For a finance house to be able to trade under the banner of Islamic finance its customers would have

to be not linked to any of the above.

2.0 Acceptable practice

Subject to the prohibitions mentioned, profit is ok in its own right, but the profit should be earned

fairly (i.e. not at the disadvantage of others) and should result from some form of trading activity.

Additionally

(i) The funder should take part in the risk involved in a project,

(ii) No party to a financial transaction should benefit disproportionately to another,

(iii) Parties should benefit in accordance with their contributions on a predetermined basis,

(iv) Financing projects should require some form of trading or partnership in trade and
(v) Profit should not be earned to the detriment of the environment.