Question

Islamic finance is receiving a lot of attention in academic research as well as in global business. With reference to the tenets of Islamic Finance, discuss the appropriateness of Islamic financial products as

sources of project finance.

Answer 1

What is Islamic Finance?

Islamic finance is a type of financing activities that must comply with Sharia (Islamic Law). The concept can also refer to the investments that are permissible under Sharia.

The common practices of Islamic finance and banking came into existence along with the foundation of Islam. However, the establishment of formal Islamic finance occurred only in the 20^th century. Nowadays, the Islamic finance sector grows at 15%-25% per year, while Islamic financial institutions oversee over $2 trillion.

The main difference between conventional finance and Islamic finance is that some of the practices and principles that are used in conventional finance are strictly prohibited under Sharia laws.

Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. Islamic finance can be seen as a unique form of socially responsible investment. This subbranch of finance is a burgeoning field. In this article, we offer an overview to provide elementary information and serve as the basis for further study.

The Big Picture of Islamic Banking

Although Islamic finance began in the seventh century, it has been formalized gradually since the late 1960s. This process was driven by the tremendous oil wealth that fueled renewed interest in and demand for Sharia-compliant products and practice.

The concept of risk sharing is central to Islamic banking and finance. It is essential to understand the role of risk-sharing in raising capital. At the same time, Islamic finance demands the avoidance of riba (usury) and gharar (ambiguity or deception).

Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the borrower's expense. Islamic law considers money as a measuring tool for value and not an asset in itself. Therefore, it requires that one should not be able to receive income from money alone. Interest is deemed riba, and such practice is proscribed under Islamic law. It is haram, which means prohibited, as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of an Islamic community.

Accordingly, Sharia-compliant finance (halal, which means permitted) consists of banking in which the financial institution shares in the profit and loss of the enterprise it underwrites. Of equal importance is the concept of gharar. In a financial context, gharar refers to the ambiguity and deception that come from the sale of items whose existence is uncertain. Examples of gharar would be forms of insurance. That could include the purchase of premiums to insure against something that may or may not occur. Derivatives used to hedge against possible outcomes are another type of gharar.

The equity financing of companies is permissible, as long as those companies are not engaged in restricted businesses. Prohibited activities include producing alcohol, gambling, and making pornography.

Basic Financing Arrangements

A brief overview of permissible financing arrangements often encountered in Islamic finance is given below.

Profit and Loss Sharing Contracts (Mudarabah)

The Islamic bank pools investors' money and assumes a share of the profits and losses. This process is agreed upon with the depositors. What does the bank invest in? A group of mutual funds screened for Sharia compliance has arisen. The filter parses company balance sheets to determine whether any sources of income to the corporation are prohibited. Companies holding too much debt or engaged in forbidden lines of business are excluded. In addition to actively managed mutual funds, passive funds exist as well. They are based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Declining Balance Shared Equity

Declining balance shared equity calls for the bank and the investor to purchase the home jointly. It is commonly used to finance a home purchase. The bank gradually transfers its equity in the house to the individual homeowner, whose payments constitute the homeowner's equity.

Lease to Own

This arrangement is similar to the declining balance one described above, except the financial institution puts up most, if not all, of the money for the house and agrees to sell the house to the eventual homeowner at the end of a fixed term. A portion of every payment goes toward the lease and the balance toward the home's purchase price.

Installment Sale (Murabaha)

An installment sale starts with an intermediary buying the home with a free and clear title to it. The intermediary investor then agrees on a sale price with the prospective buyer; this price includes some profit. The purchase may be made outright (lump sum) or through a series of deferred (installment) payments. This credit sale is an acceptable form of finance and is not to be confused with an interest-bearing loan.

Leasing (Ijarah)

Leasing, or Ijarah, involves selling the right to use an object (usufruct) for a specific time. One condition is that the lessor must own the leased object for the duration of the lease. A variation on the lease, 'ijarah wa 'iqtina, provides for a lease to be written where the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. This promise binds only the lessor. The lessee is not obligated to purchase the item.

Islamic Forwards (Salam and Istisna)

These are rare forms of financing, used for certain types of business. These are an exception to gharar. The price for the item is prepaid, and the item is delivered at a definite point in the future. Because there is a host of conditions to be met to render such contracts valid, the help of an Islamic legal advisor is usually required.

Principles of Islamic Finance

Islamic finance strictly complies with Sharia law. Contemporary Islamic finance is based on a number of prohibitions that are not always illegal in the countries where Islamic financial institutions are operating:

1. Paying or charging an interest

Islam considers lending with interest payments as an exploitative practice that favors the lender at the expense of the borrower. According to Sharia law, interest is usury (riba), which is strictly prohibited.

2. Investing in businesses involved in prohibited activities

Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The activities are considered haram or forbidden. Therefore, investing in such activities is likewise forbidden.

3. Speculation (maisir)

Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Thus, Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.

4. Uncertainty and risk (gharar)

The rules of Islamic finance ban participation in contracts with excessive risk and/or uncertainty. The term gharar measures the legitimacy of risk or uncertainty in investments. Gharar is observed with derivative contracts and short-selling, which are forbidden in Islamic finance.

In addition to the above prohibitions, Islamic finance is based on two other crucial principles:

• Material finality of the transaction: Each transaction must be related to a real underlying economic transaction.
• Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the other party.

Types of Financing Arrangements

Since Islamic finance is based on several restrictions and principles that do not exist in conventional banking, special types of financing arrangements were developed to comply with the following principles:

1. Profit-and-loss sharing partnership (mudarabah)

Mudarabah is a profit-and-loss sharing partnership agreement where one partner (financier or rab-ul mal) provides the capital to another partner (labor provider or mudarib) who is responsible for the management and investment of the capital. The profits are shared between the parties according to a pre-agreed ratio.

2. Profit-and-loss sharing joint venture (musharakah)

Musharakah is a form of a joint venture where all partners contribute capital and share the profit and loss on a pro-rata basis. The major types of these joint ventures are:

• Diminishing partnership: This type of venture is commonly used to acquire properties. The bank and investor jointly purchase a property. Subsequently, the bank gradually transfers its portion of equity in the property to the investor in exchange for payments.
• Permanent musharkah: This type of joint venture does not have a specific end date and continues operating as long as the participating parties agree to continue operations. Generally, it is used to finance long-term projects.

3. Leasing (Ijarah)

In this type of financing arrangement, the lessor (who must own the property) leases the property to the lessee in exchange for a stream of rental and purchase payments, ending with the transfer of property ownership to the lessee.

Investment Vehicles

Due to the number of prohibitions set by Sharia, many conventional investment vehicles such as bonds, options, and derivatives are forbidden in Islamic finance. The two major investment vehicles in Islamic finance are:

1. Equities

Sharia allows investment in company shares. However, the companies must not be involved in the activities prohibited by Islamic laws, such as lending at interest, gambling, production of alcohol or pork. Islamic finance also allows private equity investments.

2. Fixed-income instruments

Since lending with interest payments is forbidden by Sharia, there are no conventional bonds in Islamic finance. However, there is an equivalent of bonds called sukuk or “Sharia-compliant bonds.” The bonds represent partial ownership in an asset, not a debt obligation.