(2) islamic finance principles

8/8/2019 (2) Islamic Finance Principles

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Islamic Finance Principles

Professor Habib AhmedDurham UniversityJanuary 22, 2009

Bankers Association for Finance and TradeBankers Association for Finance and Trade

Where do we go from here?


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Agenda

Introduction to Islamic Law and Principles

Riba and Gharar

Islamic Contracts

Islamic Banking Models

Shariah Governance

Islamic Financial Sector



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Sources of Islamic Law

Two sources of law in Islam

ShariahRevealedknowledge

Quran

Hadith/Sunnah (Sayings/doings of the Prophet)

FiqhDerived knowledge through ijtihad

(exertion)

Four major schools of thought in the Sunni

tradition


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Basic Approach to Islamic Law

Islamic laws can be broadly classified into

two types Ibadat(devotional acts) Any act which is not legalized

by Shariah is void Muamalat(dealings or transactions)All transactions

are permitted unless explicitly prohibited by Islamic law

(principle ofpermissibility)

In muamalat, new transactions can beaccommodated through ijtihadas long as

they do not contain the prohibited


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Contracts-Islamic Nature

Freedom of contractsprovided the prohibited

elements are avoided

Some aspects of the contractual relationship

determined by Shariah/Fiqh to avoid Injustice

Conflicts/Misunderstandings

Exploitation

The prohibitions in transactions include: Riba

Gharar


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Riba

Riba (literal meaning increase) is prohibited...they say: trading is only like riba, whereas God has permitted

trading and forbidden riba (Quran 2:275)

Various interpretations ofriba

Implications ofriba:

Interest is forbidden

Selling debt (at a discount) is not allowed


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Gharar

GhararExcessive risk, hazard, or ambiguity Ghararcan exist in the object or terms of the

contract

Implications ofgharar:

Existence of the object (& ability to deliver)

Two sales in one

The future sale


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Agenda


Riba and Gharar

Islamic Contracts


Shariah Governance



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Major Islamic Contracts used in

Financing

1. Sale (Exchange) Contracts

1. Deferred trading contracts

Price deferred sale (murabahah)

Object deferred sale (salam, istisna)

Leasing-sale of usufructs (ijarah)

Partnerships musharakah or mudarabah

Interest free loans (qard hassan) or loans atservice charges


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Murabahah

Financing Mode in Islamic BanksDebt The financial institution buys and then sells a good to the

client at a mark-up Price paid at a later date The bank must own and posses the good The profit rate and other terms should be clearly specified in

the contract The bank can ask for guarantees or collateral

Productspot

Pricefuture

Traditional Murabahah/Bai al-Muajjal


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Salam

Financing Mode in Islamic BanksDebt

Used to finance the agricultural sector

The price has to be fixed and paid when the contract isconcluded

Commodities delivered at a later date

The delivery time should be fixed

Pricespot

Commoditiesfuture

Traditional Salam


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Istisna

Financing Mode in Islamic BanksDebt A pre-production sale used when an item/asset needs to be

manufactured/constructed

The price of the asset should be known and time of payment

can be negotiated among the parties

The seller of the asset (bank) can either manufacture it or

sub-contract it

Paymentinstallments

Assetfuture

Traditional Istisna


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Ijarah

Financing Mode in Islamic BanksLeasing A hire-purchase leasing contract Ownership is transferred to lessee at the end of the contract

period Fiqhiobjectionstwo contracts in one; purchase contract

cannot be binding Banks give away the asset at nominal value or as a gift at the

end of the lease period

Asset (for rent)fixed period

Rental Payments

Traditional Ijarah


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Mudarabah

Financing Mode in Islamic BanksEquity Partnership between bank and clients Used on the liability and asset sides Profit shared among parties at an agreed upon ratio Loss borne by financier only Financier cannot ask for a guarantee of capital or return Mudarabah can be restricted or unrestricted

FundsspotService/labour

Profit sharefutureProfit sharefuture

Traditional Mudarabah


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Musharakah

Financing Mode in Islamic BanksEquity A partnership contract in which bank contributes capital and

managerial services Like a mudarahah, but all partners manage the project The profit share among the partners at an agreed upon ratio Loss shared according to share of capital

Funds & labour Funds & labour

Profit sharefutureProfit sharefuture

Traditional Musharakah


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Agenda


Riba and Gharar

Islamic Contracts


Shariah Governance



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Ideal Islamic Banking Model

Two-tier mudarabah model

Profit-loss sharing modes of financing on both the asset and

liability side

Liabilities and EquityAssets

Profit-sharing investment

accounts (PSIA-Mudarabah

based)

Demand Deposits (qardhasan)

Capital

Equity financing

(Mudarabah/musharakah)


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Islamic Banking Practice:

2nd Best ModelOne-tier Mudarabah with Multiple Investment Tools

Liability SidePSIA (Mudarabah based)

Asset Sidemultiple investment tools, dominated by fixed-income contracts (murabahah, ijarah, istisna, etc.)


PSIA-Mudarabah based

Demand Deposits (Qard

hasan)Capital

Reserves

Debt-based financing

(Murabahah, Istisna, salam)

Leasing-based financing(Ijarah)

Equity-financing



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Tawarruq

The client wants a personal loan and approaches the bank

1. Bank buys commodity from a broker paying spot (for 100)

2. Bank sells the commodity to client payable at a future date (for 110)

3. The client sells commodity to broker spot (for 100)

[Organized tawarruq: The client appoints the bank as agent to sell thecommodity. The bank sells the commodity spot to the broker for 100 onbehalf of the client and deposits the money in clients account.]

At the end of the transaction, the client gets 100 and owes the bank 110payable in the future

1

2

3 BankClient

Broker


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Implications ofTawarruq

Tawarruq and Greshams Law (bad money

drives away good money)

Tawarruq is driving all other modes away

Tawarruq replicates a loan transaction

The resultthird best model of Islamic banking


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Islamic Banking Practice:

3rd Best Model

Fixed Liability with Multiple Investment Tools Liability SideFixed-income investment accounts (using

tawarruq)

Asset Sidemultiple investment tools, dominated by fixed-income contracts (tawarruq,murabahah, ijarah, istisna, etc.)


Fixed income investment

accounts (Tawarruq)

Demand Deposits (Qard

hasan)

Capital

Reserves

Debt-based financing

(Tawarruq,Murabahah,

Istisna, salam)Leasing-based financing

(Ijarah)

Equity-financing



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Islamic Modes of Financing

UAEBahrainPakistanSudanModes

49.2951.7350.9642.45Murabahah

2.590.892.5217.77Musharakah

4.361.96-3.10Mudarabah

18.905.5620.410.87Ijarah

3.220.63-0.95Istisna

--0.230.55Salam

21.6539.2325.8834.31Others

Source: 2007 Islamic Finance Directory,Gen. Council for Islamic Banks & Fin. Institutions


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Islamic Modes of Financing

Saudi ArabiaJordanMalaysiaIranModes

15.8115.4141.0421.02Murabahah

0.652.990.240.97Musharakah

0.0511.360.271.51Mudarabah0.0413.809.402.18Ijarah

3.741.201.720.07Istisna

---0.03Salam

79.7155.2547.3374.22Others

Source: 2007 Islamic Finance Directory,Gen. Council for Islamic Banks & Fin. Institutions


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Agenda


Riba and Gharar

Islamic Contracts


Shariah Governance



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Role ofShariah Scholars

Most Islamic banks initially created by private

initiatives by pious Muslims

Shariah compliance important feature of IF

organizations Authenticity, credibility, and public confidence of

products/services required

Establishment ofShariah bodies at different levels

Re-emergence of legal authority Shariah scholars


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Different Types ofShariah Bodies

Shariah bodies exist in different forms

Shariah Department (in the bank)

Advisor (external to the bank)

Supervisory Board (in the bank) Supervisory Board (national)

Professional Shariah Advisory Firms

International Fiqh Bodies

Depending on the regulations and size of theorganization, different models ofShariah

governance exist.


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Shariah and Legal Risks

No unified Shariah rulings

Application of Islamic contracts in non-Islamic

jurisdictions

Choice of law and dispute settlement clauses

included in contracts

Usually English law is preferred

IfShariah is the governing lawdisputes settledby commercial arbitration


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Agenda


Riba and Gharar

Islamic Contracts


Shariah Governance




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Bankers Association for Finance and TradeBankers Association for Finance and TradeBankers Association for Finance and TradeBankers Association for Finance and Trade

1970s 1980s 1990s 2000s

Islamic Banks

Takaful/Retakaful

Mutual Funds

Mudarabah Co.

Leasing Co.

Investment Banks

Islamic indices

Sukuk

Private Equity &

Venture Capital

Hedge Funds

Infrastructure/

project finance

Islamic REITs

Trust/Waqf

Management

Islamic Banks

Takaful/Retakaful

Mutual Funds

Mudarabah Co.

Leasing Co.

Investment Banks

Islamic indices

Islamic Banks

Takaful/Retakaful

Mutual Funds

Mudarabah Co.

Islamic Banks

Takaful

Evolution of Islamic Financial Sector


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Size of Islamic Financial Industry

Islamic financial sector is significant andexpanding at a fast rate More than 500 Islamic financial institutions in

over 75 countries

Over 706 Shariah compliant mutual funds Total outstanding sukukissuesUSD 83.7billion

Estimated total Islamic financial assetsunder management-$1 trillion

Islamic financial Industry estimated toreach up to $2.8 trillion by 2015


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Questions?

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