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22 Apr '16

Basic Concepts of Islamic Finance

Posted by Nosheen Z in Basic Concepts of Islamic Finance

Islamic financing has been a viable alternative to western banking since the early 1970s and complies with the major concepts of Shari law, namely that:

  • interest (usury) should not be charged or collected;
  • no form of gambling be undertaken; and
  • no investment should be made in a business which is deemed to be unlawful under Shari law.

Basic concepts

The essential basic concepts of Islamic financing are:

1. Islamic Debt financing

Ijarah – Leasing

Ijarah structure entails  the lender creating a special purpose vehicle (SPV) to purchase asset(s) that is the subject of the financing.  In turn, borrower agrees to enter into a lease agreement to lease the asset(s).  Lease payments act as part rental payments (the profit component) for use of asset and part repayment of principal debt. 

Ordinarily transaction will take on the following elements:

(i) borrower and lender enter into a purchase contract to buy asset that is the subject of the financing;

(ii) borrower and lender enter into a lease contract under the terms of which borrower agrees to lease asset that is the subject of the financing;

(iii) on completion of the lease term, borrow can either make a balloon payment to purchase asset or, alternative, if the rental has included part principal payments, can pay a small sum to the lender in exchange for ownership of asset.

This type of Islamic financing structure is very similar to hire purchase contracts.  As such, assets that are commonly the subject of this type of Islamic financing include motor cars, home appliance, electronic goods, etc.

Murabaha - Cost-plus financing / buy-sell arrangement

Essentially works by borrower asking lender to purchase asset on the understanding that after lender has purchased asset, borrower will purchase asset from lender. 

Agreement is made that lender on-sells asset to borrower at an increased price.

Repayment can either be in one balloon payment or by way of installments over a period of time.  If repayment is a balloon payment, more commonly known as a Bai’ Bithaman Ajil – or deferred payment sale agreement.

Popular structure for purchasing real estate property.  It should be noted, however, that as lender on-sells property to borrower, all land title deeds, etc. vest with the borrower.  Thus, security provisions of such an arrangement need to be considered carefully so that the lender can adequately protect themselves.

Components of this type of Islamic financing include:

(i)                     on-sell arrangement;

(ii)                    agreed mark-up on on-sell price;

(iii)                  asset must be Shari compliant;

(iv)                  asset must exist at the time of the transaction; thus, this cannot be utilized in futures trading transactions;

(v)                   all terms and conditions of the arrangement must be known by all parties at the time of entering into the arrangement;

(vi)                  reoccurring expenses cannot be passed on to the borrower.

 

Bai’ al-Inah – Sale and buy-back

 Similar concept to Murabaha.  However, due to security concerns on default, structure is changed slightly.  Lender purchases asset on behalf of borrower.  Borrower purchases asset from lender on deferred payment basis.  Asset is immediately resold to lender for cash at discount. 

Preferred financing mechanism if there is any danger that lender will become insolvent.

Musharakah  - Partnership

It's can also be referred to as Islamic Venture Financing

  • An arrangement between a lender and a borrower where both parties agree to make a capital contribution towards financing a commercial operation. 
  • Parties agree to share profits from the arrangement at a pre-agreed ratio. 
  • Losses from the arrangement need to be shared pro-rata to the capital contributions of each of the parties.

Tawarroq finance - Monetary finance

  • Lender agrees to purchase a commodity on behalf of the borrower. 
  • Lender sells commodity to the borrower. 
  • Borrower sells commodity to a third party buyer. 
  • Cash payment from third party buyer acts as monetary financing element of the transaction.
  • Borrower repays lender in installments.

Qardul Hassan – Benevolent loan

  • Consists of a loan given to a borrower on a “goodwill” basis, i.e. no interest or fees are charged
  • Borrower may, at their discretion, repay more than they borrowed
  • Seen as being the only “pure” form of Islamic financing loan as, unlike all the other financing structures, it makes no attempt to charge riba (interest), which is prohibited under Islam.

Mudharabah - Profit sharing

  • Islamic investors agree that a Mudhareb (trustee) will provide skill and expertise.
  • Mudhareb agrees to hold and manage the assts for Islamic investors. 
  • In return for providing services, Mudhareb earns an agreed share of profits from the assets managed on behalf of Islamic investors. 
  • Mudhareb cannot claim any right to the assets - merely acts as manager and trustee of assets.

II.        Commodities financing

SSalam – Advance payment

  • Under this Islamic financing structure, purchaser agrees to make advance payment for asset/goods to be delivered at a future date. 
  • It is essential that purchase price be paid at the time of making the agreement, and not on delivery of the asset/goods - failure to comply with this requirement would alter the nature of the agreement to that of a sale of debt against debt, which is prohibited under Shari law.
  •  As Shari law stipulates that items must exist at time of contract, i.e. no futures contract, asset to be purchased must be clearly stated in the purchase agreement and the quantity and quality of the purchased asset must be capable of being specified exactly – there can be no room for dispute.
  •  Assets must be goods and cannot not include commodities; such as gold, silver or money.
  • The exact date and place of delivery of the asset/goods must be specified in the agreement.
  • Istisna’a is another Islamic financing structure that follows almost exactly the same concept as found here

III.       Deposit taking functions

WWadiah - Safe-keeping

  • Agreement between two parties where on agrees to look after the property of another.
  •  Concept is used to take deposits of money, where bank acts as custodian of money deposited by customer.
  • Bank agrees they will refund sums deposited “on call”, i.e. on demand.

Hibah  - Gift

  • Hibah literally means a ‘gift’.  This is used by banks to compensate depositors for lost earnings (interest) on their deposits.  It can also be used by borrowers who have been granted Qardul Hassan loan mention above.
  • No agreement to provide Hibah can be made – it’s an arbitrary payment made at the discretion of the person making it.

IV.       Bonds

Fixed-term, fixed-income, interest-bearing securities cannot be issued under Shari law.

SSukuk – Islamic bonds

  • Although fixed-income, interest-bearing bonds cannot be issued under Shari law, it is estimated that over $500 billion in corporate and government bonds issues have been made using Sukuk (Islamic bonds) mechanism.
  • Essentially, Sukuk bonds are long-term bond issues made by SPVs where the bond sale proceeds are used to purchase assets that are then leased back to the issuer in return for rent.  Rental payments constitute part repayment of the principal and part profit revenue to the bondholders.

Salam bonds

In certain circumstances, short-term bond issues can be made using the same mechanism concepts found in Salam transactions.  It should be noted, however, that due to the precise nature of the assets/goods that are the subject of a Salam transaction, these types of bond issues are rare and for very short-term periods.

Conclusion

The growth of Islamic financing in the past decade has been stellar.  Given the large amounts of cash available in the oil rich Middle-East, it is likely that the growth of Islamic financing will continue.  Moreover, as investors in the Middle-east look to break-out an invest elsewhere, it is certain that governments around the world will need to familiarize themselves with the principal concepts of Islamic financing, and to regulate for such, if they wish to take advantage of this growth industry.