Islamic Finance

Islamic Finance

Islamic Finance has seen exponential growth in recent decades. With the rise of the economies of the Middle East, particularly the Gulf Arab countries, demand for Islamically-compliant tools for investment and financing has also increased. The Islamic Finance industry is now estimated to be worth more than $2 trillion dollars globally. The UAE serves as a major hub of Islamic Finance.

What is Islamic Finance?

Islamic Finance and Islamic banking started in earnest in the 1970s. Primarily driven by oil rich Gulf countries, Islamic finance has grown exponentially. According to the IMF, there are over 300 Islamic financial institutions in more than 75 countries with total assets worldwide exceeding 250 billion and growth rates exceeding 15 percent a year. As of 2010, there were an estimated 473 Islamic mutual funds with billions of dollars worth of assets.

The chief feature of Islamic finance law is the prohibition against interest and usury (riba) and excessive uncertainty and risk (gharar) in business. Literally, riba means excess or addition, but is usually translated as interest, usury, and unlawful gain. Gharar means doubt or uncertainty, but in Islamic finance it is defined as excessive uncertainty in a business transaction.

There is a scholarly consensus that riba is not just usury, but rather any kind of fixed predetermined rate of return on an investment that is guaranteed no matter how the investment performs. The prohibition of riba also applies to trading in gold, silver and certain foodstuffs. This is so because metals cannot be used as an end run around the prohibition on interest by having trades in these metals or commodities in unequal measure. By prohibiting riba, Islamic finance encourages risk on both sides of a transaction.

The other key prohibition in Islamic finance is the prohibition against gharar. Basically, the risk of violating the prohibition on Gharar would exist any time there is excessive uncertainty in a transaction or if an entity is actually trading in risk. However, gharar is not unequivocally forbidden like interest. Scholars look at the degree of uncertainty, the risk involved, and the potential for injustice to any of the parties involved. Along with prohibitions against riba and gharar, the financing of certain activities (including gambling, the manufacturing or distribution of alcohol, pork, and pornography) are also prohibited.

Islamic Finance provides the public with the option of avoiding prohibitions on interest and uncertainty when it comes to financing a transaction or making an investment. In many instances, modern Islamic finance involves taking pre-modern Islamic commercial contracts and molding them to meet modern financial needs. Below are some examples.

Conventional Islamic Finance Instruments

Murabaha

A murahaba transaction is an unconditional sales contract where the cost price of the goods, mark-up over the cost, and payment date are all clearly defined in the contract. However, the murabaha contract is not a typical sale on credit contract. Islamic law requires that the object of sale must be in existence at the time of the contract. This requirement has been put in place in order to avoid the prohibition against gharar.

Murahaba-based financing occurs when a bank purchases goods for a certain amount from a third party seller, then resells the goods to a borrower at a mark-up over the cost price. The sale is immediate and the payment by the borrower is deferred and is payable in installments. The murahaba transaction therefore helps the borrower raise money without violating the prohibition against interest and allows the bank to earn money in form of the fee and the mark-up.

Ijara

An ijara transaction is basically a lease by which intermediate to long-term financing of assets is facilitated. Under Islamic law, only tangible, non-perishable, identifiable, and quantifiable assets may be leased. Consequently, money, food, and fuel cannot be leased.

An ijara transaction occurs where there is a lease of assets or services with, under which there is a transfer of a usufruct for rent consideration. In an ijara transaction, the lessor is expected to maintain legal and beneficial ownership, bear the associated risk, and assume all costs of purchase (and transport, if applicable) associated with the deal. In order to convert the ijara into a traditional finance lease, the parties may include a put option or an irrevocable unilateral promise to purchase. The lessee is responsible for the rental payments and eventual purchase of the property if a put option has been put in place.

Musharaka and Mudaraba

Musharaka and mudaraba are two partnership-based Islamic finance modelts that involve profit and loss sharing. Risk is more evenly spread among the parties, and income is not guaranteed for any one party. Returns for a financier genuinely depends on the success of the venture. Generally, financiers take an active role in the venture in order to ensure profitability.

A mudaraba transaction occurs where the financier contributes capital to a partnership and the borrower, or mudarib, contributes their efforts (usually in the form of management expertise). The management expertise provided by the mudarib is treated as a form of capital for the purposes of the partnership. The financier is therefore generally not an active partner. Profits are pre-agreed and shared in accordance with each party’s contributions. A loss would mean that the financier loses its capital and the mudarib is not compensate for his or her efforts/time. The mudarib is not liable to the financier for any losses.

A musharaka transaction is similar to a mudaraba, with the key difference being that, in a musharaka, both parties generally contribute capital.

The demand for Islamic financial instruments is growing across the globe. We advise clients on how to maintain compliance under Islamic law for complex investment and financing transactions. From property acquisitions to project finance, our expertise in Islamic Finance allows us to help clients achieve their commercial goals while conforming to ethical parameters of financing under Islamic law.