Islamic Finance

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Last Updated:November 4, 2023

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What Is Islamic Banking?

With a compound annual growth rate of 17% since 2009, Islamic Finance, also known as Shari'ah compliant financing (SCF), is one of the areas of the global financial system that is expanding the fastest. As a result, the industry's global assets as of 2015 totaled at least $1.9 trillion.

This finance has acquired systemic relevance in several Asian nations, including Brunei, Bangladesh, and Malaysia, where it has attained at least a 15% market share in the domestic banking sector due to the industry's ongoing expansion.

Additionally, nations without a significant Muslim population are starting to welcome Islamic money.

Sovereign Sukuk has been introduced by Luxembourg, Hong Kong, China, the United Kingdom, and South Africa (Islamic trust certificates, similar to conventional bonds); according to the fact that every offering was at least two times oversubscribed, there is a significant demand for SCF globally.

The foundation of this finance is the idea that money shouldn't have any intrinsic value. Instead, it merely serves as a means of exchanging valuable goods and services.

The belief that you shouldn't make money from money is connected to this way of thinking about money. This implies that engaging in interest-related activities, such as paying or receiving it, should be avoided wherever possible.

Islamic finance is also based on the principle that it should not hurt anyone. Therefore, Islamic financial services should refrain from investing in things like alcohol, tobacco, and gambling because of this.

Islamic financing also promotes collaboration. This means that it is best practice to share both the rewards and the risks. This might happen between two people, between a person and a business, or between a business and another business.

You don't have to be a Muslim to use Islamic finance goods and services.

How is Islamic financing structured?

Current accounts that adhere to Shari'ah do not accrue interest. Instead, the deposit you give the bank is used as an interest-free loan in exchange for having quick access to your money. This loan is referred to as a "qard."

The bank will invest the funds you deposit into a savings account. However, they won't put it into anything that the Shari'ah deems dangerous.

You will receive a portion of any profits the bank makes. Depending on the investments made and how the profit is calculated, this may be a "wakalah" (in which the bank serves as your agent) or a "murabahah" (where a bank purchases and trades commodities to make money).

There are a few alternatives to a typical mortgage when purchasing a home.

In one arrangement, the bank has the option to purchase the desired property outright. After that, they make a profit and sell it to you, allowing you to pay it back over time. Because they are purchasing the property and then selling it to you for a profit, this agreement is also known as a "Murabaha."

Or, you can get into a "musharakah" (partnership) contract to jointly purchase the property with a bank. The bank's share of the property is then gradually paid for over time by you.

In both situations, the bank imposes an additional fee to cover their expenses and account for the fact that you reside in a home they partially own.

Musharakah

Musharakah is a profit-sharing partnership. However, unlike mudaraba, in musharakah, all partners invest, all partners can manage the company, and all partners share in losses according to their participation.

Musharakah could either be "permanent" or "diminishing." Letters of credit, investment ventures, and the acquisition of real estate or other property frequently include its utilization.

Musharaka usage is not recommended. For instance, in Malaysia, the proportion of musharaka, or at least permanent musharaka financing, fell from 1.4% in 2000 to 0.2% in 2006.

Musharaka al-Mutanaqisa, which translates as "diminishing partnership," is a common method of financing large acquisitions like real estate. In this method, a purchased asset is co-owned by the bank and the buyer (the customer), who also leases the item.

As the customer gradually pays off the cost, the bank's equity component gradually reduces from the client's percentage of the down payment to nothing. If the client defaults and the asset is liquidated, the bank and client split the proceeds in accordance with their respective present equity.

Murabaha

In an Islamic contract for a sale, known as a murabahah (or Murabaha), the buyer and seller agree on the markup (profit) or "cost-plus" price for the item or items being sold.

It is now referred to as a marked-up price and deferred payment in Islamic banking.

This method of financing a good (a house, a car, office supplies, etc.) involves the bank purchasing the goods and reselling them to the customer at a higher price while informing them of the price increase and providing the option to pay in monthly installments or all at once.

Murabahah is becoming the most popular kind of Islamic finance. According to one estimate, murabahah accounts for 80% of Islamic lending.

Murabaha loans, despite the availability of Islamic finance, "are not optimal means of financing." Musharakah, mudarabah, salam, or istisna are preferable forms of financing that should only be used when other options are impractical for a variety of reasons, according to Shari'ah supervision organizations.

Murabahah is different from conventional finance in that the predetermined return with which the bank is compensated is referred to as "profit" and not interest, and the financier is not allowed to keep any penalties for late payment for themselves.

Wakalah

In a Wakalah contract, the principal (also known as muwakkil) appoints a representative (also known as the agent or wakil) to carry out transactions on his or her behalf that the principal lacks the time, knowledge or expertise to carry out on their own.

In traditional legal terms, this is similar to a power of attorney agreement. Wakalah ought to be a non-binding agreement for a certain cost.

Selling, buying, lending, guaranteeing debts, gifting, filing lawsuits, and making payments are just a few of the services that an agent may provide. They may also be involved in many Islamic products like Musharakah, Murabaha, and Ijarah.

An illustration of wakalah may be seen in the mudarabah profit and loss sharing agreement, where the mudarib, who operates the business and receives the capital, acts as a wakil for the rabb-ul-mal, who supplies the capital in silence.

Ijarah

A lease or rental agreement is known as an ijarah, which clearly means "to offer something on rent." The term "contract for the hire of persons, services, or the usufruct" of a property, often for a specified period and price, is used in traditional Islamic jurisprudence (fiqh).

Al Ijarah is a term used in Islamic finance to describe a leasing agreement that also contains a sales agreement.

In accordance with Islamic law, a client is leased a piece of property—such as a piece of machinery, office automation, or a car—for a stream of rental and purchase payments, so that the leasing period's end coincides with the completion of purchase payments and the transfer of ownership to the lessee.

The term "operating ijarah," also known as ijarah tashgheeliah, refers to leases without sales and financing.

Ijarah thumma al bai' (hire buy) and Ijarah wa-iqtina (lease and ownership) refers to the leasing, renting, or hiring of a good with payments made in installments that culminate in the customer's purchase of the good (or the option to acquire it). Both entail two contracts that need to be documented separately: a lease and a transfer of ownership of the asset or property.

The difference between the two forms is that under Ijarah wa-iqtina (also known as ijarah muntahia bittamleek), the sale or transfer of ownership is "an option granted to the lessee" and cannot be a requirement. The arrangement includes the selling of Ijarah Thumma Bay.

Sukuk

The Islamic version of bonds, known as sukuk, resemble asset-backed securities and are unique from conventional bonds in a number of ways.

A Sukuk must be structured in a way that ensures that there is an underlying asset, the principal amount is not guaranteed, and the return to investors is correlated with the performance of the underlying assets.

In contrast to a conventional bond, which is a promise to repay a debt with a specified interest rate, a Sukuk must ensure that there is an underlying asset.

Sukuk can take on many different forms. They may be issued as asset-backed securities, in which case investors have a claim on the underlying asset, or as asset-backed securities, in which case the claim is on the issuer rather than the underlying assets.

Since Sukuk issuing started to pick up speed, a variety of new arrangements have emerged, including exchangeable and convertible trusts, lease-based and profit-and-loss sharing partnerships, and partial ownership in receivables.

Sukuk may be a good option for financing infrastructure, but there are also significant implications for financial stability and particular consumer protection issues that merit consideration.

Sukuk financing is similar to that of a public-private partnership (PPP), in which investors finance assets, then acquire ownership of them through real securitization, and then transfer those assets at maturity to the government.

Growth and Potential of Islamic Finance

Overview Though it makes up a small portion of global banking, Islamic finance is expanding quickly and offers a huge upside.

The internationalization of the Sukuk market has expanded cross-border financial flows and linkages, and the Islamic banking industry is now systemically significant in a number of member nations.

Islamic banking has the potential to promote greater financial inclusion and intermediation, particularly among Muslim populations that may be underserved by conventional banks, as well as to make it easier to finance small and medium-sized businesses through lending, while Sukuk can make it easier to invest in public infrastructure projects.

In order for this potential to be realized and for this industry to grow in a safe and sound way, it will be crucial, among other things, that nations modify their regulatory, supervisory, and consumer protection frameworks to address the particular risks in Islamic finance.

To further enhance the growth perspectives of Islamic finance in the world, it is important to acknowledge that Islamic finance is not just for the 1.5 billion Muslims.

Several Western countries are interested in it because it has interesting characteristics in terms of transparency and banking.

Islamic Finance Challenges and criticism

Islamic banking and finance have drawn criticism for closely mimicking regular banking and finance, but with "greater costs, bigger dangers," a problem that has not been resolved by "learning" through the years.

Inflation, late payments, a lack of currency and rate hedging, the absence of sharia-compliant locations to store short-term funds for liquidity, the non-Muslim ownership of much of Islamic banking, and the concentration of what ownership is in Muslim hands are further problems or complaints.

Some observers of Islamic Banking believe the industry is plagued by hand-selected, highly compensated Shariah experts who have been approving financial products using iyal (legal strategy) to adhere to sharia law, "shunning controversial issues," and/or "rubber-stamping" bank management decisions after cursory reviews.

These observers assert that the banking practices sanctioned by this small group of Islamic jurists have become more and more similar to those of conventional non-Islamic banking.

The industry has been accused of not properly adhering to the shariah regulations of murabahah by not buying and selling the commodities/inventory that are "a key condition" of shariah compliance made when the bank desires to borrow finances instead of financing a purchase.

This accusation is in addition to ignoring profit and loss sharing in favor of murâbâah. There are sometimes "no commodities at all, simply cash-flows between banks, brokers, and borrowers," Arabianbusiness lamented in 2008.

Often, the commodity is wholly unrelated to the borrower's industry, and there aren't even enough of the pertinent commodities "in existence" worldwide "to account for all the transactions taking place."