Islamic finance

Islamic finance has the same purpose as other forms of corporate finance except that it operates in accordance with the principles of Islamic law (Sharia).

The basic principles covered by Islamic finance include:

• Sharing of profits and losses.
• No interest  allowed.
• Finance is restricted to Islamically accepted transactions. i.e. No investment in alcohol, gambling etc. Therefore, ethical and moral investing is encouraged.

Key principles

The Islamic economic model has developed over time based on the rulings of Sharia on commercial and financial transactions. The Islamic finance framework seen today is based on the principles developed within this model. These include:

• An emphasis on fairness such that all parties involved in a transaction can make informed decisions without being misled or cheated. Equally reward should be based on effort rather than for simple ownership of capital,
• The encouragement and promotion of the rights of individuals to pursue personal economic well being, but with a clear distinction between what commercial activities are allowed and what are forbidden (for example, transactions involving alcohol, pork related products, armaments, gambling and other socially detrimental activities). Speculation is also prohibited (so instruments such as options and futures are not allowed). Ethical and moral investing is encouraged,
• The strict prohibition of interest (riba). Instead interest is replaced with cash flows from productive sources, such as returns from wealth generating investment activities.

How returns are earned

Riba is defined as the excess paid by the borrower over the original capital borrowed i.e the equivalent to interest on a loan. Its literal translation is 'excess'.

Within the conventional banking system, a bank get access to funds by offering interest to depositers. It will then apply those funds by lending money, on which it charges interest. The bank makes a profit by charging more interest on the money it lends than it pay to its depositers. This process is outlawed under Islamic finance.

In an Islamic bank, the money provided by depositers is not lent, but is instead channelled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.

For example, in an Islamic mortgage transaction, instead of loaning the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment.

In effect, the interest is replaced with cash flows from productive sources, such as returns from wealth generating investment activities and operations. These include profits from trading in real assets and cash flows from the transfer of the right to use an asset (for example,rent).

Islamic sources of finance

In Islamic Banking there are broadly 2 categories of financing techniques:

• "Fixed Income" modes of finance - murabaha, ijara, sukuk
• Equity modes of finance - mudaraba, musharaka

Each of these is discussed in more detail below:

Murabaha

Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan is that with a murabaha, the bank will take actual constructive or physical ownership of the asset. The asset is then sold onto the 'borrower' or 'buyer' for a profit but they are allowed to pay the bank over a set number of installments.

The period of the repayments could be extended but no penalties or additional mark up may be added by the bank. Early payment discounts are not welcomed (and will not form part of the contract) although the financier may choose (not contract) to give discounts.

Ijara

Ijara is the equivalent of lease finance; it is defined as when the use of the underlying asset or service is transferred for consideration. Under this concept, the Bank makes available to the customer the use of assets or equipment such as plant, office automation, or motor vehicles for a fixed period and price. Some of the specifications of an Ijara contact include:

• The use of the leased asset must be specified in the contract.
• The lessor (the bank) is responsible for the major maintenance of the underlying assets (ownership costs)
• The lessee is held for maintaining the asset in good shape

An Islamic lease is more like an operating lease but the redemption features may be structured to make it similar to a finance lease.

Sukuk

Within other forms of business finance, a company can issue tradable financial instruments to borrow money. Key feature of these debt instruments are they:

• Don't give voting rights in the company,
• Give right to profits before distribution of profits to shareholders
• May include securities and guarantees over assets
• Include interest based elements

All of the above are prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukuk holder is a partial owner in the underlying assets and profit is linked to the performance of the underlying asset. So for example a sukuk holder will participate in the ownership of the company issuing the sukuk and has a right to profits (but will equally bear their share of any losses).

Mudaraba

Mudaraba is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner (who is called 'rab ul mal'), while the management and work is an exclusive responsibility of the other (who is called 'mudarib').

The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. In a Mudaraba only the lender of the money has to take losses.

This arrangement is therefore most closely aligned with equity finance.

Musharaka

Musharaka is a relationship between two or more parties, who contribute capital to a business, and divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital. All providers of capital are entitled to participate in management, but are not required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to their respective capital contributions.

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