Islamic Finance Principles

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Where do we go from here?

• Islamic Finance Principles
• Professor Habib Ahmed
• Durham University
• January 22, 2009

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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
• ShariahRevealed knowledge
• Quran
• Hadith/Sunnah (Sayings/doings of the Prophet)
• Fiqh Derived 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 of
  permissibility)
• In muamalat, new transactions can be accommodated
  through ijtihad as 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 2275)
• Various interpretations of riba
• Implications of riba
• Interest is forbidden
• Selling debt (at a discount) is not allowed

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Gharar

• GhararExcessive risk, hazard, or ambiguity
• Gharar can exist in the object or terms of the
  contract
• Implications of gharar
• Existence of the object ( ability to deliver)
• Two sales in one
• The future sale

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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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Major Islamic Contracts used in Financing

• Sale (Exchange) Contracts
• 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 at
  service charges

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Murabahah
Traditional Murabahah/Bai al-Muajjal
Productspot
Pricefuture

• 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

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Salam
Traditional Salam
Pricespot
Commoditiesfuture

• Financing Mode in Islamic BanksDebt
• Used to finance the agricultural sector
• The price has to be fixed and paid when the
  contract is concluded
• Commodities delivered at a later date
• The delivery time should be fixed

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Istisna
Traditional Istisna
Paymentinstallments
Assetfuture

• 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

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Ijarah
Traditional Ijarah
Asset (for rent)fixed period
Rental Payments

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

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Mudarabah
Traditional Mudarabah
Fundsspot
Service/labour
Profit sharefuture
Profit sharefuture

• 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

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Musharakah
Traditional Musharakah
Funds labour
Funds labour
Profit sharefuture
Profit sharefuture

• 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

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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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Ideal Islamic Banking Model

• Two-tier mudarabah model
• Profit-loss sharing modes of financing on both
  the asset and liability side

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Islamic Banking Practice 2nd Best Model

• One-tier Mudarabah with Multiple Investment Tools
• Liability SidePSIA (Mudarabah based)
• Asset Sidemultiple investment tools, dominated
  by fixed-income contracts (murabahah, ijarah,
  istisna, etc.)

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Tawarruq
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Broker
Client
Bank
1
3

• The client wants a personal loan and approaches
  the bank
• Bank buys commodity from a broker paying spot
  (for 100)
• Bank sells the commodity to client payable at a
  future date (for 110)
• The client sells commodity to broker spot (for
  100)
• Organized tawarruq The client appoints the
  bank as agent to sell the commodity. The bank
  sells the commodity spot to the broker for 100
  on behalf of the client and deposits the money in
  clients account.
• At the end of the transaction, the client gets
  100 and owes the bank 110 payable in the future

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Implications of Tawarruq

• 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.)

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Islamic Modes of Financing
Source 2007 Islamic Finance Directory, Gen.
Council for Islamic Banks Fin. Institutions
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Islamic Modes of Financing
Source 2007 Islamic Finance Directory, Gen.
Council for Islamic Banks Fin. Institutions
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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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Role of Shariah 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 of Shariah bodies at different
  levels
• Re-emergence of legal authority Shariah scholars

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Different Types of Shariah 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 the
  organization, different models of Shariah
  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
• If Shariah is the governing lawdisputes settled
  by commercial arbitration

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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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Evolution of Islamic Financial Sector
1970s
1980s
1990s
2000s
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Size of Islamic Financial Industry

• Islamic financial sector is significant and
  expanding at a fast rate
• More than 500 Islamic financial institutions in
  over 75 countries
• Over 706 Shariah compliant mutual funds
• Total outstanding sukuk issuesUSD 83.7 billion
• Estimated total Islamic financial assets under
  management-1 trillion
• Islamic financial Industry estimated to reach up
  to 2.8 trillion by 2015

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Questions? habib.ahmed_at_durham.ac.uk
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