Islamic Finance in a Nutshell

A Guide for Non-Specialists

Brian Kettell

• Publisher: Wiley
• Year: 2011
• ISBN:
  9780470710036
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Islamisches Bank- & Finanzwesen

The recent turbulence in the global financial markets has drawn attention to an alternative system of financial intermediation: Islamic banking and finance, which has so far remained on the sidelines of the unrest.

Islamic Finance in a Nutshell is a quick and easy guide to understanding the fundamentals of Islamic Finance and how the Islamic Financial markets work. Designed as a quick read for practitioners needing to pick up the basics of the industry, it will enable readers to understand the differences Islamic and Western finance.

Starting with the rise of Islamic finance, the book highlights the key areas which practitioners need to grasp to understand the marketplace including financial statement analysis, Sharia'a law, making money in the absence of interest and regulation. The book also provides readers with a basic guide to Arab terminology and a guide to the top financial institutions within the Islamic markets.

This is an ideal guide for anyone with an interest in how these financial markets work, but who do not want to be bogged down in complex and unnecessary terminology.

Chapter 1

What Is Islamic Banking?

Conventional Bankers and Islamic Banking

Ask a conventional banker exactly what is Islamic banking. He will mumble something about religion. He will then say well they cannot charge interest but they use something else which is the same thing. This ‘something else’, incidentally, is never defined. He will then move on to describe Islamic banking as being about smoke and mirrors. To conclude he will then profoundly announce that, with a few tweaks, it is what he does every day anyway. And that is the end of it.

If you push him to actually describe an Islamic financial instrument, and even worse if you actually use some Islamic terminology, Murabaha, Mudaraba etc, then his eyes will start to glaze over.

Frankly this stereotyped image is all too prevalent within the conventional banking world. In an endeavour to both enlighten conventional bankers and to broaden the understanding of Islamic banking principles this chapter will go back to basics and will highlight the key characteristics of Islamic banking which differentiate it from conventional banking.

As you will learn, Islamic banking is not about smoke and mirrors. It is in fact about banking based on Islamically-ethical principles which are, in many ways, very different indeed from conventional banking principles.

Islamic banking is not about smoke and mirrors

So What Exactly Is Islamic Banking All about?

Islamic financial institutions are those that are based, in their objectives and operations, on Qur’anic principles. They are thus set apart from ‘conventional’ institutions, which have no such religious preoccupations. Islamic banks provide commercial services which comply with the religious injunctions of Islam. Islamic banks provide services to their customers free from interest (the Arabic term for which is riba), and the giving and taking of interest is prohibited in all transactions. This prohibition makes an Islamic banking system differ fundamentally from a conventional banking system.

Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. In earlier historical times there was a fierce debate as to whether riba relates to interest or usury, although there now appears to be a consensus of opinion among Islamic scholars that the term extends to all forms of interest.

The term riba, in Islamic law (the Sharia’a), means an addition, however slight, over and above the principal. According to the Federal Sharia’a Court of Pakistan, this means that the concept covers both usury and interest; that it applies to all forms of interest, whether large or small, simple or compound, doubled or redoubled; and that the Islamic injunction is not only against exorbitant or excessive interest, but also against even a minimal rate of interest. Financial systems based on Islamic tenets are therefore dedicated to the elimination of the payment and receipt of interest in all forms. It is this taboo that makes Islamic banks and other financial institutions different, in principle, from their Western conventional counterparts.

Financial systems based on Islamic tenets are therefore dedicated to the elimination of the payment and receipt of interest in all forms

There are a range of modern interpretations of why riba is considered haram (forbidden) but these are strictly secondary to the religious underpinnings.

The fundamental sources of Islam are the Holy Qur’an and the Sunnah, a term which in Ancient Arabia meant ‘ancestral precedent’ or the ‘custom of the tribe’, but which is now synonymous with the teachings and traditions of the Prophet Muhammad as transmitted by the relaters of authentic tradition (hadith). Both of these sources treat interest as an act of exploitation and injustice and, as such, it is inconsistent with Islamic notions of fairness and property rights. While it is often claimed that there is more than this to Islamic banking, such as its contribution towards economic development and a more equitable distribution of income and wealth, its increased equity participation in the economy, etc, Islamic banking nevertheless derives its specific raison d’être from the fact that there is no place for the institution of interest in the Islamic order.

This rejection of interest poses the central question of what replaces the interest rate mechanism in an Islamic framework. Financial intermediation is at the heart of modern financial systems. If the paying and receiving of interest is prohibited, how do Islamic banks operate? Here profit-and-loss sharing (PLS) principles come in, substituting profit-and-loss sharing for interest as a method of resource allocation and financial intermediation.

The basic idea underlying Islamic banking can be stated simply. The operations of Islamic financial institutions primarily are based on a profit-and-loss-sharing (PLS) principle. An Islamic bank does not charge interest but rather participates in the yield resulting from the use of funds. The depositors also share in the profits of the bank according to a predetermined ratio. There is thus a partnership between the Islamic bank and its depositors, on the one side, and between the bank and its investment clients, on the other side, as a manager of depositors’ resources in productive uses. This is in contrast with a conventional bank, which mainly borrows funds, paying interest on one side of the balance sheet, and lends funds, charging interest, on the other. The complexity of Islamic banking comes from the variety (and nomenclature) of the instruments employed, and in understanding the underpinnings of Islamic law.

An Islamic bank does not charge interest but rather participates in the yield resulting from the use of funds

Six key principles drive the activities of Islamic banks. These are:

1. the prohibition of predetermined loan repayments as interest (riba);

2. profit-and-loss sharing is at the heart of the Islamic system;

3. making money out of money is unacceptable. All financial transactions must be asset-backed;

4. prohibition of speculative behaviour;

5. only Sharia’a-approved contracts are acceptable;

6. the sanctity of contracts.

These principles, as applied to Islamic banking and finance, are set out below.

1 Predetermined Payments Are Prohibited

Any predetermined payment over and above the actual amount of principal is prohibited. Islam allows only one kind of loan and that is qard al hassan (literally ‘good loan’) whereby the lender does not charge any interest or additional amount over the money lent. Traditional Muslim jurists have construed this principle so strictly that, according to one Islamic scholar, “the prohibition applies to any advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower’s mule, eating at his table, or even taking advantage of the shade of his wall”. The principle derived from the quotation emphasises that any associated or indirect benefits which could potentially accrue to the lender are also prohibited.

2 Profit-and-Loss Sharing

The principle here is that the lender must share in the profits or losses arising out of the enterprise for which the money was lent. Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business, instead of becoming creditors. Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether these are manufacturing industries, service companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures.

This is unlike the interest-based commercial banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

The principle, which thereby emerges, is that in order to try and ensure investments are made into productive enterprises Islam encourages these types of investments in order that the community may ultimately benefit. However, Islam is not willing to allow a loophole to exist for those who do not wish to invest and take risks but rather are intent on hoarding money or depositing money in a bank in return for receiving interest (riba) on these funds for no risk (other than the bank becoming insolvent).

Accordingly, under Islam, either people invest with risk or suffer loss by keeping their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective here is that high-risk investments provide a stimulus to the economy and encourage entrepreneurs to maximise their efforts to make them succeed, with appropriate benefits to the community.

Risk-Sharing

As mentioned above one of the most important features of Islamic banking is that it promotes risk-sharing between the providers of funds (investors) and the user of funds (entrepreneurs). By contrast, under conventional banking, the investor is assured of a predetermined rate of interest.

In conventional banking, all the risk is borne by the entrepreneur. Whether the project succeeds and produces a profit or fails and produces a loss, the owner of capital is still rewarded with a predetermined return. In Islam, this kind of unjust distribution is not allowed. In pure Islamic banking both the investor and the entrepreneur share the results of the project in an equitable way. In the case of profit, both share this in pre-agreed proportions. In the case of loss, all financial loss is borne by the capital supplier with the entrepreneur being penalised by receiving no return (wages or salary) for his endeavours.

Emphasis on Productivity As Compared to Creditworthiness

Under conventional banking, almost all that matters to a bank is that its loan and the interest thereon are paid on time. Therefore, in granting loans, the dominant consideration is the creditworthiness of the borrower. Under profit-and-loss sharing (PLS) banking, the bank will receive a return only if the project succeeds and produces a profit. Therefore, it is reasoned, an Islamic bank will be more concerned with the soundness of the project and the business acumen and managerial competence of the entrepr...