Contracts and Deals in Islamic Finance

A User's Guide to Cash Flows, Balance Sheets, and Capital Structures

Hussein Kureshi, Mohsin Hayat

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781119020585
• Edition: 1
• Topic: Business
• Subtopic: Sistemi bancari e finanziari nei paesi islamici
• Index: Business

A very accessible and concise guide to Islamic finance

Contracts and Deals in Islamic Finance provides a clear breakdown of Islamic financial contracts and deal structures for beginners. The embedded requirements within selected Islamic financial contracts, such as risk weightage, capital structures, creations of cash flows, and balance sheets, are explained fully to provide a solid understanding of the backbone of the industry. Aimed primarily at beginners and those with a background in conventional banking, this book guides readers through the major contracts, how they're applied, and how to discern a contract's legitimacy. Case studies and interviews with bankers and global regulators provide real-life examples of contract application, and the author's own experiences provide deep insight into the everyday issues that arise. Ancillary instructor's materials include PowerPoint slides and lecture notes that facilitate use in the classroom.

Literature describing the application of Islamic financial contracts is few and far between, and those providing a basic breakdown of these contracts and questioning their validity are rarer still. This book is the first of its kind, offering a basic approach to understanding Islamic contracts, designed for the true beginner.

• Understand the current contracts applied in Islamic banking
• Learn how contracts are applied across different jurisdictions
• Identify illegitimate contracts and those not in the spirit of Shariah law
• Examine the current economic realities surrounding Islamic finance

By highlighting the underlying themes in Islamic finance and assessing the current practices, this book gives readers the solid understanding and up-to-date perspective that form a solid foundation upon which successful Islamic finance is practiced. For a solid introduction to the Islamic finance industry, Contracts and Deals in Islamic Finance is an accessible, practical guide.

Chapter 1
The Islamic Finance Space

As a historical religion, Islam has been in existence for 1,400 years. The word religion comes from the Latin word religio, which means to bind oneself.¹ Religious principles bind mankind to a way of life that is meant to be pleasing to God. Human history provides enough evidence that mankind has not always followed religious principles in their true spirit and has had to pay the consequences from time to time.

Finance has been around as long as man has inhabited this earth. The most basic form of finance in prehistory was money lending and remains so today. All the Semitic religions of Christianity, Judaism, and Islam warn mankind against the practice of usury, which allows interest to be the reward for money lent. Islam is not the only religion to forbid the taking of interest. The word used in the Quran is riba,²

Finance was also an integral part of the Muslim empires of the Ummayads, the Abbasids, the Fatimids, the Mamlukes, the Seljuks, and also of the Ottomans. Islam dawned on Arab traders (most previous Prophets were either craftsmen or farmers). The Prophet ([saw] peace be upon him) himself was a trader. Trade has such an importance on the fabric of Islam that the Quran itself endorses trade or bai.³

What kind of trade did Islam permit? Certainly Islam permitted certain trade practices and forbade others, like hoarding of goods,⁴ inflating prices by meeting merchants outside city walls and buying their goods before they come to market,⁵ or selling goods not in one's ownership.⁶ These obligations had an impact on the trading practices endorsed within the Muslim world. Principles of fairness, keeping one's oath, fulfilling terms of contracts were endorsed not just in conversation but in the Quran itself.⁷

Much of the Muslim world remained an agriculture-based economy, with a monarchical political system of rule. The Muslim world is famous for its bazaars, where traders came from across the globe to trade wares and to be exposed to this new religion that had shown its face on the pages of history. Although much of Orientalist literature⁸ focuses on the military conquests of the Muslim rulers, little is talked about of the impact of trade with the Muslim world, or the institutions of trade. Scholars such as Donald Quateart are working on archives found in the libraries of Istanbul to give a more clear picture of what life was like in the most recent episode of Islamic history, that of the Ottoman Empire.

In an empire as vast as the Ottoman Empire with Istanbul being the center of trade for much of the civilized world, trade and finance must have gone hand in hand. There is no evidence of the existence of modern-day banks in Istanbul; certainly, however, the oldest banks and banking families belonged to Italy and lived in the 1500s. There is also no concrete evidence of cooperatives, or benevolent funds that could be the prototype of modern-day insurance. We would have to wait until the libraries of Istanbul reveal these secrets to come to any conclusion.

However, with vast stores of grain coming from different parts of the Empire where different currencies were employed it is not difficult to imagine that some informal structures of commodity exchanges must have existed, some mechanisms must have been developed to hedge risks of price volatility, and some mechanisms must have existed to raise capital and borrow capital. Development comes in times of peace, and unless one were to buy Kinross's version of Ottoman history, the Empire offered its citizens a period of respite for close to 500 years. Media headlines tend to focus on atrocities alone, but that is another matter. Another element of genius within the fabric of the Empire was that Christians, Jews, Indian Muslims, Arab Muslims, Italians, and Venetians alike were allowed to serve the Empire and to develop trade, commerce, and institutions of law in a manner not seen at any other phase of at least Islamic history. Humans, whether Muslims or non-Muslims, must have developed innovative commercial contracts, mechanisms of trade, financial products, and even derivatives over a period of time within the boundaries of the Empire. It is no surprise therefore that the first formal codification of commercial law is found in the Mejelle, which was a Hanafi document developed in the seventeenth and eighteenth centuries within the Ottoman Empire.⁹

So, how far back does Islamic finance go? One can say the contracts of sale of murbahah, bai al inah, bai al wafa, bai al dayn, or bai al sarf even predate Islam. Islam just eliminated certain features of these contracts and retained others depending on whether certain features contradicted any legal maxims. The application of these sale contracts to financial intermediation in a fractional reserve system is far more recent and can be first seen in the 1970s in places like Egypt, Sudan, Iran, and other pockets of the Muslim world.¹⁰

However, one must note that the past 200 years for every Muslim country has been one of colonial domination, with many countries gaining formal political independence in the latter half of the previous century, and all after World War II. As such, almost all Muslim countries have inherited legal systems from the times of their colonial rulers, and other institutions of rule, government, and commerce. We must not forget that much of the Muslim world did not experience the Industrial Revolution in the manner that Europe and the United States did, nor could many wonderful inventions and advancements in the sciences be attributed to a Muslim world that still predominantly had pockets of agricultural economies and trade-based economies. The Muslim world also inherited a dollar-based and an interest-based global financial system.

The need for oil in the twentieth century put the Muslim world into prominence again with much of the natural resource being found under the sands of the ancient cities that were once home to peoples of prehistory.

It is also important to keep in mind that the Muslim world is divided in its interpretations of the religion and in the social structure of their societies, with certain countries adopting monarchies, or constitutional monarchies, and others adopting a democratic form of government. Military dictatorships have been common in the Muslim world until the recent demise of such figures as Saddam Hussein and Qaddafi. Iran has a unique theocratic form of government, where religious clerics are key stakeholders in the running of the government. Some Muslim countries have a large percentage of non-Muslims as their citizens as well. All these factors influence not only the exchange of ideas within the Muslim world but also the development of any consensus of issues of importance within the sphere of political and commercial life. Needless to say there is need for convergence and unity among the Muslim countries in their understanding of the religion and in coordinating efforts to serve the needs of close to 1.3 billion Muslims across the globe.

Modern Phase of Islamic Finance

The modern phase of Islamic finance may have been the brainchild of political ideologists that saw the post–World War II world economic system built on the principles of interest. Efforts were made to develop in theory and in practice an economic and a financial system that did not depend on riba, but any such attempt could only meet with limited success when the currencies of each Muslim country were pegged to the U.S. dollar. The U.S. dollar system is based on interest. Had the Muslim world adopted a more isolationist attitude to international trade the results may have be different, and ironically two economies, China and India, that during the 1970s and 1980s had turned their back on international trade are now leading exporters on the global economic stage.

Nevertheless, the Muslim world developed institutions to collaborate, the first of its kind being the Islamic Development Bank (IDB), which possibly embodies the aspirations of many Muslims in fulfilling the goals of a Muslim society.¹¹ The IDB is unique in that its capital is provided by its member states, which are Muslim countries, and it funds projects related to infrastructure development, poverty alleviation, access to education, and clean water and such. The IDB is dedicated to providing funding on a sustainable basis to various segments of the Muslim world to improve the well-being of the ummah in general. One may think of it as a world bank for Muslim countries. The existence of IDB created a unique problem of providing funds to member countries not on an interest basis but on shariah-compliant basis, and it is likely that within the halls of IDB meetings the first financial products were developed.

Institutions such as Accounting and Auditing for Islamic Financial Institutions sprang up when the idea of offering shariah-compliant financial products took germ as a commercially viable proposition for the private sector to adopt. Since 1971, when IDB was set up, other countries, like Pakistan, Malaysia, and Indonesia, also took the mandate to move their financial systems away from a riba-based structure to a more shariah-compliant alternative. Shariah advisors were placed within central banks and other regulating bodies to come up with a framework for “Islamic Banking and Islamic Insurance.” No other co...