Evolution and Growth of Islamic Finance

Islamic Finance - The concept
 
The basis of Islamic Finance denounces usury, termed as riba 

(which is the lending or borrowing of money at Interest) but it doesn’t stop just there. The concept is more accurately that money has no intrinsic value – it is only a measure of value, and since money has no value itself, there should be no charge for its use.Therefore, Islamic Finance is said to be asset based as opposed to currency based whereby an investment is structured on exchange or ownership of assets, and money is simply the payment mechanism to effect the transaction. The basic framework of an Islamic Financial System is based on elements of Shariah, which governs Islamic societies. Shariah, the law of Islam, originates from two primary sources: The Quran, the Holy Book of the Muslims and its practices, and the Sunnah, the way of life prescribed as normative in Islam, based on the teachings and practices of Prophet Muhammad (pbuh). The other two sources are Ijama (The consensus of Shariah scholars) and Qiyas (The Analogy)   
 
The growth and development of Islamic Finance  
 
As mentioned, the basis of Islamic Finance is from the Shariah, so the concepts of Islamic Finance have been around since the origination of Islam itself. The practices of what we see today have been used throughout the last 1500 odd years across the modern Muslim world and beyond. However, the modern Islamic finance really originated in the 1960s, escalating with the petro-dollar boom of the 1970s when in 1975, the Islamic Development Bank was formed to promote acceptable financial practices according to Islam. While many banks originating in the Middle East strictly follow these principles, many also follow Western practices based on Islamic finance some follow both the practices. Interestingly, many of the international large banks (HSBC, UBS, Standard Charted and Citigroup are notable examples) all have Islamic banking arms, both in the Middle East and the West. The IMF published an article in 2008 which estimated that there are now more than 300 Islamic financial institutions operating in more than 75 countries at the end of 2007 and the numbers have substantially increase . With the industry sector maintaining a growth rate of 15% per annum over the last 10 years, it is predicted that this growth will continue or speed up in the coming years. The main reason for the growth stems from a number of sources like Muslims worldwide are starting to opt for Shariah compliant products that were not previously available to them. The increase in oil wealth of the Muslim nations in the Middle East and their decision to opt for Shariah compliant structured investments is making the western governments and conventional financial institutions consider using Islamic Finance, due to their increasing competitiveness and ethical focus, Islamic products are attracting both Muslims and non- Muslims. With Islam as the fastest growing religion in the world, and being the second largest religious group in the UK, USA and France, Islamic Finance is certainly likely to grow at a rapid pace.
 
The Principles of Islamic Finance
 
The principles of Islamic finance are laid down in the sharia, Islamic law. Islamic finance, comprising financial transactions in banks and non-bank financial institutions formal and non-formal financial institutions, is based on the concept of a social order of brotherhood and solidarity. The participants in banking transactions are considered business partners who jointly bear the risks and profits. Islamic financial instruments and products are equity-oriented and based on various forms of profit and loss sharing. As Islamic banks and their clients are partners, both sides of financial intermediation are based on sharing risks and gains: the transfer of funds from clients to the bank (depositing) is based on revenue-sharing and usually calculated ex post on a monthly basis1; the transfer of funds from the bank to the clients is based on profit-sharing (lending, financing), either at a mutually agreed-upon ratio as in the case of mudarabah or at a mutually agreed-upon fixed rate. Such ratios and rates vary between institutions and may also vary between contracts within the same institution, contingent upon perceived business prospects and risks. Islamic banking finances only real transactions with underlying assets; speculative investments such as margin trading and derivatives transactions are excluded. Lending, or financing, is backed by collateral; collateral-free lending would normally be considered as containing a speculative element, or moral hazard. Similarly, to avoid speculation and moral hazard, normally only investors with several years of successfully business experience are financed. The paying or taking of riba, interest, is strictly prohibited.
 
The same principle of partnership is applied to Islamic insurance. It is based on a collective sharing of risk by a group of individuals whose payments are akin to premiums invested by the Islamic banking institution in a mudarabah arrangement for the benefit of the group.
The fundamental principle of solidarity at the societal level finds its expression in a special category of financial products without remuneration, qard. Investors without adequate business experience who are considered high-risk may receive a moderate amount of financing on qard hasan terms, free of any profit-sharing margin, but usually repaid by installments and backed by collateral. Similarly (but rarely in Indonesia), depositors may save in an Islamic financial institution without receiving remuneration, usually with the expectation that the funds are used for social or religious purposes.
 
“A sound Shariah banking system that is competitive, efficient and compliant with prudential practices, and capable of supporting real economic sector through the implementation of share based financing and trades with real underlying transactions in the spirit of brotherhood and good deeds to promote well-being for all society.”
 
The Shariah Board
 
A Shariah board is a committee of usually a minimum of 3 Islamic Scholars, acting as an advisory board which issues a ruling as to whether a particular undertaking is in accordance with prescribed principles. What essentially this means is that the board look into specific investments and decide if the investment or process follows Shariah guidelines or is Halal (permissible, as opposed to Haram (meaning forbidden). Some think of it as a sort of due diligence for the customer. Others consider the board to be similar to compliance officers so that they do not have to worry that the investment follows the guidelines of Islamic Finance and its Shariah validity.
Shariah Boards for different companies will usually have different Scholars. However, the Shariah board consists of those that are knowledgeable in Shariah principles (Fiqh), either from economic, legal or religious standpoints and when working in the finance field, they will usually have Fiqh-al-Muamalat (law of dealings) knowledge and experience. They will also usually be members of either AAOIFI (Accounting and Auditing of Islamic Financial Institutions who are based in Saudi Arabia) or IFSB (Islamic Financial Services Board who are based in Malaysia).
 
Non-Muslims too are inclining towards Islamic Finance
 
It would seem obvious why Muslims would use Islamic Finance, but realistically, Muslims are only now being able to get the opportunity to do so, and while not all Muslims would necessarily shift, there is growing popularity. What is surprising is the growing number of non-Muslims taking up Islamic Finance. In the UK, Salaam Insurance, the UK’s first Takaful Company, has a significant part of their customer base made up from non-Muslims. This is in large part due to the conventional pricing of the product range but also due to the ethical nature of Islamic Finance itself. If products are developed using Islamic principles along with a Western approach, Islamic Finance could become an even more significant market over the coming years. After the impact of the excesses and greed by conventional banks in the run up to the credit crunch, the public, governments and financial institutions are all looking for a better way of managing money and a fair way of wealth distribution
 
The difference between Islamic and Conventional Financing
 
If we took the example of purchasing a property again, it could be done in three possible ways – Musharaka, Murabaha and Ijara. The payments might be the same for all these processes as well as for the standard western practice of payment of interest used commonly for mortgages. The difference is that the rate of return is based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not necessarily on the financial impact. Some consider this as just a play on words but to Muslims there is an inherent difference in the way the transaction is carried out, and all based upon the previously mentioned prohibition of Riba. The intention is to avoid injustice and unfair enrichment at the expense of another party. It does not mean that Equities Bonds and Insurance is not acceptable in Shariah, it is permissible, so long as the company being invested in does not engage in the prohibited practices of Riba (interest). Conventional bonds are considered as Riba and thus not allowed. Instead there exists Sukuk (Islamic Bonds), which is an Islamic type of bond secured on assets and not debt. In general terms, the transaction is structured on an asset base, and so, if a series of payments arise from an asset based transaction, these can be traded at a market price.  The issue with conventional insurance is its interest based nature, the uncertainty of returns and removal of risk from one party to another. Instead, Takaful (mutual insurance) is based upon the notion of shared responsibility and provides for shared financial security, so that, in theory, members contribute to a pot, not for the result of profit, but in case one of the members suffers misfortune in their investments. Takaful is thus not based on gaining interest, but really to insure against any losses incurred. 2008 saw the launch of the UK’s first Takaful company and there is expectation of more to follow.
 
The products / instruments offered in Islamic Finance system
 
Murabaha (Cost-plus sale)
 
Murabaha essentially is undertaking a trade with a markup and is used for short-term financing, similar in form to purchase finance. An example would be a bank purchasing a tangible asset of some sort from a supplier with the resale based on the cost plus an agreed mark up. This is most often used to finance property, since the bank would not be allowed to charge interest on any 3 loan. Once such a debt covenant is in place between a bank and the customer, repayments can begin until a completion point where the asset is transferred to the customer. There is no exposure to variations in interest rates as there is a fixed markup percentage, identified at the outset.
 
Ijara (Islamic Leasing)
Ijara is a leasing contract whereby one party leases an asset for a specific amount of time and cost from another party, usually a bank. The bank would bear all the risk and a portion of the installment payment goes towards the final purchase of the asset at the time of transfer of asset. This can also be set up as a lease-purchase contract for the term of the asset’s specified lifetime.
 
Musharaka (Equity Participation)
There is very little difference between this and a joint venture agreement. The parties involved contribute in varying degrees of assets, technical expertise etc. and agree to a percentage of the returns as well as the risk. All parties must invest a certain amount of capital. In the case of purchasing a property under this sort of arrangement, it is purchased by both the bank and the customer together, and the repayments made are partly rent and partly a buyback. Mudaraba (Partnership Financing)
Mudaraba is very similar to Musharaka and is a trustee type finance contract under which one party provides the labour while the other provides the capital.
 
Istinaa (Commissioned Manufacture)
Istinaa is the solution for manufacture of goods since speculation prevents the selling of something that one does not yet own. With a promise to produce a specific product that can be made under certain agreed specifications at a determined price and on a fixed date, an Istinaa contract is established. Specifically, in this case, the risk taken is by a bank that would commission the manufacture and sell it on to a customer at a reasonable profit for undertaking this risk.