Islamic finance

Islamic finance

Islamic finance

Islamic finance is based on Islamic law, ie Shariah.

Main principles:

  • Money should not be traded, ie Riba (interest) is not allowed.
  • Profits are generated from legitimate trade and assets based investments.
  • Alcohol, pornography, financial services, pork, armaments, tobacco and gambling, are not allowed.
  • Risks should be shared between Islamic banks and the company.

Murabaha:

  • This is an asset purchase financing.
  • Islamic bank buys asset for cash.
  • Islamic bank sells asset to customer on deferred payment terms.
  • Customer can make the payment by instalments and the ownership of the asset belongs to the customer.
  • The agreed (fixed) mark up for profit is disclosed to customer.

Ijara:

  • This is an asset lease financing.
  • Islamic bank buys asset for cash.
  • Islamic bank leases asset to the client who then pays by instalments.
  • Islamic bank is responsible for ownership obligations including maintenance, repair and insurance.
  • Clients does not own the asset as they only use the asset.

Sukuk:

  • This is an asset-backed bond issued by the company.
  • Company places the asset to the trust or Special Purpose Vehicle (SPV) which then sells the asset to investors via sukuk and gets cash.
  • Company then leases the asset back from investors under ijara contract.
  • Investors who buy the sukuk would effectively own the asset, ie if the asset condition is good, more profits could be distributed to investors.
  • When the sukuk matures, company purchases the asset back from investors. In this case, if the asset is impaired, investors would get less cash from the company, ie investors share profits from good asset conditions and risks from bad asset conditions.

Musharaka:

  • This is an equity financing arrangement between the bank and client.
  • Both parties provide capital for the project where losses from the project are shared based on the capital contribution by both parties.
  • Profits from the project could be shared between both parties based on their capital contributions or other pre-agreed ratios.
  • Both parties need to be involved in managing the project themselves.

Mudaraba:

  • This is an equity financing arrangement between the bank and client.
  • One party provides capital and one provides management skills to the project.
  • The party providing capital would bear losses from the project.
  • Both parties share profits from the project on a pre-agreed ratio.
  • The party providing capital does not involve in the project management, and therefore, agency problem arises between these two parties.

Case Study – Islamic finance

According to the Islamic Financial Services Board, the value of the global Islamic finance services exceeds $2.19 trillion in 2018 where it has matured in Muslim-majority business hubs in Saudi Arabia, Malaysia and the United Arab Emirates.

Exam rehearsal question:

Required:

Explain the differences between Islamic finance and other conventional finance. (4 marks)

Comment:

Interest:

Interest is allowed in conventional finance, for example, stated coupon rate in the debt finance.

However, Islamic finance does not allow interest (riba).

Law:

Activities allowed to be financed should comply with laws in the country when conventional finance is used.

However, Islamic finance requires activities need to follow Sharia law, ie no gambling is allowed.

Risks sharing:

Conventional banks may not share risks with another party if finance is provided, ie banks could obtain stated interests when though the project is not successful.

However, in Islamic finance, the use of Mudaraba contract states if losses occur in the project, only the capital provider (Islamic bank) suffers losses.

Benefits sharing:

Conventional banks may not share benefits with another party if finance is provided, ie banks could obtain stated interests even through the project is quite successful.

However, in Islamic finance, the use of Musharaka contract states if profits are yielded from the project, both the capital provider (Islamic bank) and the other party could share benefits jointly.

Tutorial note: any 4 points are required.

Exam rehearsal question:

Required:

In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial instruments. (5 marks)

Comment:

Riba:

Riba is not allowed in Islamic finance as interest may be compounded even if no activities are undertaken in the business which may cause financial troubles if parties could not repay that high amount of costs.

Financial instruments:

The use of Mudaraba contract states if losses occur in the project, only the capital provider (Islamic bank) suffers losses.

The use of Musharaka contract states if profits are yielded from the project, both the capital provider (Islamic bank) and the other party could share benefits jointly.

The use of Murabaha contract involves the Islamic bank buying the asset for the client and sells it to the client at an agreed price with disclosed mark up. Client is then allowed to pay at instalment to the Islamic bank.

The use of sukuk involves one party sells the tangible asset to the investor through a sukuk where funds are raised. Then sukuk matures, that party buys that asset back from the investor and by doing so, if the asset condition is worse when asset is bought back, the investor suffer would suffer a loss.

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