Islamic Banking&Finance

Introduction:

Let me briefly explain the principles of Islamic Finance and Banking, it means that we conduct business in a Shari’a compliant manner. Shari’a again is Islamic law, that derives its rulings from the Muslim holy book Qur’an and the Sunnah of the Prophet Muhammad pbuh, which is his sayings and actions. The most important thing to remember when we are speaking about Islamic Finance is that it is forbidden in Shari’a to involve yourself in interest, usury, gambling and other things deemed unpermissable . It’s clearly stated in the Qur’an:

“Oh those who believe, fear Allah and give up what still remains of the interest if you are believers. But if you do not, then listen to the declaration of war from Allah and His Messenger…” [2:278-279]

But one thing we have to understand is that trade is permissible and it’s not to be confused with the business of interest. So the trading in money is not allowed, meaning: Money is used as a measurement of value of a product, it is not an asset in itself.

Business deals also have to be completely transparent, if a deal is going to be signed then both parties have to be fully aware of all costs and obligations etc. For example, my father once told me to participate in a lottery with my cell phone by sending a text message, after sending it they started charging me for 20-30€ per month for some messenger program that I would never use. It was not stated anywhere that I would have to start paying this sum of money, this deal would hence have been deemed invalid in Shari’a and the company, that was deceiving the customer in this case me, would have been punished. Not to mention that it was lottery which is considered gambling in Shari’a which in itself is unlawful. Also, trading in businesses which are unlawful, such as alcohol or tobacco is not allowed.

The Islamic system also makes people think more on society rather than themselves and it transfers with the “Zakat” system, which means almsgiving, money from the rich to the poor. Any Muslim that has about 85 grams of pure gold which is about 1700€ of savings or capital is obliged to pay 2.5% of all his wealth to the poor annually.

So back to the core issue Finance& Banking. When people hear that Islamic banks are not allowed to involve themselves in the business of interest, everyone including most Muslims become very confused, we are brought up with the idea that the only way a bank can survive is with interest, but this of course is not true. Even the banks we are used to get a large part of their profits from interest free investments.

So how is it that the Islamic banks give out loans and actually generate a profit?

The Islamic Bank of Dubai reported a $304.9 million profit for the 9 first months of this year but how do they do it? This is where the Islamic modes of financing come in.

Islamic modes of Financing:

• Musharakah-Active Partnership
• Mudarabah-Partnership
• Murabahah-Sale

This might be a bit confusing for some people because Arabic terms will be used, but I will explain the meanings of these terms as I go on, it’s very important that these words are being used because these are the “real” terms.

1.Musharakah-Active Partnership

The actual word means “Sharing” and in business and trade it means that all the partners in a deal share the profit or loss.

Musharakah can be used when a company wants to invest in something and they don’t have enough own capital to do it. When they sign a Musharakah contract with an Islamic bank it means that the company will invest some of their money and the bank invests the rests and the two parties split the profit or loss according to a agreed ratio. So if a Musharakah deal is signed and the company invests $10 Million and the Bank $90 Million, the split on the profit or loss would usually be 10/90, other ratios can also be mutually agreed upon.

The way this differs from a conventional, interest bearing loan is that firstly the Islamic bank only gets money if the investment is profitable, the conventional gets its interest money either way. So the Bank is actually interested if the investment will bring in money or not. Secondly the interest bearing loan is viewed as unfair to either the debtor or the creditor. If the investment makes a huge profit the creditor still only receives the interest percentage and if the investment actually suffers loss then it’s unfair upon the debtor who still has to pay the interest and he might have to declare bankruptcy.

2.Mudarabah-Passive Partnership

Mudarabah is a agreement that is signed by two partners, a so called “rabb-ul-mal” and a “mudarib”

The “rabb-ul-mal” is the one who provides the capital and the “mudarib” the one who provides the work. The difference to “Musharakah” is that in this type of deal the investor “rabb-ul-mal” does not have a right to interfere with the management or the work, this is only done by the “mudarib”. This is why it’s called Passive Partnership. The ratio of the profit will be agreed before signing the contract, but in this deal there is no splitting of the loss, since only one party invests capital. The loss for the other party is that he will not have a job.

A good example of this is that one friend of mine wanted to open a electronics shop in my town, but he did not have the required capital to start the business so me and my friend thought that we could provide the capital and he would do the actual work and we would split the profit in a agreed manner. This is what Mudarabah is in a practical example. Unfortunately we have not signed the Mudarabah contract since we are poor students and lack the willpower.

3. Murabahah-Sales contract

Murabahah is the simplest of the Islamic modes of financing and some may even debate that it does not belong to the financing category. What Murabahah means is that a party does not have enough capital to buy something so the Islamic bank buys the product and sells it to the party with an increased price. So it’s a simple Sales contract. So if you don’t have money to buy a car worth $5000 I can buy the car and sell it to you for $5500. You will receive the ownership instantly but the payment can be transferred at a later date as agreed upon. That is Murabahah in a practical everyday situation. Some people might now say that this is the same as interest when it in reality is not, according to Shari’a, in Murabahah you are indeed increasing the sum of a product, but you are paying an increased sum on the actual product and not on money like you do in an interest bearing deal.

Islamic Mortgage:

Islamic Mortgage is when you buy a house in a Shari’a compliant manner, so as always no interest is allowed. The way to do this is with the so called Diminishing Musharakah, this means that the party that wants to buy a house will come up with 10-20% (usually) of the sum and the Islamic bank will invest the rest.

So if you want to buy a $300.000 worth house you invest $60.000 and the bank the remaining $240.000, and during a fixed time, let’s say 20 years you will pay back to the bank the sum that they invested and you will also pay a rent for the house, which is measured according to how much more you have to pay to the bank. So if the house you pay would normally have a rent of $1000 per month, and you already came up with 20% of the sum, then you will be paying $800 per month to the bank as rent, and as you pay off your loan the rent decreases.

Charitable loans:

The Islamic banks also give out so called, charitable loans to people in need. In this type of loan the debtor only pays back the loan and no increase. These loans can be issued to for example students.

Conclusion:

Some of the modes of financing are not what the Islamic banks are striving for, they are merely a step in the right direction, and although they are Shari’a compliant they are not the goal that they are striving for. We also have to remember that the current Islamic Finance is only about 35 years old, so it is indeed a very young branch and it is constantly being improved. The industry suffers a lot of challenges when the whole world is run on interest, but some countries have already changed their economics system. Countries like Sudan, Iran and Pakistan have succeeded in this. Even some Western banks such as Deutche Bank and HSBC have also opened Shari’a compliant branches. I hope that people have benefitted from this presentation and maybe it opened the eyes for some to understand that the interest bearing system is not the only one in this world, there is an alternative.