Islamic Finance 2024 PDF

Islamic finance Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. Islamic finance can be seen as a unique form of socially responsible investment....

Islamic finance Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. Islamic finance can be seen as a unique form of socially responsible investment. Islamic finance began in the seventh century. The concept of risk sharing is central to Islamic banking and finance. It is essential to understand the role of risk-sharing in raising capital. At the same time, Islamic finance demands the avoidance of riba (usury) and gharar (ambiguity or deception). Three Principles Govern Islamic Finance Principle of equity: Scholars generally invoke this principle as the rationale for the prohibition of predetermined payments (riba), with a view to protecting the weaker contracting party in a financial transaction. The term riba, which means “hump” or “elevation” in Arabic, is an increase in wealth that is not related to engaging in a productive activity. The principle of equity is also the basis for prohibiting excessive uncertainty (gharar) as manifested by contract ambiguity or elusiveness of payoff. Transacting parties have a moral duty to disclose information before engaging in a contract, thereby reducing information asymmetry; otherwise the presence of gharar would nullify the contract. Principle of participation: Although commonly known as interest-free financing, the prohibition of riba does not imply that capital is not to be rewarded. According to a key Shari’ah ruling that “reward (that is, profit) comes with risk taking,” investment return has to be earned in tandem with risk- taking and not with the mere passage of time, which is also the basis of prohibiting riba. Principle of ownership: The rulings of “do not sell what you do not own” (for example, short-selling) and “you cannot be dispossessed of a property except on the basis of right” mandate asset ownership before transacting. Islamic finance has, thus, come to be known as asset-based financing, forging a robust link between finance and the real economy. It also requires preservation and respect for property rights. C. Key Instruments of Islamic Finance In Islamic finance, the term “loan” refers only to a benevolent loan (qard al hasan), a form of financial assistance to the needy to be repaid free of charge. Other instruments of Islamic finance are not referred to as “loans’ but rather as financing modes falling under one of the three categories: Profit- and-loss sharing (PLS), non-PLS contracts, and fee-based products. PLS Financing Products PLS financing is closest to the spirit of Islamic finance. Compared with non-PLS financing, its core principles of equity and participation, as well as its strong link to real economic activities, help promote a more equitable distribution of income, leading to a more efficient allocation of resources. There are two types of PLS financing: musharakah and mudârabah. Musharakah is a profit-and-loss sharing partnership and the most authentic form of Islamic financing. It is a contract of joint partnership where two or more partners provide capital to finance a project or own real estate or movable assets, either on a permanent or diminishing basis. Partners in musharakah have a right to take part in management; they seem to bear the greatest risk among all Islamic financing modes with the potential for earning the highest reward. However, whereas profits are distributed according to pre-agreed ratios, losses are shared in proportion to capital contribution. Mudârabah is a profit-sharing and loss-bearing contract where one party supplies funding (financier as principal) and the other provides effort and management expertise (mudarib or entrepreneur as agent) with a view to generating a profit. The share in profits is determined by mutual agreement but losses, if any, are borne entirely by the financier, unless they result from the mudarib’s negligence, misconduct, or breach of contract terms. Mudârabah is sometimes referred to as a sleeping partnership because the mudarib runs the business and the financier cannot interfere in management, though conditions may be specified to ensure better management of capital. Islamic banks mainly make use of mudârabah financing to raise funds; mudârabah contracts are also used for the management of mutual funds. Practices related to legal and prudential frameworks governing Islamic banking activities. Musharakah can be limited (shirkat al-inan) or unlimited (mufawadah). In the case of shirkat al-inan, the musharakah is limited in scope to a specific undertaking; different shareholders have different rights and are entitled to different profit shares; and each partner is the agent only, but not the guarantor of the other partner. In the case of mufawadah, which is an unlimited and equal partnership, all participants rank equally in every respect (initial contributions and final profits), and every partner is both the agent and the guarantor of the other. Diminishing musharakah (musharakah mutanaqisa) is mostly used in home financing: one partner promises to buy the equity share of the other party gradually until the title of ownership of the equity is completely transferred to the buying partner. This type of contract is widely used in Iran. Non-PLS Financing Products Non-PLS contracts are most common in practice. They are generally used to finance consumer and corporate credit, as well as asset rental and manufacturing. Non-PLS financing instruments include murâbaḥah, ijārah, salam, and istisna’. Murâbaḥah: is a popular Shari’ah-compliant sale transaction mostly used in trade and asset financing. The bank purchases the goods and delivers them to the customer, deferring payment to a date agreed by the two parties. The expected return on murâbaḥah is usually aligned with interest payments on conventional loans, creating a similarity between murâbaḥah sales and asset-backed loans. However, murâbaḥah is a deferred payment sale transaction where the intention is to facilitate the acquisition of goods and not to exchange money for more money (or monetary equivalents) over a period of time. Unlike conventional loans, after the murâbaḥah contract is signed, the amount being financed cannot be increase in case of late payment or default, nor can a penalty be imposed, unless the buyer has deliberately refused to make a payment. Also, the seller has to assume any liability from delivering defective goods. Murâbaḥah transactions are widely used to finance international trade, as well as for interbank financing and liquidity management through a multistep transaction known as tawarruq, often using commodities traded on the London Metal Exchange (LME).However, in some jurisdictions, tawarruq transactions are not considered compliant with Shari’ah principles. Ijārah is a contract of sale of the right to use an asset for a period of time. It is essentially a lease contract, whereby the leaser must own the leased asset for the entire lease period. Since ownership remains with the leaser, the asset can be repossessed in case of nonpayment by the lessee. However, the leaser is also responsible for asset maintenance, unless damage to the leased asset results from lessee negligence. This element of risk is required for making ijārah payments permissible. A variety of ijārah takes a hire-purchase form, whereby there is a promise by the leaser to sell the asset to the lessee at the end of the lease agreement, with the price of the residual asset being predetermined. A second independent contract gives the These Shari’ah-compliant products are similar to conventional financial contracts based on mark-up sales and leasing contracts. The majority of Islamic financing (70 to 80 percent) takes the form of murâbahah (Demirgüc-Kunt, Klapper, and Randall, 2013). Recently, Sudan has set a 30 percent limit to murâbaḥah in banks’ financing portfolios. Tawarruq means in Arabic the acquisition of minted silver, or al wariq, against another asset. However, tawarruq has become controversial among Shari’ah scholars because of its divergence of its use from the spirit of Islamic finance. Under commodity murâbahah, a customer in need of liquidity or financing arranges for an Islamic bank to buy metals for that amount on his behalf. The bank then sells the metals to the customer at a mark-up that is payable over a period of time (overnight, one month, 12 months, etc.). In turn, the client immediately sells the metals on the spot market and obtains the needed liquidity. Tawarruq is most disliked by Shari’ah scholars when the borrower sells the commodity back to the original seller. lessee the option to buy the leased asset at the conclusion of the contract or simply return it to the owner. Salam is a form of forward agreement where delivery occurs at a future date in exchange for spot payment.13 Such transactions were originally allowed to meet the financing needs of small farmers as they were unable to yield adequate returns until several periods after the initial investment. A vital condition for the validity of a salam is payment of the price in full at the time of initiating the contract, or else the outcome is a debt-against-debt sale, which is strictly prohibited under Shari’ah. The subject matter, price, quantity, and date and place of delivery should be precisely specified in the contract. In the event that the seller can neither produce the goods nor obtain them elsewhere, the buyer can either take back the paid prices with no increase, or wait until the goods become available. Should one of the parties fail to fulfill their contract, the bank will get back its initial investment, but will have to accept the lost profit. To reduce exposure to credit risk, the bank may ask for a financial guarantee, mortgage, advance payment, or third-party guarantee. Istisna’ is a contract in which a commodity can be transacted before it comes into existence. The unique feature of istisna’ (or manufacturing) is that nothing is exchanged on the spot or at the time of contracting. It is perhaps the only forward contract where the obligations of both parties are in the future. In theory, the istisna’ contract could be directly between the end user and the manufacturer, but it is typically a three-party contract, with the bank acting as intermediary. Under the first istisna’ contract, the bank agrees to receive payments from the client on a longer-term schedule, whereas under the second contract, the bank (as a buyer) makes progress installment payments to the producer over a shorter period of time.