Frequently Asked Questions in Islamic Finance pdf

FREQUENTLY ASKED QUESTIONS IN ISLAMIC FINANCE -Book Sample

Preface – FREQUENTLY ASKED QUESTIONS IN ISLAMIC FINANCE

The ongoing turbulence in the global financial markets has drawn attention to an alternative system of financial intermediation, Islamic banking and finance. This sector of the financial markets has so far remained on the side­ lines of this turbulence. It is a sector which has undergone rapid growth in recent years. Despite this growth the financial community remains largely uninformed as to the key characteristics of the industry.

But what exactly is Islamic banking and how does it work? This short text is designed to answer the frequently asked questions almost always raised, by non-specialists, whenever the subject of Islamic banking gets mentioned. It is literally FAQs. Readers seeking more specialized knowledge need to refer to some of my other publications listed earlier.

Even amongst conventional bankers there is much misunderstanding as to what Islamic banking is all about. If you ask a conventional banker what Islamic banking is, he will mumble something about religion. He will then say, ‘Well they cannot charge interest but they use something else which

is the same thing’. This ‘something else’, incidentally, is never defined. The banker will then move on to describe Islamic banking as being about smoke and mirrors. To conclude, he will then profoundly

If pushed to actually describing an Islamic financial instru­ ment or, even worse, to define some Islamic terminology such as Murabaha or Mudaraba, then the banker’s eyes will start to gloss over.

Frankly, this stereotyped image is all too prevalent within the banking world. In an endeavour to both enlighten con­ ventional bankers and broaden the understanding of Islamic banking principles these FAQs attempt to answer some of the key issues involved which distinguish Islamic banking from conventional banking.

As the reader will learn, Islamic banking is not about smoke and mirrors. It is in fact about banking based on Islamically ethical principles which are, in many ways, very different indeed from conventional banking principles.

The earliest history of Islamic banking goes back to attempts by Muslim Brotherhood members in the early 1930s to establish Islamic banking in India, an experiment which failed. Egyptian President Gamal Abdel-Nasser shut down the second attempt in 1964, after only one year, later arresting and expelling the Muslim Brothers.

Islamic banking is a banking system that is consistent with the Sharia’a (Islamic law) and, as such, an important part of the system is the prohibition on collecting and paying interest (riba, in Arabic). The Sharia’a also prohibits trading in financial risk because this is seen as a form of gambling,

something forbidden in Islam. Another prohibition under the Sharia’a is that Muslims cannot invest in businesses that are considered haram (forbidden or sinful) such as those that sell alcohol and pork, engage in gambling or produce un- Islamic media.

The central religious precept driving the Islamic finance industry is the idea that riba is haram. At first glance, this appears to rule out most aspects of modern finance. But although the Qur’an bans the creation of money, by money, it does allow money to be used for trading tangible assets and businesses – that can then generate a profit.

Consequently, Islamic financial products are designed to create trading or business arrangements that pay profits to investors from business transactions backed by tangible assets, ideally sharing risk and rewards.

The structure of an Islamic bank is radically different from its conventional counterpart. A conventional bank is primarily

a borrower of funds on the one hand and a lender on the other. An Islamic bank is rather a partner with its depositors, as well as with entrepreneurs, sharing profit or loss on both sides of the balance sheet.

Another distinction is that a conventional bank would not stop charging interest even if the deployment of its capital fails to bear profit for the entrepreneur, whereas an Islamic bank cannot claim to have a right to profit if the outcome is a genuine loss.

Islamic banks have been operating in places such as Bahrain, Saudi Arabia, Malaysia and Dubai for some time. Conventional bankers have traditionally viewed the sector as a small, exotic niche, focused on household investors. But in the past ten years something extraordinary has occurred behind the scenes.

Several Western investment banks have increasingly started working with Muslim clerics to create a new range of finan­ cial products designed for devout Muslims. Somewhat sur­ prisingly, many argue, these have also been welcomed by non-Muslims. The new Islamic banking products range from simple savings schemes or mortgages, to the type of complex capital market products that large corporations and govern­ ments use to raise billions of dollars.

Some devout Muslims view this trend with dismay, claim­ ing that it perverts the true spirit of their religion. However, many more welcome it.

Estimates of the size of the Islamic finance industry currently vary wildly from $700 billion to $800 billion. However, whatever the numbers, everyone agrees that the business is expanding rapidly.

The increased demand for Muslim financial institutions in the West has, as mentioned, prompted Western firms to begin providing these services. HSBC, Lloyds Bank, Deutsche Bank, BNP and Citigroup are among the most notable examples of Western firms adapting to tap these new funds.

What Exactly Is Islamic Banking All About?

Islamic financial institutions are those that are based, in their objectives and operations, on Qur’anic principles. They are thus set apart from ‘conventional’ institutions, which have no such religious preoccupations. Islamic banks provide com­ mercial services which comply with the religious injunctions of Islam. They provide services to their customers free of interest, (the Arabic term for which is riba), and the giving and taking of interest is prohibited in all transactions. This prohibition makes the Islamic banking system differ funda­ mentally from the conventional banking system.

Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is

loaned and the amount of the loan. In historical times, there was a fierce debate as to whether riba relates to interest

or usury, although there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.

The term riba, in Islamic law (the Sharia’a), means an addi­ tion, however slight, over and above the principal. According to the Federal Sharia’a Court of Pakistan, this means that the concept covers both usury and interest; that it applies to all forms of interest, whether large or small, simple or com­ pound, doubled or redoubled; and that the Islamic injunction is not only against exorbitant or excessive interest but also against even a minimal rate of interest. Financial systems based on Islamic tenets are therefore dedicated to the elimi­ nation of the payment and receipt of interest in all forms. It is this taboo that makes Islamic banks and other financial insti­ tutions different, in principle, from their Western conventional counterparts.

There are a range of modern interpretations of why riba is considered haram (forbidden) but these are strictly secondary to the religious underpinnings.

The fundamental sources of Islam are the Holy Qur’an and the Sunnah, a term which in Ancient Arabia meant ‘ancestral precedent’ or the ‘custom of the tribe’, but which is now syn­ onymous with the teachings and traditions of the Prophet Mohammed as transmitted by the relaters of authentic tradi­ tion (hadith). Both of these sources treat interest as an act of exploitation and injustice and, as such, it is inconsistent with Islamic notions of fairness and property rights. While it is often claimed that there is more to Islamic banking than this, such as its contribution towards economic development and a more equitable distribution of income and wealth, its increased equity participation in the economy, and so on, Islamic banking, nevertheless derives its specific raison d’eˆtre from the fact that there is no place for the institution of inter- est in the Islamic order.

This rejection of interest poses the central question of what replaces the interest rate mechanism in an Islamic framework. Financial intermediation is at the heart of modern financial systems. If the paying and receiving of interest is prohibited, how do Islamic banks operate? Here, profit and loss shar­

ing (PLS) comes in, substituting for interest as a method of resource allocation and financial intermediation.

The basic idea underlying Islamic banking can be stated simply. The operations of Islamic financial institutions primarily are based on a PLS principle. An Islamic bank does not charge interest but rather participates in the yield resulting from the use of funds. The depositors also share the profits of the bank according to a predetermined ratio. There is thus a partnership between the Islamic bank and its depositors on one side, and the bank and

its investment clients on the other side as a manager of depositors’ resources in productive uses. This is in contrast with a conventional bank, which mainly borrows funds paying interest on one side of the balance sheet and lends funds, charging interest, on the other. The complexity of Islamic banking comes from the variety (and nomenclature) of the instruments employed, and in understanding the underpinnings of Islamic law.

Six key principles drive the activities of Islamic banks:

1. predetermined loan repayments as interest (riba) is prohibited;
2. PLS is at the heart of the Islamic system;
3. making money out of money is unacceptable. All financial transactions must be asset-backed;
4. speculative behaviour is prohibited;
5. only Sharia’a approved contracts are acceptable;
6. the sanctity of contracts.

These principles, as applied to Islamic banking and finance, are set out below.

1. Predetermined payments are prohibited

Any predetermined payment over and above the actual amount of principal is prohibited. Islam allows only one kind of loan and that is qard al hassan (literally ‘good