Islamic Finance For Dummies pdf

ISLAMIC FINANCE FOR DUMMIES – Book Sampleas

Contents

• About This Book
• Conventions Used in This Book What You’re Not to Read Foolish Assumptions
• How This Book Is Organized
• Part I: The Basics of Islamic Finance
• Part II: Introducing Islamic Commercial Law Part III: Eyeing Islamic Banking Operations
• Part IV: Islamic Investment Markets: Equity and Bonds Part V: Reporting, Corporate Governance, and Supervision
• Part VI: Islamic Insurance: Takaful Part VII: The Part of Tens
• Icons Used in This Book Where to Go from Here
• Part I: The Basics of Islamic Finance
• Chapter 1: Easing into Islamic Finance
• Defining the Concepts and Principles of Islamic Finance
• Searching for balance
• Believing that Allah is the owner of all wealth Promoting a responsible free-market economy Citing
• key principles that Islamic firms follow
• Identifying Types of Islamic Financial Products
• Products based on equity participation (profit and loss sharing)
• Products based on investment financing (sale and lease contracts)
• Products for social development Islamic funds
• An alternative to bonds: Sukuk Islamic insurance
• Introducing Islamic Financial Institutions
• Realizing Why Islamic Finance Is in Demand — and Growing
• Chapter 2: Getting to Know Islam and the Role of Sharia
• Introducing the People of Islam
• A Brief History of the Islamic Religion
• Revelations to the Prophet Muhammad (pbuh) Migration to Medina
• Compiling the Quran Composing sunnah and hadith
• Exploring the framework of sharia
• The Core Beliefs of Islam The Pillars of Islam
• Adhering to a Code of Conduct: Sharia
• Being wary of radicalism
• Respecting Muslim beliefs about the purpose of sharia
• Considering the objectives of Islamic law Noting the areas of life governed by sharia Citing the
• sources of Islamic law
• Chapter 3: The History of Islamic Finance
• Looking Way Back: The Golden Age of Islam
• The sixth century: Pioneering venture capital (mudaraba)
• The seventh through ninth centuries: Developing commercial instruments
• The 11th century: Applying the mudaraba concept in Europe
• The 13th century: Slowing the progress of Islamic finance
• Recognizing Developments in Early 20th-Century Thought
• Writing the future: Muslim economists in the 1900s Getting the ball rolling: The Mit Ghamr Savings
• Bank and Tabung Haji
• Moving into the Modern Industry
• Establishing the Islamic Development Bank Opening other Islamic banks
• Creating additional industry sectors
• Setting accounting and auditing standards with the AAOIFI
• Using Islamic banking concepts in the West Introducing international Islamic indexes Setting up the Islamic Financial Services Board
• Chapter 4: Touring the Islamic Finance Industry Looking at Current Islamic Financial Institutions
• Islamic banks
• Islamic investment fund operators
• Islamic indexes for benchmarking the industry Islamic bond (sukuk) issuers
• Islamic insurance (takaful) providers Accounting standards
• Considering the Impact of the Global Credit Crises Gazing into the Crystal Ball of Islamic Finance
• Studying recent growth Anticipating worldwide expansion
• Eyeing Industry Challenges
• Dealing with regulatory and tax issues
• Help wanted: Finding trained and skilled Islamic bankers
• Satisfying sharia scholars: The search for compliant products
• Educating clients and crossing the language barrier
• Part II: Introducing Islamic Commercial Law Chapter 5: Adhering to Islamic Commercial Ethics
• Considering the Role of Business Ethics A Quick Primer on Islamic Values
• Promoting justice and benevolence Being stewards of the earth Moderating consumption Developing
• positive characteristics Helping and caring for others
• Connecting Islamic Values to the World of Commerce
• Honoring Islam while supporting material pursuits Insisting on sincere salesmanship
• Advertising in socially responsible ways Searching for ethical market mechanisms Seeking a just
• relationship with employees Respecting sharia prohibitions
• Chapter 6: Focusing on Contracts
• Starting with Sharia Compliance
• Citing the Sources of Sharia and Islamic Commercial Contracts
• Consensus among Islamic scholars: Ijma Analogy: Qiyas
• Minor sources
• Introducing Islamic Contract Law
• Understanding the unilateral promise (wa’d) Recognizing a bilateral promise (muwaada) Entering a
• contract (’aqd)
• Classifying Contracts
• Effect of the contract Use of the contract
• Part III: Eyeing Islamic Banking Operations
• Chapter 7: Contrasting Conventional and Islamic Commercial Banking
• Reviewing the Functions of Commercial Banks
• Exploring primary functions Delving into secondary functions
• Studying the Structure of a Commercial Bank
• Stockholders Board of directors Audit committee
• Chief executive officer (CEO) Operational-level management Business segments
• Differentiating between Conventional and Islamic Commercial Banks
• The oversight of a sharia board
• Concepts of money and the basis of transactions Relationships with clients or customers
• Investments in the bank
• Chapter 8: Charting the Relationship between Conventional and Islamic Banks
• Understanding the Nature of Individual Banks’ Cooperation
• Connecting across borders Issuing letters of credit
• Representing each other (for a commission) Offering sharia-compliant windows at conventional banks
• Exchanging funds
• Banking on Financial Industry Common Ground
• Transferring information Developing human resources Providing technical assistance
• Observing Regulations of Central Banks
• Focusing on primary functions of central banks Seeing how Islamic banks fit into national banking
• systems
• Chapter 9: Tracing the Sources and Uses of Funds in Islamic Banks
• Discovering the Sources of Bank Funds
• Capitalizing on bank capital: Money in hand Focusing on borrowed funds
• Working with Debt Instruments Borrowing Funds from Other Banks Attracting Deposits
• Checking into current accounts Surveying savings accounts Eyeing investment accounts
• Realizing How an Islamic Bank Uses Funds
• Keeping some cash Purchasing fixed assets Funding financial instruments Serving the community
• Chapter 10: Familiarizing Yourself with Islamic Financial Instruments
• Discovering What Islamic Financial Products Are Available
• Examining Equity Financing Products
• Sharing the profit and loss with venture capital (mudaraba)
• Supporting joint ventures (musharaka)
• Figuring Out Asset-Based Financing Instruments
• Making purchases with cost plus profit (murabaha) contracts
• Reverse murabaha (tawarruq) Leasing or renting (ijara)
• Financing construction projects or purchase orders (istisna)
• Talking about Trade Financing Instruments
• Deferred payment sale (bay al-muajil) Purchase with deferred delivery (salam)
• Part IV: Islamic Investment Markets: Equity and Bonds Chapter 11: Introducing the Islamic Capital
• Market
• Eyeing the Origins of the Islamic Capital Market
• Pioneering Islamic investment funds Opening the door for Islamic bonds (sukuk)
• Meeting demand for additional market instruments
• Adhering to Criteria for Islamic Investments
• Fleeing from forbidden industries Forgetting about financial market trading
• Respecting Investors’ Objectives
• Searching for safety
• Hoping for worthwhile returns Seeking capital gains Maintaining liquidity
• Shopping at the Islamic Capital Market
• NASDAQ Dubai Bursa Malaysia
• London Stock Exchange
• Labuan International Financial Exchange Luxembourg Stock Exchange
• Tadawul (the Saudi Arabian stock exchange) Tapping into the Islamic Equity Market
• Managing Islamic equity funds
• Weighing pros and cons of investing in Islamic equities
• Going international with Islamic indexes Understanding the Islamic unit trust and mutual funds
• market
• Investing in Islamic exchange- traded funds (IETFs)
• Diversifying with the Sukuk (Islamic Bond) Market Developing the Islamic Derivative Market
• Tracking Industry Trends for Islamic Funds Promoting International Islamic Capital Markets
• International Islamic Financial Market Malaysia International Islamic Financial Center
• Chapter 12: Managing Assets in Islamic Investments
• Considering the Contracts That Support Sharia- Compliant Funds
• Mudaraba funds
• Ijara (leasing) funds Murabaha (cost plus) funds
• Seeing Commodity and Equity Funds in Action
• Commodity funds Equity funds
• Screening Stocks for Islamic Investments
• Avoiding prohibited industries Passing the financial test
• Purifying a Fund of Noncompliance
• Conducting screening reviews Taking action on noncompliance
• Benchmarking the Performance of Islamic Funds: Islamic Indexes
• Dow Jones Islamic Market (DJIM) indexes S and P Shariah indexes
• FTSE Bursa Malaysia Hijrah Shariah Index MSCI Global Islamic Indices
• Developing New Methods for Managing Market Risk
• Identifying the issues
• Creating products that mitigate market risk
• Chapter 13: Investing in Islamic Bonds: Sukuk Defining Sukuk
• Reviewing how conventional bonds work Realizing how sukuk differ
• Putting bonds and sukuk side-by-side
• (Usually) Trading Sukuk Like Conventional Bonds Earning Credit Quality Ratings
• Walking through the Process of Issuing Sukuk
• Identifying the parties involved
• Setting up the sukuk’s general structure Creating the SPV for acquiring assets Insuring sukuk
• purchases
• Listing Types of Sukuk
• Sukuk al mudaraba (sukuk based on equity partnership)
• Sukuk al murabaha (cost plus or deferred payment sukuk)
• Sukuk al-salam (deferred delivery purchase sukuk) Sukuk al-ijara (lease-based sukuk)
• Sukuk al musharaka (joint venture sukuk) Sukuk al istisna (Islamic project bond) Innovative sukuk
• Charting the Growth of Sukuk
• Part V: Reporting, Corporate Governance, and Supervision
• Chapter 14: Issuing Financial Statements Getting a Financial Statement Refresher
• Recognizing the most commonly issued statements Spotting statement users
• Issuing statements publicly and regularly Focusing on statements for financial institutions
• Walking through the Balance Sheet
• Assets Liabilities
• Investigating the Income Statement
• Income Expenses Tax/zakat
• Noting Unique Financial Statements Used by Islamic Financial Institutions
• Applying Specific Accounting Standards Chapter 15: Considering Corporate Governance
• Clarifying What Corporate Governance Looks Like Appreciating the Role of Corporate Governance in
• Financial Institutions
• Meeting the Stakeholders of Islamic Financial Institutions
• Shaping Islamic Corporate Governance to Meet Specific Needs
• Ensuring compliance through sharia governance Recognizing why account holders care about corporate
• governance
• Setting aside reserves to mitigate investment risk and equalize profit
• Implementing Basic Elements of Good Governance in Islamic Finance
• Striving for accountability and transparency Managing risk
• Developing internal control systems Conducting audits
• Following the Guiding Principles of IFSB
• Chapter 16: Supervising Operations: The Sharia Board
• Adapting the Sharia Board to a Rapidly Changing Industry
• Finding its legs: The first two decades of the industry
• Gaining confidence: The development of new products in the 1980s
• Establishing key standards as the industry goes global
• Who’s Who: Outlining the Structure of a Sharia Board Holding a Seat: Sharia Board Membership
• Listing the qualifications
• Eyeing potential issues surrounding sharia board membership
• Recognizing the Sharia Board’s Role
• Assuring operational compliance Reviewing new products
• Performing other compliance- related functions
• Considering Real-World Models of Sharia Corporate Governance
• Chapter 17: Managing Risk in Islamic Financial Institutions
• Realizing the Business Necessity of Risk Management Knowing Where the Buck Stops: The How and Who
• of Risk Management
• Seeing How Risk Management Is Different for Islamic Financial Firms
• Sharing risk with stakeholders
• Playing catch-up with the more established conventional system
• Grappling with Generic Risks
• Minimizing credit risk Keeping market risk in check Lessening liquidity risk Managing operational
• risk Rising above reputation risk
• Dealing with Risks Unique to Islamic Finance
• Examining equity investment risk Coping with displaced commercial risk Facing rate of return risk
• Avoiding sharia noncompliance risk
• Part VI: Islamic Insurance: Takaful
• Chapter 18: Takaful: Exploring the Fundamentals of Islamic Insurance
• Appreciating the Need for Takaful
• Lacking certainty Gambling with premiums Collecting interest
• Exploring Takaful
• Grasping the principles behind takaful Identifying the parties involved Noting key features of
• takaful Introducing takaful structures
• Examining the Evolution of Takaful
• Eyeing the Future Growth of the Takaful Industry
• Chapter 19: Takaful and Retakaful Products, Structures, and Governance
• Checking Out General Takaful Products
• Individual general takaful products Business general takaful products
• Exploring Family Takaful Products
• Applying participants’ contributions Assisting policyholders
• Exploring family takaful products
• Understanding Takaful Structures
• Wakala model: The principal-agent relationship Mudaraba model: Partnership
• Combination model: Principal-agent relationship and partnership
• Getting Familiar with Retakaful (Reinsurance)
• Gauging the necessity of retakaful Seeing how retakaful works
• Spotting some of the players in the retakaful industry
• Noting the Role of the Sharia Board in Takaful Companies
• Part VII: The Part of Tens
• Chapter 20: Ten Reasons the West Should Pay Attention to Islamic Finance
• Islamic and Conventional Finance Can Coexist The Industry Is Poised for Growth
• The Gulf Is Rich in Oil (and Cash)
• The Muslim Population Is Large and Growing Quickly Muslim Customers Want and Need Sharia-Compliant
• Products
• Non-Muslim Investors Notice, Too Socially Responsible Investing Is Thriving
• Western Indexers and Rating Agencies Are in the Mix
• London Is Leading the Charge
• Globalization Is Here
• Chapter 21: Ten Economic Benefits of Following Islamic Principles
• Reducing Economic Disparity Inviting More People into the Markets
• Promoting Simplicity and Transparency
• Connecting Financial Markets and Economic Activity Linking Savings and Investment
• Avoiding Economic Bubbles (And Bursts) Spurring Economic Development Encouraging Longer-Term
• Investment
• Reducing the Impact of Harmful Products and Practices Striving for Greater Stability
• Appendix: Glossary
• Cheat Sheet

Islamic and Conventional Finance Can Coexist

Since the tragedy of September 11, 2001, distrust of Islam, sharia law, and Muslims in general has become the norm in some U.S. communities. The media has a habit of playing into people’s fears by running stories about interpretations of sharia law that lead to honor killings, suicide bombings, and other violence.

If you’ve read any other chapters in this book, you may already realize that the sharia code of conduct doesn’t, in and of itself, advocate such violence. Instead, the primary focus of sharia is the promotion of social justice. As with other belief systems, interpretations of source material differ. And the people who act on the most radical interpretations tend to be the most newsworthy.

A financial industry built on sharia compliance doesn’t threaten the Western world or seek to undermine conventional financial structures. Instead, it recognizes that for some people, especially (but not exclusively) Muslims, traditional banking, investment, and insurance products don’t fit the bill. Such products violate a code of conduct by which many Muslims strive to live, and so demand exists for new financial products that meet those folks’ needs.

A vibrant Islamic finance industry can and will exist in the future alongside its conventional counterpart. In fact, the Islamic financial industry will thrive in part because its conventional counterpart recognizes its value and makes an

effort to participate in its success.

The Industry Is Poised for Growth

When I was born, the modern Islamic financial industry was still quite new. Since then, the industry has grown up and out to encompass new products, involve new markets, and attract many new customers. I expect the industry to mature in my lifetime, which means substantial growth will continue for many years to come.

As I note in Chapter 4, the global asset value of the Islamic finance industry in 2011 was estimated to be $1 trillion. By 2016, some experts project that amount to be $5 trillion — a huge increase. Predictions about the growth of Islamic finance institutions and instruments vary. Some say to expect 10 or 15 percent growth each year in the coming decade; others anticipate 30 percent growth per year or even more. Although the numbers differ, almost all industry experts are bullish about the Islamic financial industry’s outlook.

The Gulf Is Rich in Oil (and Cash)

A key factor influencing the optimistic perspective on the Islamic finance industry is the wealth concentrated in the countries of the Gulf Cooperation Council (GCC) — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. Almost half of the world’s oil and gas reserves are in the Gulf region, and although many governments are actively seeking to reduce their dependence on oil and gas, large-scale alternative energy projects will take time to develop. Meanwhile, oil and gas are energy mainstays.

Some of the world’s wealthiest countries and individuals are looking for sharia-compliant products in which to invest. A 2012

 Trade Arabia article about the economic outlook for the GCC notes that while the U.S. economy tries to recover and Europe continues to struggle with its debt crises, GCC nations are liquid and well-capitalized. In fact, the article notes that determining how to safely invest extra funds in an uncertain economy is an obstacle for the region. As more sharia-compliant products emerge to fulfill customer objectives (including returns and liquidity), more Gulf wealth — more global money, period — will funnel into Islamic financial products.

The Muslim Population Is Large and Growing Quickly

From just 2008 to 2010, the global Muslim population grew from approximately 1.3 billion to 1.6 billion; that’s an increase of about 300 million people in just two years. And some people predict that it will jump another 35 percent by 2030 — nearly twice as fast as the non-Muslim population — to account for more than a quarter of the projected world population. If a reasonable number of those people seek out sharia-compliant financial products, the Islamic financial industry will soon be in high demand.

Although much of the growth will occur in the Asia-Pacific region, the West will see part of it as well. Projections in Europe, for example, indicate that the Muslim population will reach 58 million by 2030 (it was 44 million in 2010). In the United States, the population was 2.6 million in 2010 and is projected to reach

6.2 million by 2030.

Muslim Customers Want and Need Sharia-Compliant Products

Muslim population statistics represent real people who are a captive market of the Islamic finance industry — people with religious beliefs that drive them toward sharia-compliant products. I cover sharia compliance in detail throughout this book; basically, it means adherence to certain restrictions of Islam. For example, Muslims are prohibited from participating in interest-based transactions, gambling, creating or consuming products made from pork, supporting the creation of weapons of mass destruction, and more. Just this abbreviated list of prohibitions offers an idea of why sharia-compliant Muslims can’t put their money into conventional banks or purchase conventional investment instruments.

Muslims want and need financial products that offer the same types of rewards everyone seeks (such as security for their savings and rewards for their investments) without compromising their moral code. The global financial industry is paying attention to population projections and preparing to meet the needs of its future customers.

Non-Muslim Investors Notice, Too

When capital markets get as rocky as they have been since 2007, investors look to reduce risk while still earning a profit. Although no one can predict the future volatility or stability of Western markets, the lessons of 2007 and 2008 will stick with investors for quite some time. When products enter the market that offer the potential for increased portfolio diversification and reduced risk, customers take note.

 Islamic investment products are very different from conventional equity and bond funds. (For a conventional investor, this diversity may be attractive.) As I explain in Part IV, Islamic investments are based on business contracts that increase transparency and reduce speculation so that all contract partners (including investors) know what to expect and what risks are involved. In addition, screening equities for sharia compliance includes looking closely at companies’ financial ratios to eliminate those that, say, carry too much debt.

The end result of such diligence on the part of Islamic fund developers is that sharia-compliant investment products often involve less risk than their conventional counterparts. (Note that I say less risk; sharia compliance doesn’t eliminate risk.) For this reason — and because knowledge of the industry itself is growing, especially among the world’s wealthiest investors — I believe that Islamic financial products will attract even greater numbers of non-Muslim customers in the future.

Socially Responsible Investing Is Thriving

Sharia law promotes social justice, and sharia-compliant investments are a subset of a larger trend: socially responsible investing (SRI). As I note in Chapter 11, SRI is a broad term that refers to making investment choices in support of companies whose activities mesh with your values.

Investors who seek out SRI must do their homework before making decisions about where to place their money. SRI requires transparency from investment funds because investors don’t want to unknowingly support industries they oppose.

 Therefore, fund managers must consistently screen companies to determine whether (in their core business or any subsidiary business) the companies participate in activities the investors want to avoid. In other words, socially responsible investors look for fund managers to do exactly what Islamic fund managers already do.

According to The Forum for Sustainable and Responsible Investment (ussif.org), in 2010 more than $3 trillion in total assets (including $1 out of every $8 of professionally managed

U.S. investments) were being sustainably and responsibly managed. As public knowledge of Islamic investments grows, I anticipate that investors (including non-Muslims) who are already seeking out socially responsible funds will increasingly find that sharia-compliant funds meet some of their investment needs.

Western Indexers and Rating Agencies Are in the Mix

The emergence of Islamic indexes is a huge industry development (see Chapter 12). The first player in the Islamic indexing field was none other than Dow Jones Indexes, and it has been joined by Standard & Poor’s, FTSE, and MSCI. The result is that Western investors have access to benchmarks that track the performance of the Islamic finance industry in ways that are familiar and build confidence.

Similarly, Western investors who consider purchasing sukuk, the Islamic alternative to conventional bonds, can now compare sukuk by using the ratings systems so familiar to bondholders (see Chapter 13). The Dow Jones Sukuk Index, created in 2006, was the first of its kind. And Standard & Poor’s, Moody’s, and

 Fitch now all rate sukuk products by using the same ratings systems they use for conventional bonds. Familiarity with these agencies and the tools they use to communicate the strength and risk of bond products gives Western investors confidence and comfort, which will undoubtedly lead to greater participation in the Islamic capital markets.

London Is Leading the Charge

Just as having Dow Jones Indexes and Standard & Poor’s involved in the Islamic capital markets may comfort Western investors, so may the knowledge that one of the world’s largest centers of Islamic finance is London, England. With about two dozen British banks providing Islamic finance services, managing approximately $19 billion in assets as of 2011, the nation’s Islamic finance sector ranks ninth in the world. A natural extension of this market’s size is that more education outlets offer Islamic finance training in Britain than anywhere else.

Certainly, many more Muslims live in Europe than in the U.S., so the captive market for Islamic financial products there is much larger. But Western financial professionals as a whole can’t ignore the size and growth of London’s Islamic banking sector.

Britain’s role as an industry leader demonstrates how effectively Islamic and conventional financial systems can coexist and support each other. And I think London’s example will influence other Western nations to develop their own Islamic banking industries.

Globalization Is Here

 In the past, most companies could build a solid business just by

serving or distributing products to a local, regional, or national customer base. These days, companies of all sizes can easily seek customers across the globe, and doing so has become a matter of survival. Western financial firms certainly recognize the need to tap into global markets, and technology makes it simple to transfer assets quickly among institutions thousands of miles apart.

The financial institutions that succeed in the new economy will be global entities that meet the needs of customers in every major market; many of those customers will be Muslims seeking sharia-compliant products. Governments that recognize this fact and want their financial sectors to thrive will alter their monetary policies to accommodate Islamic financial practices.

This process is already underway in some Western countries, including the United Kingdom, France, Germany, Luxembourg, and Russia. No matter how many misconceptions about sharia proliferate, businesspeople understand market share. It’s only a matter of time until the sheer size of the Islamic financial market prompts regulatory changes in other Western nations. (See

Chapter 4 for regulatory and tax barriers to Islamic finance.)