Islamic finance products, services and contracts

Overview

Islamic finance products, services and contracts are financial products and services and related contracts that conform with Sharia (Islamic law). Islamic banking and finance has its own products and services that differ from conventional banking. These include Mudharabah (profit sharing), Wadiah (safekeeping), Musharakah (joint venture), Murabahah (cost plus finance), Ijar (leasing), Hawala (an international fund transfer system), Takaful (Islamic insurance), and Sukuk (Islamic bonds). Sharia prohibits riba, or usury, defined as interest paid on all loans of money (although some Muslims dispute whether there is a consensus that interest is equivalent to riba). Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haraam ("sinful and prohibited"). As of 2014, around $2 trillion in financial assets, or 1 percent of total world assets, was Sharia-compliant, concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia.

Principles

To be consistent with the principles of Islamic law (Shariah) and guided by Islamic economics, the contemporary movement of Islamic banking and finance prohibits a variety of activities:

Paying or charging interest. "All forms of interest are riba and hence prohibited". Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to prevent use of interest. Investing in businesses involved in activities that are forbidden (haraam). These include things such as selling alcohol or pork, or producing media such as gossip columns or pornography. Charging extra for late payment. This applies to murâbaḥah or other fixed payment financing transactions, although some authors believe late fees may be charged if they are donated to charity, or if the buyer has "deliberately refused" to make a payment. Maisir. This is usually translated as "gambling" but used to mean "speculation" in Islamic finance. Involvement in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future is maisir and forbidden in Islamic finance. Gharar. Gharar is usually translated as "uncertainty" or "ambiguity". Bans on both maisir and gharar tend to rule out derivatives, options and futures. Islamic finance supporters (such as Mervyn K. Lewis and Latifa M. Algaoud) believe these involve excessive risk and may foster uncertainty and fraudulent behaviour such as are found in derivative instruments used by conventional banking. Engaging in transactions lacking "'material finality'. All transactions must be "directly linked to a real underlying economic transaction", which generally excludes "options and most other derivatives". Money earned from the most common type of Islamic financing—debt-based contracts—"must" come "from a tangible asset that one owns and thus has the right to sell—and in financial transactions it demands that risk be shared." Money cannot be made from money, as "it is only a medium of exchange." Risk and return on distribution to participants should be symmetrical so that no one benefits disproportionately from the transaction. Other restrictions include

A board of shariah experts is to supervise and advise each Islamic bank on the propriety of transactions to "ensure that all activities are in line with Islamic principles". (Interpretations of Shariah may vary by country, with it being most strict in Sudan somewhat less in Turkey or Arab countries, less still in Malaysia, whose interpretation is in turn more strict than the Islamic Republic of Iran. Mahmud el-Gamal found interpretations most strict in Sudan and least in Malaysia.) Islamic banking and finance has been described as having the "same purpose" (Institute of Islamic Banking and Insurance), or having the same "basic objective" (Mohamed Warsame), as conventional banking but operating in accordance with the rules of shariah law. Benefits that will follow from banning interest and obeying "divine injunctions" include an Islamic economy free of "imbalances" (Taqi Usmani)—concentration of "wealth in the hands of the few", or monopolies which paralyze or hinder market forces, etc.—a "move towards economic development, creation of the value added factor, increased exports, less imports, job creation, rehabilitation of the incapacitated and training of capable elements" (Saleh Abdullah Kamel). Other describe these benefits (or similar ones) as "principals" or "objectives" of Islamic finance. Nizam Yaquby, for example declares that the "guiding principles" for Islamic finance include: "fairness, justice, equality, transparency, and the pursuit of social harmony". Some distinguish between sharia-compliant finance and a more holistic, pure and exacting sharia-based finance. "Ethical finance" has been called necessary, or at least desirable, for Islamic finance, as has a "gold-based currency". Zubair Hasan argues that the objectives of Islamic finance as envisaged by its pioneers were "promotion of growth with equity ... the alleviation of poverty ... [and] a long run vision to improve the condition of the Muslim communities across the world."

Criticism Modernist/Minimalist critic Feisal Khan argues that in many ways Islamic finance has not lived up to its defining characteristics. Risk-sharing is lacking because profit and loss sharing modes are so infrequently used. Underlying material transactions are also missing in such transactions as "tawarruq, commodity murabahas, Malaysian Islamic private debt securities, and Islamic short-sales". Exploitation is involved when high fees are charged for "doing nothing more substantial than mimicking conventional banking /finance products". Haram activities are not avoided when banks (following the customary practice) simply take the word of clients/financees/borrowers that they will not use funds for unIslamic activities. Others (such as convert Umar Ibrahim Vadillo) agree that the Islamic banking movement has failed to follow the principles of shariah law, but call for greater strictness and greater separation from the non-Muslim world.

Overview of products, contracts, etc.

Banking makes up most of the Islamic finance industry. Banking products are often classified in one of three broad categories, two of which are "investment accounts":

Profit and loss sharing modes—musharakah and mudarabah—where financier and the user of finance share profits and losses, are based on "contracts of partnership". "Asset-backed financing", (also known as trade-based financing" or "non-PLS financing"), "debt-like instruments" which are based on "debt-based contracts" or "contracts of exchange". They are structured as sales and allow for "the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money". They involve the financing "purchase and hire of goods or assets and services", and like conventional loans repayment is deferred, increased, and made on a "fixed-return basis". Unlike conventional loans, the fixed return is called "profit" or "markup", not "interest". According to Feisal Khan, "virtually every" Islamic banking advocate argues that these "non-non-participatory" forms of finance are acceptable only as "an interim measure" as Islamic banking develops, or for situations such as small and personal loans where participatory financing is not practical. Faleel Jamaldeen states that debt-based contracts are often used to finance not-so-minor purchases (homes, cars, etc.) for bank customers. These instruments include mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam), and cash advances for the manufacture of assets (istisna'). the third category consists of

Modes based on contracts of safety and security, include safe-keeping contracts (wadi’ah) for current deposits (called checking accounts in the US), and agency contracts (wakalah). Current account deposits are regarded as trusts or safe-keeping and offer the depositors safety of their money against the bank's guarantee to return their funds on demand. (A current account the customer earns no return, but sources do not agree over whether the bank is allowed to invest the account funds. According to one report, in practice no examples of 100 percent reserve banking are known to exist.) Non-banking finance Islamic non-banking finance has grown to encompass a wide range of services, but as of 2013, banking still dominates and represented about four-fifths of total assets in Islamic finance. The sukuk market is also a fast-growing segment with assets equivalent to about 15 percent of the industry. Other services include leasing, equity markets, investment funds, insurance (takaful), and microfinance. These products—and Islamic finance in general—are based on Islamic commercial contracts (aqad i.e. a commitment between two parties) and contract law, with products generally named after contracts (e.g. mudaraba) though they may be combinations of more than one type of contract.

Profit and loss sharing

While the original Islamic banking proponents hoped profit-loss sharing (PLS) would be the primary mode of finance replacing interest-based loans, long-term financing with profit-and-loss-sharing mechanisms is "far riskier and costlier" than the long term or medium-term lending of the conventional banks, according to critics such as economist Tarik M. Yousef. Yousef and other observers note that musharakah and mudarabah financing have "declined to almost negligible proportions". In many Islamic banks asset portfolios, short term financing, notably murabaha and other debt-based contracts account for the great bulk of their investments.

Mudarabah

A "mudarabah" (profit sharing) contract is a kind of partnership where one partner (rabb-ul-mal) gives money to another (mudarib) for investing in a commercial enterprise. The "sleeping" rabb-ul-mal party provides 100 percent of the capital. The mudarib party provides its expertise and management. Profits generated are shared between the parties according to a pre-agreed ratio—usually either 50%-50%, or 60% for the mudarib and 40% for rabb-ul-mal. If there is a loss, the first partner "rabb-ul-mal" will lose his capital, and the other party "mudarib" will lose the time and effort invested in the project. The structure of mudaraba is very similar to that of venture capital where the venture capitalist finances the entrepreneur who provides management and labor, so that both profit and risk are shared. Such participatory arrangements between capital on one hand and labor and management on the other, reflect the view of Islamic banking proponents that under Islam the user of capital would not bear all the risk/cost of a failure. And that this would result in a balanced distribution of income and prevent financiers from dominating the economy.

Musharakah (joint venture)

Musharakah is a relationship between two or more parties that contribute capital to a business and divide the net profit and loss pro rata. Unlike mudarabah, there may be more than two partners and all the providers of capital are entitled (but not required) to participate in management. Like mudarabah, the profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner in proportion to respective capital contributions. This mode is often used in investment projects, letters of credit, and the purchase or real estate or property. Musharakah may be "permanent" (often used in business partnerships) or "diminishing" (often used in financing major purchases, see below). In Musharaka business transactions, Islamic banks may lend their money to companies by issuing "floating rate interest" loans, where the floating rate is pegged to the company's individual rate of return, so that the bank's profit on the loan is equal to a certain percentage of the company's profits. Use of musharaka (or at least permanent musharakah) is not great. In Malaysia, for example, the share of musharaka financing declined from 1.4 percent in 2000 to 0.2 percent in 2006

Diminishing Musharaka

A popular type of financing for rydamajor purchases—particularly housing—is Musharaka al-Mutanaqisa (literally "diminishing partnership"). A musharaka al-mutanaqisa agreement actually also involves two other Islamic contracts besides partnership—ijarah (leasing by the bank of its share of the asset to the customer) and bay' (gradual sales of the bank's share to the customer). In this mode of finance the bank and the purchaser/customer start with joint ownership of the purchased asset—the customer's sharing being their down-payment, the banks share usually being much larger. The customer leases/rents the asset from the bank—bank assessing (at least in theory) an imputed rent for use of the asset—while gradually paying off the cost of the asset while the bank's share diminishes to nothing. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia. However, at least one critic (M. A. El-Gamal) complains that this violates the sharia principle that banks must charge 'rent' (or lease payment) based on comparable rents for the asset being paid off, not "benchmarked to commercial interest rate[s]".

Asset-backed financing

Asset-backed or debt-type instruments (also called contracts of exchange) are sales contracts that allow for the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money. They include Murabaha, Musawamah, Salam, Istisna’a, and Tawarruq.

Murâbaḥah

Murabaha is an Islamic contract for a sale where the buyer and seller agree on the markup (profit) or "cost-plus" price for the item(s) being sold. In Islamic banking it has become a term for financing where the bank buys some good (home, car, business supplies, etc.) at the request of a customer and marks up the price of that good for resale to the customer (with the difference clearly stated to the customer) in exchange for allowing the customer/buyer to defer payment. (A contract with deferred payment is known as bai-muajjal in Islamic jurisprudence.) Murabaha has also come to be "the most prevalent" or "default" type of Islamic finance. Most of the financing operations of Islamic banks and financial institutions use murabahah, according to Islamic finance scholar Taqi Uthmani, (One estimate is that 80% of Islamic lending is by Murabahah.) This is despite the fact that (according to Uthmani) "Shari‘ah supervisory Boards are unanimous on the point that [Murabahah loans] are not ideal modes of financing", and should be used when more preferable means of finance—"musharakah, mudarabah, salam or istisna'—are not workable for some reasons". Murabahah is somewhat similar to a conventional mortgage transaction (for homes) or hire purchase/"installment plan" arrangements (for furniture or appliances), in that instead of lending a buyer money to purchase an item and having the buyer pay the lender back, the financier buys the item itself and re-sells it to the customer who pays the financier in installments. Unlike conventional financing, the bank is compensated for the time value of its money in the form of "profit" not interest, and any penalties for late payment go to charity, not to the financier.

Economists have questioned whether Murabahah is "economically indistinguishable from traditional, debt- and interest-based finance." Since "there is principal and a payment plan, there is an implied interest rate", based on conventional banking interest rates such as LIBOR. Others complain that in practice most "murabaḥah" transactions are merely cash-flows between banks, brokers and borrowers, with no actual buying or selling of commodities.

Bai' muajjal, also called bai'-bithaman ajil, or BBA, (also known as credit sale or deferred payment sale) In Bai' muajjal (literally "credit sale", i.e. the sale of goods on a deferred payment basis), the financier buys the equipment or goods requested by the client, then sells the goods to the client for an agreed price, which includes a mark-up (profit) for the bank and is paid either in installments over a pre-agreed period or in a lump sum at a future date. The contract must expressly mention cost of the commodity and the margin of profit is mutually agreed. Bia'muajjal was introduced in 1983 by Bank Islam Malaysia Berhad. Because in Islamic finance the markup in murabahah is charged in exchange for deferred payment, bai' muajjal and murabahah are often used interchangeably, (according to Hans Visser), or "in practice ... used together" (according to Faleel Jamaldeen). However, according to another (Bangladeshi) source, Bai' muajjal differs from Murabahah in that the client, not the bank, is in possession of and bear the risk for the goods being purchased before completion of payment. And according to a Malaysian source, the main difference between BBA (short for bai'-bithaman ajil) and murabaha—at least as practiced in Malaysia—is that murabaha is used for medium and short term financing and BBA for longer term.

Bai' al 'inah (sale and buy-back agreement)

Bai' al inah (literally, "a loan in the form of a sale"), is a financing arrangement where the financier buys some asset from the customer on spot basis, with the price paid by the financier constituting the "loan". Subsequently, the asset is sold back to the customer who pays in installments over time, essentially "paying back the loan". Since loaning of cash for profit is forbidden in Islamic Finance, there are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah. According to the Institute of Islamic Banking and Insurance, it "serves as a ruse for lending on interest", but Bai' al inah is practised in Malaysia and similar jurisdictions. Bai al inah is not accepted in the Middle East and North Africa (MENA) but in 2009 the Malaysian Court of Appeals upheld it as a shariah-compliant technique. This was a demonstration of "the philosophical differences" in Shariah between these "two centers of Islamic finance", according to Thomson Reuters Practical Law.

Musawamah

A Musawamah (literally "bargaining") contract is used if the exact cost of the item(s) sold to the bank/financier either cannot be or is not ascertained. Musawamah differs from Murabahah in that the "seller is not under the obligation to reveal his cost or purchase price", even if they do know it. Musawamah is the "most common" type of "trading negotiation" seen in Islamic commerce.

Istisna

Istisna (also Bia Istisna or Bai' Al-Istisna) and Bia-Salam are "forward contracts" (customized contracts between two parties to buy or sell an asset at a specified price on a future date). They are also contracts made before the objects of sale comes into existence, and should be as detailed as possible to avoid uncertainty. Istisna (literally, a request to manufacture something) is a "forward contract on a project" and unlike Bia-Salam can only be a contract for something manufactured, processed, or constructed, which would never exist were it not for the contract to make it. Also unlike bia salam,

The price need not be paid in full in advance. Financing payments may be made in stages to purchase raw materials for manufacturing, construction materials for construction of a building. When the product/structure is finished and sold, the bank can be repaid. The contract may be canceled unilaterally before the manufacturer or builder starts work. It is not necessary that the time of delivery be fixed. Examples of istisna in the Islamic finance world include:

projects and residential properties financed by the Kuwait Finance House under construction as of 2012. the Barzan project, the "biggest financing operation in the energy sector" carried out by QatarEnergy uses Istisna and Ijara and as of 2013, had US$500M "earmarked" for it.

Bai Salam

Like istisna, Bai Salam (also Bai us salam or just salam) is a forward contract in which advance payment is made for goods in the future, with the contract spelling out the nature, price, quantity, quality, and date and place of delivery of the good in precise enough detail "to dismiss any possible conflict". Salam contracts predate istisna and were designed to fulfill the needs of small farmers and traders. The objects of the sale maybe of any type—except gold, silver, or currencies based on these metals. Islamic banks often use "parallel" salam contracts and acting as a middleman. One contract is made with a seller and another with a purchaser to sell the good for a higher price. Examples of banks using these contracts are ADCB Islamic Banking and Dubai Islamic Bank.

Basic features and conditions of a proper salam contract A salam transaction must have the buyer paying the purchase price to the seller (the small farmer or trader, etc. being financed) in full at the time of sale. Salam cannot specify that a particular commodity or a product come from a particular place—wheat from a particular field, or fruit from a particular tree as this would introduce excessive uncertainty (gharar) to the contract. (The specified crop or fruit might be ruined or destroyed before delivery.) To avoid dispute, the quality and quantity (whether weight or volume) of the commodity purchased must be fully specified leaving no ambiguity. The exact date and place of delivery must be specified. Any exchange of gold, silver, wheat, barley, date, or salt on a deferred basis in salam is a violation of riba al-fadl and forbidden. Salam is a preferred financing structure and carries higher order of shariah compliance than contracts such as Murahabah or Musawamah.