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Islamic Finance Principles
    Professor Habib Ahmed
      Durham University
               January 22, 2009


      Bankers’ Association for Finance and Trade
                    Agenda
• Introduction to Islamic Law and Principles
    – Riba and Gharar
•   Islamic Contracts
•   Islamic Banking Models
•   Shari’ah Governance
•   Islamic Financial Sector


              Bankers’ Association for Finance and Trade
         Sources of Islamic Law
Two sources of law in Islam
• Shari’ah—Revealed knowledge
    – Quran
    – Hadith/Sunnah (Sayings/doings of the Prophet)
•   Fiqh– Derived knowledge through ijtihad
    (exertion)
•   Four major schools of thought in the Sunni
    tradition

             Bankers’ Association for Finance and Trade
    Basic Approach to Islamic Law
•   Islamic laws can be broadly classified into
    two types
    –   Ibadat (devotional acts) – Any act which is not legalized
        by Shari’ah is void
    –   Muamalat (dealings or transactions)—All transactions
        are permitted unless explicitly prohibited by Islamic law
        (principle of permissibility)
•   In muamalat, new transactions can be
    accommodated through ijtihad as long as
    they do not contain the prohibited
                 Bankers’ Association for Finance and Trade
         Contracts-Islamic Nature
•   Freedom of contracts—provided the prohibited
    elements are avoided
•   Some aspects of the contractual relationship
    determined by Shari’ah/Fiqh to avoid
    –   Injustice
    –   Conflicts/Misunderstandings
    –   Exploitation
•   The prohibitions in transactions include:
    –   Riba
    –   Gharar

                 Bankers’ Association for Finance and Trade
                             Riba
• Riba (literal meaning ‘increase’) is prohibited
“...they say: trading is only like riba, whereas God has permitted
    trading and forbidden riba…” (Quran 2:275)
• Various interpretations of riba
• Implications of riba:
      –Interest is forbidden
      –Selling debt (at a discount) is not allowed




                 Bankers’ Association for Finance and Trade
                        Gharar
•    Gharar–Excessive risk, hazard, or ambiguity
•    Gharar can exist in the object or terms of the
     contract
•    Implications of gharar:
    – Existence of the object (& ability to deliver)
    – Two sales in one
    – The future sale




               Bankers’ Association for Finance and Trade
                    Agenda
• Introduction to Islamic Law and Principles
  – Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector


            Bankers’ Association for Finance and Trade
    Major Islamic Contracts used in
              Financing

1. Sale (Exchange) Contracts
  1. Deferred trading contracts
     1. Price deferred sale (murabahah)
     2. Object deferred sale (salam, istisna)
  2. Leasing-sale of usufructs (ijarah)
2. Partnerships – musharakah or mudarabah
3. Interest free loans (qard hassan) or loans at
   service charges

              Bankers’ Association for Finance and Trade
                      Murabahah
Traditional Murabahah/Bai al-Muajjal
                          Productspot




                             Pricefuture

Financing Mode in Islamic Banks—Debt
•   The financial institution buys and then sells a good to the
    client at a mark-up
•   Price paid at a later date
•   The bank must own and posses the good
•   The profit rate and other terms should be clearly specified in
    the contract
•   The bank can ask for guarantees or collateral
                 Bankers’ Association for Finance and Trade
                            Salam
Traditional Salam

                            Pricespot



                          Commoditiesfuture


Financing Mode in Islamic Banks—Debt
•   Used to finance the agricultural sector
•   The price has to be fixed and paid when the contract is
    concluded
•   Commodities delivered at a later date
•   The delivery time should be fixed

                 Bankers’ Association for Finance and Trade
                            Istisna
Traditional Istisna

                       Paymentinstallments



                            Assetfuture


Financing Mode in Islamic Banks—Debt
•   A pre-production sale used when an item/asset needs to be
    manufactured/constructed
•   The price of the asset should be known and time of payment
    can be negotiated among the parties
•   The seller of the asset (bank) can either manufacture it or
    sub-contract it
                 Bankers’ Association for Finance and Trade
                            Ijarah
Traditional Ijarah
                       Asset (for rent)fixed period



                     Rental Payments

Financing Mode in Islamic Banks—Leasing
•   A hire-purchase leasing contract
•   Ownership is transferred to lessee at the end of the contract
    period
•   Fiqhi objections—two contracts in one; purchase contract
    cannot be binding
•   Banks give away the asset at nominal value or as a gift at the
    end of the lease period
                Bankers’ Association for Finance and Trade
                        Mudarabah
Traditional Mudarabah

             Service/labour                  Fundsspot




              Profit sharefuture          Profit sharefuture
 Financing Mode in Islamic Banks—Equity
 •   Partnership between bank and clients
 •   Used on the liability and asset sides
 •   Profit shared among parties at an agreed upon ratio
 •   Loss borne by financier only
 •   Financier cannot ask for a guarantee of capital or return
 •   Mudarabah can be restricted or unrestricted

                  Bankers’ Association for Finance and Trade
                      Musharakah
Traditional Musharakah

              Funds & labour                 Funds & labour



               Profit sharefuture            Profit sharefuture



 Financing Mode in Islamic Banks—Equity
 •   A partnership contract in which bank contributes capital and
     managerial services
 •   Like a mudarahah, but all partners manage the project
 •   The profit share among the partners at an agreed upon ratio
 •   Loss shared according to share of capital

                Bankers’ Association for Finance and Trade
                    Agenda
• Introduction to Islamic Law and Principles
  – Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector


            Bankers’ Association for Finance and Trade
    Ideal Islamic Banking Model
• Two-tier mudarabah model
  – Profit-loss sharing modes of financing on both the asset and
    liability side
           Assets                    Liabilities and Equity
• Equity financing              •Profit-sharing investment
(Mudarabah/musharakah)          accounts (PSIA-Mudarabah
                                based)
                                •Demand Deposits (qard
                                hasan)
                                •Capital


               Bankers’ Association for Finance and Trade
         Islamic Banking Practice:
              2nd Best Model
One-tier Mudarabah with Multiple Investment Tools
• Liability Side—PSIA (Mudarabah based)
• Asset Side—multiple investment tools, dominated by fixed-
  income contracts (murabahah, ijarah, istisna, etc.)
             Assets                     Liabilities and Equity

 •Debt-based financing             •PSIA-Mudarabah based
 (Murabahah, Istisna, salam)       •Demand Deposits (Qard
 •Leasing-based financing          hasan)
 (Ijarah)                          •Capital
 •Equity-financing                 •Reserves
 (Mudarabah/musharakah)

                Bankers’ Association for Finance and Trade
                             Tawarruq
                                   2

                                 Broker
      Client                                      1           Bank
                       3


The client wants a personal loan and approaches the bank
1. Bank buys commodity from a broker paying spot (for £100)
2. Bank sells the commodity to client payable at a future date (for £110)
3. The client sells commodity to broker spot (for £100)
     [Organized tawarruq: The client appoints the bank as agent to sell the
     commodity. The bank sells the commodity spot to the broker for £100 on
     behalf of the client and deposits the money in client’s account.]
     At the end of the transaction, the client gets £100 and owes the bank £110
     payable in the future

                    Bankers’ Association for Finance and Trade
     Implications of Tawarruq
• Tawarruq and Gresham’s Law (bad money
  drives away good money)
• Tawarruq is driving all other modes away
• Tawarruq replicates a loan transaction
• The result—third best model of Islamic banking



            Bankers’ Association for Finance and Trade
           Islamic Banking Practice:
                3rd Best Model
Fixed Liability with Multiple Investment Tools
• Liability Side—Fixed-income investment accounts (using
  tawarruq)
• Asset Side—multiple investment tools, dominated by fixed-
  income contracts (tawarruq, murabahah, ijarah, istisna, etc.)
             Assets                      Liabilities and Equity

 •Debt-based financing              •Fixed income investment
 (Tawarruq, Murabahah,              accounts (Tawarruq)
 Istisna, salam)                    •Demand Deposits (Qard
 •Leasing-based financing           hasan)
 (Ijarah)                           •Capital
 •Equity-financing
 (Mudarabah/musharakah)             •Reserves
                 Bankers’ Association for Finance and Trade
               Islamic Modes of Financing
Modes                           Sudan             Pakistan            Bahrain                UAE
Murabahah                       42.45               50.96              51.73                 49.29
Musharakah                      17.77                2.52               0.89                 2.59
Mudarabah                        3.10                   -               1.96                 4.36
Ijarah                           0.87               20.41               5.56                 18.90
Istisna                          0.95                   -               0.63                 3.22
Salam                            0.55                0.23                  -                   -
Others                          34.31               25.88              39.23                 21.65
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions



                            Bankers’ Association for Finance and Trade
              Islamic Modes of Financing
Modes                         Iran            Malaysia             Jordan          Saudi Arabia
Murabahah                    21.02              41.04               15.41               15.81
Musharakah                    0.97               0.24                2.99                0.65
Mudarabah                     1.51               0.27               11.36                0.05
Ijarah                        2.18               9.40               13.80                0.04
Istisna                       0.07               1.72                1.20                3.74
Salam                         0.03                  -                  -                      -
Others                       74.22              47.33               55.25               79.71

 Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions




                           Bankers’ Association for Finance and Trade
                    Agenda
• Introduction to Islamic Law and Principles
  – Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector


            Bankers’ Association for Finance and Trade
         Role of Shari’ah Scholars
• Most Islamic banks initially created by private
  initiatives by pious Muslims
• Shari’ah compliance important feature of IF
  organizations
• Authenticity, credibility, and public confidence of
  products/services required
• Establishment of Shari’ah bodies at different levels
• Re-emergence of legal authority Shari’ah scholars



              Bankers’ Association for Finance and Trade
    Different Types of Shari’ah Bodies
•    Shari’ah bodies exist in different forms
    1.   Shari’ah Department (in the bank)
    2.   Advisor (external to the bank)
    3.   Supervisory Board (in the bank)
    4.   Supervisory Board (national)
    5.   Professional Shari’ah Advisory Firms
    6.   International Fiqh Bodies
•    Depending on the regulations and size of the
     organization, different models of Shari’ah
     governance exist.

                  Bankers’ Association for Finance and Trade
          Shari’ah and Legal Risks
•    No unified Shari’ah rulings
•    Application of Islamic contracts in non-Islamic
     jurisdictions
    – ‘Choice of law’ and ‘dispute settlement clauses’
      included in contracts
    – Usually English law is preferred
    – If Shari’ah is the governing law—disputes settled
      by commercial arbitration


               Bankers’ Association for Finance and Trade
                   Agenda
• Introduction to Islamic Law and Principles
  – Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector


             Bankers’ Association for Finance and Trade
            Evolution of Islamic Financial Sector
      1970’s             1980’s              1990’s                2000’s
Islamic Banks   Islamic Banks       Islamic Banks        Islamic Banks
Takaful         Takaful/Retakaful   Takaful/Retakaful    Takaful/Retakaful
                 Mutual Funds        Mutual Funds         Mutual Funds
                 Mudarabah Co.       Mudarabah Co.        Mudarabah Co.
                                      Leasing Co.          Leasing Co.
                                      Investment Banks     Investment Banks
                                      Islamic indices      Islamic indices
                                                            Sukuk
                                                            Private Equity &
                                                            Venture Capital
                                                            Hedge Funds
                                                            Infrastructure/
                                                            project finance
                                                            Islamic REITs
                                                            Trust/Waqf
                                                            Management


                      Bankers’ Association for Finance and Trade
Size of Islamic Financial Industry
• Islamic financial sector is significant and
  expanding at a fast rate
  – More than 500 Islamic financial institutions in
    over 75 countries
  – Over 706 Shari’ah compliant mutual funds
  – Total outstanding sukuk issues—USD 83.7
    billion
• Estimated total Islamic financial assets
  under management-$1 trillion
• Islamic financial Industry estimated to
  reach up to $2.8 trillion by 2015

           Bankers’ Association for Finance and Trade
     Questions?

habib.ahmed@durham.ac.uk




  Bankers’ Association for Finance and Trade

				
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