Islamic Financial Instruments & Transactions

							   Islamic Finance 101



         Islamic Financial Instruments &
                  Transactions

Mahmoud A. El-Gamal                Department of Treasury
Rice University                       Washington, DC
Houston, TX
                                   April 26, 2002: 1 p.m.
More thorough explanations at:
http://www.ruf.rice.edu/~elgamal
           Two main prohibitions



   • Ribā: (lit. increase, Hebrew: Ribit)
         – Superficial translations: “interest”, “usury” (exorbitant interest).
         – In fact: there is Ribā without interest (or time), as well as interest
           without Ribā (embedded in most Islamic banking instruments).
         – Islamic Law recognizes the time value of money.
         – Correct definition: The unbundled sale of credit, e.g. an interest-
           bearing loan, interest being the price of credit.

   • Bay`u l-Gharar:
         – The unbundled sale of risk, e.g. gambling, insurance, derivatives,
           payment or premium being the price of unbundled risk.


IF 101: April 26, 2002           © Mahmoud A. El-Gamal                    Slide #2 of 10
History of Usury and Ribā prohibitions


    • Non-Abrahamic prohibitions of “usury”:
          – Code of Hammurabi (ca 2100 BC): interest ceilings of 33% and
            20% on loans-in-kind.
          – Hindu law: total interest may not exceed principal.
          – Plato,…: Capital not viewed as a valid “factor of production”.

    • Judeo-Christian-Islamic prohibition of “Ribā”:
          – Exodus [22:25], Leviticus [25:35-7], Deuteronomy [23:19-20],
            Bava Metzia, Chapter 5, Mishna 2.
          – Luke [6:27-36], Benedict XIV (De Synodo Diocesana, X.iv, n.6),
            First Council of Carthage (345)-until-Fourth Council of the
            Lateran (1215).
          – Qur’an [30:39], [3:130], [2:275-279], various Prophetic traditions.


 IF 101: April 26, 2002          © Mahmoud A. El-Gamal                 Slide #3 of 10
Universality of prohibitions of Ribit


     • Interpretations of Exodus [22:25], later Canonical Texts
           – Rare: “Ami” (my people) interpreted to mean poor debtors.
           – Commonly (Ami = children of Israel) interpreted to apply prohibition of
             Ribit only to inter-faith loans; c.f. Talmud (Bava Metzia 70b – 71a).
           – Maimonides (Laws of Loans, Ch. 5, Law 2) restricted permission of
             charging moderate interest to cases of necessity.
           – Fourth Council of the Lateran (1215) allows Jews to charge interest at
             non-usurious (non-exorbitant) rates.
           – Distinguish consumption loans (to the needy) from productive loans.

     • Sixteenth Century – modern day:
           –   Heter ‘Iska: replaced loan-financing with silent partnership investment.
           –   Moral hazard problems led to refinements of HI to allow for fixed interest.
           –   Calvin permitted moderate interest on loans.
           –   Modern debates on interest rate ceilings (as in the code of Hammurabi).


  IF 101: April 26, 2002             © Mahmoud A. El-Gamal                      Slide #4 of 10
Islamic Sharīca: Prohibition of Ribā


     • Al-Sharīca:
           – Lit.: “The Way” … to a water hole … in the desert! (comp. Halakhah).
           – Revealed Law in Canonical Texts: The Qur’an and Prophetic traditions.

     • Islamic Law: A mixture of canon and common law
           –    Fiqh (jurisprudence): (lit.) understanding of the Sharīca
           – Canon Law: All rulings must be referred back to the Canonical Texts.
              • Unanimous interpretations are raised to the same authoritative level.
           – Common Law: Jurists rely on precedents in opinion, interpretation, etc.

     • Universal Prohibition of Ribā (interest on loans):
           – Explicit in Canonical Texts. Virtually no dissent on interpretation.
           – Islamic finance avoids loans as finance contracts: loans are for charity.


  IF 101: April 26, 2002             © Mahmoud A. El-Gamal                      Slide #5 of 10
Neither a borrower nor a lender be …



    • Finance without interest-bearing loans:
          – Equity finance:
                • Obvious “profit/loss-sharing” rules in partnerships, silent
                  partnerships, and (contemporary) ownership of common shares.
                • Recent trend: Islamic mutual funds, VC, private equity funds, etc.
                • Silent partnerships used to generate Islamic banks’ “liabilities-side”.

          – Debt finance (Islamic banking “assets-side”):
             • Form: initiate debt (including implied interest) through cost-plus
                  sales (Murabaha), leasing (’Ijara), etc.
                     – OCC #867 (1999) & OCC #806 (1997) recognized respective
                       contracts as “secured lending within the business of banking”.
                • Substance: Enforcement of closer ties to “real” transactions,
                  marking collateral value and implied rate of return to market.


 IF 101: April 26, 2002              © Mahmoud A. El-Gamal                      Slide #6 of 10
  “Sharīca Compliant Finance”


   •   Islamic financial institutions appoint religious scholars to serve on
       “Sharīca boards”, approve contracts and monitor operations.
   •   Efforts are underway to “harmonize Sharīca and accounting
       standards” (e.g. AAOIFI, etc.).
   •   What do Sharīca boards consider to check for Sharīca compliance?
        – Real and legitimate transactions underlying financial contracts.
        – Absence of Ribā (interest on a “loan-like” contract) and Gharar.
        – A contract form that ensures the above.
        – A contract wording that ties the contract form to historical forms
           known in classical jurisprudence (hence the Arabic names).
        – In the tradition of Canon Law, the names imply permissibility.
        – In the tradition of Common Law, the names and contract
           specifics ensure derivation from precedents and valid analogies.

IF 101: April 26, 2002         © Mahmoud A. El-Gamal                 Slide #7 of 10
  “Sharīca Compliant Finance”


   • Example 1: Home financing
         – Object to the “mortgage loan” language, since interest-bearing
           loans (secured or otherwise) clearly constitute Ribā.
         – First step: The Islamic financing firm “acquires” the property.
         – Second step: The firm typically finances the customer’s purchase
           of the property in one of three ways:
               • Cost-plus credit sale (Murābaha): Customer buys the property from
                 firm on credit, amortization schedule calculated in similar manner to
                 conventional mortgage (often LIBOR+ used as benchmark).
               • Lease-to-own (‘Ijāra wa qtinā’): Customer pays rent for portion
                 owned by firm + buys back part of firm’s equity. Rent determined
                 by market rental rate of comparable properties, or LIBOR+.
               • Rolling partnership (mushāraka mutanāqisa): similar to lease,
                 different treatment of taxes, insurance, capital gains sharing, etc..


IF 101: April 26, 2002             © Mahmoud A. El-Gamal                      Slide #8 of 10
  “Sharīca Compliant Finance”


   • Example 2: Investing in stocks (Islamic mutual funds)
         – Eliminate companies with primary or substantial businesses that are
           illicit in Islam (e.g. liquor, tobacco, gambling, pornography, etc.).
         – Eliminate companies with excessive debt-to-assets (highly leveraged).
         – Eliminate companies with excessive interest income (idle capital).
         – Within the resulting universe of securities, apply standard portfolio
           management techniques to provide a variety of risk-return profiles under
           different business conditions (e.g. sectoral bias, growth, value, …).

         – Some have argued for regional, developmental, and ethical biases being
           incorporated in the portfolio selection methodologies (ethical investing),
           but such considerations seem currently to be secondary at best.



IF 101: April 26, 2002             © Mahmoud A. El-Gamal                     Slide #9 of 10
Growing pains of Islamic Finance


    •   Contemporary Islamic finance is a only a few decades-old.
    •   Its emergence and growth coincided with (and resulted from) increased
        degrees of adherence to explicit Islamic forms (from ritual worship, to
        dress-codes, to social processes, to economic life).
    •   This explains the focus on contract forms and names.
    •   There is an ongoing effort to bridge a centuries-wide gap of
        jurisprudence development to meet today’s Muslims’ needs within
        various national legal/regulatory frameworks.
    •   This often puts form above substance, and results in higher (legal and
        other) short-term transactions costs (in this instance, including your
        time… Thank you!).


 IF 101: April 26, 2002         © Mahmoud A. El-Gamal                 Slide #10 of 10