Understanding Islamic Banking and Finance

Islamic banking and finance are based on the principles of Shariah law, which prohibits the collection and payment of interest. This is a fundamental difference from conventional banking, where interest is a key component.

Islamic banking products are designed to provide a return on investment without charging or paying interest. For example, Mudarabah, a form of investment partnership, allows investors to share in the profits of a business without any guarantee of return.

In Islamic finance, assets are valued based on their market price, not their face value. This is in contrast to conventional finance, where assets are often valued at their face value. This approach helps to prevent overvaluation and promotes transparency.

Islamic banking and finance aim to promote economic justice and fairness, by ensuring that all parties in a transaction benefit equally. This is achieved through the use of Shariah-compliant instruments, such as Sukuk, which represent ownership in an asset rather than debt.

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Islamic banking and finance are built on a set of principles that differ from conventional banking. Islamic finance is banking, lending, and saving practices that comply with Islamic law. This means that Islamic banking views lending as a relationship that unfairly favors the lender, so loans must be interest-bearing and interest cannot be earned.

Islamic investors are prohibited from investing in companies that engage in forbidden activities, limiting the scope of public equities they can hold. This is due to the nature of the underlying company or the features of the financial instrument. Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits rather than paying interest.

Two fundamental principles of Islamic banking are the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors. This is what sets Islamic banking apart from conventional banking. Islamic banks have windows or sections that provide designated Islamic banking services to their customers, often in conventional banks.

Here are some key concepts to keep in mind:

Financial Instruments are a crucial part of Islamic banking and finance. They are designed to be Shariah-compliant, which means they follow Islamic law and principles.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has been publishing standards for Islamic financial instruments since 1993, and by 2010, they had issued 25 accounting standards and 41 shari'ah standards.

Some common types of financial instruments in Islamic banking include Murabaha, Musawamah, Salam, Istisna'a, and Tawarruq, which are all asset-backed financing contracts that allow for the transfer of one commodity for another commodity or for money.

The AAOIFI sets best practices for handling the financial reporting requirements of Islamic financial institutions, while the Islamic Financial Services Board (IFSB) focuses on the identification, management, and disclosure of risk related to Islamic financial products.

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Musharakah, or joint venture, is a profit and loss sharing partnership where all partners invest and share in losses according to the ratio of their investment.

This type of partnership is often used in investment projects, letters of credit, and the purchase or real estate or property. It can be either "permanent" or "diminishing", but use of musharaka is not great, with its share of financing declining from 1.4 percent in 2000 to 0.2 per cent in 2006 in Malaysia.

In a musharakah, all partners are given the option of participating in the management of the business, which is a key aspect of this type of partnership.

Musharakah is similar to mudarabah, another profit and loss sharing partnership, but in mudarabah, one partner provides the capital and the other provides the expertise and management.

Murabahah is a type of asset-backed financing instrument that allows for the transfer of one commodity for another commodity.

It is a sales contract that enables the transfer of a commodity for money. This type of financing is often used in Islamic finance.

In Islamic finance, fixed-income investments are a challenge because they often involve riba, which is forbidden.

Retirees can consider investing in real estate, which can provide a steady income while complying with Sharia law. This can be done through direct or securitized investments, such as a diversified real estate fund.

A typical ijarah sukuk, or leasing bond equivalent, involves the issuer selling financial certificates to an investor group, who then rent them back to the issuer in exchange for a predetermined rental return.

The rental return may be a fixed or floating rate, pegged to a benchmark like the Secured Overnight Financing Rate (SOFR).

Special purpose vehicles are often set up to act as intermediaries in the transaction, making it more complex.

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Islamic banks offer a range of deposit options that are designed to comply with Shariah law.

In Islamic banking, deposit accounts are structured in a way that's similar to conventional banks, but with a key difference: instead of earning interest, depositors receive a share of the profits.

Investment accounts in Islamic banks are based on profit and loss sharing and asset-backed finance, and they play a similar role to time deposits in conventional banks.

One example of an Islamic bank that offers a fixed term deposit is Al Rayan Bank in the UK, which talks about "Fixed Term" deposits or savings accounts.

In Islamic banking, return on deposits is measured as "expected profit rate" rather than interest.

Demand deposits, which promise the convenience of returning funds to depositors on demand, are structured with qard al-hasana contracts, or less commonly as wadiah or amanah contracts.

Islamic banks also offer demand deposits that pay little if any return on investment and/or charge more fees.

The original proponents of Islamic banking called for keeping distinct accounts for various types of deposits so that return can be assigned to each type.

In practice, Islamic financial institutions often pool all types of deposits, which can make it difficult to track the source of the funds.

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Islamic funds are professionally managed investment funds that pool money from many investors to purchase securities that have been screened for Sharia compliance. They include mutual funds holding equity and/or sukuk securities.

As of 2014, there were 943 Islamic mutual funds worldwide, and as of May 2015, they held $53.2 billion of assets under management. This suggests a significant growth in the industry.

To invest in equity mutual funds, companies must be screened to exclude those involved in prohibited activities, such as alcohol, tobacco, and adult entertainment. They must also be free from prohibited speculative transactions, which are likely leveraged with debt.

Companies are examined based on their financial ratios to meet certain financial benchmarks. This ensures that the funds are invested in Sharia-compliant companies.

Creators of benchmarks to gauge the funds' performance include the Dow Jones Islamic market index series and the FTSE Global Islamic Index Series. These benchmarks help investors compare the performance of Islamic funds with conventional funds.

Islamic equity funds under-performed both Islamic and conventional equity benchmarks from 2000 to 2009, particularly during the 2007-08 financial crisis.

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Leasing, or Ijarah, is a financial transaction where one party sells the right to use an object for a specific time.

In this type of lease, the lessor must own the leased object for the duration of the lease.

A variation of the lease, 'ijarah wa 'iqtina, allows the lessor to sell the leased object at the end of the lease at a predetermined residual value, binding only the lessor.

Musawamah is a type of contract used in Islamic commerce where the seller is not obligated to reveal their cost or purchase price.

This contract is often used when the exact cost of an item cannot be ascertained or is not necessary to disclose.

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Istisna and Bai are types of forward contracts used in Islamic finance. They allow for immediate payment for goods in the future, but with specific conditions to ensure Shariah compliance.

Istisna contracts are limited to manufacturing, processing, or construction, and can be applied in supply chain management. They can be used for financing raw materials or construction materials, with payments made in stages.

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Bai Salam, on the other hand, can be applied to anything except gold, silver, or currencies based on these metals. It's a preferred financing structure in Islamic finance, carrying a higher order of Shariah compliance than other contracts.

A key difference between Istisna and Bai Salam is that Bai Salam cannot be cancelled unilaterally, and the full price must be paid in advance. The time of delivery must also be specified.

Salam contracts predate Istisna and were designed to help small farmers and traders. They are often used by banks, such as ADCB Islamic Banking and Dubai Islamic Bank.

Examples of Istisna contracts in practice include the Kuwait Finance House and the Barzan gas project in Qatar. These contracts require detailed specifications to avoid uncertainty.

Leasing (Ijarah) is a type of agreement where you sell the right to use an object for a specific time.

One key condition is that the lessor must own the leased object for the duration of the lease. This ensures the lessor has control and responsibility for the object throughout the agreement.

A variation of leasing is called 'ijarah wa 'iqtina, where the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. This means the lessor is committing to sell the object at a specific price when the lease ends.

The lessee is not obligated to purchase the item, as this promise only binds the lessor.

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In an installment sale, the buyer and seller agree on a sale price that includes some profit for the seller. This type of sale is also known as Murabaha.

The sale can be made outright or through a series of deferred payments, which is an acceptable form of finance.

The buyer pays a lump sum or a series of installments, and the seller makes a profit on the sale.

In Islamic banking and finance, traditional insurance is not permitted due to its use of fixed income, a type of riba, and the purchase of something with an uncertain outcome, known as gharar.

However, a possible Sharia-compliant alternative is cooperative or mutual insurance, where subscribers contribute to a pool of funds invested in a Sharia-compliant manner.

Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policyholders, making it a viable option for Muslims seeking insurance coverage.

Investing in company shares is also allowed in Sharia law, as long as the companies do not engage in forbidden activities, such as holding interest-bearing debt or trading debts for more than their face values.

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Islamic investments can be a bit more complex than traditional ones, but they're definitely worth exploring. Some permissible Islamic investments include profit and loss sharing contracts, such as Mudarabah, where the bank pools investors' money and assumes a share of the profits and losses.

In Mudarabah, the bank invests in a group of mutual funds that have been screened for Sharia compliance. These funds exclude companies holding too much debt or engaged in forbidden lines of business.

A key feature of Mudarabah is that it's based on the concept of profit and loss sharing, where the bank and the client share the profits and losses equally. This is in line with Islamic principles of fairness and risk-sharing.

However, critics argue that Mudarabah is far riskier and costlier than traditional long-term lending. They also point out that property rights in many Muslim countries are not properly defined, making it difficult to implement Mudarabah.

Islamic scholars have developed various screens to identify permissible companies for investment. These screens exclude companies that engage in forbidden activities, such as holding interest-bearing debt or receiving impure income.

Some of the key screens include:

These screens help ensure that investments are Sharia-compliant and align with Islamic principles.

Traditional insurance is not permitted as a means of risk management in Islamic law because it involves the purchase of something with an uncertain outcome, a form of gharar.

Insurers often use fixed income, a type of riba, as part of their portfolio management process to satisfy liabilities.

Cooperative or mutual insurance is a Sharia-compliant alternative that allows subscribers to contribute to a pool of funds, which are then invested in a Sharia-compliant manner.

The funds withdrawn from the pool to satisfy claims are distributed among policyholders, with unclaimed profits also being distributed among them.

This type of structure is not common, so Muslims may need to rely on existing insurance vehicles if needed.

Compliance with Sharia is a top priority for Islamic banks and financial institutions. They establish Shariah Supervisory Boards (SSBs) to ensure that all operations and activities comply with Shariah principles.

These SSBs are composed of jurists specializing in Islamic commercial jurisprudence and their fatwas and rulings are binding. They have at least three members, are not employees of the financial institution they supervise, and are appointed and remunerated by a general assembly rather than the institution's board of directors.

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Their duties include calculating zakat payable by Islamic financial institutions, disposing of non-shariah-compliant income, and advising on the distribution of income among investors and shareholders.

Islamic financial institutions have guidelines and standards for Shariah compliance from organizations such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB).

Regulators in countries like Bahrain, Indonesia, and Malaysia have developed guidelines for SSBs in their respective jurisdictions. Some countries have centralized SSBs, while others have Shariah advisory firms offering services to Islamic financial institutions.

Islamic banks and financial institutions must also ensure that the investments they make are Shariah-compliant. They use filters to screen companies for Shariah compliance, excluding those with prohibited income sources or excessive debt.

Here are some key requirements for Shariah compliance:

Note that each Islamic financial institution has its own SSB, and while guidelines and standards exist, they are not regulations, and each institution must follow its own SSB's rulings.

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Islamic banking and finance face several challenges and limitations. One of the main issues is the lack of a common understanding of money laundering and terrorism financing, which can lead to noncompliance with global standards. This is a concern highlighted by the International Monetary Fund.

Islamic banks have their own Shariah boards that rule on their policies, but this can create challenges for leadership in managing the bank's business and religious pursuits. Scholars have engaged with questions around leading and managing Islamic banks, recognizing the need to bring together diverse beliefs, values, and views.

Stock prices in Muslim countries can be influenced by the mood of investors, particularly during the holy month of Ramadan when stocks tend to yield higher returns. This is because Ramadan encourages Muslims' optimism, which has a positive effect on stock prices.

Lack of conformance with Islamic financial principles is a significant challenge in the industry. Critic Feisal Khan argues that risk-sharing is lacking because profit and loss sharing modes are so infrequently used.

The use of underlying material transactions is also a concern, as seen in transactions such as "tawarruq, commodity murabahas, Malaysian Islamic private debt securities, and Islamic short-sales". These transactions lack the required material transactions.

High fees are often charged for mimicking conventional banking/finance products, which can be considered exploitation. This is a major issue in Islamic finance.

Banks often take the word of clients/financees/borrowers that they will not use funds for un-Islamic activities, which is not a reliable method. This lack of reliable references is a major issue in the industry, as seen in articles with self-published sources and articles lacking reliable references.

Here is a list of some of the specific issues with Islamic finance:

Islamic banks face unique challenges in managing their Shariah boards, which rule on their bank's policies. This can be a complex task.

Their leadership must balance business and religious pursuits, which can be a distinct challenge. Scholars have only recently begun to conceptualize Islamic banks as hybrid organizations.

Behavioural economists have found that stock prices can be influenced by the mood of investors, such as positive events like sunshine and upcoming holidays.

Late payments and defaults are a significant challenge for Islamic banks. In Islamic finance, late payments are a serious problem, with some people taking advantage of legal and religious devices to delay payments.

Islamic banks face a unique issue with late payments, as they are often unable to enforce late fees due to concerns about riba, or interest. This can make it difficult for banks to recover their losses.

In many Islamic countries, penalties and late fees have been established, but they are often deemed unenforceable. This lack of enforcement creates an environment where debtors may feel they can delay payments without consequence.

Debtors may feel that paying Islamic banks last involves no cost, as they are not subject to the same penalties as conventional banks.

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