Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments permitted under this form of law. Islamic finance can be seen as a unique form of socially responsible investment. This sub-branch of finance is a booming field. In this article, we offer an overview to provide basic information and serve as a basis for further study.
The big picture of Islamic banking
Although Islamic finance began in the 7th century, it has gradually formalized since the late 1960s. This process has been motivated by the immense oil wealth which has generated renewed interest and demand for products and services. Sharia-compliant practices.
The early Islamic caliphates had better developed market economies than the nations of Western Europe in the Middle Ages.
The concept of risk sharing is at the heart of Islamic bank and financial. Understanding the role of risk sharing in raising capital is essential. At the same time, Islamic finance requires avoiding riba (wear) and gharar (ambiguity or deception).
Islamic law considers the loan with interest payments as a relationship that promotes lender, which charges interest at the borrower’s expense. Islamic law views money as a tool for measuring value and not as an asset in itself. Therefore, it requires that one cannot receive income only in money. Interest is deemed to be riba, and such a practice is prohibited by Islamic law. It is haram, which means forbidden, because it is considered usurious and abusive. In contrast, Islamic banking exists to promote the socio-economic goals of an Islamic community.
Therefore, Sharia Compliant Finances (halal, which means authorized) consists of a banking transaction in which the Financial institution shares in the profits and losses of the business he is underwriting. Equally important is the concept of gharar. In a financial context, gharar refers to the ambiguity and deception that results from the sale of items whose existence is uncertain. Examples of gharar would be forms of insurance. This could include purchasing premiums to insure against something that may or may not happen. Another type of gharar is derivatives used to hedge against possible outcomes.
The equity financing companies is allowed, as long as these companies are not engaged in restricted activities. Prohibited activities include the production of alcohol, gambling and pornography.
Core funding arrangements
A brief overview of qualifying financing arrangements often encountered in Islamic finance is given below.
Profit and loss sharing contracts (Mudarabah)
The Islamic bank pools investor money and bears a share of the profits and losses. This process is agreed with the depositors. What does the bank invest in? A group of mutual fund examined for Sharia compliance arose. The filter analyzes the balance sheets of companies to determine if any sources of income for the company are prohibited. Companies with too much debt or engaged in prohibited activities are excluded. In addition to actively managed mutual funds, there are also passive funds. They are based on indices such as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.
Declining balance Equity
The declining balance of shared equity requires the bank and the investor to jointly buy the house. It is commonly used to finance the purchase of a home. The bank gradually transfers its equity in the house to the individual owner, whose payments constitute the owner’s equity.
Rent to become an owner
This arrangement is similar to the declining balance described above, except that the financial institution pays most, if not all, of the money for the house and agrees to sell the house to the prospective owner at the end of the period. ‘a period determined time. A portion of each payment goes towards the lease and the balance towards the purchase price of the house.
Installment sale (Murabaha)
An installment sale begins with an intermediary who buys the house with a free and clear title to this one. The intermediary investor then agrees on a sale price with the potential buyer; this price includes some profit. The purchase can be made directly (lump sum) or through a series of deferred payments (installments). This credit sale is an acceptable form of financing and should not be confused with an interest-bearing loan.
Leasing, or Ijarah, consists of selling the right to use an object (usufruct) for a fixed period. A condition is that the lessor owns the rented object for the duration of the lease. A variant of the lease, ‘ijara wa’ iqtina, provides that a lease must be written when the lessor agrees to sell the leased object at the end of the lease at a predetermined price. residual value. This promise only binds the lessor. The tenant is not obliged to buy the property.
Islamic fronts (Salam and Istisna)
These are rare forms of financing, used for certain types of businesses. This is an exception to the gharar. The price of the item is prepaid and the item is delivered at a specific time in the future. Because there are a multitude of conditions that must be met to make such contracts valid, the help of an Islamic legal advisor is usually required.
Basic investment vehicles
Some permitted Islamic investments are listed below.
Sharia law allows investment in shares of companies (ordinary actions) as long as these companies do not engage in prohibited activities. Investment in companies can be made in shares or by direct investment (capital investment).
Islamic scholars have made some concessions on licensed businesses, as most use debt either to meet liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). A set of filters excludes companies that hold interest-bearing debt, earn interest or other unclean income, or exchange debt for an amount greater than its face value. Further distillation of the above filters would exclude companies with a debt-to-total assets ratio of 33% or greater. Companies whose “impure income plus non-operating interest” is equal to or greater than 5% would also be excluded. Finally, Islamic scholars would exclude companies with accounts receivable / total assets equal to or greater than 45%.
Retirees who want their investments to conform to the principles of Islam face a dilemma fixed income investments include riba, which is prohibited. Therefore, specific types of real estate investment could provide stable retirement income without violating Sharia law. These investments can be direct or securitized, like a diversified real estate fund.
In a typical ijarah sukuk (equivalent in leasing), the issuer will sell the financial certificates to a group of investors. The group will own the certificates before re-letting them to the issuer in exchange for a predetermined rental income. As with the interest rate of a conventional bond, the rental yield can be a fixed or variable rate indexed to a benchmark index, such as London Interbank Offered Rate (LIBOR). The issuer undertakes to redeem the bonds at a later date at their nominal value. Special Purpose Vehicles (SPVs) are often put in place to act as intermediaries in the transaction.
A sukuk can be a new loan or the Sharia-compliant replacement for a conventional bond issue. The issue may even benefit from liquidity through a listing on local, regional or global stock exchanges, according to a CFA Magazine article titled “Islamic Finance: How New Practitioners of Islamic Finance are Mixing Theology and Modern Investment Theory” (2005).
Basic insurance vehicles
Traditional insurance is not permitted as a means of risk management in Islamic law. This is because it constitutes the purchase of something with uncertain outcome (a form of gharar). Insurers also use fixed income securities, a type of riba, as part of their portfolio management process to settle liabilities.
A possible Sharia-compliant alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policyholders. Such a structure rarely exists, so Muslims can avail themselves of existing insurance vehicles if necessary.
The bottom line
Islamic finance is an age-old practice that is increasingly recognized around the world. The ethical and economic principles of Islamic finance even arouse interest outside the Muslim community. Considering the increasing development of Muslim nations, expect this area to evolve even more rapidly. Islamic finance will continue to meet the challenges of reconciliation Islamic investment policy and modern portfolio theory.