I was reading the book Islamic Finance in a Nutshell by Brian Kettel. I thought I might as well review this book on the blog as well. Capitalist system has boom bust cycles. After every boom period there is a bust period where deleveraging takes place. Once enough deleveraging has taken place the boom cycle again starts. Central banks try to smooth out this boom bust cycle but not with much cycle. The most recent bust had been the 2007-2008 Financial Market Crash which is also now known as the Great Recession. Did you read my post on how to make sense of US Dollar?
Brian Kettel starts by saying that Islamic Finance is an alternate system of financial intermediation and banking which has stayed on the sidelines But in recent years has seen rapid growth prompting people to ask questions like what is Islamic Finance. Sharia is the basis of Islamic Finance. Sharia is a complete code of life. In 2010 the value of Islamic finance banking assets was expected to reach $1 trillion. In 2019, it is reported that the value of Islamic banking assets has exceeded $2 trillion so you can see Islamic finance is experiencing rapid growth. Islamic Finance is experiencing annual growth rates in excess of 15%. Demand for this rapid growth is coming from the Middle East, Muslim countries as well as from all over the world even the western countries. Right now UK is one of the biggest centers of Islamic Finance.
What is Islamic Banking?
ALLAH has prohibited taking and giving usury which is basically the interest in the present day banking system. Instead of charging interest, Islamic finance banking is based on Profit and Loss sharing also known as PLS banking. Islamic banking does not provide loans. Instead Islamic banking uses profit and loss sharing, purchase and resale of goods and services and providing services for fees. In traditional banks when you deposit money in an account you get a fixed rate of return contractually. You get a fixed rate of return that can be 2%, 3% more whatever. The banks are supposed to give you this rate of return no matter how good their business is going. Read how psychology drives the foreign exchange market.
In an Islamic bank things are different, It all depends on the Islamic banks investment decisions and overall profitability. If the bank makes profit, you get a fixed percentage of that profit. On the other hand if the Islamic bank makes a loss, you also get a share of that loss as a fixed percentage. It is all specified in the contract. So when you deposit your money in an Islamic bank you can get a profit as well as a loss. In extreme case you can lose a good portion of your deposit if the Islamic bank suffered a huge loss. This is what profit and loss sharing means in practice. What this means is that when you choose an Islamic bank always do your due diligence and choose an Islamic bank that has a good track record of profitability over the last decade at least. In an Islamic bank the rate of return is not fixed and it can be positive as well as negative. Just keep this in mind.
The risk profile of an Islamic bank is quite different from a traditional bank. For example in Profit and Loss sharing PLS, credit risk is shifted onto the depositors. We can say in some ways Islamic banks are less risky than traditional western banks when the downturn in the economy comes and asset prices fall as Islamic banks are able to share the risk with their depositors. Read about ICOs.
Over the years UK has emerged as a major Islamic Finance center. In the beginning Islamic finance only catered to retail banking. Since this book has been written some years back we don’t have recent figures. Islamic finance has seen huge growth in the previous decade. Now Islamic finance has to compete with the traditional western banks in the markets with better products and services. Islamic finance is now catering for investment banking. Islamic finance is expanding rapidly in the Middle East Gulf countries. In Europe Muslim population is around 20 million. Europe also has a huge potential customer base who will like to deposit their money in an Islamic bank and escape dealing with paying or receiving interest in compliance with Quranic injunctions.
Developing Sharia compliant financial products and services that can compete with the traditional products and services offered by the traditional western banks is a huge challenge. According to Brian Kettel customer segmentation can help in developing Sharia compliant products and services. For highly conservative customers who are willing to pay a premium for strict Islamic compliance, products and services that ensure very strict sharia compliance. While there many be many customers who want a competitive product that is part sharia compliant with better competitive rates.
Islamic finance has this challenge that it will always have to compete with the interest based traditional banking. In UK law has been made to abolish double stamp duty that was hindering the development of Islamic Finance in UK. There is a growing demand for Islamic banking across the world and existing banks can also take advantage by developing Sharia compliant products and services to cater to this increased demand. Credit risk management is a challenging area for Islamic banking. Too many of the Islamic banks have almost similar structure. Current contracts need to be made more simple. Liquidity risk management is also a challenge due to the absence of Islamic money markets. Islamic Financial Services Board (IFSB) is an international standard setting institution established in Malaysia. IFSB is doing a good work at standardizing the regulation standards.
If you ask a traditional bankers what is Islamic banking, he will reply that it is all smoke and mirrors in which instead of charging interest they are charging something else. This is a valid point as many Muslims are also skeptical. For a bank to be truly Islamic is should not charge Riba. Riba is a term used in Quran. Riba is the amount charged above the loan amount based on the time for which the loan amount is lent. Usury is charging very high interest rates. For sometime there was debate whether riba is interest or usury. Now the consensus opinion of all Islamic scholars is that all forms of interest is riba. Riba means addition however small over the principle amount. So all forms of interest no matter how small prohibited in Islam according to the consensus of the Islamic scholars. Islamic banking sole purpose is to provide products and services that eliminate all forms of interest.
Islamic finance is based on Quran and Sunnah. Islamic considers interest a form of exploitation and injustice and is against the Islamic principles of fair play. Financial intermediation is the heart of modern financial system and is based on paying and receiving interest. So how do Islamic banks operate when they don’t charge any interest on their products and services? Islamic banking substitutes profit and loss sharing (PLS) with interest. So all its products and services are based on the principle of profit and loss sharing. Following are the principles of Islamic Finance:
- All forms of riba are prohibited.
- Profit and loss sharing replaces paying and receiving interest.
- Making money from money is prohibited. All transactions should be asset backed.
- Speculative behavior is prohibited.
Let’s discuss the above main principles in detail below.
Islam allows only one type of loan where no interest is charged. Islam believes in a profit and loss sharing partnership instead for lending money on credit. The user of capital and the provider of capital should share the risk in the business venture. It is prohibited that only one party take all the risk. This is unlike the traditional banking where the borrower of money takes on the risk and has to repay the loan alongwith interest whether the business venture fails or succeeds. So in Islam you either invest your money and share the risk or forgo profit and loss sharing by keeping the money idle. In essence Islam encourages the principle of higher the risk higher the return. Higher risk investments are a stimulus to the economy and as a reward provide high returns. In the modern financial system the entrepreneur bears all the risk while the provider of capital is guaranteed a fixed rate of return whether the investment succeeds or fails.
In Islamic economic system, the risk is shared between the entrepreneur and the provider of capital. Both share the profit if the project succeeds in a fixed proportion as agreed in the contract. In case of loss the loss is borne by the capital provider while the entrepreneur gets nothing in return meaning no salary and no profit. In conventional banking all that matters is the credit worthiness of the borrower. The bank is only interest in whether the borrower has the credit worthiness to repay the loan amount alongwith the interest on that loan amount. On the other hand, an Islamic bank can only make profit if the project invested in succeeds. So an Islamic bank will be more concerned with the soundness of the project and whether the entrepreneur has the experience to manage that project and succeed.
Islam prohibits making money from money. Money is only considered as a medium of exchange and a method to define a value for a thing. But money itself has no value. Entrepreneurship has more value. Islam encourages Muslims to invest their money in productive investments and discourages them to keep their money idle. Money cannot be used to make more money without using the intermediate step of being used in the purchase of goods and services.
Uncertainty or risk is known as Gharar. Gharar is prohibited. Predetermined profit is prohibited. If the transaction involves uncertainty it is also prohibited. Islam believes in the sanctity of contractual obligations and full disclosure of information as a sacred duty. Asymmetric information and moral hazard are two problems that Islamic finance has to face. Asymmetric information means that the seller has more information about the product or service as compare to the buyer. Profit and loss sharing projects mean that Islamic bank has less information which may lead to adverse selection and moral hazard problems. Adverse selection is a consequence of asymmetric information as the riskiness of the profit and loss project is not observable for the bank. Adverse selection takes place before entering into the profit and loss sharing project.
Moral Hazard problem occurs after the profit and loss sharing project is formally signed. Important question from where does the asymmetric information risk comes from within the Islamic bank. In a Profit and Loss Sharing (PLS) project, partners are free to enter into a profit sharing agreement regardless of the capital contribution of the parties. Losses are shared strictly in accordance with the capital contribution. Moral hazard and adverse selection are two serious issues that have not been satisfactorily solved in Islamic banking. The onus is on the depositor to do the due diligence and ensure that the bank chosen is safe for making the deposit.
Coming back to Riba. Riba prohibition is central in Islamic finance. Riba has been divided into two types: 1) Riba al Nasiah which is the interest on borrowed money. 2) Riba al Fadl is when a superior thing is received in return for an inferior things. Riba means effortless profit. When you lend, you are guaranteed to receive the interest in addition to the loan. Islamic scholars have put forward the following reasons why Riba is prohibited:1) It is unjust to the borrower who has to pay the interest even if the project was a failure and there was no profit made. It is unjust for the lender to demand interest when the business venture made a loss. Quran says if the debtor is facing difficulty paying back the debt it is the lender obligation to make it easier for the debtor to repay the loan amount. It would be highly unjust to demand an interest late payment. It would be a good idea if the matters of late payment are adjudicated and decided in a court by a judge instead of leaving the thing on the lender and the borrower. Enforcement of Contracts one of the most important things in the successful operation of a modern economy. It should be a judge who decides whether there was wilful default and whether there is an element of dishonesty.
According to Islam interest corrupts the society. Right to get interest gets created immediately as soon as the contract for lending gets signed. As we have witnessed again and again too much debt makes the economy unstable and results in the repeated financial crisis what we witness after every few decades. The most recent being the 2008 Financial Crisis that nearly brought down the whole global financial system with the collapse of many banks who had too much debt obligations on its balance sheets.
In traditional western banks, banks don’t care about the project as they are entitled to the interest on their loans even if the business project fails. Now if Islamic banks cannot charge interest how do they make money? The answer is simple. Islamic banks develop sharia compliant financing mechanisms that encourage trade and investment without charging any interest. Let’s see how this done. First is deferred sale contracts. It is permissible to sell an object immediately with deferred price payment to be made later in lumpsum or in installments. This is permissible because the seller is making a sacrifice by not getting paid today. So an increase in the deferred price can be viewed as a form of compensation to the seller. There are four deferred sales contracts: 1) Murabaha: Murabaha is sale with known profit. The object is transferred at the time of sale but the price becomes due in future as a debt in the future which can be recovered in installments. 2) Salam: In Salam price is paid at the time of the contract but the object becomes due as debt in kind. 3) Istisna’a : In Istisna’s price is paid at the time of the contract and the object of sale is manufactured and delivered later in future. 4) Ijara: In Ijara sale of the use of the rights of the assets are delivered to the user who then makes periodical rental payments.
As said above other forms of contracts are the Profit and Loss (PLS) contracts in which both parties share the profit and loss. Profit cannot be determined and fixed upfront. Mudaraba PLS contracts have been standardized in Islamic banking. Islamic bank is the investor who provides funds to the entrepreneur to undertake a business project and make a profit based on his entrepreneurial skills. Contract specifies the ratio in which the profit will be shared. In case of loss, Islamic bank takes the loss while the entrepreneur foregoes the salary and the profit that were expected. In Musharaka two or more parties share the equity and agree to share the profit according to an agreed proportion and loss according to their share in the equity.
Murabaha
In a Murabaha contract the purchaser asks the seller to buy a commodity or a product and then sell it to him at a profit. So in case of a Murabaha the bank buys an asset on behalf of the client and then sells it to him with cost plus a certain markup which is the bank’s profit. You might says this is a form of interest. But Islamic scholars allow Murabaha and have never questioned the addition of the markup to the cost of purchase. What makes the Murabaha legal is that bank first purchases the asset and then sells it to the client with a markup. There was no mere exchange of money for money. Bank is also taking risk in case the price of the asset falls in the market and the client refuses to purchases the asset from the bank.
In Islamic finance money has no utility. It cannot be used directly to satisfy human wants. In simple terms we cannot eat currency notes to satisfy our hunger. But we can use currency notes to buy bread and satisfy our hunger. So we can says commodities have direct utility. Now this is important commodities can have different quality. Bread can be of high quality or poor quality. On the other hand money has the same quality. Dirty $100 notes have the same value as brand new $100 notes.
Keeping the above facts, Islamic finance treats money and commodity differently. Time value of money is pure and simple Riba in Islamic finance. If the sellers sells the item at a higher price and the buyer buys that item at an inflated price knowing the fact that it is so, it is legal in Islamic finance. When money is exchanged for money no excess is allowed in Islamic finance. The item to be sold should be in the constructive possession of the seller meaning he should be in legal control even if he doesn’t physically possess the asset.
It should have become clear to you now that Islamic Finance treats money differently than the traditional western concept which takes money and commodity as almost equal. We need to first define what money is in Islam. The book does not make this point clear at all. Practical examples of Murabaha are mortgages, working capital, letters of credit, car purchases etc. Murabaha has been used to finance mortgages, car purchases as well purchase of land.
Mudaraba
Mudaraba is a form of contract in which one party provides the capital while the other party provides knowledge, skill, experience, effort and time to a business project. The profit share is divided in the contract with mutual consent. In the case of loss the capital provider bears the loss. In case of negligence on the part of the entrepreneur, the bank can go to the court and claim damages. So in a Mudaraba there is no loss sharing. One party provides the capital in Mudaraba and bears the loss while the management skill to make the business project a success is provided by another party that has no share in the loss but shares the profit in an agreed upon ratio. Mudaraba is like a sleeping partnership in which the bank has no say in the daily management of the business venture. Mudaraba contract has been further modified into a two tiered contract in which the bank acts as the intermediary between the depositors and the entrepreneur. The bank receives funds from the depositors as unrestricted Mudaraba. There are no constraint on the bank regarding activity, duration or location of the business enterprise in which it decides to invest the capital.
Bank tells the entrepreneur the types of projects and the duration of the projects as well as the location of the projects. Bank later on has the right to monitor the projects. Once the project is commenced, bank cannot interfere in the daily management of the project. Bank cannot demand any form of guarantee such as security or collateral from the entrepreneur in an attempt to insure its capital against a potential loss. Doing so will null and void the Mudaraba contract. However if negligence and mismanagement is proved against the entrepreneur, he will be liable to reimburse the loss.
The most famous example of a Mudaraba contract was between Prophet Muhammad (peace be upon him) with Hazrat Khadija as a young man. She provided him with the capital and he provided his managerial skills to make profit from his trading journey to Syria. At the commencement of the business project, the entrepreneur is bound to return the capital to the bank. Islamic banks use the depositor money as Mudaribs. Unlike traditional banking where the rate of interest is fixed and guaranteed and the capital is also guaranteed, there is no such guarantee of profit in a Mudaraba project.
Musharaka
Musharaka is a form of partnership in a project in which the parties combine their capital and labor. Just like Mudaraba, in Musharaka profits can be shared with a mutually agreed proportion. Musharaka can be considered as a risk sharing and profit sharing arrangement. Musharaka contract does not mean lending money but active participation in the business venture. The losses are always shared strictly in accordance with the capital share. It is not necessary that partners contribute equal share in the capital. Musharaka has been used to working capital facility to a business enterprise.
Musharaka has been used to finance house purchase. Bank agrees to pay 80% of the house price while the client pays 20%. 80% payment is then divided into equal three monthly payments which can be eight in number or more or less. Client pays rent to the bank for using the house 80% while payment the three monthly installments and acquiring the ownership of the remaining portion of the house and diminishing the rent payments as well. After the installments have been paid, the ownership is fully transferred to the client and he becomes the owner of the house.
What is Ijara?
Ijara is a term in Islamic finance which means giving something on rent. When you transfer the usufruct of a property to another person in exchange for a rent claimed from him, this is a form of lease. The second type of Ijara is when you hire a person on daily wages for performing some services. Usufruct means the right to draw profit, utility and advantage produced a property without altering it. Under Ijara a bank can buy a machinery and and lease it out to its client with the right to buy it in the end. The profit element in the Ijara may look like interest payment but it is allowed in Islamic finance. You might wonder how is this legal. Sharia allowed charging a fixed amount on tangible asset where is does not allow charging fixed amount on financial asset. By converting financial capital into a tangible asset we make charging a fixed amount on the tangible asset legal. By buying the machinery the bank takes on the risk of reduced demand of that machinery in the future in which case the client may refuse payments. In Dubai Ijara has been used to lease an Airbus aircraft. Ijara Wa Iqtina is a modification of the normal Ijara contract. In Ijara Wa Iqtina, at the end of the lease period the client also becomes the owner of the property. Ijara Wa Iqtina is a sort of a lease purchase agreement. Now you might wonder what is the different between Ijara and a Western lease contract.
What is Istisna’a?
Istisna’a is a financing method used for the production of specific goods. Istisna’a is frequently used for construction financing. Banks can use Istisna’a by using back to back Istisna’a which is two Istisna’s contracts. In the first agreement, the customer approaches the bank for provision of equipment property with detailed specification that the bank should purchase for the customer. The bank adds a profit and enters into the agreement with the customer. When the agreement is signed the bank enters into a second agreement with the contractor. The contractor manufactures the item, equipment building and hands it to the bank on the payment.
What is Salam?
Salam is a contract in which the seller agrees to provide some specific goods to the buyer at a later date in the future in return for an advanced price fully paid at the spot. Salam involves selling a thing which does not exist at present. Salam was allowed by Prophet Mohammad ( peace be upon him) for small farmers who could no finance the sowing of their crops. These small farmers could not take loans as Riba had been prohibited but they needed capital to finance the sowing of crop and feeding their families. They were allowed to sell agricultural products. In Arabia people used to export goods and at the same time import goods. But when Riba got banned they could not take loans to finance import and export of goods. To overcome this problem, selling of goods in advance was permitted.