Sunday, November 7, 2010

Understanding Islamic Finance

May people don't understand that Islamic Finance is not Islamic Banking. There is no Banking in Islam as trade of Money is Riba and Haram just that Investment and Finance, which is all based on the trade of a commodity such as property, project or bullion.

I wrote an article the other day on Helium and this is what I said...

There are not much differences in conventional or Islamic banking but typically, there is no such thing as Islamic Banking, just a figure of speak, but more of a Trade and Finance. Going back to the days of Christianity, Usury or Charging Interest was a practice by the Jewish community for things sold or trades where payment was to be made at a later date, thus started the Banking System, where the community will pool their money to someone who they know, a company or sort for a portion of their profits, whom by lending money to others at a higher rate.
In Islam, this is forbidden as it causes much pain and misery to the borrower where in those days, rates can be as high as 20% per week as how it's still happening today, going by the name of loan sharks. Borrowers in those days who default are being sold as slaves for the rest of their lives along with their families.
The act of Riba or literally "Increasing" causes the fall of the financial institutions going way back to the Barings Bank scandal by Nick Leeson and other institutions like the recent AIA , ABN AMRO, Royal Bank of Scotland and all thanks to the domino effect by the Lehman Brothers.

However, in Islam, there won't be such a problem as the risk factor is shared among the depositor who is called the investor based on an agreement between the institution and the financer. Of course, just as how you run a business, you won't like it if your silent partner is taking more than he should, since you have to cover the costs and other overheads, and thus, in a savings account, the expected rate of return normally works to about 5-8% of the investment amount. This is normally called the Mudharabah account.  Literally, this is the instant access account based on the bank's speculation on the markets and other projects. The equivalent are the Cash Instant Access ISA accounts in UK or even your current account.

Fixed deposits or Term Deposit Account (Certificates of Deposit) are Haram in Islam as they promised a fixed amount of return in terms of percentage or anything that is certain. In Islam, everything has no certainty as that is the will of Allah, thus why Muslims are to say Insyallah or God Willing in anything that is to be done in the future. However, in a General Investment Account , which is similar to a Fixed Term Depository, the depositor agrees to the percentage of profits they expect out of the investment pool. This is a shared risk between the depositor and the financial institution where the bank will take up insurance plan (takaful) to back the investment plan. 

Normally, the bank will invest in property or low risk, high return investments such as sukuk or bonds, Gold Bullion, Foreign Exchange or Leasing plans. These are usually advertised by the bank of their investment holdings and works similar to a unit trust fund. However, the investment managers are prohibited from taking on risks that are haram or even makhruh (hated) by the Prophet. These includes Pig Farms, Brewery, Winery , Vineyards (for wine) and try to refrain from property leasing or investment related to the tobacco industry and anything that causes harm to humanity including firearms, military and likewise.

As for financing schemes, they come in many forms, such as SUKUK which are bonds, Ijarah which literally means leasing, Musyarah Mustaqinah with Ijarah for home loans where it shares the equity with the bank, with decreasing equity amount as stated in the agreement. You will hear or see these terms in an Islamic financial agreement.

Ijarah - (Operating Lease) - which means the act of leasing of an asset pursuant to a contract under which a specified permissible benefit in the form of a usufruct is obtained for a specified period in return for a specified permissible consideration. It is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset to its customer at an agreed rental fee and pre-determined lease period upon the `aqad (contract). The ownership of the leased equipment remains in the hands of the lessor. Works just like any other hire-purchase agreement.
Ijarah Muntahiah Bi Tamlik (Financial Lease) - works just like an Ijarah but after the completion of the lease, the equipment or item in particular is transferred to the lessee by means of a gift or norminal sale agreement, usually in place for Project financing, Asset acquisition or Contract Financing (Factoring).

Ijarah Mausufah Fi Zimmah (Forward Lease) is particularly used for property under construction, even when the property or asset is not owned by the lessee, such as a property developer or strata title. During the construction period, the lessor (bank) can ask the lessee to pay a portion of the normal lease or rent that has been agreed upon during the 'aqad. The forward lease rental payment is considered a debt till it is completed (agreement term) and then forth will the property be delivered to the lessee as a debt satisfied. This is usually in place for property financing and the lease cannot be increased or otherwise during the term of agreement.

Istisna’a (Purchase Order) - which means a purchase contract of an asset whereby a buyer will place an order to purchase the asset which will be delivered in the future. In other words, the buyer will require a seller or a contractor to deliver or construct the asset that will be completed in the future according to the specifications given in the sale and purchase contract. Both parties of the contract will decide on the sale and purchase prices as they wish and the settlement can be delayed or arranged based on the schedule of the work completed.

Musyarakah (Partnership / Profit And Loss Sharing)  - Musyarakah means partnership. Musyarakah refers to the commingling of capital provided by the partners for the purpose of sharing in profit. Musyarakah is established by means of an agreement or arrangement whereby two or more persons agree that each of them contributes to the capital of the partnership either in the form of cash or in kind and shares in its profit and loss.  Any profit derived from the venture will be distributed based on a pre-agreed profit sharing ratio, but a loss will be shared on the basis of equity participation.

Musyarakah Mutanaqisah (Diminishing Partnership)  - Musyarakah mutanaqisah or diminishing partnership is a form of Musyarakah (partnership) in which one of the partner promises to purchase the equity share of other partner gradually until the title of the equity is completely transferred to him. This transaction starts with the formation of partnership, after which buying and selling of the equity take place between the two partners. One partner may lease his share of the asset to the other partner on Ijarah (lease) basis. The partnership will come to an end with one partner being the sole owner of the asset or business venture.

Kafalah (Guarantee) - The Shariah principle of guarantee whereby the guarantor will guarantee the performance, action and undertaking to 3rd party. The guarantor will underwrite any claim and obligation that should be fulfilled by the principal. This concept is also applicable to a guarantee provided on a debt transaction in the event a debtor fails to fulfill his debt obligation. The same definition can be applied for Dhaman

In terms of Savings and Investments these terms come to play, which goes by a few terms.

Mudharabah (Profit Sharing) which goes in Finance and Investment plans.Mudharabah means partnership in profit whereby one party provides capital (rabb al-mal) and the other party acts as an entrepreneur (mudharib) who solely manages the project. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. In the event of a business loss, the loss shall be borne solely by the provider of the capital unless it is due to the misconduct or negligence of the mudharib.

Qardh (Benovalent Loan) - Qardh means non-interest bearing loan or benevolent loan which refers to a loan given by a person (lender) to the borrower without any expectation of extra returns.  The borrower is only obliged to pay the loan at its original amount to the lender within the agreed stipulated period of time.Current Accounts are part of a Qardh.

Another funny term which many sees in Divorce and Court settlements are Wakalah, which is a contract of agency which gives the power to a person to nominate another person to act on his behalf as long as he is alive based on the agreed terms and conditions. Some also term is as Power of Attorney.

In terms of economics, the Bank shares the risk with the investment account holder, similar to what the Building Societies, Cooperatives and Mutual Societies in the British Banking System where they do micro lending and calculated risk with customers they can trust. Islamic Financing is all about trust and that is what makes it strong as trade of money without anything backing it is wrong. Even now, investments of Gold are common nowadays but it's what makes Islamic Bonds stronger. Some banks even offer Instant Access Qardh accounts based on real physical gold, where they deposit cash to exchange for real gold, held by the bank within the vaults plus a small handling fee and when the investor wish to sell when the gold is higher, they can sell it to the bank directly at the rates they agree on or they can take out physical gold bars.

It works best for the depositor and to the Bank as they are assured of their capitals and investment as they don't take on the toxic investments such as bad debt of other people. The way of finance allows more credit to be made available to the masses and not just to one institution or company, where if it fails, the whole investment is at a loss. As the saying goes, don't put your eggs in one basket is true for Islamic Finance. Compare the rates of return of a true Building Society to a Large bank, where the Non-Performing Loans are at a highs now with defaults, foreclosures and so forth.

Banks don't make money if they foreclose a property, as it will be sold at a lower price than it will normally do, plus of the debt lost from the borrower. He or She will tend to not pay the financier for the difference and like any landlord, any rent is better than no rent.Thus with Home Finance, the lessee can pay less if they can't really make it and then play catch up as long as the full amount is settled at the agreed time and date.

Another thing offered by Islamic Finance is pawn broking or commonly known as Ar-Rahnu. This works similar to a pawn broker where they give up to 80% of the value of the asset for a cash loan and charge a specific administration fee and storage charge instead of interest.  For Gold and Silver, they are converted into Dinars and Dirhams where 4.5 Grams of Gold is one Dinar and 10 Dirhams of Silver (4.5 Grams each) is to the value of 1 Gold Dinar. They then buy the gold from the seller at a profit rate (similar to when you sell at a goldsmith) and then offer the amount less 20 to 40% based on the credit risk ( such as fluctuations of Gold Price, Currency, Economics etc) to the seller for the secured loan. If he redeems it by the agreed time according to the Aqad, then he just pay the specified selling price at either the gold price or otherwise. Dependant on the agreement, price of gold usually rise with time. Should he defaults, the collateral is sold or taken away by the bank and they have to refund the fair value price difference to the seller. Either way, the bank don't loose money.

Why it's getting popular in UK is that there is no interest and as such, if they lock in a profit rate of say 3% (or at inflation) or at the price of gold, then the full amount payable will be that amount only. Just like Capital and Interest but if inflation or if the Price Index / Interest goes up at Bank of England, they can't raise it up. This will save plenty for the borrower as in the last few years, rates have been steadily increasing by percentage points and that equates to a few hundred pounds or a total of 30,000 over the next few years for many (based on a 250,000 pound house @ 7% APR now) . And because the amount is bearable for the borrower, they usually tend to pay off faster and thus redeem their property earlier, without penalties.

1500 years of financial freedom and knowledge comes to show that Islamic Finance is the secure way to go, provided the laws of Shariah are adhered to strictly.

References : Al-Rajhi Bank Malaysia ; Kuwait Finance House (revisions)
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