23 Jun 2009

Islamic finance: An introduction

by Ben Sandstad, Hagbarth Strom

Islamic finance is premised upon the belief that commercial activity should be beneficial to society and reflect sound moral and ethical standards.

With the global financial crisis constricting the availability of capital, borrowers need to consider all options available for their financing needs. While these options typically take the form of conventional banking and capital markets options (whether domestic or international) alternative sources of financing are also being scrutinised. One such alternative source is Islamic-compliant financing (Islamic finance).

Islamic finance has in recent times been one of the most dynamic sectors of the global financial industry. As of June 2008, the Islamic financial industry, including Islamic banks, mutual funds, insurance schemes and Islamic branches of conventional banks, was estimated to be worth around US$800 billion.[1] There are more than 300 Islamic banks operating worldwide and more than a fifth of the world's population are Muslims.[2] While not immune to the global financial crisis, Islamic finance appears to have suffered less than the "conventional" international finance market. The Gulf region has to some degree been cushioned from the global economic crisis by funds accumulated during the oil boom, although the recent dive in oil prices has reduced this cushion.

Islamic finance is seen as a viable alternative for Australian borrowers, given Australia's proximity to several of the most populous Muslim countries in the world, notably Indonesia, Malaysia and Brunei, in addition to Australia's rich asset base and stable economy.

This is the first in a series of articles that will look at Islamic finance as an alternative for Australian borrowers and consider the principles underpinning Islamic finance, the most prevalent structures used in Islamic finance in both the structured finance and capital markets contexts, and structural issues for Australian borrowers when accessing the Islamic finance market.

Background to Islamic finance and Shariah law

While Islamic finance methods were widely practiced across the Middle East from the 7th century (when the Prophet Mohammed lived) onwards, modern Islamic finance only really started in the early 1970s with the establishment of the first Islamic banks.

Islamic finance is designed to allow Muslims to pursue their business and financial activities within the context of their religious values without violating fundamental Shariah principles. As such, Islamic finance is financing which complies with the principles of Islamic law, known as Shariah.

Shariah is considered the legal framework of Islam and governs all aspects of a Muslim's life, from moral and spiritual obligations to business and banking activities. Shariah law is derived from several sources, but the most important of these is the Quran, the holy book of Islam, as it was revealed to the Prophet Mohammed. The second and third sources of Shariah are the Sunnah and Hadith. The Sunnah can be described as the sayings and actions of the Prophet Mohammed, while the Hadith are the written records of the Prophet Mohammed's words and deeds. The extent of the contribution of Hadith to the Sunnah is disputed among Islamic scholars and, while the terms are sometimes used interchangeably, they are considered separate sources of Shariah. Other secondary, but nonetheless important, sources of Shariah include the Sahaba (the sayings and statements of the earliest converts to Islam) and Fiqh (Islamic jurisprudence).

Islam is divided into two main denominations, Sunni and Shia, and while we will not delve into the distinctions in this article, it is important to remember in the context of Islamic finance that there are certain differences between these denominations.

A great deal of religious jurisprudence, interpretation and scholarly work on Islamic finance stems from the four Sunni schools of thought, the Hanafi, Maliki, Shafi and Hanbali schools. The followers of these four schools have the same basic belief system but diverge in certain ways in their interpretation of Shariah, thus at times leading to varying conclusions on Islamic finance structures and transactions.

Participants in Islamic financing transactions can, however, obtain comfort as to the Shariah compliance of an Islamic finance transaction. A committee of Shariah scholars will consider the transaction and issue a fatwa (judgment) on the transaction's Shariah compliance.

Fundamental Shariah principles in Islamic finance

Islamic finance is premised upon the belief that commercial activity should be beneficial to society and reflect sound moral and ethical standards. Three broad principles must be borne in mind when discussing Islamic finance: the role of money, the importance of assets as a subject of investment and the principle of risk-sharing.

Money has no intrinsic value in Islamic finance. Rather, money is considered merely a medium of exchange and cannot by itself be a subject matter of trade. Profit can only be generated based on the production or sale of something having intrinsic value or utility (and not through the exchange of money alone). Therefore, Islamic banks cannot provide conventional finance products.

Islamic finance requires an asset basis. There must be an actual asset which is the subject of the finance contract. Unlike Western banking, where financial transactions are largely debt-based and interest-bearing, Islamic finance relies on structural arrangements of asset creation, transfer and ownership between borrowers and lenders.

The principle of profit- and loss-sharing is considered to create a proper balance between lenders and borrowers and is an important tenet of Islamic finance and necessarily present in all Shariah-compliant transactions. Shariah requires that parties to a transaction act in a just, fair and ethical manner with one another. Financial exploitation by one party of another is prohibited and the parties to a transaction must share risk in a reasonable manner. In order to receive a return, one must take part in the real risk involved in the production of such return. Such profit- and loss-sharing creates a real linkage between the purpose of the financing and the outcome. This can be contrasted with conventional practices of separating risk from ownership and outcome.

In addition to these broad principles, there are certain well publicised prohibitions in Islamic finance that must be adhered to:

Interest (Riba)

The prohibition of riba (the generation of money from money or, simplistically, interest) is arguably the most important principle of Islamic finance and flows directly from the above principles. Any return on funds provided by a financier needs to be earned by way of profit derived from a commercial risk taken by the financier. By contrast, conventional interest is charged irrespective of the outcome of a venture and is considered a return on money simply for use of money. Should the borrower's business venture fail, the borrower would still be liable to the lender for interest payments. This disconnect between financing and the underlying business is not considered appropriate by Shariah.

Risk and Uncertainty (Gharar)

Another important prohibition in Islamic finance is gharar, generally translated as risk, hazard or uncertainty. Specifically, gharar is uncertainty as to a fundamental term of the contract, such as subject matter, existence of object, price or time for delivery. Transactions that have excessive risk due to uncertainty around key terms are forbidden by Shariah. For example, gharar is often observed within derivative transactions, such as forwards, futures and options, with the result that in Islamic finance most derivative contracts are prohibited due to the uncertainty involved in the future delivery of the underlying asset. Insurance is another area affected by gharar and specific Islamic insurance structures (Takaful) have been developed as a result.

Speculation (Maisir)

The prohibition of maisir covers gambling and other games of chance, such as lotteries and betting on races. While general commercial risk is permissible, forms of speculation which are regarded as akin to gambling are prohibited. Speculative trades where there is little or no certainty as to the outcome, such as currency market speculation or investment in derivatives, would not be permitted. Where the distinction between general commercial risk and speculation is not clear the commercial substance of a transaction will be analysed. Whilst distinct concepts, there is some degree of overlap between gharar and maisir.

Unethical investments (Haram)

Dealings in certain areas such as alcohol, drugs, pork products and adult entertainment are considered unethical and are prohibited, or haram. The application of this principle may be proportional to the level of prohibited activity, although different Islamic scholars vary in their interpretation of this principle. For example, while financing an alcohol distillery would be prohibited, financing a hotel that incidentally generates income from alcohol sales may, depending on the proportion of revenue from the alcohol sales, be permissible.

Islamic financing techniques

A number of techniques have been developed which comply with Shariah principles and allow Muslims to participate in financings. We will cover five of the most common structures in our series of articles on Islamic finance.

These principal structures are:

(i) Ijara: this is a lease arrangement whereby a financier purchases and leases to the customer a specific asset in return for a rental fee. Similar to conventional leases, the Ijara and can be structured as a finance lease or an operating lease;

(ii) Murabaha: this is a purchase and resale arrangement, whereby a financier purchases goods as requested by the customer and sells them to the customer on a deferred payment basis incorporating a mark-up;

(iii) Musharaka: this is a partnership arrangement under which two or more parties establish a joint commercial venture, contribute capital and labour, and share the profits and losses;

(iv) Mudaraba: this is an investment or partnership whereby one party provides capital (rab al-maal) and the other party provides labour (mudarib). Unlike in the musharaka structure, where both parties are liable for any losses, in a mudaraba structure any loss is borne by the investor only; and

(v) Istisna: this is a contract of sale for specified items which are yet to be manufactured or constructed.

Often, Sukuk (Islamic bonds) are referred to as another Islamic financing structure. Sukuk are capital market securities, taking the form of trust certificates or notes representing a proportional or undivided ownership interest in an asset or pool of assets. Sukuk are used in combination with the Shariah compliant financing techniques described above to produce a Shariah compliant capital markets instrument to allow investment in underlying assets.

By the end of 2007, outstanding sukuk globally exceeded US$90 billion.[3] Gross sukuk issuance increased dramatically up to 2007, from US$7.2 billion in 2004 to almost US$39 billion in 2007.[4] While issuance declined significantly in 2008 to US$14.9 billion, the sukuk market attracted the same number of issuers as in 2007 and current estimates of the pipeline of sukuk range around the US$45 billion mark.[5]

Unlike conventional bonds sukuk do not pay interest but generate returns through actual transactions based on the shariah-compliant financing structures described above. While a conventional bond is a loan of money creating a creditor-debtor relationship, an Islamic bond represents an ownership stake in an existing asset. Thus, while trading in conventional bonds is a sale of debt, trading in sukuk generally equates to a transfer of ownership interests.

In subsequent articles we will discuss each of the above financing structures and how they are implemented in the banking market as well as in the capital market (using sukuk).

[1] Jobst, Andreas ; Kunzel, Peter ; Mills, Paul S. ; Sy, Amadou N. R. "Islamic Bond Issuance - What Sovereign Debt Managers Need to Know" Policy Discussion Paper No. 08/3, July 2008, International Monetary Fund, p 3.

[2] The CIA World Factbook (accessed on 22 April 2009 - https://www.cia.gov/library/publications/the-world-factbook/geos/xx.html)

[3] Jobst, p 4.

[4] Ibid.

[5] "Sukuk Issuance Fell Dramatically in 2008 but Long-term Market Prospects are Good, Says S&P" (accessed on 27 April 2009 - http://www.islamicfinance.de/?q=node/176)

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.