Islamic banking: a technical perspective

Islamic banking: a technical perspective
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How can Islamic finance be viable if interest is not charged or paid? Bala Shanmugam FCPA and Lokesh Gupta explain.

Islamic finance has emerged in recent decades as one of the most important alternative forms of funding in the financial world. There has always been a demand among Muslims for financial products and services that conform to the Shariah (Islamic law).

With the development of viable Islamic alternatives, Muslims as well as non-Muslims are beginning to employ Shariah-compliant solutions to meet their financial needs.

Islamic finance is based on the principles of Shariah. This system shares similar functions as the conventional financial system. The basic principles underlying Islamic transactions are that it must not be 'tainted' with elements of interest and that risk must be shared between banker and customer.

Islamic banking was more or less an abstract concept until the first half of the 20th century but now it has been given a practical shape and has developed into a fully-fledged system and discipline.

Perhaps the most important development has been the growing integration of Islamic finance into the global economy. According to the latest statistics presented during the fifth International Islamic Finance Conference organised by Monash University in Malaysia in September, assets of Islamic finance are estimated to be almost US$850bn.

This is partly due to oil-driven financial liquidity and increasingly savvy Muslim consumers seeking Islamic financial products.
Modus operandi

Conventional banks make profit by paying less interest on deposits and charging more interest on loans. Under Islamic finance, making money from money is strictly prohibited. Money is not perceived as a commodity and consequently it cannot be 'rented out' for a fee.

Hence, there is no direct linkage between deposits and credit under Islamic banking. In Islamic banking, deposits and financing transaction are conducted through underlying assets, following a profit and loss sharing principle. Alternatively, transactions can be structured as a direct sale and purchase, based on a mark-up amount that serves as the banker’s profit margin.

Islamic finance is therefore a mix of commercial bank and investment bank. As with conventional banks, Islamic banks have to be viable to attract investors by generating an adequate rate of return. Like other financial intermediaries, Islamic banks have at one end the 'source of funds' and at the other end 'application of funds'.

The special investment account is related to investment accounts exclusively specified for projects preferred by individual corporate investors. Shareholder funds and deposits are channelled into general financing, trade financing (such as working capital and domestic and international import/export-related financing) and treasury products (Islamic money market instruments) and services.

Rather than charging fixed rates to borrowers, Islamic banks share in the profits and losses of the borrowers’ business transactions, and divide their share of the profit with general and special investors who have deposited funds in the bank.

Rates of return, calculated ex post, are variable, depending on entire business transactions rather than on any predetermined fixed rate that would be tantamount to interest. The profits earned by banks undergo further deduction for operating expenses, zakat (Islamic welfare tax) and taxation before they are shared with shareholders as dividends.
Source of funds

Mobilisation of funds from surplus units in the economy is an important task of any financial intermediary. Muslim savers have unique needs related to returns, liquidity, maturity, safety and stability in that they must be Shariah-compliant.

The bank can raise its initial equity by following the musharakah (equity participation) principle. Under this principle the capital owner enters into a partnership by contributing equity in returns for sharing profit and losses at a predetermined ratio (for example 70:30 or 60:40).

Under the savings account mode of transaction, the bank accepts deposits from customers looking for safe custody of their funds and a degree of convenience in their usage together with the possibility of some profits. In this case the principle of wadiah is employed, whereby the bank requests permission to use these funds so long as these funds remain with the bank.

The depositors can withdraw the balance at any time and the bank guarantees the refund of all such balances. The profits generated by the bank from the deployment of such funds belong to the bank.

However, the bank may, at its absolute discretion, reward customers with hibah (gift) as a token of appreciation, by returning a portion of the profits generated from the usage of their funds. Such a 'gift' can be paid at any time, but in practice most Islamic banks pay on a regular basis (monthly, quarterly).

It is not uncommon to pay in kind rather than in cash. In some countries depositors receive gifts such as carpets or air tickets.

The current account is also based on the Islamic contract of wadiah, whereby depositors are not guaranteed a return on their funds. Normally, depositors do not receive any return for depositing funds in a current account, but some banks provide hibah, which again varies, depending on bank policies.

Banks allow depositors to withdraw their money at any time and conditions for minimum limits and withdrawals are relaxed in comparison to wadiah savings accounts.

In countries such as Iran, qard hassan (interest-free loan) is used as an underlying principle for a current account, whereby deposits are treated as benevolent loans by the depositors. The bank is free to utilise these funds at its own risk. The depositor in his/her role as the lender is not entitled to any return as the latter would constitute riba (excessive charging of interest). It must be reiterated that in either case (wadiah or qard hassan) the amount deposited is guaranteed to be returned.
Investment account

The investment account is based on the mudharabah principle and deposits are accepted by banks from investors for a fixed or unlimited period of time.

Under this principle the bank acts as an investment manager, invests the money in permitted investments and financing activities, realises profits and shares the outcomes with depositors based on the ratio agreed upon earlier.

The investment can be further classified into two categories: the general investment account where the investment account holder authorises the bank to invest the account holder’s funds in a manner which the Islamic bank deems appropriate, without laying down any restriction as to where, how and for what purpose the funds should be invested; and the special investment account where the account holder imposes conditions, restrictions and preferences as to where, how and for what purpose their funds are to be invested.
Application of funds in financing

Islamic financing comprises the financial services that are based on Islamic principles: risk sharing and prohibition of products and services having riba.

Profit and loss sharing is viewed as a major feature to ensure justice and equity in the economy. In addition, banks also follow other principles such as the avoidance of gharar: uncertainty, risk, speculation, focus on halal (religiously permissible activities, and other ethical and religious goals).
The future

Islamic finance has, over the 30-odd years of growth, recorded very impressive figures. This has happened not only in Muslim countries but in other countries as well.

The returns and prospects have been good enough to lure major global financial institutions such as HSBC, Citibank, ABN AMRO, Deutche Bank, and Standard Chartered to participate in this alternate form of financing.

Also, in view of the bright prospects, established financial centres such as London and Singapore have amended existing financial regulation to cater for Islamic transactions. In fact, last week Hong Kong declared its interest in becoming a prominent player in this market.

While on the one hand the Shariah dictates what is permissible and what is not it also provides guidelines on how to structure transactions so as to keep them halal. The flexibility allowed in undertaking most transactions makes room for a very innovative form of financing. In a nutshell, most facilities that conventional banks provide can be undertaken by Islamic financial institutions, so long as it is Shariah-compliant.

While Islamic finance, which is pretty much in its infancy, has some teething problems (standardisation, legal framework), it is only a matter of time before it becomes a force to be reckoned with and a very real alternative to conventional finance.
Forms of financing transactions

Bai bithaman ajil means sale with deferred payments (monthly instalments). In other words, it is not a spot sale. This is used for property and vehicles, as well as financing of consumer goods.

Technically, this financing facility is based on the activities of buying and selling. The assets that the customer wishes to purchase for example, are bought by the bank and resold to the customer at an agreed price, after the bank and the customer determine the tenure of the instalment period.

The price at which the bank sells the asset to the customer will include the actual cost of the asset and will also incorporate the bank’s profit margin. The profit earned by the bank is legitimate from the Shariah point of view since the transaction is based on a sale contract rather than a loan contract.

Murabaha is referred to as cost-plus financing and is a popular method for providing short-term trade financing. It is the sale of goods at a price, which includes a stated profit known to both the banker and the customer.

Under murabaha, the bank purchases, in its own name, goods that an importer or a buyer wants, and then sells them to the customer at an agreed profit. The bank takes title of the goods, and is therefore engaged in buying and selling. Its profit is derived from a real service that entails a certain risk, and is thus seen as legitimate.

Murabaha is one of the most widely used modes of short-term financing and follows a lump sum repayment schedule. It is suitable for purchase of commodities by customers operating in industry or trade. It enables customers to buy finished goods, raw materials, machines or equipment through the bank which may not be otherwise available directly to them due to their credit worthiness.

Ijarah in Arabic means to give something on rent. Ijarah can be defined as a process by which usufruct of a particular property is transferred to another person in exchange for a rent claimed from the customer. Ijarah resembles leasing as it is practised in today’s commercial world.

The unique feature offered by this financial instrument is that the asset remains the property of the bank and can be put on rent every time the lease period terminates. Ijarah is suitable for high-cost assets with a long life span. Both contracting parties benefit where the bank receives the rent as return and also retains the asset. On the other hand the lessee enjoys the immediate benefits of using the asset without incurring a large capital expenditure.

The Islamic concept of al-ijarah thumma al-bai or in brief AITAB refers to an ijarah contract ending with purchase.

It is a type of lease that concludes with an option to buy back in which the legal title of the leased asset will be passed to the lessee at the end of the lease period. AITAB comprises two contracts: an ijarah (leasing/renting) contract and then a bai (sale) contract.

Musharakah financing involves basic partnership principles of sharing in and benefiting from risk. The transaction is based on equity participation (musharakah) in which the partners bring together their capital and know how jointly to generate a surplus.

Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio.

However, it is permissible to have profit sharing not according to the proportion of shares (ownership) but liability is limited to contrib-ution of their shareholders. Investors cannot be held liable for more than the amount of capital they have invested.

Istisna financing (project financing) is a kind of sale where a commodity is transacted before it comes into existence.

For instance, one can order a manufacturer to make a specific commodity for the purchaser.

If the manufacturer undertakes to make the goods for the customer with material from the manufacturer, the transaction is known as istisna. The price of the commodity to be manufactured must be agreed by both parties.

Istisna is a contract of exchange with deferred delivery, applied to specified made-to-order items. Istisna is suitable for high-technology industries such as the automotive, shipbuilding and construction industries.
About the author

Professor Bala Shanmugam FCPA is the chair of accounting and finance and also director of banking and finance at the school of business at Monash University Malaysia
Lokesh Gupta, a senior business consultant by profession, is currently pursuing his M.Phil in the area of Islamic Banking at Monash University Malaysia. His specialisation is in the area of retail banking and electronic payments


Reference: November 2007, volume 77:10, p. 62-65 (Asia edition)



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