FINANCIAL MANAGEMENT: CHAPTER 11 - ISLAMIC FINANCE

History of Islamic finance

The financial industry has historically played an important role in the economy of every society. Banks mobilize funds from investors and apply them to investments in trade and business. The history of banking is long and varied, with the financial system as we know it today directly descending from Florentine bankers of the 14th – 17th century. However, even before the invention of money, people used to deposit valuables such as grain, cattle and agricultural implements and, at a later stage, precious metals such as gold for safekeeping with religious temples.

Around the 5th century BC, the ancient Greeks started to include investments in their banking operations. Temples still offered safe-keeping, but other entities started to offer financial transactions including loans, deposits, exchange of currency and validation of coins. Financial services were typically offered against the payment of a flat fee or, for investments, against a share of the profit.

The views of philosophers and theologians on interest have always ranged from an absolute prohibition to the prohibition of usurious or excess interest only, with a bias towards the absolute prohibition of any form of interest. The first foreign exchange contract in 1156 AD was not just executed to facilitate the exchange of one currency for another ata forward date, but also because profits from time differences in a foreign exchange contract were not covered by canon laws against usury.

In a time when financial contracts were largely governed by Christian beliefs prohibiting interest on the basis that it would be a sin to pay back more or less than what was lent, this was a major advantage.

Islamic banking is banking or banking activity that is consistent with the principles of sharia (Islamic law) and its practical application through the development of Islamic economics. As such, a more correct term for Islamic banking is sharia compliant finance.

Sharia prohibits acceptance of specific interest or fees for loans of money (known as riba, or usury), whether the payment is fixed or floating. Investment in businesses that provide goods or services considered contrary to Islamic principles (e.g. pork or alcohol) is also haraam ("sinful and prohibited"). Although these prohibitions have been applied historically in varying degrees in Muslim countries/communities to prevent unIslamic practices, only in the late 20th century were a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community.

As of 2014, sharia compliant financial institutions represented approximately 1% of total world assets By 2009, there were over 300 banks and 250 mutual funds around the world complying with Islamic principles and as of 2014 total assets of around $2 trillion were sharia-compliant. According to Ernst & Young, although Islamic Banking still makes up only a fraction of the banking assets of Muslims,  it has been growing faster than banking assets as a whole, growing at an annual rate of 17.6% between 2009 and 2013, and will grow by an average of 19.7% a year to 2018

Islamic capitalism
Islamic Finance and banking is as old as the religion itself with its principles primarily derived from the Quran.  An early market economy and an early form of mercantilism, sometimes called Islamic capitalism, was developed between the eighth and twelfth centuries. The monetary economy of the period was based on the widely circulated currency the gold dinar, and it tied together regions that were previously economically independent.
A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, partnership (mufawada, including limited partnerships, or mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal),  cheques, promissory notes,  (Muslim traders are known to have used the cheque or ṣakk system since the time of Harun al-Rashid (9th century) of the Abbasid Caliphate., trusts, transactional accounts, loaning, ledgers and assignments. Organizational enterprises independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.

Usury in Islam

The word "riba" has been defined as interest, usury, excess, increase or addition, which according to Shariah terminology, implies any excess compensation without
due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial."
The criticism of usury in Islam was well established during the lifetime of the Islamic prophet Muhammad and reinforced by several verses in the Qur'an dating back to around 600 AD. The original word used for usury in this text was Riba, which literally means “excess or addition”. This was accepted to refer directly to interest on loans so that, according to Islamic economists Choudhury and Malik by the time of Caliph Umar, the prohibition of interest was a well-established working principle integrated into the Islamic economic system.
This interpretation of usury has not been universally accepted or applied in the Islamic world. A school of Islamic thought which emerged in the 19th century, led by Syed Ahmad Khan, argued for a differentiation between sinful "usury", which they saw as restricted to lending for consumption, and legitimate "interest", for lending for commercial investment

Principles and prohibitions

Like every other aspect of Muslim life, Islamic banking is governed by Sharia’a and its interpretation (Fiqh). Together, these provide the ethical framework outlining the essence of economic well-being and the development of individuals. This framework does not specifically apply to Islamic banks, but to life and business generally. Fairness, honesty, avoidance of hoarding and avoidance of tort are an integral part of Sharia’a law, but so are the prohibition of riba, gharar and maysir.

In brief, these prohibitions are defined as follows:

Riba (or usury) is the predetermined interest collected by a lender, which the lender receives over and above the principal amount it has lent out.

Gharar (or uncertainty) is defined as to knowingly expose oneself or one’s property to jeopardy, or the sale of a probable item whose existence or characteristics are not certain. An example in the context of Islamic finance is advising a customer to buy shares in a company that is the subject of a takeover bid, on the grounds that the share price is likely to increase. Gharar does not apply to business risks such as investing in a company.

Maysir (or speculation) is an event in which there is a possibility of total loss to one party. Maysir has elements of gharar, but not every gharar is maysir.

In the context of the Sharia’a framework, money is seen as nothing more than a means to facilitate trade (rather than a store of value). Consequently, in combination with the aforementioned prohibitions, it is not possible for Islamic banks to provide financing in a similar fashion to conventional banks. Instead, other structures are applied in which the bank often plays a much larger role in the financing structure and becomes a partner in the project to be financed – rather than just a provider of money.

As defined in the accounting, auditing and governance standards for Islamic financial institutions, Islamic banks are founded on the concept of profit-sharing and loss-bearing, which is consistent with the Islamic concept that ‘profit is for those who bear risk’. Profits are distributed according to a ratio defined in the contract, and any losses are distributed equally depending on the share in the project a party holds. The bank or financier partners with the company or individual seeking financing; the bank therefore holds part of the title to the underlying assets as well, depending on its degree of ownership.

Islamic financial products

Islamic financial products work on the basis that the bank and the customer share the risk of investments on agreed terms. Profits are distributed based on negotiated terms; risk is distributed based on the share of the ownership. In addition, Islamic financial products typically have an underlying asset or enterprise that requires financing. The remainder of this article describes the most used instruments in Islamic finance.

Partnership contracts

The Mudaraba and Musharaka contracts are partnership arrangements in which either one (Mudaraba) or more partners (Musharaka) provide capital and/or skill and expertise to a Sharia’a-compliant project or business. Any profit that is generated is distributed between the partners based on a ratio that is pre-agreed in the contract and reflects a return on capital, but also the effort put in to managing the project or business. However, losses are distributed between the partners on the basis of the ratio of the capital provided. This implies that in a Mudaraba where only one party provides the capital, the loss is 100% borne by the capital provider (Rab al Mal), unless the managing party has been negligent in which case he bears all the loss.

Mudaraba and Musharaka transactions are typically applied to private equity investments or to asset management-type instruments. In the latter, the skill of the bank is their ability to seek out investment opportunities and to mobilise funds. In retail finance Musharaka contracts are often applied to provide home purchase plans.

Cost plus financing

Murabaha contracts are contracts for the deferred sale of goods at cost plus an agreed profit mark-up. Murabaha has a variety of applications and is often used as a financing arrangement, for instance for receivables and working capital financing. A special form of Murabaha is the Commodity Murabaha, in which the underlying asset is a physical commodity (often an LME base metal).

Commodity Murabaha is mainly used for inter-bank liquidity management.

Leasing

Ijara contracts in Islamic finance are largely comparable with conventional leasing contracts, in which the lessee pays periodical rental payments to the lessor in return for the use of an asset. Both operational lease (Ijara) and finance lease (Ijara wa Iqtina – or lease ending in ownership) are permissible.

Investment certificate or bond

Sukuk is a bond-type instrument, but unlike a conventional bond, the Sukuk holder also owns a proportional part of the underlying asset. The Sukuk can be based on each of the above mentioned instruments, with the Sukuk al Ijara being most applied. The basic structure involves an SPV that acquires the asset or enterprise on behalf of the Sukuk holders.

ISLAMIC BANKING

The term “Islamic banking” refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. The contemporary movement of Islamic finance is based on the belief that "all forms of interest are riba and hence prohibited".In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). Furthermore the Shariah prohibits what is called "Maysir" and "Gharar". Maysir is involved in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future whereas Gharar describes speculative transactions. Both concepts involve excessive risk and are supposed to foster uncertainty and fraudulent behaviour. Therefore the use of all conventional derivative instruments is impossible in Islamic banking. In the late 20th century, a number of Islamic banks were created to cater to this particular banking market.

Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital while adhering to Islamic law. Because Islam forbids simply lending out money at interest, Islamic rules on transactions (known as Fiqh al-Muamalat) have been created to prevent it. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which is seen in conventional banking. Islamic banking introduces concepts such as profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar).

Interpretations of Shariah may vary slightly by country. According to Humayon Dar, the Islamic Republic of Iran follows a more liberal interpretation of the Shariah than Malaysia, whose interpretation is more liberal than Turkey or Arab countries. Mohammed Ariff also found less exacting interpretation of Shariah compliance in Iran were the government had decreed "that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest and would hence be permissible.

Types of Islamic lending

In an Islamic mortgage transaction, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabahah. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia.

There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus, the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. The Islamic Banking and Finance Database provides more information on the subject

In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio. However, in practice, this is not the case, and no examples of 100 per cent reserve banking are known to exist. Islamic banks have micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).

Advise, standards, Islamic laws

Advisory councils and consultants

Islamic banks and banking institutions that offer Islamic banking products and services (IBS banks) are required to establish a Shariah Supervisory Board (SSB) to advise them and to ensure that the operations and activities of the banking institutions comply with Shariah principles. On the other hand, there are also those who believe that no form of banking that involves interest payments can ever comply with the Shariah.

A number of Shariah advisory firms have now emerged to offer Shariah advisory services to the institutions offering Islamic financial services. Issue of independence, impartiality and conflicts of interest have also been recently voiced. The World Database for Islamic Banking and Finance (WDIBF) has been developed to provide information about all the websites related to this type of banking.

Financial accounting standards

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), has been publishing standards and norms for Islamic financial institutions since 1993. By 2010, it had issued "25 accounting standards, seven auditing standards, six governance standards, 41 shari'ah standards and two codes of ethics." The standards issued by AAOIFI are mandatory for Islamic financial institutions in Bahrain, Sudan, Jordan and Saudi Arabia, and recommended for other Muslim countries and Islamic financial institutions according to Muhammad Akram Khan. Established in Algiers in 1990, its original name was Financial Accounting Organization for Islamic Banks and Financial Institutions. It later moved its headquarters to Bahrain^]

Islamic laws on trading

The Qur'an prohibits gambling (games of chance involving money). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty).

The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." Other modern scholars, such as Dr. Sami al-Suwailem, have used Game Theory to try and reach a more measured definition of Gharar, defining it as "a zero-sum game with unequal payoffs".

There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.

What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk. Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading.

ISLAMIC FINANCIAL TRANSACTION TERMINOLOGY

Bai' al 'inah (sale and buy-back agreement)

Literally, "A loan in the form of a sale". Bai' al inah is a financing arrangement where the financier buys an asset from the customer on spot basis, with the price paid by the financier constituting the "loan". Subsequently the asset is sold back to the customer with deferred payment made in installments, constituting paying back the loan. There are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah, however this is practised in Malaysia and the like jurisdictions.

Bai' bithaman ajil (deferred payment sale)

This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. Like Bai' al 'inah, this concept is also used under an Islamic financing facility. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan. The problem here is that this includes linking two transactions in one which is forbidden in Islam. The common perception is that this is simply straightforward charging of interest disguised as a sale.

Bai' muajjal (credit sale)

Literally bai' muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Bai' muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed.

Mudarabah

"Mudarabah" or Profit-and-loss sharing contract is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The capital investment should normally come from both partners. both should have some skin in the game.

The Mudarabah (Profit Sharing) is a contract, with ONE party providing 100 percent of the capital and the other party providing its specialized knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. If there is a loss, the first partner "rabb-ul-mal" will lose his capital, and the other party "mudarib" will lose the time and effort invested in the project The profit is usually shared 50%-50% or 60%-40% for rabb-ul-mal.

According to economist Tarik M. Yousef, long-term financing with mudarabah or musharakah (both profit-and-loss-sharing mechanisms) is "far riskier and costlier" than the long term or medium-term lending of the conventional banks. As a consequence there has been a "divergence" between the theory of equity-based Islamic finance and the reality of murabahah-dominated practices of Islamic banks.

Murâbaḥah

This concept refers to the sale of good(s) (such as real estate, commodities, or a vehicle) where the purchase and selling price, other costs, and the profit margin are clearly stated at the time of the sale agreement. With the rise of Islamic banking since 1975, Murabahah has become "the most prevalent" Islamic financing mechanism. Murabahah works as finance when the lender/buyer pays the bank/seller for the good(s) over a period of time, compensating the bank/seller for the time value of its money in the form of "profit" not interest. With a fixed rate of profit determined by the profit margin for the purchase of a real asset, this is a fixed-income loan. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled.

This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores.

Musawamah

If the exact cost of the item(s) sold to the lender/buyer cannot be or are not ascertained, a financial transaction cannot be done on the basis of Murabahah, it is called musawamah (bargaining) Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Bai Salam

Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.

Basic features and conditions of Salam

1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.
2. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain.
3. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned.
4. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa.
5. The exact date and place of delivery must be specified in the contract.
6. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed.
7. This is the most preferred financing structure and carries higher order Shariah compliance.

Hibah (gift)

This is a token given voluntarily by a debtor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities.

While it appears similar to interest and may in effect have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion. It cannot be guaranteed, similar to dividends earned by shares. Additionally, it is not time bound but is instead at the bank's discretion. However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah. It is important to note once again that although the preceding descriptions of Hibah do sound like interest payments, there is a fundamental difference beneath: Hibah is voluntary, and at the sole discretion of the giver, whereas payment of interest is contractual obligation that is made in advance between the parties.

Istisna

Istisna (Manufacturing Finance) is a process where payments are made in stages to facilitate step wise progress in the Manufacturing / processing / construction works. Istisna enables any construction company get finance to construct slabs / sections of a building by availing finances in installments for each slab. Istisna also helps manufacturers to avail finance for manufacturing / processing cost for any large order for goods supposed to supply in stages. Istisna helps use of limited funds to develop higher value goods/assets in different stages / contracts.

Ijarah

Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.

Ijarah thumma al bai' (hire purchase)

Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price. The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.

Ijarah-wal-iqtina

A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the ome an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

Musharakah (joint venture)

Musharakah is a relationship between two parties or more that contribute capital to a business and divide the net profit and loss pro rata. This is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance.  All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans)

Qard hassan/ Qardul hassan (good loan/benevolent loan)

Qard hassan is a loan extended on a goodwill basis, with the debtor only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on 'riba, for it alone is a loan that truly does not compensate the creditor for the time value of money

Sukuk (Islamic bonds)

Sukuk,  is the Arabic name for financial certificates that share some similarities with conventional bonds hence are also commonly referred to as Islamic Bonds. A major difference between conventional bonds and sukuk is the structure of sukuk removes interest based elements which is replaced by an asset based income structure using most typically Ijara or Wakala contracts. Similarities are found at the issuance stage where Sukuk issuance  in terms of documentation and regulation such as Reg S /144A and Reg S resembles closely that of a bond.

According to data published by the Islamic Financial Services Board, total outstanding sukuk as of end of 2014 was $294 Billion, of which $188 Billion was from Asia, and 95.5 Billion from the countries of the Gulf Cooperation Council.

Takaful (Islamic insurance)

Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

Wadiah (safekeeping)

In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.

Wakalah (power of attorney)

This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney.

Other Sharia-compliant financing

Islamic equity funds

Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds exceed US$5 billion and are growing by 12–15% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the market or are thinking of launching similar Islamic equity products.

Despite these successes, this market has been undermarketed, as emphasis is on products rather than on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high-net-worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets (e.g. Malaysia and Gulf-based investment funds). Others cater to the Gulf and broader Middle East region, focusing on foreign rather than local market.

Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index ^[ (Dow Jones Indexes pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series.

According to a study by Raphie Hayat and Roman Kraeussl of 145 Islamic equity funds from 2000 to 2009, the funds have under-performed Islamic as well as conventional equity benchmarks, particularly as the financial crisis set in. The study also found fund managers to be unsuccessful in their attempts to time the market.

Islamic derivatives

With help of Bahrain-based International Islamic Financial Market and New York-based International Swaps and Derivatives Association, global standards for Islamic derivatives were set in 2010. The “Hedging Master Agreement” provides a structure under which institutions can trade derivatives such as profit-rate and currency swaps.

Microfinance

Microfinance is a key concern for Muslims states and recently Islamic banks as well. Microfinance is ideologically compatible with Islamic finance, capable of Shariah-compliancy, and possesses a sizeable potential market. Islamic microfinance tools can enhance security of tenure and contribute to transformation of lives of the poor. The use of interest found in conventional microfinance products and services can easily be avoided by creating microfinance hybrids delivered on the basis of the Islamic contracts of mudaraba, musharaka, and murabahah. Already, several microfinance institutions (MFIs) such as FINCA Afghanistan have introduced Islamic-compliant financial instruments that accommodate sharia criteria.

Assessment and controversy

Studies

One of the controversies with regard to Islamic finance is the connection between the returns on accounts in Islamic banks and in conventional banks -- specifically the closeness of the results which is thought by Islamic banking skeptics to be suspicious coincidence but an important way of satisfying customers worried about risk but who want to be Islamically correct. A 2014 of the long-term relationship between Conventional Banks’ term-deposit rates (TDRs) and participation banks’ (Islamic Banks) TDR in Turkey using "the most recent econometric techniques" found three of four participation banks term-deposit rates "significantly cointegrated" with those of Conventional Banks, and "permanent causality" from Conventional to all Islamic Banks.^[

Another study found "strong and consistent empirical evidence" that the development of Shariah-compliant Islamic banking in Muslim countries does not "crowd out" the conventional banking but leads to "higher banking sector development, as measured by the amount of private credit or bank deposits scaled to GDP."

Authenticity

In March 2009, Sheikh Muhammad Taqi Usmani of the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI), a Bahrain-based regulatory institution that sets standards for the global Islamic Banking industry, declared that 85% of Sukuk, or Islamic bonds, were "un-Islamic". Usmani has been called "the granddaddy of modern-day Islamic finance".According to another veteran of Islamic economics, Muhammad Akram Khan, criticizes Islamic banking as professing to have "put its business on a basis other than interest" but in practice devising "a whole host ruses and subterfuges to conceal interest."  In a 2006 dissertation Suliman Hamdan Albalawi concluded that the Islamic banking movement has "become main-stream," and Islamic banks at least in Saudi Arabia and Egypt have "departed from using profit-loss-sharing (PLS) techniques as a core principle of Islamic banking"

Fatwa shopping

Journalist John Foster complains that techniques such as lease agreements that appear to outsiders to be mortgages "dressed up in Arabic terminology" (Mudarabah, or Ijarah), are one cause for questioning Islamic Banking, as is the practice of “Fatwa shopping” -- i.e. shopping for an Islamic scholars seal of approval, confirming the product is Shari'ah compliant.^[

Foster quotes an "investment banker based in Dubai" as saying,

“We create the same type of products that we do for the conventional markets. We then phone up a Sharia scholar for a Fatwa ... If he doesn't give it to us, we phone up another scholar, offer him a sum of money for his services and ask him for a Fatwa. We do this until we get Sharia compliance. Then we are free to distribute the product as Islamic.”

According to Foster, "top scholars" often earn "six-figure sums" for each fatwa on a financial product.^[

Risk

Whether Islamic banking is more or less risky than conventional banking is disputed.

Zeti Akhtar Aziz, the head of the central bank of Malaysia maintains that sharia-compliant banks are "inherently more stable" than conventional peers and Speculation is forbidden. But according to the Economist magazine, "Dubai's debt crisis in 2009 showed that sukuk [Islamic bonds] can help to inflate debt to unsustainable levels." According to one author (Mahmoud A. El-Gamal), while Islamic banks often avoid use of the word "customer" or "depositor" in favor of the term ‘partner’,

In these institutions, investment-account holders neither have the protection of being creditors of the Islamic financial institution, nor do they have the protection of being equity holders with representation on those institutions’ boards of directors. This introduces a host of other well-documented risk factors for the institution.

Islamic banks are also criticized by some for not applying the principle of Mudarabah in an acceptable manner. Where Mudarabah stresses the sharing of risk, critics point out that these banks are eager to take part in profit-sharing but they have little tolerance for risk. To some in the Muslim community, these banks may be conforming to the strict legal interpretations of Sharia but avoid recognizing the intent that made the law necessary in the first place.

For example, the Malaysian bank RHB offers Islamic banking products, including vehicle loans. The product dislosure sheet, however, explains that in the event that the borrower defaults on the loan, the vehicle may be repossessed and any the borrower will be "responsible to settle any shortfall after your motor vehicles is auctioned off." This is an obvious contradiction to claims of risk-sharing. But he have to bear in mind that there are some different contracts used in Islamic financing. The one used at the RHB in vehicle financing is AITAB which is not at the same level with Mudharabah contract in terms of risk-sharing.

Some Islamic banks charge for the time value of money, the common economic definition of interest (riba). These institutions are criticized in some quarters of the Muslim community for their lack of strict adherence to Sharia.

The concept of Ijarah is used by some Islamic Banks (the Islami Bank in Bangladesh, for example) to apply to the use of money instead of the more accepted application of supplying goods or services using money as a vehicle. A fixed fee is added to the amount of the loan that must be paid to the bank regardless if the loan generates a return on investment or not. The reasoning is that if the amount owed does not change over time, it is profit and not interest and therefore acceptable under Sharia.

Non-Muslim influence

The majority of Islamic banking clients are found in the Gulf states and in developed countries. The majority of financial institutions that offer Islamic banking services are majority owned by Non-Muslims. With Muslims working within these organizations being employed in the marketing of these services and having little input into the actual day-to-day management, the veracity of these institutions and their services are viewed with suspicion. One Malaysian Bank offering Islamic based investment funds was found to have the majority of these funds invested in the gaming industry; the managers administering these funds were non Muslim. These types of stories contribute to the general impression within the Muslim populace that Islamic banking is simply another means for banks to increase profits through growth of deposits and that only the rich derive benefits from implementation of Islamic Banking principles.

Riba as interest being a "settled issue"

Islamic finance is based on the belief that "all forms of interest are riba and hence prohibited" When a minority member (i.e. one of the non-Muslim MNA -- Member of the National Assembly -- representing their religious group, rather than an electoral district) of the National Assembly of Pakistan questioned this in 2004, members of leading Islamist political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged a walkout from the Assembly, protest what they termed derogatory remarks on interest banking:

Taking part in the budget debate, M.P. Bhindara, a minority MNA ...referred to a decree by an Al-Azhar University's scholar that bank interest was not un-Islamic. He said without interest the country could not get foreign loans and could not achieve the desired progress. A pandemonium broke out in the house over his remarks as a number of MMA members...rose from their seats in protest and tried to respond to Mr Bhindara's observations. However, they were not allowed to speak on a point of order that led to their walkout.... Later, the opposition members were persuaded by a team of ministers...to return to the house...the government team accepted the right of the MMA to respond to the minority member's remarks.... Sahibzada Fazal Karim said the Council of Islamic ideology had decreed that interest in all its forms was haram in an Islamic society. Hence, he said, no member had the right to negate this settled issue.

The decree notwithstanding, a minority of scholars (Muhammad Abduh, Rashid Rida, Mahmud Shaltut, Syed Ahmad Khan, Fazl al-Rahman, Muhammad Sayyid Tantawy and Yusuf al-Qaradawi) have questioned whether riba includes all interest payments. Others (Muhammad Akran Khan) have questioned whether riba is a crime forbidden by sharia (Islamic law) and subject to punishment like murder and theft, or simply a sin to be discouraged, since "neither the Prophet nor the first four caliphs nor any subsequent Islamic government ever enacted any law against riba

International standardization /regulations of Islamic finance

The Islamic Financial Services Board (IFSB) is an international standard-setting organisation that promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors. The IFSB also conducts research and coordinates initiatives on industry related issues, as well as organises roundtables, seminars and conferences for regulators and industry stakeholders.

Establishment

The Islamic Financial Services Board (IFSB), which is based in Kuala Lumpur, was officially inaugurated on 3rd November 2002 and started operations on 10th March 2003. It serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market and insurance. In advancing this mission, the IFSB promotes the development of a prudent and transparent Islamic financial services industry through introducing new, or adapting existing international standards consistent with Sharî'ah principles, and recommend them for adoption.

To this end, the work of the IFSB complements that of the Basel Committee on Banking Supervision, International Organisation of Securities Commissions and the International Association of Insurance Supervisors.

As at April 2015, the 188 members of the IFSB comprise 61 regulatory and supervisory authorities, eight international inter-governmental organisations, and 119 market players (financial institutions, professional firms and industry associations) operating in 45 jurisdictions.

Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act 2002, which gives the IFSB the immunities and privileges that are usually granted to international organisations and diplomatic missions.

Adoption of Standards

Since its inception, the IFSB has issued twenty-four Standards, Guiding Principles and Technical Note for the Islamic financial services industry. The published documents are on the areas of:

1. Risk Management (IFSB-1)
2. Capital Adequacy (IFSB-2)
3. Corporate Governance (IFSB-3)
4. Transparency and Market Discipline (IFSB-4)
5. Supervisory Review Process (IFSB-5)
6. Governance for Collective Investment Schemes (IFSB-6)
7. Special Issues in Capital Adequacy (IFSB-7)
8. Guiding Principles on Governance for Islamic Insurance (Takāful) Operations (IFSB-8)
9. Conduct of Business for Institutions offering Islamic Financial Services (IIFS) (IFSB-9)
10. Guiding Principles on Sharī`ah Goverance System (IFSB-10)
11. Standard on Solvency Requirements for Takāful (Islamic Insurance) Undertakings (IFSB-11)
12. Guiding Principles on Liquidity Risk Management (IFSB-12)
13. Guiding Principles on Stress Testing (IFSB-13)
14. Standard on Risk Management for Takāful (Islamic Insurance) Undertakings (IFSB-14)
15. Revised Capital Adequacy Standard (IFSB-15)
16. Revised Guidance on Key Elements in the Supervisory Review Process (IFSB-16)
17. Core Principles for Islamic Finance Regulations (IFSB-17)
18. Recognition of Ratings on Sharī`ah-Compliant Financial Instruments (GN-1)
19. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards: Commodity Murābahah Transactions (GN-2)
20. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders (GN -3)
21. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio (GN-4)
22. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions (ECAIS) on Takāful and ReTakāful Undertakings (GN-5)
23. Quantitative Measures for Liquidity Risk Management (GN-6)
24. Development of Islamic Money Markets (TN-1)

The standards prepared by the IFSB follow a lengthy due process as outlined in its Guidelines and Procedures for the Preparation of Standards/Guidelines which involve, among others, the issuance of exposure draft and, where necessary, the holding of a public hearing.