Transcript
Islamic Finance is a key aspect of emerging economies, such as Malaysia, Indonesia, and Saudi Arabia. It has experienced rapid growth, with Islamic Finance assets increasing from $200 billion in 2003 to $3.3 trillion in 2020. In this video, we will learn about the basics of Islamic Finance, including some key principles and examples of Islamic financial structures.
Islamic Finance, as defined by the IMF, refers to financial services that adhere to Islamic or Sharia law. Sharia Financial law can be complex, but for today, let’s focus on a few key principles.
The first principle is the prohibition of Reba, which is often translated as interest. In Islamic finance, the charging of interest, a fundamental element of conventional finance, is not allowed. This prohibition aims to prevent the exploitation of the poor by the rich through making money from money. Consequently, even basic debt financing structures like loans and mortgages, which involve charging interest, are not permitted in Islamic finance.
The second principle to remember is the prohibition of Gharar and Maysir, which refer to uncertainty and gambling, respectively. Financial contracts that are considered excessively speculative, such as derivatives, including futures, are often banned due to their involvement in uncertain transactions. Islamic finance aims to avoid such uncertainty and gambling.
The third principle is the prohibition of financing Haram (forbidden) activities. Haram refers to activities that are prohibited by Sharia law. For example, financial arrangements involving Reba (interest) and Gharar (uncertainty) are considered Haram. Additionally, investing or financing businesses related to pork or alcohol, which are forbidden in Islam, are examples of Haram finance. To ensure compliance, credit cards from Islamic financial institutions may be programmed to restrict payments at certain establishments like nightclubs.
It is important to note that not every Islamic country interprets these principles in the same way. For instance, Gulf region Islamic scholars tend to be stricter than those in Malaysia, leading to variations in the application of Sharia law. This diversity creates a unique risk in Islamic finance known as Sharia risk, where an Islamic financial product deemed acceptable by one country’s scholars may later be declared void by other scholars for breaching Sharia law.
Given the prohibition of interest, a crucial question arises: How do banks and financiers in Islamic finance generate profits? Let’s explore some examples.
One classic example is the profit-sharing structure called Mudarabah. Mudarabah is a partnership in which the financier provides the capital, while the other party manages the business. Both parties agree on the predetermined profit-sharing ratio, with the financier bearing all losses. Mudarabah structures are commonly used in business ventures but have also been applied in Islamic commercial banking. In this case, the client provides funds to the bank, which manages the money and uses it in its business operations. The bank agrees to pay a ratio of profits earned back to the depositor, allowing Islamic banks to engage in commercial banking without paying interest to depositors.
Besides profit-sharing structures, Islamic finance employs profit and loss-sharing arrangements like Musharakah. Musharakah is a joint venture partnership in which all parties contribute funds for a project or asset, sharing in its ownership, profits, and losses. This structure has been adopted for property finance since conventional mortgages involving interest are prohibited. In property finance using Musharakah, a company seeking financing to acquire a property can enter into a Musharakah contract with a bank. Both parties contribute capital to purchase the desired property, with the company gradually buying out the bank’s share over time. The bank then leases or rents its share in the property to the company, earning profit through the rent received.
For trade finance, a structure called Murabaha is often used. Under Murabaha, if a company needs capital to buy goods, the financier purchases the goods first. The goods then belong to the financier, and the company agrees to pay the financier at a later date, including a markup. The financier immediately provides the goods to the company. This arrangement allows the company to obtain finance for its goods, and the financier receives repayment and profit through the deferred payment and markup on the goods.
Another notable Islamic financial structure is the Sukuk, which functions similarly to bonds but without charging interest. Suppose a government needs money. In that case, it can establish a special purpose vehicle (SPV) that issues Sukuk certificates, each with a fixed face value. The money collected from investors is used to purchase land from the government for a specified duration. The SPV then leases the land back to the government, which pays rent to the SPV. The SPV distributes regular payments, matching the rent, to the investors. At the end of the specified period, the SPV sells the land back to the government for a price equal to the value of all the Sukuk. The money received by the SPV is given back to the investors. In this way, the government obtains the needed funds, investors receive a profit through government rent payments, and investors eventually retrieve their capital.
In summary, Islamic Finance is guided by principles that prohibit the charging of interest, uncertainty, and financing of forbidden activities. Instead, Islamic financial structures focus on profit-sharing, profit and loss-sharing, and asset-based transactions. Examples include Mudarabah, Musharakah, Murabaha, and Sukuk. These structures allow for financial transactions while adhering to Islamic principles. It’s important to note that interpretations and practices may vary across different countries and scholars within the Islamic finance industry.
