Tuesday , 16 April 2024

What Is Islamic Finance All About? Read On!

Islamic Finance doesn’t have all the answers but if we’re going to improve the systems we have, it’s important to understand how other systems work — especially one that has been around for a cool 1,300 years, and is now a sector holding $3.2 trillion in global assets.

This version of the original article by Stefan Von Imhof (alts.co) has been edited [ ] and abridged (…) to provide you with a faster and easier read. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

Next Saturday, July 9th, Muslims worldwide celebrate Eid al-Adha so, in the spirit of Eid, this article is all about Islamic finance so let’s find out 👇

What is Islamic Finance?

Islamic finance is a set of financial rules that adhere to Sharia law, based on the teachings of the Quran. It views money uniquely, taking strong stances on fundamental concepts such as:

  • Speculation & risk
  • Fairness & justice
  • Protection of the weak and vulnerable
  • The connection between finance and the real economy.

This is all done as an attempt to prevent exploitation and reduce inequality.

Principles of Islamic Finance

There are a few key principles to understand:

  1. Gains from interest are prohibited. This is the biggest one. Lenders are not allowed to collect interest or profit from interest on loans.
  2. A focus on altruism. Any interest, dividends, or other returns from lending capital must be donated to charity.
  3. No derivatives. Financial instruments deemed too intangible, or not part of the “real” economy, are banned.
  4. Prohibited industries. Businesses are prohibited from engaging in specific enterprises, including gambling, alcohol, pork, pornography, and weapons.
  5. No excessive risk. Investments with a high degree of uncertainty, or gharar, are not allowed. All possible risks must be identified to investors. Islamic finance also prohibits selling something one does not own, as it introduces the risk of its unavailability later on.

Critically, Islamic finance is not just for those who follow Islam. Given the global economy, it’s for anyone wanting to do business with any of the 80 countries participating in its economic principles.

A Short History of Islamic Finance

Islamic finance dates way back to the 7th century, a full 900 years before the first incarnations of capitalism, and is based on the foundational concept of riba which…refers to any excess value above the original amount (i.e., the increased cost of a loan over time due to interest payments) with compound interest considered the most harmful and dangerous of ribas.

In a nutshell, Islamic law views interest payments as a relationship that vastly favors the lender. Since it doesn’t consider money an asset, but rather a tool for measuring value, it dictates that money must not be allowed to create more money.

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Islamic finance prohibits riba, or interest, and places emphasis on sharing investment risk.

Modern Incarnations of Riba

…Modern Islamic banking began with Mit-Ghamr Islamic Saving Associations (MGISA) which were founded in Egypt in 1963 to invest people’s savings in a manner compliant with Sharia law.

Fast-forward to today, and the rule of law still applies. Receiving or paying interest is a major sin. In fact, not only are Islamic banking institutions not allowed to charge interest, they are not allowed to offer a return on deposits.

How do Islamic Banks Make Money Without Interest?

On the consumer side: Banks get around riba by providing a “service” to earn profits, in what is known as non-interest banking in which a customer is not just a bank’s customer, but also a partner. They own assets together in a joint-ownership structure where both parties share the risks as well as the profits.

Instead of creating a loan, Islamic banks purchase assets with their customers’ money at an agreed-upon increased price, and provide a bank account that offers a profit/loss on each investment. An interest-free loan contract is then created to facilitate these mutually agreed price & repayment terms, in what’s known as a Sukuk.

This is how financing for homes, cars, and businesses works across the Muslim world. Companies like Lariba offer “riba-free financing,” where each financed asset has two rights of ownership:

  1. The first is the ownership of title to the property
  2. The other right is the right to use the property

For example, a bank can own a house but rent out the right to use the house.

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By 2025, Islamic Finance markets are expected to hold $4.5 trillion in assets — about the same held by all Canadian banks.

On the business side: Equity financing of companies is both allowed and encouraged (as long as the company is not engaged in a restricted industry) and, at first glance, looks a bit like venture capital. Banks succeed when the businesses they invest in succeed, and if the underlying business fails (or fails to grow), the banks take it on the chin. Since borrowers give banks a share in their profits rather than paying interest, however, it’s more similar to a non-dilutive revenue-based financing arrangement.

Other Islamic Finance Principles

Understanding Islamic finance means understanding that the principles go deeper than just riba. Islamic finance principles have much in common with ESG principles. ESG investments are generally known as “socially responsible investing” but Islamic finance takes on the added dimensions of shared risk and profit & loss sharing. As stated above, lenders are more like partners in a venture, with both parties sharing the full risk of a potential loss.

Let’s go deeper into Islamic finance from the perspective of personal finance and corporate finance.

Personal Finance

There are four types of personal finance arrangements:

  1. Ijara,
  2. Murabaha,
  3. Wakala, and 
  4. Musharaka.

1. Ijara

Ijara is basically a lease. A bank buys an asset outright and then promises to lease it to a customer. Over time, the lessee makes principal repayments in a “diminishing musharaka,” similar to an amortization schedule. At the end of the lease, the lessee can buy the home outright from the lessor.

4

An ijara is basically a lease. This flowchart makes it seem more complicated than it actually is.

2. Murabaha

Similar to ijara, a murabaha loan occurs when a bank purchases an asset at a mutually agreed price that includes a markup. The lender buys the asset at the inflated price, and creates a loan for the full amount. After the last loan payment, the customer becomes the asset owner. For example, let’s say a bank and a homebuyer agree to buy a home worth, say, $300k. For the bank to make money, they both agree that the homebuyer’s loan price is, say, $375k  and that is what the homebuyer is responsible for paying over 30-years. In this way, no interest is paid and, until the lease ends, the homebuyer is legally considered a renter.

Buying a home under Murabaha through Islamic financial firm Guidance Residential

At the end of the lease, the bank must allow the renters to purchase the home with their accumulated credit. Unlike with traditional home loans, however, the renters are under no obligation to buy the house so, if the renters decide not to buy the home, the bank must sell it and distribute proceeds to the previous renters.

If this all seems like a form of hidden interest, in many ways it is. Islamic finance has developed some creative workarounds for riba but consider how important it is for Muslims to have avenues that ensure they are faithful to governing laws.

3. Wakala

Under a wakala agreement, a customer allows a bank to act as its agent, allowing the bank to invest money for them in Sharia-compliant trading activities — which is crucial for their retirement.

These Sharia-compliant activities go deeper than riba. Remember, any money received in the form of interest must be donated to charity. The donor must make clear that the donation money is interest money and not zakat (annual religious charitable payment) or sadaqah (voluntary charity). The charity that you donate to cannot just build more mosques; it must use the money to directly relieve hardship and poverty.

4. Musharaka

Musharaka is another joint venture where the customer and bank contribute funding an investment and agree to share the returns. The risk proportions are decided in advance.

This is the scheme Islamic finance advocates are often most excited about. Musharaka is essentially a form of revenue-based financing, which can be especially useful in underdeveloped countries. It’s also considered the purest form of Islamic finance.

Under musharaka, small businesses can work without worrying about interest repayments leading to crushing debt, and everyone has skin in the game.

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Musharaka is the cornerstone of Islamic small business financing. It’s basically a form of revenue-based financing.

Islamic corporate investing

Deutsche Bank, Citibank, and HSBC started their Islamic divisions in the 1990s, but the rise of Islamic banks on Main Street is a rising trend, and 25 Islamic financial institutions now operate in the U.S. but how do these institutions decide what industries to invest in (or what not to invest in)

  • Industries like pork, arms manufacturing, and gambling are a big no-no
  • Some industries are a gray area such as media where investing in a news company might be permissible, for example, but a movie production company wouldn’t be if a “significant portion” of their output is considered inappropriate.
  • Non-Islamic financial services companies are out, and all companies must meet certain criteria concerning interest-bearing debt. Most scholars have accepted that companies need less than 1/3rd of their market cap in interest-bearing debt to comply.

However, because loans are joint ventures, far more time & money is spent on customer due diligence. These costs are ultimately borne by both parties, resulting in higher costs for everyone than traditional interest-bearing instruments.

Others point out that the convenient riba workarounds aren’t so convenient after all, and just create unnecessary steps that achieve basically the same thing as interest would.

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Perhaps the biggest problem, though, is that riskier projects can’t get funding if they don’t meet traditional benchmarks. Any VC will tell you that being too conservative with your investments is a slippery slope towards mediocrity. Some of the Islamic world’s best & brightest feel they have no other choice but to look elsewhere for financing. An important example of this is student loans.

Islamic finance and student loans

Access to student loans is especially difficult for Muslim students.

  • Currently, Muslim students are encouraged to apply for grants from organizations such as the extremely well-funded Islamic Development Bank. However, these education grants are limited to students practicing Islam.
  • In addition, if Muslim students cannot get any scholarships, they’re encouraged to simply delay entry into university instead of taking on loans. This means qualified Muslim students often put off higher education until they’re in a position to afford to pay for it outright.
9Student loans are a particularly hot-button issue in the Muslim community.

Given that even U.S. public colleges now average over $10k/year, saving up for college just isn’t a viable approach and Islamic financial institutions stepping up to meet the demand with Sharia-compliant loans is not as simple as you’d think. Remember, Islamic loans are joint ventures between banks and borrowers. Financing an education is different from financing a home; there is no underlying “asset” here. The banks would essentially need to subjectively quantify career paths based on a cost-benefit analysis. Yikes.

There is a movement in the U.K. to provide halal loans for Muslim students. Some universities offer inflation-based loans, where students are responsible for paying back the “original” loan with an equivalent inflationary value (right now — bad deal). Naturally, there is some debate on whether inflation-based loans are considered riba.

Conclusion

Arguably, Islamic finance’s most compelling features (a focus on charity, and creating wealth through joint ownership agreements) have resonated outside the Islamic community. However, its primary function has always been to comply with the word of God in all financial transactions. For better or worse, many perceive current systems as broken, and are increasingly seeking new financial ideas that provide an alternative. Crypto is a perfect example, but I do think it’s noteworthy that some features of Islamic finance are quite similar to the ones crypto & DeFi promised to bring to the world — and of this writing many of crypto’s promises are rapidly falling apart.

Anyways, there’s no question that Islamic finance still has plenty of room for innovation and improvement. Finance has changed a great deal since the Quran, and has in some ways struggled to deal with an increasingly complex financial world.

Islamic finance has always existed for the Muslim community (the industry is expected to grow 10-12% over the next 3 years), where money is treated as a medium of exchange, not a commodity but new financial products have been created to meet the needs of investors steadfast in following the Quran.

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