A focus on: Basics of Islamic Finance

So, what is Islamic Finance, really? Give me the basics.

To put it relatively simply, Islamic Finance is an alternative way of going about financial dealings; these are conducted in such a way that they comply fully with the religious requirements of Islam. It is generally fully governed by and compliant with Sharia Law, the Islamic Law derived from the Holy Koran as well as the Sunnah, the habits and sayings of the Prophet Muhammed. The overarching statements and rules are implicit in these texts, but the intricacies of how they apply to real world situations tend to be decided based on interpretation by panels of senior financial professionals and learned scholars of Islam.

What is the main difference from conventional finance?

It is a wildly different model that stems mostly from a fundamental and theological difference in the view of economics. In Islamic Finance, given its religious groundings, the dominant idea is that God as a creator is responsible for all happenings, including economic situations. This view is not subscribed to by conventional banking and finance. From this stems the chief idea that in Islam, money is not viewed as a tangible asset, but simply as a measure and store of value, and as such, should not itself exclusively generate more money. This restricts ways in which business can be done. The most prominent difference is that interest, known as “riba”, is not allowed. This means that banks cannot charge borrowers for interest on their loans and customers cannot receive interest on their deposits.

What else separates the two?

Islam does not allow an excess of uncertainty and hence, does not allow gambling either. As a result, it is forbidden to speculate wildly in the financial markets with overly leveraged instruments and complex derivatives. Big bets on volatile products are therefore not desirable. An ethical investment policy also applies. Islamic financial institutions may not invest in or have dealings with any business that violates the basic rules of the religion or could be construed as immoral. It is absolutely out of question to invest in companies related to, or directly involved in: pork products, alcohol, pornography, arms and defense, amongst others.

How then, are banks able to provide services to customers?

In order to fund their operations as a business, instead of charging interest, banks accrue a fee that takes into account all of its running costs. This includes cost of human capital, technology and infrastructure; the cost is then shared by the banks’ customers in the form of said fee. This means that an increase of the customer base is usually translated into a reduction of fees charged. Of note is that the opposite, is clearly also true.

In order to reward customers for their deposits, instead of offering interest-bearing accounts, the bank engages in investments and will share any profit (or loss) with the customers. This sharing agreement is absolutely crucial in Islam and contrasts vigorously with the way conventional banks tend to work, where self-interest is often evident.

Can companies raise bonds, or customers borrow money then?

Firms, sovereigns and governments can raise a different kind of finance. This is done in the form of Sukuks. These are akin to bonds, except they do not formally guarantee a return, even though they are often backed by governments. In a way they resemble the ownership aspect of equities, except that they follow a bond-like structured payout.

If a customer wanted to borrow money for a car, a new TV or even a house, they would engage in a form of credit similar to leasing called “Murabaha”. In this instance, instead of customers buying the goods directly, the bank would purchase them on their behalf and sell it back to the customer who would then make regular payments according to an agreed schedule that would also include a fee.

How did Islamic Banks fare during the financial crisis?

On average, they did not fare as badly as their standard counterparts. This is partly because of the limited scope of products in which the banks can be involved. Instruments like Collateralised Debt Obligations (CDOs), which suffered abysmally during the crisis, were mostly absent from the balance sheets of institutions abiding to Islamic financial principles.

While they did not underperform as severely, it must be noted that in economic booms, there is also less scope to take advantage of this trend. The response to economic stimulus is notably more tempered and tepid. The International Monetary Fund does suggest that this view is somewhat simplistic and that it does not reflect the fact that Islamic Finance institutions do not have a great ability to share risk given their inability to engage in products that may help spread it around more easily.

What does the future hold for Islamic Finance?

While only 1% of the world’s financial transactions are guided by Islamic principles, this is growing fast at a rate of 15-20% a year. Interestingly, not only Muslims are taking interest in this form of finance. Many non-Muslims, especially in Malaysia, are finding that this way of doing business fits in nicely with their morals and ethics. As a result, many global banks such as HSBC and Citi are offering Sharia-compliant accounts for anyone interested. It would not be surprising to see this growth rate increase significantly in the coming years as Islamic Finance finds ways to mimic more of the conventional offerings of banks.