Faizal Karbani - Mastering Islamic Finance - A Practical Guide To Sharia-Compliant Banking, Investment and Insurance-FT Publishing International (2015)

PRAISE FOR MASTERING ISLAMIC FINANCE
‘Excellent reading and an accessible guide for those who want to understand
Islamic finance from first principles. This book combines the theoretical and
applied aspect of Islamic finance.’
Dr Mohamad Akram Laldin, Executive Director, Sharia Scholar,
International Shari’ah Research Academy for Islamic Finance (ISRA)
‘A comprehensive introduction that demystifies Islamic finance by clearly

explaining – with plentiful examples – not only its terminology and struc-
tures but also the reasons those structures have been developed.’
John Gilbert, Consultant, Hogan Lovells International LLP
‘This book clearly demystifies Islamic finance for those who are new to it
or need to work within the Islamic finance requirements. Constructive and
clear, it’s an excellent source of learning and of reference.’
Ruth Martin, formerly managing director the CISI, and Chair of the
Education, Training and Qualifications Group of the Islamic Finance
Secretariat
‘An excellent insight into Islamic finance enabling all to gain an under-
standing of the key concepts surrounding the fascinating subject of Islamic
finance.’
Paul Jennings, Deputy CEO, ABC International Bank plc
Mastering Islamic
Finance
A practical guide to Sharia-compliant
banking, investment and insurance
FAIZAL KARBANI
Pearson Education Limited
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Harlow CM20 2JE
United Kingdom
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First published 2015 (print and electronic)
© Pearson Education Limited 2015 (print and electronic)
The right of Faizal Karbani to be identified as author of this work has been asserted
by him in accordance with the Copyright, Designs and Patents Act 1988.
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ISBN: 978–1-292–00144–9 (print)
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Print edition printed in Great Britain by Henry Ling Ltd, at the Dorset Press,
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NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT
EDITION
Writing this book has given me great satisfaction in being able
to share my knowledge and experience about a subject I am
very passionate about; in many ways it marks the culmination
of many years of study and professional experience. To this end,
I must thank all those who have supported and encouraged me
through the years – too many to mention individually, but I
include teachers, friends, family and professional colleagues. A
special tribute goes to my parents, who have been unshakeable
in their unconditional love and support throughout my life
and worked tirelessly to give me the best possible foundation
in life; also a special thanks to my wife, Tassnima, my children
– Emaan, Mustafa and Misbah and my siblings – Shamim,
Merunisha, Salma and Arif for their love, support and help
over the years.
Contents
About the author xi

Publisher’s acknowledgements xii
Author’s acknowledgements xiii
Part 1 BACKGROUND 1
1 The Islamic finance phenomenon 3

Introduction 5
The Islamic finance phenomenon 5
Why does Islamic finance exist? 7
Why is Islamic finance a sizeable and growing market? 8
Key challenges facing the industry 13
Conclusion 16
2 Islam – key beliefs, principles and practices 17

Introduction 19
Belief system 19
Key practices – the five pillars of action 21
Importance of the Qur’an and the Sunnah 22
Interpretation of the sharia 24
The role of scholars and sharia supervisory boards in Islamic
finance 26
Conclusion 27
3 How Islamic finance differs from conventional banking 29

The Islamic economic model 31
Key Islamic finance principles 35
Conclusion 43
4 Valid commercial contracts in Islamic finance 45

Introduction 47
Key conditions for validity of contracts 47
Integrity of contractual arrangements 51
vii
Contents
Status and use of promises 52

Conclusion 53
Part 2 ISLAMIC FINANCE IN PRACTICE 57
5 Key transaction types in Islamic finance 59

Introduction 61
Equity-type: transactions 61
Mudarabah (Partnership – one party contributes capital) 62
Musharakah (Partnership – all parties contribute capital) 64
Asset finance: 68
Murabaha (Sale of an asset at a known profit mark-up) 68
Ijarah (Leasing of an asset) 77
Istisn’a (Sale of an item to be constructed or manufactured) 80
Salam (Sale of fungible item yet to be produced) 84
Other key transaction types: 89
Wakala (Agent providing services to a Principal) 89
Hawalah (Transferring a debt) 92
Rahn (Providing security) 93
Kafalah (Providing a guarantee) 94
Conclusion 95
6 Sukuk 97
Introduction 99
Definition 100
Mechanics of a sukuk transaction 101
Types of sukuk 102
Asset-based versus asset-backed sukuk 108
Sukuk and the secondary market 109
A strong future for sukuk 109
Conclusion 111
7 Sharia-compliant investments and wealth management 113

Introduction 115
Sharia-compliant investments 115
Zakat by Iqbal Nasim 126
Sharia-compliant estate distribution and Islamic wills by
Haroon Rashid 133
Conclusion 144
8 Takaful – Islamic insurance 147

Introduction 149
viii
Contents
Sharia perspective on conventional insurance 149

Takaful – the Islamic alternative 150
Takaful models 151
Types of takaful policy 155
The future of the takaful industry 158
Conclusion 158
9 The future of Islamic finance 161

Introduction 163
Recommendations for success by IFSB and IDB/IRTI 163
Opinion pieces 166
The Christian view of usury by Robert Van de Weyer 167
The future of Islamic finance by Dr Sayd Farook 171
The secret to long-term success: get the direction of travel right
by Faizal Karbani 176
Index 181
ix
About the author
Faizal Karbani is the founder and CEO of Simply Sharia Ltd, a UK firm
solely dedicated to providing sharia-compliant financial solutions along with
supporting Islamic finance through recruitment and training.
Over the last decade Faizal has become a leading UK practitioner of the
industry. Highly trusted and recognised, he supported both the technical
team advising the UK government on tax implications for sharia-compliant
products and the government consultation on sharia-compliant student
finance in Britain. Under his leadership and direction, Simply Sharia
launched the first certified sharia-compliant green energy EIS, offered to UK
investors in 2014.
His clients have included Qatar Islamic Bank in London (QIB UK),
Gatehouse Bank, Arab Banking Corporation, Barclays Capital, British
Bankers Association (BBA) as well as a host of individuals and other
businesses.
Faizal is also an Approved Trainer for the Islamic Finance Qualification
(IFQ) and undertakes bespoke Islamic finance training programmes for
professionals. He is a regular speaker on Islamic finance related topics and is
a member of the Advisory Board appointed by the University of Nottingham
in respect of its Islamic finance programmes.
Prior to working in Islamic finance, Faizal, who is a qualified Chartered
Accountant, worked at PriceWaterhouseCoopers and GlaxoSmithKline.
xi
Publisher’s acknowledgements
We are grateful to the following for permission to reproduce copyright material:
FIGURES
Figure 1.2 from Global Islamic Finance Report 2013, Edbiz Consulting;
Figure 1.3 from Pew Research Center’s Forum on Religion and Public
Life, The Future of the Global Muslim Population, January 2011, www.
pewforum.org/2011/01/27/the-future-of-the-global-muslim-population/,
Pew Research Center; Figures 1.5 and 1.6 from Thomson Reuters Zawya,
Sukuk Perceptions and Forecast Study 2014, Islamic Finance Gateway; Figure
3.1 from Week 11, 2014: Global Debt, http://www.ercouncil.org/chart-
of-the-week/week-11-2014-global-debt.html, Economic Research Council;
Figure on page 79 from Islamic KD Ijara Fund, www.kuwait.nbk.com/
investmentandbrokerage/investmentfunds/ijarafunds/islamickdijarafundiv/
default_en_gb.aspx
TEXT
Extracts on pages 67, 79 and 90–1 from Al Rayan Bank (formerly

Islamic Bank of Britain (IBB)); Extract on page 79 from Islamic KD Ijara
Fund, www.kuwait.nbk.com/investmentandbrokerage/investmentfunds/
ijarafunds/islamickdijarafundiv/default_en_gb.aspx; Extract on pages 87–8
from Dubai Islamic Bank (DIB), www.dib.ae/personal-banking/finance/
al-islami-personal-finance/salam-finance/faqs#tab-section
In some instances we have been unable to trace the owners of copyright
material, and we would appreciate any information that would enable us to
do so.
xii
Author’s acknowledgements
I am indebted to several people in helping me to write this book. My dear

friend, Faisal Sheikh and my colleague, Anas Hassan have in particular
played a significant role in reviewing and providing valuable feedback on
the book.
Faisal is a Wealth Manager at Barclays – as someone interested to learn
more about Islamic finance and a financial professional, he is typical of
someone that the book is aimed at. Therefore his feedback was very relevant
and insightful and I’m sure resulted in enhancing the overall quality of the
book.
Anas’ professional career has centred around Business Strategy and he
currently works alongside me as the Head of Business Finance at Simply
Sharia. His feedback on the draft chapters was invaluable in helping me
project the message in the most effective way.
Others who have provided me feedback and advice as I’ve been writing
the book include Lawrie Chandler, Tasnim Raja, Tarek El-Diwani, Kate
Edmunds, Nyra Mahmood and my wife, Tassnima Karbani.
I would also like to acknowledge all the contributors to the book:
Iqbal Nasim, who has written about the obligatory form of charity due
from Muslims every year, known as Zakat. He is a leading authority on the
subject and is the Chief Executive of the UK based charity called National
Zakat Foundation.
Haroon Rashid, who has written on the subject of Sharia compliant estate
distribution and Islamic Wills. Haroon is a lawyer who has specialised in
this area and is widely recognised as a leading authority on the subject
and has played a key role in pioneering Islamic Wills that are tax efficient
in the UK.
Robert Van De Weyer, who has contributed an opinion piece entitled
the ‘Christian View of Usury’. Robert is a practising Christian priest
and a former Economics lecturer at Cambridge University. He presents
a fascinating view of how Islamic finance principles are consistent with
Christian and broader ethical values.
Dr Sayd Farook, has contributed an opinion piece entitled ‘The Future of
Islamic Finance’, where he provides an amazing insight into the journey
xiii
Author’s acknowledgements
of Islamic Finance to date and what he believes the industry needs to do

to achieve its potential. Dr Sayd is the Global Head of Islamic Capital
Markets at Thomson Reuters and has been played a significant role in
producing some of the most insightful analysis and reports on the global
Islamic finance industry to date.
xiv
Part
BACKGROUND
1
1. The Islamic finance phenomenon

2. Islam – key beliefs, principles and practices
3. How Islamic finance differs from
conventional banking
4. Valid commercial contracts in Islamic
finance
1
The Islamic finance phenomenon
Introduction
The Islamic finance phenomenon
Why does Islamic finance exist?
Why is Islamic finance a sizeable and growing market?
Key challenges facing the industry
Conclusion
1 · The Islamic finance phenomenon
INTRODUCTION
Islamic finance is estimated to be an industry worth over a staggering $1.7

trillion1 in terms of global banking assets and is growing globally at more
than 15 per cent per year. For some, it represents an opportunity to tap
into a lucrative new market, while for others it is now necessary to provide
services or products in this sector so that current or potential customers are
not lost. This book seeks to equip practitioners with an understanding of
the key concepts underpinning Islamic finance and the prevalent and devel-
oping market practices. It will also explain the main product and service
types and, where applicable, how they differ from comparable conventional
finance instruments.
The book assumes the reader to have no previous knowledge of the
subject. Islamic finance is a faith-based proposition and thus to understand
the finance, one must understand key features of the faith. Therefore the first
part of the book focuses on understanding more about the beliefs, values and
principles that underpin the practice. The second part of the book looks at
the application of Islamic finance by discussing the key transaction types and
market practices and products.
Whether you are a banker, lawyer, asset manager, wealth manager,
accountant or any person with an interest in Islamic finance, this text aims
to give you a solid knowledge foundation of the area, a tool kit and frame
of reference to understand and apply yourself to the sector. People may
perceive Islamic finance to be mysterious, specialised and accessible only to
Muslims, made worse by the use of jargon and foreign terminology. This
book seeks to explain the guiding principles and practices with a clear,
jargon-free narrative that defines any reference to foreign terminology. The
book will also demonstrate that while Islamic finance is a faith-based propo-
sition, it is underpinned by a few core principles which need not exclude
any section of society from involvement, whether as a practitioner, supplier
or consumer.
THE ISLAMIC FINANCE PHENOMENON
While Islamic assets represent only about 1 per cent of the global financial
market,2 it has been the remarkable growth and the potential of the Islamic
finance industry that have really captured the attention of governments, the
financial services sector and other stakeholders such as regulators and central
banks globally.
1
Ernst & Young, ‘World Islamic Banking Competitiveness Report 2013−14’.
2
UKIF, ‘Islamic Finance Report – March 2012’.
5
Mastering Islamic Finance
Figure 1.1 Global assets of Islamic finance
1800 1700
1631
1600 $ Bn, assets end-year
1400 1289
1200 1130
1000 861 933
800 677
600 509
400
200
0
2006 2007 2008 2009 2010 2011 2012 2013
Figure 1.1 shows this impressive growth in global Islamic banking assets.3
This growth has spurred interest in Islamic finance across the world and
not just in predominantly Muslim countries. Institutions specialising in
this sector, such as Islamic banks and Islamic insurance providers, have
emerged. Islamic finance has also become significant for many mainstream
institutions and service providers, especially large international law firms
and investment banks. The Islamic finance industry is estimated to comprise
7164 firms offering services to the sector, spanning 61 countries in the East
and West, and an estimated 38 million customers globally with Islamic
banks.5 Banks account for the bulk of Islamic assets globally, with Islamic
insurance and investment funds making up the rest. There are now more
than 1,000 sharia-compliant funds around the globe with assets under
management of more than $60 billion.6
Although three-quarters of Islamic finance assets worldwide are in
Muslim countries, the UK (at 2.3 per cent) and ‘others’ (countries with less
than 1 per cent of the market – see Figure 1.2) are notable exceptions.
3
‘Islamic Finance Report’, City UK, October 2013. Figure for 2013 from Ernst & Young, ‘World
Islamic Banking Competitiveness Report, 2013−14’.
4
‘Opportunities for Islamic finance in the UK’ (www.gov.uk/government/news/
opportunities-for-islamic-finance-in-the-uk).
5
Ernst & Young, ‘World Islamic Banking Competitiveness Report 2013−14’.
6
Ernst & Young, ‘Islamic Funds & Investment Report 2011’.
6
Share of global Islamic finance industry Figure 1.2
Others, 21.2%
Bangladesh, 1.0%
Iran,
Egypt, 1.3%
25.5%
Indonesia, 1.3%
UK 2.3% Saudi Arabia,

Turkey 2.5% 9.5%
Qatar 4.2%
Bahrain, 4.4%
Kuwait, 46.3%
Malaysia, 9.5%
UAE, 7.4%
Source: ‘Global Islamic Finance Report 2013’, Edbiz Consulting.
WHY DOES ISLAMIC FINANCE EXIST?
In a world where there is no obvious link between faith and finance, what
is it about the Islamic faith that motivates Muslims to demand financial
products and services that accord with their faith?
The teachings of Islam permeate all aspects of life, from family, social and
business dealings to worship, morals and even areas such as private hygiene.
Islam does not subscribe to a secular model whereby religion plays little or
no role in public affairs; there is no separation of ‘church’ and ‘state’ as such.
Islam is an Arabic term and means ‘submission to God’s will’. A believer
endeavours to live his/her life in a way that is consistent with the values and
teachings of the Islamic faith, with the ultimate aim of pleasing God and
gaining God’s favour and acceptance.
The Islamic faith lays down some clear principles and guidelines for
business and financial dealings. For practising believers it is therefore very
important to follow these teachings. Not only do they believe there is benefit
to be gained from following the guidance but they are wary of the conse-
quences of not following the teachings.
This can be demonstrated by reference to the rulings around interest. A
key feature of Islamic finance is that paying or receiving interest is forbidden.
The Qur’an, the Muslim holy book and the primary source of guidance for
Muslims, warns against this in the strongest terms:
7
Those who take interest will not stand on the Day of Judgement except
as he who has been driven mad by the touch of the devil. That is because
they have said, ‘trading is like interest’, but God has permitted trading
and prohibited interest. Whosoever receives an advice from his Lord and
stops, he is allowed what has passed and his matter is up to God. And
those who revert back are the people of the Hellfire. O you who believe!
Fear God and give up what remains due to you from interest if you are
really believers; and if you do not, then take notice of war from God and
his Messenger, but if you repent you shall have your capital sums. Deal not
unjustly and you shall not be dealt with unjustly.
(Qur’an, Chapter 2, verses 278–279)
Based on the above passage from the Qur’an alone, the seriousness of the
issue of interest is obvious. Much of conventional finance is underpinned
by interest; theoretically it is very difficult for Muslims to engage with the
industry at all. Of course, Muslims have the same need for financial services
as any other group in societies across the world, whether that is in relation
to business, purchasing properties, investing or protection. It is no surprise,
therefore, that increasing numbers of Muslims seek to fulfil this need in
compliance with their religious duties.
WHY IS ISLAMIC FINANCE A SIZEABLE AND

GROWING MARKET?
Islam is an ancient religion and yet it seems that Islamic finance has
only relatively recently emerged as a significant industry. The reality is
that Islamic finance is as old as the religion itself. However, a number of
developments in the second half of the twentieth century have driven the
importance and growth of the industry. Broadly, these can be summa-
rised as:
■■ growth of the Muslim population worldwide leading to rising promi-
nence of the Islamic faith in the world;
■■ the economic development of countries with large Muslim populations
leading to rising affluence among Muslims;
■■ the greater integration of Muslim and non-Muslim economies (which
may be considered to be a function of globalisation) leading to institu-
tions tapping the liquidity of Muslim nations.
Key growth factors

Rising prominence of the Islamic faith in the world
It is estimated that Muslims around the world total in the region of 1.6
8
Muslim population by region, 2010 and 2030 Figure 1.3
Muslim population by region

2010 2030
Estimated Projected
percentage percentage
of global of global
Estimated Muslim Projected Muslim
Muslim population Muslim population
population population
World 1,619,214,000 100% 2,190,154,000 100%
Asia-Pacific 1,005,507,000 62.1 1,295,625,000 59.2
Middle East-North Africa 321,869,000 19.9 439,453,000 20.1
Sub-Saharan Africa 247,544,000 15.0 385,939,000 17.6
Europe 44,138,000 2.7 58,209,000 2.7
Americas 5,256,000 0.3 10,927,000 0.5
Population estimates are rounded to thousands. Percentages are calculated from unrounded numbers.
Figures may not add exactly due to rounding
Source: Pew Research Center Forum on Religion & Public Life, ‘The future of the global Muslim population’, January 2011.
billion people, accounting for approximately 23 per cent of the world’s

population. This makes Islam the second biggest religion in the world after
Christianity. Islam has been the fastest-growing religion in the world for
some time and it is estimated that it will continue to be so, such that by
2030 Muslims will total a projected 2.2 billion people – 26.4 per cent of the
world’s population (see Figure 1.3).7
Several factors account for the faster projected growth among Muslims
than non-Muslims worldwide. Generally, Muslim populations tend to have
higher fertility rates than non-Muslim populations. In addition, a larger
share of the Muslim population is in, or soon will enter, the prime repro-
ductive years (ages 15–29). Improved health and economic conditions in
Muslim-majority countries have led to greater-than-average declines in
infant and child mortality rates and life expectancy is rising even faster in
Muslim-majority countries than in other, less developed countries.8 Figure
1.4 shows the top 10 countries with the largest Muslim populations. Clearly,
as the number of Muslims globally increases, so does the potential demand
for products that accord with the Islamic faith.
7
Pew Research Forum (www.pewforum.org).
8
All these facts around the Muslim population and its growth have been sourced from the Pew
Research Center.
9
Figure 1.4 Top 10 Muslim countries by population
Morocco
Algeria Population - million
Turkey
Iran
Nigeria
Egypt
Bangladesh
India
Pakistan
Indonesia
0 50 100 150 200 250
Rising affluence among Muslims

The oil boom in the 1970s and 1980s and continuing wealth derived from
oil in the Middle East have prompted the beneficiaries of this wealth to
demand more financial products that are compliant with Islam. Indeed,
in a report entitled ‘Addressing the Muslim market’, published in 2007,
global management consulting firm AT Kearney estimated that the OPEC
(Organization of the Petroleum Exporting Countries) nations had more than
$500 billion in current account surpluses annually, which they were increas-
ingly channelling through Islamic financial institutions.
As the industry has matured in terms of scale, market practices and
regulation, and there has been greater demand and awareness among
the masses, the provision of products has broadened and become more
mainstream. The first commercial Islamic bank was Dubai Islamic Bank,
formed in 1975, soon to be followed by Islamic banks in Egypt, Sudan,
Bahrain and Kuwait.
Ten of the world’s 24 rapid growth markets as categorised by profes-
sional services firm Ernst & Young in a recent report have large Muslim
populations and offer strong growth prospects for the Islamic finance sector
(retail, finance for small and medium-sized enterprises, trade finance, wealth
management) (see Table 1.1).9
Ernst & Young, ‘World Islamic Banking Competitiveness Report 2012–13’.

9
10
Rapid growth markets Table 1.1
Rapid growth markets GDP compound annual growth rate (CAGR) 2000–10
Qatar 12.8%
China 10.3%
Kazakhstan 8.5%
India 7.4%
Vietnam 7.2%
Nigeria 6.4%
Ghana 5.6%
Russian Federation 5.3%
Indonesia 5.2%
Malaysia 5.0%
UAE 4.9%
Egypt 4.9%
Ukraine 4.7%
Republic of Korea 4.6%
Thailand 4.4%
Turkey 4.2%
Colombia 4.1%
Argentina 4.1%
Poland 3.9%
Chile 3.8%
Brazil 3.7%
South Africa 3.6%
Saudi Arabia 3.4%
Mexico 2.3%
The Ernst & Young ‘World Islamic banking competitiveness report

2013–14’ went on to highlight six of these 10 markets in particular. The
credentials for growth in these six markets are very strong, as shown in
Table 1.2.
As Table 1.2 on the next page indicates, despite the size and growth of
the industry in recent years, the level of penetration of Islamic finance in
many Muslim countries is still relatively low. Penetration in a number of
Muslim-majority countries is limited, with Islamic banking accounting for
11
Table 1.2 Potential for growth
CAGR % Growth Size of % market

of Islamic rate vs. Islamic share of
finance conventional assets $bn Islamic
– 5 years finance finance
(2008–12)
Qatar 31% 1.8× faster $54bn 24%
Indonesia 42% 3.1× faster $20bn 4.6%
Saudi Arabia 11% 3.6× faster $245bn 53%
Malaysia 20% 2.1× faster $125bn 20%
UAE 14% 3× faster $83bn 17%
Turkey 29% 1.6× faster $39bn 5.6%
only 4–6 per cent of total banking assets in Turkey, Egypt and Indonesia.10
Hence there is plenty of room for growth.
Tapping the liquidity of Muslim nations

As the wealth of Muslims and majority-Muslim nations has risen, so too has
the ability of companies, banks and governments to tap into this liquidity
to help finance large-scale projects and initiatives.
An instrument known as a sukuk has been at the forefront of raising such
finance. (Given the prominence of sukuk in the Islamic finance industry, a
whole chapter of this book – Chapter 6 – will examine this instrument in
detail.) A sukuk is often referred to as an Islamic bond because from a returns
perspective it shares many of the features of a bond: that is, the returns are
often expressed as a specific yield on the amount invested. In reality, a sukuk
is quite different to a bond. While a bond is a debt instrument, a sukuk is
an investment in an underlying asset, and it is the economic return on that
asset that dictates the returns to an investor. Many sukuk are based on the
underlying asset being leased subject to a contract. The returns tend to be
predictable and known, which leads to similarities with the return profile of
conventional bonds.
Figures 1.5 and 1.6 show how both the number of sukuk issues and the
amount raised through sukuk issuance have soared in recent years.
The success of the sukuk market has attracted the attention of many
non-Muslim governments, banks and corporates. The liquidity and avail-
ability of capital have been curtailed in many western countries in particular
due to the financial crisis that began in 2008. In this context, tapping the
liquidity of Muslim nations has emerged as a credible option to raise capital
UKIF, ‘Islamic Finance Report – March 2012’.

10
12
Global aggregate sukuk historical trend, 1996−2013 Figure 1.5
$ Billion # Issues
160 800
581
140 Amount issued 700
120 Number of issues 600
572
100 500
425
80 400
60 253 300
230 213
188 183
40 150
200
115
20 47 55 49 100
41
2 1 0 4
0 0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD
May
2013
Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.
Sukuk issuance: breakdown by country ($m, 2013 YTD) Figure 1.6
1,756
2,589 Malaysia
Saudi Arabia
5,166 UAE
Indonesia
Turkey
7,274 Bahrain
33,869 Pakistan
Brunei Darussalam
Other
Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.
– for example, the UK government raised £200 million through the issue of
a sovereign sukuk in June 2014.
KEY CHALLENGES FACING THE INDUSTRY
While the Islamic finance market credentials are relatively strong, being a
fairly new industry it faces a number of challenges if it is to achieve its full
potential. Some of the key issues are outlined below.
13
Regulatory environment
As any industry matures, the infrastructure around it needs to develop. One
of the key parts of this infrastructure is regulation. The financial services
industry in particular is highly regulated throughout the world and it is
important that regulation for the Islamic finance industry develops to:
■■ give it a level playing field versus conventional finance in terms of taxes
and other areas;
■■ make products and services more portable across borders;
■■ standardise, as much as practically possible, sharia rulings, documen-
tation and accounting treatment.
Sharia authenticity
A key success factor in the development of Islamic finance is for the industry
to remain true to the spirit and objectives of the Islamic teachings. After
all, the industry is a faith-based proposition; the faith is centred on certain
social and ethical values. If these are hijacked or diluted at the expense of
commercial ends, the industry will lose credibility in the medium to long
term and will not fulfil its potential. Practices such as commodity murabaha
(described in detail in Chapter 5), a synthetic transaction designed to
overcome the prohibition of interest by using a metal trade, have probably
damaged the credibility of the industry. Product providers need to innovate
and bring products to the market that the consumers want but are true to
the spirit and objectives of the sharia.
Another dimension to this issue of sharia authenticity is for product
providers to be bold enough to bring new products to the market that do
not simply seek to mimic the economic effect of conventional products, but
are potentially very different and present a real alternative to conventional
products. For example, instead of using commodity murabaha, industry
players need to be bold enough to practise other techniques in which there
is a genuine trade and/or profit and loss sharing.
Scale
As mentioned earlier, Islamic finance represents about 1 per cent of the
global financial market. In the short time frame of the modern Islamic
finance industry (around 40 years), it is clear from empirical research that
the overwhelming majority of Muslim consumers want sharia-compliant
products that come with a competitive price and service compared to similar
products in the conventional space. Two good examples of where scale is
required to achieve competitive pricing are retail banking and protection/
14
insurance. In both of these areas, sharia-compliant providers have struggled

to compete effectively with conventional players. The Islamic finance
industry needs to build scale and achieve world-class operational efficiency
and service standards.
Islamic finance for all

Naturally, adherence to Islamic teachings and principles appeals to Muslims.
However, the objectives of the sharia (called maqasid al sharia) are very much
rooted in protecting and promoting the welfare of individuals and society as a
whole. Indeed, a well-known Islamic scholar, Imam Abu Hamid Al-Ghazali
(died 1111 ce), summarised the objective of the sharia as follows:
The very objective of the sharia is to promote the well-being of the people,
which lies in safeguarding their faith (deen), their lives (nafs), their intellect
(ñaql), their posterity (nasl), and their wealth (mal).Whatever ensures the
safeguarding of these five serves public interest and is desirable, and
whatever hurts them is against public interest and its removal is desirable.
In this context, Islamic finance can be presented to Muslim and non-Muslims
as an ethical form of finance, the principles of which aim to promote the
well-being of society. Hence there is a real opportunity to make Islamic
finance more appealing and inclusive to all and present it as a real, viable
alternative to conventional finance. Indeed, in the wake of the recent global
financial crisis, many around the world have questioned conventional
financial products and systems and there has been something of a resurgence
in looking at alternative products and systems.
The human capital challenge

For an industry growing at more than 15 per cent a year, it is widely
recognised that a key enabler for this growth to continue is to have the
right amount and quality of human capital coming through. In an article
by Nazneen Halim, editor of Islamic Finance News, she says it is anticipated
by 2015 that more than 50,000 individuals will be needed in the Islamic
finance industry globally.11 This will require the training and education
of professionals serving this industry and attracting and retaining the
best possible talent to the industry. Professionals from outside of Islamic
finance have a lot to offer the industry – they can bring valuable profes-
sional experience to the table and help Islamic finance players achieve
best commercial practice, operational efficiency and world-class service
standards.
11
Halim, N. (2013) ‘Transforming Islamic finance – the human capital challenge 2013’, Islamic
Finance News.
15
One aspect to the human capital challenge facing the Islamic finance
industry is to ensure there are enough new sharia scholars coming through
who understand the financial system and regulatory environment enough to
provide sharia advice that is rooted in the realities of the legal, regulatory
and commercial environments.
All of the above issues are recognised in the industry and there is much
debate and discourse on these. We will revisit several of these areas in the
last chapter of the book, ‘Chapter 9,’ The future of Islamic finance’.
CONCLUSION
In summary, the religious imperative for Muslims to follow the teachings

of their faith, coupled with demographic and other changes in the Muslim
world rooted in wealth and population growth, has made Islamic finance an
attractive market segment. A quote from information provider Thomson
Reuters in the marketing for its event entitled ‘The Global Islamic Economy
Summit 2013’, which took place in Dubai in November 2013, sums it up
well:
The Islamic economies of the world represent more than $8 trillion in
GDP, and a 1.6 billion population growing at double the rate of the global
population. Disposable income for the Islamic economy is estimated at
$4.8 trillion – and with 62% of the population under the age of 30, the
next generation of Muslims are increasingly asserting their Islamic sensi-
tivities with everything from food preferences to banking and finance, to
fashion, cosmetics, travel and healthcare.
The Islamic finance industry is young, developing and full of promise and
opportunity. It has gone through and will continue to go through a number
of growing pains, and needs to rise and overcome a number of challenges
if it is to fulfil its potential. This book aims to take the reader on a journey
in which the first step is to gain some appreciation of the faith from which
this industry stems, then to appreciate the conceptual principles, values and
economic framework pertinent to Islamic finance, and finally to look at the
practice, application and key market segments of this industry. We finish
with several opinion pieces on the future of the industry. By the end of this
journey, my hope is that the reader will have a good grasp of the subject,
feel empowered to engage with the industry, and is enlightened as to some
of the key challenges, opportunities and imperatives the industry faces as it
strives to forge ahead.
16
2
Islam – key beliefs, principles
and practices
Introduction
Belief system
Key practices – the five pillars of action
Importance of the Qur’an and the Sunnah
Interpretation of the sharia
The role of scholars and sharia supervisory boards in Islamic finance
Conclusion
2 · Islam – key beliefs, principles and practices
INTRODUCTION
To understand Islamic finance it is important also to understand a little

about the Islamic faith. Practitioners who have a base level of under-
standing of the faith will not only comprehend the various principles
underpinning sharia-compliant financial transactions better, but will
be tuned into the mindset of a faith-based buyer of a sharia-compliant
financial product. Indeed, all too often, those involved in the Islamic
finance industry have shown a lack of understanding of the considerations
important to those looking at sharia-compliant products from a faith
perspective, and as a result certain products and services have not achieved
their potential.
BELIEF SYSTEM
Islam is a monotheistic faith and at its very heart is the belief that there
is One God who has no partner, associate or offspring; that this God
created everything, including mankind – the first human being Adam.
Furthermore, God sent Prophets to mankind through the ages to remind
them and teach them that God was their Creator, and that they were charged
with the responsibility to do good, uphold justice and to reject and fight
against all wrong and evil. In addition to the Prophets, Muslims believe
God sent scriptures through the ages as a means of advising and instructing
mankind on how to live their lives. These scriptures include the Torah, the
Bible and the Qur’an. Muslims believe that after death every person will be
held accountable for what they did in their lives; that one day this world
will come to an end and every person will be resurrected, and there will be
a Day of Judgement. At this time, God will judge the deeds of each person
and those who are successful will be admitted to Heaven for ever – a place
full of joy and bliss – and those who are not successful will be admitted to
Hell – a place of torment and punishment.
The six pillars of faith

Indeed, the belief system of a Muslim is often summarised by reference to
six key beliefs (see Figure 2.1), four of which are referred to explicitly above:
1. Belief in the One God. Muslims may refer to God by a number of
names, Allah being the most common and coming from the root word
illah, which means God. Other names refer to the attributes of God, e.g.
Ar-Rahman (Most Merciful), Al-Karim (Most Generous), etc.
2. Belief in the Prophets of God. These include Noah, Abraham, Moses
19
and Jesus. Muhammad (PBUH)1 is believed to be the last and final

Prophet of God. Hence you will find a relatively high level of common-
ality between the three Abrahamic faiths – Islam, Christianity and
Judaism.
3. Belief in the holy scriptures. As mentioned, the holy scriptures include
the Bible, the Torah and the Qur’an. We will discuss the Qur’an in further
detail below.
4. Belief in the resurrection after death on the Day of Judgement. The
essence of this belief is that one day the world will come to an end, and
every person will be resurrected and will be judged by God based on their
deeds in this life.
The other two key beliefs are:
5. Belief in the angels. These are creatures that humans cannot see; the
Islamic teachings describe them as creatures made from light and who are
dedicated to the servitude of God.
6. Belief in predestination and the Divine Decree. This refers to the
belief that everything happens by God’s Will and that matters such as
our lifespan have been predestined for us; furthermore, God, through his
infinite knowledge, knows everything, including the events of the future.
Figure 2.1 Six pillars of belief
Belief in Belief in Belief in Belief in Belief in Belief in

one God the prophets the holy the Day of the angels the Divine
of God scriptures Judgement Decree
1
PBUH is short for Peace Be Upon Him. Islam teaches that whenever Prophet Muhammad or
any other of the prophets are mentioned, reverence and respect must be shown by invoking
the Peace of God upon them. Every time any of the Prophets of God, including Prophet
Muhammad is mentioned, PBUH has been implied in the rest of the book.
20
KEY PRACTICES – THE FIVE PILLARS OF ACTION
Following on from these six ‘pillars’ of faith, there are five ‘pillars’ of action
for a Muslim (see Figure 2.2). These are all obligatory acts subject to having
the ability and/or means to perform them:
1. To testify to the Oneness of God and to the Prophethood of Muhammad.
2. To pray five times a day at appointed times. Prayer times are staggered
throughout the day, starting with the prayer just before sunrise, the
second around lunchtime, the third mid-afternoon, the fourth at sunset
and the fifth at night.
3. To pay a minimum amount of one’s wealth to the poor and needy every
year. There are rules as to what qualifies a person to pay this and to those
who are eligible to receive this type of charity.
4. To fast from dawn to sunset during a particular lunar month of the year
– this month in the Muslim calendar is called Ramadan.
5. To undertake the pilgrimage to the Holy Mosque in Mecca at least once
in one’s life.
These five pillars of action have a huge impact on how Muslims express their
faith and live their lives on a practical basis. The five obligatory prayers, in
particular, mean that Islam has a very practical impact on the daily lives of
Muslims. Indeed, in the world of Islamic finance – if you are dealing with
Five pillars of action Figure 2.2
Testification Five daily Fasting in Paying Pilgrimage

of faith prayers Ramadan charity to Mecca
yearly
21
Islamic banks or go to Islamic finance conferences – there will almost always

be facilities for prayers. Also you will often find Muslim work colleagues or
clients requesting a place to pray so that they can fulfil their duty to pray at
prescribed times.
Another key practical element of Islamic faith is the importance of the
holy day, Friday. Muslims are required to attend a congregational prayer at
the time of the normal daily lunchtime prayer on a Friday. Hence in Muslim
countries such as Saudi Arabia, the weekend is set to include Friday and it
is a day off for most people. In Europe and other non-Muslim countries, you
will see Muslims making an effort to go to their local mosque during their
lunch break to fulfil the obligation to pray in congregation on a Friday and
hear the sermon delivered by the leader of the congregation, known as the
imam. Knowing this is important if and when you engage in work related to
Islamic finance as you will be mindful of the client’s/colleague’s requirement
to pray, about inappropriate times to request meetings such as Friday lunch-
times, and so on.
Throughout the year there are key events and dates to be aware of. The
ones with the greatest impact are Ramadan, the month of fasting, and the
pilgrimage season. In both cases in Muslim countries there will be public
holidays at these times; in non-Muslim countries you will find that many
Muslims generally have time off or change their working patterns. Indeed,
it is often commented that things become very quiet in the Muslim world
in terms of work and trade during the month of Ramadan, as priorities are
redirected to family and spiritual development.
The six pillars of faith and the five pillars of action referred to above start
to give you a framework of the Islamic faith in terms of beliefs and key
practices. In Chapter 3, we will discuss how Islam views money and wealth,
which will further help you to understand the mindset of a practising
Muslim when entering into commercial and financial transactions.
IMPORTANCE OF THE QUR’AN AND THE SUNNAH
An important question to answer is: ‘What are the key sources of knowledge
upon which the Islamic teachings are based?’
The two foremost sources are the Qur’an, the holy book, and the Sunnah, the
example of the Prophet Muhammad. Let us discuss each of these in turn.
The Qur’an
The Qur’an is the Muslim holy book. It has a very high status in Islam
because Muslims believe it to be the literal word of God. Muslims believe
22
that it was revealed to Prophet Muhammad over a period of 23 years by

God through the Angel Gabriel. Angel Gabriel would visit the Prophet
every so often during this period, each time revealing certain verses of the
Qur’an.
Due to this belief that the Qur’an is the literal word of God and therefore
in essence it is as though God is talking directly to mankind, the Qur’an
is held in the highest esteem by Muslims and is regarded as the foremost
source for Islamic knowledge and guidance. Indeed, a significant proportion
of Muslims will make it part of their daily routine to read a portion of the
Qur’an, and many millions have committed the entire book to memory.
The Qur’an is written in Arabic and its translation can be found in most
languages. The key principles pertaining to Islamic finance, such as the
prohibition of interest, can be seen in the teachings of the Qur’an.
The Sunnah
The Sunnah refers to the example and teachings of the Prophet Muhammad.
It is very clear from the Qur’an that the believers are required to follow the
example and teachings of the Prophet.
Qur’anic verses:
O believers obey Allah, obey the Messenger and those in authority among
you. If you dispute about anything, refer it to Allah and the Messenger.
(Chapter 4, verse 59)
And whatever the Messenger gives you, accept it, and from whatever he
forbids you, keep back, and be careful of your duty to Allah.
The status of the Prophet Muhammad is also very high in Islam. Muslims
believe Muhammad to be the last Messenger of God. He was born in
Mecca in what is now known as Saudi Arabia in 571 ad. His life history
has been well documented and we see that in his youth he earned respect
as being a person of integrity and truth, often referred to as ‘Al-Amin’ (the
trustworthy).
It was the Prophet’s job to provide an example and practical model in
terms of implementing God’s teachings. For instance, it was commanded by
God to pray in the Qur’an, but it was through the example and teachings
of Prophet Muhammad that Muslims know how to carry out the prayers in
practice.
Given the status of the Prophet and the importance of following his
example and teachings, his life and sayings have been extensively recorded
and have been the subject of much scrutiny and study. His recorded sayings
are referred to as the hadith and have been the subject of intense verification
by scholars with respect to their authenticity. As a result, today we have
23
books of hadith, or the Prophet’s sayings, in which the recorded sayings are
categorised according to the strength of their validation.
The primary sources of teachings pertaining to Islamic finance are the
Qur’an and the Sunnah, which provide the basis for Islamic finance. You
will often hear the word sharia mentioned in the context of Islamic finance.
Sharia refers to the framework of rules, principles and guidance derived from
the Islamic teachings, primarily from the Qur’an and Sunnah. Sometimes,
sharia is referred to also as Islamic law and often, in the context of Islamic
finance, products are referred to as sharia-compliant.
INTERPRETATION OF THE SHARIA
Accepting that the Qur’an and the Sunnah are the prime sources of knowledge
for Islamic finance does not mean that there cannot be differences in inter-
pretation. However, it is important to appreciate that these are not usually
disputes of principle but of application. It may be helpful to understand the
background to these differences of interpretation.
The interpretation and detailed rulings coming out of the study of the
Qur’an and Sunnah is called fiqh in Arabic. Such work falls to sharia scholars,
who have studied the sharia in depth and therefore have the requisite
knowledge to perform this role. The role is analogous to a lawyer who inter-
prets statute and case law. This is relevant to the field of Islamic finance as
scholars may sometimes have different opinions or views on the permissi-
bility or otherwise of certain financial products and structures.
There are some important points to note on these differences of opinion/
schools of thought:
1. The differences do not usually emanate from the key underlying principles
but from the detailed rules around application.
2. Islam essentially has two broad divisions – the Sunnis and the Shias. Again
the pillars of faith and action are essentially the same. The key differences
relate to opposing views on the succession of leadership after the Prophet’s
death. Of the world’s Muslim population, 87–90 per cent are Sunni and
10–13 per cent are Shia.2
3. Within the Sunnis there are four established schools of thought, named
after the scholars who produced detailed works on their interpretation of
the sharia. These school of thought are:
■■ The Hanafi school of thought: named after Imam Abu Hanifa
(703–767 ce). This school originates from Iraq and is the dominant
school of thought in the Indian sub-continent and Turkey.
2
Pew Research Center: ‘Religion & public life project’.
24
■■ The Maliki school of thought: named after Imam Malik (717–801 ce).
This school originates from Medina in Saudi Arabia.
■■ The Sha’afi school of thought: named after Imam Shafi (769–820 ce).
This school of thought emerged in Egypt.
■■ The Hanbali school of thought: named after Imam Hanbal (778–855
ce). This school originates from Damascus and is particularly influ-
ential in Saudi Arabia and the Arabian Gulf region.
Imam Shafi advocated an approach to interpreting the sharia, which is
widely used by contemporary scholars. He recommended that the following
hierarchical order be used when interpreting the sharia:
1. The Qur’an.
2. The Sunnah.
3. Ijma – consensus of the scholars.
4. Qiyas – analogy, that is to derive rulings for a particular situation based
on established rulings for other scenarios, where there is a clear analogy
with the situation being considered.
These scholars were alive either at the same time or in adjacent time periods.
It is well documented that they had a healthy respect for each other and the
differences of opinion they had were mutually respected, and even still today
one school of thought is not seen as superior to another. Within the Sunnis
all of the four schools are seen as valid.
The main school of thought within the Shia sect is referred to as
the Jaafri school, named after Imam Jaafar. Although Shias represent a
minority in terms of the global Muslim population, it is the dominant
sect in Iran, which has the largest share of the global Islamic finance
market.
Outside of these schools of thought, contemporary scholars play the role
of interpreting the sharia in relation to subjects, situations or topics not
expressly covered in the Qur’an and the Sunnah and the established and
accepted schools of thought.
In the contemporary world, it is worth noting that there is a body
called the Islamic Fiqh Academy, set up by the Organisation of the Islamic
Conference (OIC) in 1981. The Academy is based in Jeddah and its members
comprise sharia scholars and experts in science, economic and social issues
from around the world. Its role is to debate and provide guidance on contem-
porary issues.
In terms of Islamic finance, therefore you will find sharia scholars having
differences of opinion on certain matters emanating sometimes from the
differences between the established schools of thought, and other times from
their interpretation of the sharia.
25
THE ROLE OF SCHOLARS AND SHARIA SUPERVISORY BOARDS IN

ISLAMIC FINANCE
When Islamic banks and other organisations in the Islamic finance industry
bring products to the market, it is necessary that they make sure that the
products are sharia-compliant. Usually qualified scholars, who have the
requisite level of knowledge, are engaged to verify whether the products
are compliant and to sign off the products before they go to market. This
opinion/certification by scholars is called a fatwa. Scholars in making their
assessment and forming their opinion will rely first and foremost on the
teachings within the Qur’an and the Sunnah. If no direct ruling or precedent
relevant to the situation at hand can be found from these, scholars will use
their knowledge of the sharia to come up with a ruling that is compatible
with the principles and values underpinning the Islamic teachings.
Scholars play a key role in the Islamic finance industry. Scholars are charged
with making sure that the product design, key features and legal documen-
tation such as product prospectuses are in line with the sharia, as well as
ensuring the product implementation and practice remain sharia-compliant.
To this end, most Islamic finance institutions usually commission an annual
sharia audit and the resulting report generally features in the institution’s
published financial statements.
The model of engaging scholars is not the same across the global Islamic
finance industry.
The Malaysian model

Malaysia is often cited as the most advanced nation when it comes to
the legal, institutional, research/educational and regulatory framework
it has built for the Islamic finance industry. A key reason for this success
and progression has been the political will and commitment from the
government to develop Malaysia as a world leader in Islamic finance, and
to have the best-in-class infrastructure to support this. Malaysia in 1983
passed an official Islamic Banking Act creating a dual banking system in
the country – the conventional banking system and the Islamic system.
The fruits of this comprehensive and cohesive national approach orches-
trated from the top can be seen in the increasing popularity and growth of
sharia-compliant products in the country, the high quality of Islamic finance
research produced in Malaysia, and Malaysia’s increasing profile and market
share of the global Islamic finance market, as seen in Chapter 1. Malaysia
is the only country to have a university, The Global University of Islamic
Finance (INCIEF) dedicated to Islamic finance and a government research
institute dedicated to Islamic finance, International Shari’ah Research
Academy of Islamic Finance (ISRA).
26
Malaysia has tackled the need for sharia scholars by creating a national
central supervisory board. If any organisation wants to launch a sharia-
compliant product it needs to get approval and certification from this central
board. Individual banks or other organisations can have their own sharia
advisers or scholars but ultimately sign-off has to come from the central board.
Model outside of Malaysia

Outside of Malaysia the dominant model is for individual banks and other
organisations to have their own respective sharia supervisory boards. These
boards will typically have at least three scholars who are engaged to ensure
the products and services of the bank/other organisation are sharia-compliant
and remain so.
This model prevalent outside of Malaysia is reflective of Islamic finance
in these countries being more of a commercial phenomenon driven by
commercial organisations with limited governmental involvement and
political will to create a cohesive national and institutional infrastructure. In
my view the Malaysian model is far superior, with the role of scholars being
a very good example. With a central board, two key advantages result:
1. There is consistency in judgement as to what scholars will approve as
sharia-compliant. Without this, we have seen examples in the market
whereby a particular sharia supervisory board will approve a product,
while another does not.
2. It removes a potential conflict of interest. It is conceivable that if a scholar
is employed and paid by a bank, he/she may be put under pressure to
approve products, or that there may be the perception of a lack of impar-
tiality, which may be equally damaging. By having a central board that
is not paid or engaged by the bank/other organisation seeking product
approval, this problem does not arise.
CONCLUSION
This chapter has provided a summary of the key beliefs underpinning the
Islamic faith and the key sources of knowledge with respect to Islamic
teachings. We discussed that Islamic law (the sharia) is subject to interpre-
tation and that while the key principles are uniform across the faith, it is
possible to have differences of opinion on matters of application. A differen-
tiating feature of the Islamic finance industry is the central role that sharia
scholars play in the industry: in ensuring products are compatible with the
sharia and giving confidence to the market by providing official certification
that products are sharia-compliant.
27
All of this knowledge is directly relevant to the foundation and practice

of Islamic finance. With Islamic finance being a faith-based proposition, this
background knowledge is important and will serve well those engaged in
the Islamic finance industry or those undertaking any work in this space.
28
3
How Islamic finance differs from
conventional banking
The Islamic economic model

Key Islamic finance principles
Conclusion
3 · How Islamic finance differs from conventional banking
THE ISLAMIC ECONOMIC MODEL
Modern discourse on economic models tends to be dominated by two

opposing ideologies, namely capitalism and socialism, neither of which is
explicitly associated with particular religions. It is rare to see a discussion
about economic models that refer to a particular religion. The Islamic faith
is holistic in nature; there is no separation between ‘church’ and ‘state’,
so to speak. As mentioned previously, Islam means submission to God’s
Will and by implication believers should, in every sphere of their lives,
including finance, seek to follow the guidance and values espoused by their
faith.
Capitalism in its purest form is defined by individual freedom, free
markets with no intervention and an unbridled pursuit of wealth. Socialism
focuses on the collective, with little or no scope for individuals to pursue or
increase personal wealth through private enterprise.
Much of the world today has a heavy bias towards capitalism, with
varying degrees of state regulation and intervention to protect the interests
of society at large and those who are vulnerable, such as the poor and sick.
Socialism as an economic system is less prevalent in today’s world and there
are only a few examples of economies that are using this as a basis for their
economic system – examples include Cuba and North Korea. It is more
common to refer to socialists as those who campaign for a greater role for
the state in protecting and helping the vulnerable and poor and for greater
equality in wealth distribution.
So how does the Islamic economic system compare with these models?
Islam purports to be a religion and way of life that is in harmony with
the nature of man. To this end it recognises that man has an innate desire
to seek wealth as a means of fulfilling his needs and achieving a higher
quality of life. Islam encourages human endeavour, enterprise and trade and
promotes the idea of people having the freedom to express their talents and
entrepreneurial skills. Indeed, seeking wealth and livelihood through honest
effort and trade is seen as a commendable act and a blessing from God, as
evidenced by the reported statement from Prophet Muhammad:
It is better for one of you to take some rope and go to a mountain and
bring a bundle of firewood on his back and sell it by which Allah saves
his honour and dignity, than for him to ask people who then give to him
or refuse.
‘Collection of Prophetic sayings’ by Imam Bukhari
At the core of what makes the Islamic system different is the belief that God
is the real owner of all wealth and resources. Capitalism confers absolute
ownership of private property to individuals. Socialism (broadly speaking)
rejects the notion of private ownership of assets. Islam recognises ownership
31
of private property by individuals, but requires that ownership to be subser-

vient to the rules and guidance of the true owner, God.
Another way of expressing the Islamic concept of ‘ownership’ of assets is
that individuals are the guardians of these assets which have been given to
them by God.
Islam presents a framework of God-given principles and values against
which the individual pursuit of wealth needs to be set. Note that some of
these, particularly the first two, are embedded to a greater or lesser degree
in the ‘capitalism’ prevalent in most western societies today.
Protecting the public interest

Protecting the public interest is a paramount principle in Islam. Therefore
any activity that is deemed to be against the wider public interest would
not be tolerated. What is deemed to be against the public interest will be
determined by:
■■ an assessment of the product’s or activity’s positive and negative features
and its potential impact on the public. For example, the polluting effects
of a particular type of manufacturing process may outweigh the potential
gain in short-term wealth;
■■ the activity may be prohibited in the sharia, such as the consumption of
alcohol, pork, pornography and gambling. If this is the case, the activity
would be automatically seen as against the public interest as for Muslims,
as it would be in contravention of divine law.
Protecting the weak, poor, vulnerable and sick people

One of the five pillars of Islam is the obligation on the part of a believer to
give a percentage (usually 2.5 per cent) of their wealth every year to charity
(this is referred to as zakat). The prime use of this would be to alleviate the
difficulty of the poor and needy. This is the minimum society would be
expected to do, but Islamic principles would dictate that there would be a
greater welfare state if required, funded by taxes/charitable giving by society
to ensure that those in need are looked after.
Accountability to God
There is a strong concept in Islam of accountability to God for all of one’s
actions in this life. When it comes to wealth this can be seen from the
following statement from Prophet Muhammad:
The feet of the son of Adam will not move on the Day of Judgement till
he is asked regarding five matters: how he spent his life, how he utilised
32
his youth, how he earned his wealth and how he spent it, and what he did
with his knowledge.
‘Collection of Prophetic sayings’ by Imam Tirmidhi
Hence earning wealth unlawfully, any dishonesty, violating the rights of

others or the irresponsible use of wealth are all serious issues from an Islamic
perspective.
Islamic values regarding wealth

Islam warns against making the pursuit of wealth such a dominant force that
it takes people away from what it considers to be the purpose of life: namely,
to seek God’s favour and acceptance by His worship, good conduct and
deeds. The following passages from the Qur’an, when referring to righteous
people, provide evidence of this:
By men whom neither traffic nor merchandise can divert from the
Remembrance of God.
Wealth and children are allurements of the life of this world: but the
things that endure, good deeds, are best in the sight of thy Lord, as
rewards and best as the foundation for hopes.
The following statements made by the Prophet Muhammad warn against

greed, promote moderation as opposed to aggression in seeking wealth, and
commend contentment as a virtue:
Hakim Ibn Hizam reported that the Messenger of Allah (PBUH) said:
‘This wealth is verdant and sweet. Anyone who takes it in a generous
spirit will be blessed in it but anyone who takes it in an avaricious way
will not be blessed in it, like someone who eats and is not satisfied. The
upper hand (he who gives) is better than the lower hand (he who takes).’
‘Collection of Prophetic sayings’ by Imam Bukhari and Imam Muslim
Ibn ‘Amr reported that the Messenger of Allah (PBUH) said: ‘The
successful man is he who becomes a Muslim, has adequate provision and
whom Allah makes satisfied with what He gives him.’
‘Collection of Prophetic sayings’ by Imam Muslim
Jabir reported that the Messenger of Allah (PBUH) said: ‘O People! Fear
Allah and be moderate in seeking a livelihood. No self will die until it has
received its full provision, even if it is slow in coming. Fear Allah and be
moderate in seeking. Take what is lawful and leave what is unlawful.’
‘Collection of Prophetic sayings of ibn Majah’
33
Prohibition of interest and the fractional reserve banking system

The prohibition of interest is central to Islamic finance and later in this
chapter we will discuss in detail the definition and scope of this prohibition
and some of the perceived wisdom behind this ruling. In the context of an
Islamic economic model, interest would be banned. This has serious conse-
quences for the contemporary global financial system. The modern world
runs a global monetary system that is based on the concept of fractional
reserve. The value of paper money and coins of a particular country’s
currency in circulation is a multiple of the real wealth of a country. Central
banks and commercial banks have been given the legal right to create money
for lending at interest. From an Islamic viewpoint this system is fundamen-
tally at odds with the principles of Islamic finance for the following reasons:
■■ Paper money and coins should be used as a common and accepted measure
of value allowing society to trade, buy and sell with ease as opposed to
having to barter. That is, the role of money should be as a medium of
exchange, measure of value and store of wealth and should directly reflect
the real underlying value of assets in existence.
■■ The fractional reserve system relies strongly on confidence in the system.
A bank will hold only a ‘fraction’ of the money it has supplied into the
market. If the public loses confidence in a particular bank or the banking
system and many of them want to withdraw their money at the same
time, the bank will almost certainly not be able to give everyone their
money, which has been seen from time to time in the form of bank runs.
■■ Interest is at the heart of the fractional reserve system, where the role of
money goes way beyond being a common measure of value and medium
of exchange. Money itself is traded through the charging of interest with
no need for any real underlying trade or item of value, which is fundamen-
tally against Islamic principles.
An Islamic economic model would be built on a monetary system whereby
money production would be the role of the state (as opposed to banks
which then charge interest on the supply). The money has to have a close
link to the real wealth of a country – some have proposed paper currencies
backed by gold and silver. Indeed, proponents of monetary reform outside
of Islamic finance have long advocated a return to the Gold Standard. Some
prominent economists, such as Nobel Prize winners Robert Mundell and
James Robertson, have written extensively on the benefits of returning to
the Gold Standard.
Others, such as the former Malaysian prime minister Dr Mahathir
Mohamad and Islamic finance writer Tarek El-Diwani, have proposed the
replacement of paper money with a chosen commodity, such as gold. They
argue that a real commodity such as gold, which has intrinsic value, holds
34
its purchasing power in the long run and is less prone to inflation, resulting
in a more stable monetary system.
Given that modern-day conventional banking is built around the fractional
reserve system and interest, a number of academics and practitioners within
the Islamic finance industry have questioned the suitability of banks playing
a significant role in the advancement of Islamic finance. Many of them have
argued that it would be better to have structures outside of the banking
arena, such as funds, private equity/venture capital houses and cooperatives.
To summarise, the Islamic economic model promotes the rights of
individuals to seek wealth within the framework of a moral code designed
to protect wider societal interests. There is a strong degree of personal
accountability driven by the notion of an individual being a guardian of
assets which are ultimately owned by God; the pursuit of wealth should not
distract from the real purpose of life. The payment or receipt of interest are
prohibited because wealth must be created or earned through real activities
or assets.
KEY ISLAMIC FINANCE PRINCIPLES
Islam encourages trade and business activity. Commerce is considered a part

of a healthy and vibrant society. The following four principles are key to
determining whether a commercial transaction is sharia-compliant:
1. The subject matter is permissible under the sharia. Examples of prohibited
activity would be the sale of alcohol, pork or the provision of gambling.
2. The transaction is interest-free (the Arabic word for interest is riba).
3. The trade or transaction is free from contractual uncertainty and ambiguity
in the key terms and subject matter of the underlying deal (the Arabic
word for such uncertainty/ambiguity is gharar).
4. The transaction is based on a real service or asset and any return to any
party can be justified only by that party taking some risk with respect to
the underlying asset or service.
It is therefore important we understand more about these principles.
Activities permitted by the sharia

There are certain trades and activities that are expressly prohibited under the
sharia, such as the consumption of alcohol or pork. Any transaction related
to such items would ordinarily be rendered impermissible.
Other items may not be permitted because of the perceived or actual harm
they cause to individuals and/or society. Tobacco is a good example. Most
35
Islamic scholars would not permit investment in a tobacco business because

of the harm that smoking inflicts on people’s health.
The Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI)1, a key regulatory organisation in the Islamic finance
industry, has specified the following industries as impermissible to invest in:
■■ conventional banking and insurance;
■■ pork;
■■ alcohol;
■■ gambling;
■■ adult entertainment;
■■ tobacco.
One can say it is a form of ethical screening that takes its lead from the
teachings of the Islamic faith.
Prohibition of interest (riba)

This prohibition marks the biggest difference between conventional finance
and Islamic finance. While interest plays a central role in modern-day
economics, banking and finance, the Qur’an contains a clear instruction not
to engage in any transaction that involves interest. The following citations
from the Qur’an and the Prophetic teachings show how interest has been
prohibited in the strongest terms in Islam:
Those who take Riba (interest) will not stand on the Day of Judgement
except as he who has been driven mad by the touch of the devil. That
is because they have said, ‘trading is like Riba [interest]’, but God has
permitted trading and prohibited Riba [interest]. Whosoever receives an
advice from his Lord and stops, he is allowed what has passed and his
matter is up to Allah. And those who revert are the people of the Hellfire.
O you who believe! Fear God and give up what remains due to you from
Riba [interest] if you are really believers; and if you do not, then take
notice of war from Allah and his Messenger, but if you repent you shall
have your capital sums. Deal not unjustly and you shall not be dealt with
unjustly.
Qur’an, (Chapter 2, verses 278–279)
Jabir ibn Abdullah narrated that the Prophet cursed the receiver and the
payer of riba, the one who records it and the witnesses to the transaction,
and he said: ‘They are equal in guilt’
1
AAOIFI is the Accounting and Auditing Organisation for Islamic Financial Institutions and is
a leading sharia and accounting standard-setting body for the Islamic finance industry.
36
Given these stern warnings against riba, it is important to examine its

definition and scope, so that we are clear what exactly is prohibited.
Interest charged on money lent is not allowed. The mainstream and
dominant view among Islamic scholars is that any increase on the capital
lent is impermissible. Even if it equates to a small percentage in terms of an
interest rate, say 1 per cent, this is still prohibited. This is different to the
common contemporary position adopted by Christian theologians, namely
that the usury referred to in the Bible represents an ‘excessive or exploitative’
interest charge.
Another dimension to this prohibition is in the realm of barter. The
Prophet said the following:
Abu Sa’id al-Khudri reported that the Holy Prophet said: ‘Gold is to be
paid for by gold, silver for silver, wheat by wheat, barley for barley, dates
by dates and salt by salt, like for like and equal for equal, payment hand
to hand. He who makes an addition to it or asks for an addition, deals in
riba. The receiver and the giver are equally guilty.’
There are three dimensions to this prohibition:

1. The countervalues exchanged must be equal, so for example if I exchanged
200g of salt for 100g of salt, then the excess exchanged is construed as
interest.
2. ‘Like for like’ includes the fact that the quality must be the same:
Abu Sa’id al-Khudri narrated that Bilal bought Barni [fine-quality]
dates to the Prophet and the Prophet asked him, ‘From where have you
bought these?’ Bilal replied, ‘I had some inferior dates and I exchanged
two measures of those for one measure of Barni dates to give it to the
Prophet.’ The Prophet replied, ‘Beware! Beware! This is definitely riba!
Don’t do so, but if you want to buy superior dates, sell the inferior dates
for money and then buy the superior kind with that money.’
The Prophet instructed that the inferior dates should be sold first
for money and the better quality dates should be purchased with the
proceeds. This exercise helps to ensure that fair value is achieved for both
parties in the transaction.
3. The transaction must be at spot with no delay, so for example if I
exchanged 100g of salt now for 100g of salt later, this would be construed
as riba. In this case, the party receiving the salt has use of that salt before
they have to recompense the other party, and hence may have an unfair
advantage in the transaction.
The consensus among scholars is that the principle laid down by the Prophet
for the commodities mentioned above can be extended to apply to commod-
ities that possess two characteristics:
37
1. The commodity is/can be sold by weight.

2. The commodity has the natural ability to be used as a medium of exchange.
Most scholars, based on the fact that gold and silver are included in the six
commodities mentioned by the Prophet and were typically used as money
in the time of the Prophet, extend the above principles to exchange of
paper and electronic money. Rules of sharia-compliant foreign exchange are
derived from these principles.
Some of the wisdoms behind the prohibition of interest

The holy Qur’an and the Prophetic teachings, as we have seen, are explicit
in their prohibition of interest. But what are the reasons behind the prohi-
bition? The Qur’an and the Prophetic teachings are not so explicit in
numerating these reasons, but scholars and proponents of Islamic finance
have cited a number of wisdoms behind the prohibition of interest. Some of
the key ones are as follows.
Better allocation of finance
From an Islamic perspective, money is merely a store of value and a medium
of exchange. It should not be treated as a commodity in its own right.
Hence the focus should be on the real exchange of goods, services and assets
– money being the common measure of value that facilitates this exchange.
Financiers of projects, businesses or assets cannot simply demand a return on
the amount of finance they have provided; they must take some level of asset
or commercial risk (as opposed to just credit risk as found in an interest-
bearing loan) if they are to legitimately seek a return on their investment.
Therefore in an Islamic system, financiers are encouraged to allocate
funds to the best-quality projects as their success is inextricably linked to
the projects they finance. In contrast, the interest-based system encourages
the allocation of funds to the most creditworthy applications. It is therefore
argued that the net impact of better-quality projects being backed is better
productivity and wealth creation in the economy.
Fairer wealth distribution
The interest-based system, with its natural tendency to allocate funding
to the most creditworthy, promotes a situation where the rich get richer.
This is because it is the rich who can usually offer the best collateral against
money they borrow. The world today does exhibit huge wealth inequality
between the rich and the poor and does seem to support the statement ‘the
rich get richer’. In a report published in January 2014 by the charity Oxfam
International, entitled ‘Working for the few’, the following facts emerged:
■■ The 85 richest people in the world have as much wealth as the 3.5 billion
poorest.
38
■■ Almost half of the world’s wealth is now owned by just 1 per cent of the
global population.
■■ Seven out of 10 people live in countries where economic inequality has
increased over the past 30 years.
In addition, common wisdom in modern business practice is to leverage the
business with interest-bearing debt. Interest-bearing debt will tend to be
cheaper than equity finance, hence the overall returns to shareholders are
greater with leverage than without. This leverage also allows businesses to
grow very fast quickly. While this is positive at one level, it also means that
often it allows the first few firms to dominate a particular market; newer,
smaller competing firms are either bought out or fail to compete effectively
due to their inferior resources. This in turn means economic power rests
with the rich few, barriers to entry to business increase, people tend to be
employed rather than having the opportunity to have their own business and
local businesses give way to national or international corporations.
Reduction in dangerous levels of debt

A natural output of the interest-bearing system is debt. The fractional reserve
banking system encourages advancing debt; money can be created without a
corresponding increase in real wealth and can be lent at a profit. Hence for those
who stand to make a profit from this – there is a real motivation to maximise
the loans they give – the only rational issue holding them back is the credit risk
they take. Indeed, the world economy today runs on a system whereby govern-
ments, businesses and individuals borrow money extensively on interest.
Figure 3.1 is from a report by the Swiss-based financial watchdog, Bank
for International Settlements (BIS). It shows how global debt has increased
Global debt, 2001–13 Figure 3.1
110
100 Total
90 Government
80 Financial corporations
70 Non-financial corporations
60
50
40
30
20
10
0
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1
’01 ’01 ’02 ’02 ’03 ’03 ’04 ’04 ’05 ’05 ’06 ’06 ’07 ’07 ’08 ’08 ’09 ’09 ’10 ’10 ’11 ’11 ’12 ’12 ’13
39
over time. In the space of just over 10 years, it almost tripled in size, from
around $35 trillion in 2001 to around $100 trillion in 2013. It is also inter-
esting to see that the debt issued by governments since the financial crisis
started in 2008 has been the key growth driver (a significant factor being
the quantitative easing programme in many economies); the debt issued by
financial corporations, while it was growing rapidly previously, has slowed
since the inception of the financial crisis.
History has proved that in adverse economic times many of these borrowers
will default on their loan obligations, which in turn can lead to the type of
global financial crisis we saw starting in 2008. Indeed, the head of BIS, Jaime
Caruana, said in July 2014 that the world economy was just as vulnerable
to a financial crisis as it was in 2007, with debt levels on average 20 per
cent higher than they were in 2007 in both the developed and the emerging
economies. He further warned that borrowers needed to be cognisant and
prepared for the fact that interest rates were at an all-time low (to stimulate
recovery), but that increases were inevitable. Otherwise, there could be a
significant number of defaults on loans when interest rates increased2.
In contrast, a system that is biased towards equity finance means that
those receiving the finance are not faced with a fixed overhead of a loan
repayment in bad times, but rather share the bad times with the financier in
terms of the returns each party gets. Hence, arguably an equity-based system
is less prone to crash.
Less endemic inflation

The fractional reserve banking system, by giving commercial banks the
right to create money and lend on interest, creates a driver to increase the
money supply. If the money circulating in the economy increases at a faster
rate than the real production of goods and services, the result is inflation
– more money is chasing the same amount of goods and services, so the
natural consequence is for prices to increase. Indeed, inflation is endemic
in every major economy in the world. Inflation has a distortive effect in the
economy and at high levels can be a destructive and destabilising force in
the economy.
Better productive use of resources

In the world today a huge amount of resources is devoted to banking and
other industries dedicated to the provision of money on interest. Indeed, the
brightest talent from the top universities in the world are often enticed by
a career in conventional banking because of the lure of attractive remuner-
ation. In essence, the role of these financiers is relatively passive in relation
Source: Evans-Pritchard, A. (2014) BIS chief fears fresh Lehman from worldwide debt surge. The
2
Telegraph, 14 July.
40
to the projects/assets they are financing – the end goal is to make a return
on the money advanced, irrespective of the success or otherwise of whatever
the money is used for. In a world without interest, these resources can be
diverted to the production of real goods and services and therefore boost
economic output; the role of financiers would be to partake in the risks and
rewards associated with real economic activity, such as becoming partners in
business ventures, owning assets or trading assets.
Prohibition of gharar (excessive uncertainty): the need for contractual

certainty
This principle requires there to be as much clarity as possible regarding the
contractual terms between the two parties in a commercial transaction, so
as to minimise the chances of a contractual dispute between the parties. As
such there must not be gharar in a transaction. Gharar has often been trans-
lated as ‘excessive uncertainty’. The word ‘excessive’ is used because life by
its very nature has uncertainty associated with it and it is therefore impos-
sible to eliminate uncertainty completely.
For example, consider an individual buying a property ‘off plan’ (in other
words, before it has been constructed, a common practice in the case of
modern new-build city apartment blocks). For such a transaction to be free
from gharar there needs to be absolute clarity on price, timescales involved,
the location of the house, the size (external, internal rooms, etc.), what will
be included and the finish (carpets, kitchen, etc.), and a comprehensive list
and description of the various features. If any of this is lacking, there is a
chance that the expectations of the buyer might differ from what is actually
delivered. This in turn will invariably lead to a dispute between the buyer
and the house developer.
It is worthwhile looking more closely at the different aspects of where
gharar can occur.
Gharar in the subject matter

Gharar can arise in the form of uncertainty surrounding the existence,
ownership, deliverability, availability or nature of the object of a contract.
The example given above of buying a property whereby the description
of the features of the property are incomplete and/or ambiguous is a good
example of gharar in the subject matter.
A seller must own what they are seeking to sell. Hence ‘short selling’ is
not allowed. Again this principle is to protect the integrity of a commercial
deal, whereby the buyer has greater certainty and assurance that they are
transacting with a party that has the legitimate right to sell.
Generally, clarity and certainty regarding the existence, possession by the
seller and deliverability of the subject matter would be part of the conditions
41
to ensure there was no gharar. There are exceptions to the subject needing to
be in existence and possessed by the seller at the time of executing the sales
contract (contracts of salam and istisn’a, which will be discussed in Chapter
5). The ability of the seller to deliver the subject matter on the agreed terms
is very important.
Gharar in the price

The mainstream view is that the price in any commercial transaction must
be stipulated clearly and with certainty prior to exchange. However, some
scholars are of the opinion that goods or services that have a standard market
price may be sold without specifying the price. Here the contracting parties
would resort to the prevailing standard market price and there should be no
scope for the parties to dispute.
Gharar over a time period

A transaction may allow for deferred payment or deferred delivery (immediate
delivery is required in certain instances, e.g. currency exchange) if mutually
agreed between the parties. To avoid gharar the deferment period needs to be
known with certainty, with some scholars allowing the period to be linked
to a certain event in the future, e.g. payment to be made by the start of the
next harvest season.
Where both the object and price are deferred, the contract is referred to
as a suspended sale or one with ‘double deferment’. These are not seen as
concluded valid sales contracts. Arrangements whereby both countervalues
will be exchanged at a future date, conditional upon an event that may or
may not happen in the meantime are further invalidated due to the uncer-
tainty (gharar) relating to the occurrence or otherwise of the future event.
Asset or service backing with real risk sharing

Islamic finance requires commercial transactions to be underpinned by
real assets and/or services. Money is merely a store of value and medium of
exchange and facilitates real trade. An accompanying principle is ‘al ghunm
bil ghurm’, i.e. ‘there is no return without risk’. That is, under the sharia any
return to any party is legitimate only if they have taken some real risk in
relation to the underlying asset or service.
So, for example, a common sharia-compliant transaction is that of leasing
an asset. In such a case, the lessor buys the asset, bears the risks associated
with owning the asset and so can legitimately earn a return through
leasing/renting that asset to a lessee. Another common type of transaction
within Islamic finance is equity-based transactions. For example, a financier
becomes a partner/shareholder in a project/business and agrees to share the
profits/losses of that venture; this is based on risk sharing.
42
CONCLUSION
This chapter outlines the Islamic economic framework and principles

pertinent to the very foundation of Islamic finance. Indeed, if one grasps
the essence of this framework, it provides a strong basis to comprehend the
sharia-compliance or otherwise of financial products.
The prohibition of interest in Islam is the single most important
difference relative to conventional finance. Interest is central and pivotal to
the modern global conventional financial system. Therefore a significant part
of this chapter has been dedicated to defining the scope and exploring the
wisdoms behind the prohibition of interest. It is hoped the reader has a clear
comprehension of the rules and the reasons underpinning them – from this
the reader can start to appreciate the value proposition of Islamic finance.
43
4
Valid commercial contracts in
Islamic finance
Introduction
Key conditions for validity of contracts
Integrity of contractual arrangements
Status and use of promises
Conclusion
4 · Valid commercial contracts in Islamic finance
INTRODUCTION
As with conventional trade and finance, Islamic finance recognises trade

between two parties by virtue of binding agreements or contracts. The
reasons for devoting a chapter to the topic of sharia-compliant commercial
contracts are as follows:
1. Such contracts will be a feature of all transactions pertaining to sharia-
compliant trade. It is therefore essential to understand the principles
underpinning Islamic contract law.
2. While there are many similarities between modern-day English
commercial law and sharia principles, there are some differences or areas
where the sharia has additional requirements.
3. The sharia places great emphasis on clear and unambiguous agreement
between two contracting parties and encourages evidence of this agreement
in writing, as demonstrated by the following extract from the Qur’an:
O you who believe! When you deal with each other in transactions
involving future obligations in a fixed period of time, reduce them into
writing … but for a transaction which you carry out on the spot among
yourselves, there is no blame on you if you reduce it not to writing. But
take witnesses whenever you make a commercial contract.
This chapter will complete the section of the book aimed at equipping the
reader with the key concepts and principles required to understand the
practice of Islamic finance.
KEY CONDITIONS FOR VALIDITY OF CONTRACTS
The Arabic word for contract is aqd (plural: uqud) and it literally means ‘to
bind’. Islamic commercial law classifies contracts into two broad categories:
bilateral contracts and unilateral contracts.
Bilateral contracts refer to the usual situation found in commerce and
trade – there are two contracting parties agreeing commercial terms
pertaining to the subject matter being transacted. Unilateral contracts refer
to a situation where one party has decided to confer some benefit, unilat-
erally, on another party. Usually it is a gratuitous gesture – for example,
inheritance given through a will or a donation, e.g. office space free of charge
by a building owner. Due to the gratuitous nature of such contracts, the
conditions required for bilateral contracts (discussed below) do not apply;
indeed, there can even be gharar, the principle of uncertainty set out in
Chapter 3.
47
To recap, a sharia-compliant trade or transaction must be free from

contractual uncertainty and ambiguity in the key terms and subject matter
of the underlying deal. This is because bilateral contracts require that both
parties are protected by clarity in contract terms and by clear principles
that need to be adhered to, while with unilateral contracts, one party is
conferring benefit to another of their free will and hence there is no need to
protect the parties involved.
We will be focusing on bilateral contracts. For such contracts to be valid,
they need to meet some basic criteria.
Contracting parties
The respective parties to a contract must be:
■■ sane: both parties must be mentally sound at the time of contracting with
each other;
■■ mature: the parties must be old enough to understand the implica-
tions of their actions. In Islam this is usually taken to be when a person
reaches the age of puberty. As we know, English law will usually define a
particular age to enter into certain transactions, e.g. a person cannot own
a property in the UK until the age of 18. This is the approach adopted
in most Muslim countries, i.e. defining a particular age, usually 18, to
provide certainty in law.
Subject matter
We discussed the need, in the last chapter, for the subject matter to be free
from gharar or uncertainty. The conditions in Islamic law with respect to the
subject matter of a contract are required to broadly protect the buyer and
to mitigate the risks of the seller not being able to complete his side of the
bargain. The following are the general conditions attached to the subject
matter of a contract.
Valuable/permissible
The sharia must recognise the item or service being transacted as having
value/being permissible. Anything that Islam prohibits, such as alcohol and
pork, would not be considered to have value and therefore any contract based
on such subject matter would be invalid.
Existence
The subject matter must be in existence at the time of entering the contract.
There are a couple of exceptions to this condition, which will be discussed
fully in Chapter 5. In brief, they are istisn’a (this refers to the sale of an item
48
that still needs to be manufactured or constructed) and salam (this refers to

the sale of fungible items and allows payment by the buyer prior to delivery
of the goods; this was permitted originally for farm produce whereby farmers
could get paid in advance of producing their crops), both of which allow for
flexible payment terms before the item being purchased has been manufac-
tured or delivered.
Ownership
The Prophetic saying ‘do not sell what is not with you’ is often cited as
evidence of the principle that a seller must own what they are seeking to
sell. Therefore the practice of ‘short selling’, whereby shares, for example, are
sold before being legally acquired, is not allowed. The conventional method
of short selling is borrowing a stock and selling it on the market (clearly the
borrower does not own what they are selling). The short sale is made with
the expectation of the price going down, which would allow the investor to
buy the shares at a lower price in order to return the shares borrowed earlier
and make a profit. This has been expressly forbidden by AAOIFI’s sharia
standard 21. Some of the flexibility afforded by conventional short selling
has been achieved in a sharia-compliant way by using a non-refundable
deposit by the buyer (called arbun) without them having to pay fully for the
shares. However, this only enables the buyer to benefit from any upside in
the shares by the time the full amount is due – as the buyer cannot sell on
the shares until they have fully gained ownership of them.
Deliverability
The seller must have the ability to deliver the subject matter to the buyer,
allowing the buyer to take possession at the time of sale. Again this is to
protect the buyer from acquiring something they cannot take possession
of. There is scope for possession to take place constructively as opposed to
physically, for example a car is sold today whereby the buyer can pick it
up from a specific location any time in the next week. The car, from today,
is in the ownership and constructive possession of the buyer. Accordingly,
the risks associated with owning the car pass to the buyer from today and
they can even sell the car onwards from today. The parties to a sale can even
mutually agree to delay the delivery of the subject matter to a later date.
Offer and acceptance

There has to be an unambiguous acceptance by the buyer of the terms
offered by the seller or vice versa (either way both parties have to agree
terms unequivocally without doubt). This requires agreement at a particular
point in time during a session when the parties are together (physically or
remotely) negotiating terms. If one party made an offer and the other party
49
left the room, no agreement could be assumed and subsequent sessions

would commence by assuming that no offer was made or agreement reached.
Offer and acceptance can be evidenced verbally, in writing, by a
handshake or any other way the relevant parties agree as long as it is clear
and understood.
If the above three components of a contract, namely:
1. contracting parties;
2. subject matter;
3. offer and acceptance
comply with the principles stipulated, a valid bilateral contract results
between the parties. Any conditions attached to a contract, e.g. the
requirement of collateral, are generally permissible as long as:
■■ they are mutually agreed by the contracting parties;
■■ they are reasonable, e.g. a car buyer stipulates that he/she wants the car to
be serviced prior to executing the purchase. However, a condition such as
‘I will buy your car for £x if you buy my house for £y’ is an unreasonable
condition and would not be valid;
■■ the conditions are in line with generally accepted market practice,
e.g. there is a one-year manufacturer’s warranty on electrical goods
purchased.
It is worth noting that there is a general principle in sharia to abide by the
laws and customs of the country one lives in, as long as there is nothing
in those laws and customs that is expressly in contradiction to sharia
principles.
In the next chapter we will start looking at the practice of Islamic finance
by discussing the various types of bilateral contract used in the industry.
Broadly, these bilateral contracts fall into the following categories:
■■ sale of goods or services;
■■ leasing of assets;
■■ partnership agreements between two or more parties;
■■ security contracts such as providing collateral;
■■ agency contracts, i.e. becoming the agent of a principal in return for
remuneration;
■■ providing services of safe custody, e.g. a bank charging a fee for the safe
custody of the monies held in a current account.
50
Options with contracts

The sharia seeks to protect consumers/buyers with certain options that they
can exercise, which include the:
■■ option of inspecting the goods/quality – if the goods on inspection do not
measure up to what was sold by description and/or quality, then the buyer
has the right to return or not go ahead with the transaction;
■■ option of defect – in a similar way the buyer has the right to return the
goods and claim a refund if they prove to be defective;
■■ option to change mind – buyer and seller have the right to change their
mind before the execution of the contract – similar to a ‘cooling-off’
period;
■■ option of price – the buyer has the right to a fair price within the market
range.
INTEGRITY OF CONTRACTUAL ARRANGEMENTS
In general, contractual arrangements that seek to subvert the sharia prohi-

bitions and principles would be invalid. Indeed, the sharia has specifically
banned certain contractual arrangements which could be used to overcome
sharia prohibitions, as outlined below.
‘Back-to-back’ sales between the same parties

The sharia prohibits back-to-back sales of the same object between the same
contracting parties, the second sale being contingent upon the first. This is
referred to as ‘bai al-inah’ in Arabic.
For example, I sell my bike to Adam for £500 cash now and simulta-
neously Adam agrees that once he owns the bike, he will sell it back to
me for £600, giving me three months to pay. This has the same effect of
giving me a cash loan of £500 on interest, whereby I have to pay £600 in
total in three months’ time. Hence, although the two individual sales are
halal (permissible) in their own right, as a combined set of arrangements
it is open to abuse to mimic the effect of an interest-bearing loan and
therefore prohibited.
Prohibition of contingent contracts

The Prophet Muhammad forbade combining two contracts into one where
one of the contracts is conditional upon the other. The AAOIFI standard on
contract combination states the following:
51
It is permissible in sharia to combine more than one contract in one set,

without imposing one contract as a condition on the other, and provided
that each contract is permissible on its own. Combining contracts in this
manner is acceptable unless it encounters a sharia restriction that entails
its prohibition on an exceptional basis.
Again the overriding reason for this prohibition is that by combining
contracts such that one is contingent on another, the arrangement can be
manipulated to subvert sharia principles. A good example of this is an
extension of the back-to-back sales example between the same two parties
– if one sale is contingent on the other, the effect is to combine the two
contracts to subvert the prohibition of interest.
STATUS AND USE OF PROMISES
A promise in Arabic is called a ‘wa’d’. A unilateral promise is where one

party promises to do something in the future, e.g. I promise to sell my
car to Fred for £1,000 in one month’s time. From an Islamic viewpoint,
keeping one’s promise is regarded as very important and not to do so is
regarded as immoral and a sign of hypocrisy. The question then arises, are
promises enforceable? The OIC’s Islamic Fiqh Academy has ruled that a
promise in commercial dealings is enforceable subject to the following
conditions:
■■ The promise is one-sided.
■■ The promise must have caused the person to whom the promise was made
to incur some actual liabilities or losses.
■■ If the promise is to purchase something, then the actual sale must take
place at the appointed time with the exchange of offer and acceptance.
The mere promise itself should not be taken as a sale.
■■ If the person making the promise backs out of the promise, the court may
force them to either fulfil it or pay the actual damages to the person to
whom the promise was made. Damages will include actual liabilities and
not opportunity costs.
The use of promises is very important and widespread in the practice of
Islamic banking and finance. Without them many transactions we see today
may run into problems from a sharia point of view.
An important example is in the area of home finance. The prevalent form
of sharia-compliant home finance involves the consumer renting the house
from the financier, and then as a second step buying the house from the
financier. If this arrangement was structured as two contracts whereby one
was contingent on the other, then as we have seen, this would be prohibited.
52
However, if the purchase of the house was a promise made by the consumer
in addition to the rental agreement, then this would not fall foul of the
contingent contract prohibition.
As long as these promises are enforceable, it allows banks and other
product providers to reduce the level of risk and uncertainty with transac-
tions. Concerns have been expressed about the fact that legally binding
promises in substance are very similar to contracts and hence the danger
is that the prohibition of contingent contracts can be subverted through
the guise of using promises. Proponents of these structures would point
out that in substance both parties to the transaction are fully aware of their
respective commitments and that there is no intention to manipulate or
circumvent sharia principles but a desire to have a structure that allows
the bank to play its role as a financier while having some comfort that its
customer will honour the original intention and commitment to acquire
the property fully.
It is worth noting that two unilateral promises made by two parties
regarding the same item would effectively amount to a forward contract,
i.e. a contract concluded at a future date. From a sharia perspective, such an
arrangement is regarded as neither a valid contract nor binding/enforceable
promises.
CONCLUSION
This chapter presents the basic framework and principles of Islamic contract
law. The purpose behind the sharia rulings is to protect the buyer and
minimise the chances of contractual disputes.
The approach adopted in this book is to present the mainstream and
most accepted viewpoints. A key point of reference has been the position
adopted by AAOIFI on the topics covered in the book. AAOIFI is a leading
self-regulatory body for the Islamic finance industry – it comprises reputed
sharia scholars and professionals from around the world and issues sharia and
accounting standards (to complement conventional accounting standards)
for the Islamic finance industry.
However, it is important to appreciate that underlying many of the
topics in Islamic finance is a healthy debate and discourse among scholars
and practitioners about the application of traditionally understood sharia
principles to modern-day financial practice. An example is the tradi-
tional and mainstream view that futures contracts are not allowed as
both countervalues – the price and the commodity/subject matter – are
exchanged in the future. However, Dr Mohammad Hashim Kamali,
Professor of Law at the International Islamic University Malaysia, argues
in his book Islamic Commercial Law: An Analysis of Futures and Options
53
(2001) that prohibiting futures on this basis is not necessarily the right
conclusion. He argues that:
1. There is a principle in sharia that all commercial activity is permis-
sible unless there is a clear prohibition; in the case of futures it is a
relatively new phenomenon and has no clear parallel in traditional
Islamic law.
2. Furthermore, futures trading is economically beneficial because it facili-
tates better production planning in the agriculture and agro-based
industries. In these sectors it is also utilised as a hedging device against
violent movement in the price of commodities over a period of time
which, in the case of agricultural produce, stretches over crop seasons,
often from sowing to harvesting time. Futures trading is also used by food
processors, merchants and manufacturers as a means of ensuring sales and
purchases in advance, without them having to face the uncertainties of
marketing at a later occasion: that is, after harvesting or production, as
the case may be.
Professor Kamali makes the specific point that futures trading can be
allowed if it is used for the beneficial purposes of better planning, etc.
– this meets the overall objective of the sharia to enhance the welfare of
society (as mentioned in Chapter 1 – the maqasid of the sharia as defined
by Imam Ghazali). He makes the general point that it is imperative for
scholars and those charged with defining what is permissible and what is
not (such as sharia standard-setting bodies like AAOIFI) to not dogmati-
cally apply sharia rules, but to think about the objectives of sharia in their
deliberations.
It is beyond the scope of this book to look at all the areas where there are
such debates; the idea of this chapter is to give the reader the mainstream,
widely accepted fundamentals underpinning Islamic contract law. However,
it is important to be aware of the bigger picture and indeed, a recurring
theme in this book is the growing view that the Islamic finance industry
needs to do more than merely produce products which prima facie meet the
sharia rulings but to be a more substantive value proposition by defining
itself more in line with the objectives of the sharia – namely, to protect and
enhance the interests of society at large.
This brings us to the end of this chapter and the first section of the
book aimed at establishing the principles and foundation underpinning
the practice of Islamic finance. In essence, all commercial trade is allowed
as long as it does not violate the key prohibitions of interest, contractual
uncertainty and impermissible activity; the trade must be underpinned
by real assets or services and the conditions required for valid contracts
must be met. We now have the basic framework and understanding
54
to look at the industry in practice – the key transaction types, specific

instruments such as sukuk and particular components of the industry
such as Islamic investments/asset management and Islamic insurance
(takaful).
55
Part
ISLAMIC FINANCE IN
2
PRACTICE
5. Key transaction types in Islamic finance

6. Sukuk
7. Sharia-compliant investments and wealth
management
8. Takaful – Islamic insurance
9. The future of Islamic finance
5
Key transaction types in
Islamic finance
Introduction
Equity-type: transactions
Mudarabah (Partnership – one party contributes capital)
Musharakah (Partnership – all parties contribute capital)
Asset finance:
Murabaha (Sale of an asset at a known profit mark-up)
Ijarah (Leasing of an asset)
Istisn’a (Sale of an item to be constructed or manufactured)
Salam (Sale of fungible item yet to be produced)
Other key transaction types:
Wakala (Agent providing services to a Principal)
Hawalah (Transferring a debt)
Rahn (Providing security)
Kafalah (Providing a guarantee)
Conclusion
5 · Key transaction types in Islamic finance
INTRODUCTION
Part 1 of the book aimed to set the foundation in terms of the principles,
beliefs and conceptual framework underpinning the practice of Islamic
finance.
We now turn to the actual practice of Islamic finance. Before we launch
into the different types of products and transactions, it is instructive to ask
the question: in the absence of interest, how could financiers interact with
those seeking finance on a commercial basis? The answer to this question
will reveal what lies at the heart of Islamic finance.
Broadly, in the absence of interest, financiers can seek to make a return
as follows:
1. They can invest their money in partnership with others in some kind
of business venture. In essence, this is equity-based finance and the
financier’s return will depend on the success or otherwise of the business
venture.
2. They can buy assets or goods required by those seeking finance and sell
them or lease them to such people, thereby making a profit/return on
their investment.
We now start looking at the key transaction types found in the practice of
Islamic finance. The key categories are as follows:
1. Equity-type transactions.
2. Asset finance.
3. Others – this covers other key areas including the provision of services
such as money transfer, providing collateral and guarantees.
The following transaction types serve to give practitioners in Islamic finance
the practical tool kit required to understand and apply the structures under-
pinning sharia-compliant products.
EQUITY-TYPE TRANSACTIONS
Islam looks favourably upon partnership/equity type arrangements, as

evidenced by the following Prophetic statement, attributed to God, i.e. the
Prophet Muhammad reported that God says:
I will become a partner in a business between two partners until they
indulge in cheating or breach of trust.
The Islamic perspective is that in essence God blesses partnerships that are
run with integrity and honesty.
61
At the heart of equity-based investment is to take commercial risk associated

with owning a business. In turn this means sharing the profits or bearing
the losses emanating from that business with the other owners. Equity-based
transactions are not foreign to modern-day finance; indeed, the modern-day
stock markets are testimony to widespread equity investment. Partnerships,
private equity and venture capital finance are all built around equity finance.
Islamic finance, in placing equity-based finance as a core and central feature
of its offering, is not so much bringing something new to the table but
rather propagating its wider use, as a profit and loss and risk-sharing model
of finance, instead of interest-based finance.
There are two main models or structures used in the practice of Islamic
finance in terms of equity-based transactions:
1. Where the financier puts all the capital into the partnership business
venture and the other party brings the effort, know-how and skill in
undertaking and running the business. In Arabic such an arrangement is
called mudarabah.
2. Where all parties put capital into the partnership business venture. In
Arabic such an arrangement is called musharakah.
We will now consider each of these in turn, first describing the key features
of each transaction type and then looking at the application of these concepts
in practice.
MUDARABAH
The key features of this transaction type are as follows:

■■ The capital is provided by one of the parties to the partnership. In Arabic
this party is called the rabb-ul-maal, which literally translates into the
‘owner of wealth’. This party may be considered similar to a passive
investor.
■■ The other party provides the expertise, effort and management in under-
taking the business venture/project. In Arabic this party is called the
mudarib – in essence, the project manager.
■■ The two parties, the rabb-ul-maal and the mudarib, agree a profit-sharing
ratio upfront.
■■ Any losses will be borne by the rabb-ul-maal in terms of capital
contributed. The mudarib will obviously have lost the time he put into
the project. The exception to this rule is if the mudarib is proven to have
been negligent in carrying out his duties, in which case he is required to
compensate the rabb-ul-maal to the extent of losses incurred due to his
negligence.
62
■■ The mudarib must not receive a salary from his work, as the essence of
mudarabah is a sharing of profits, not a hiring of the mudarib’s labour. Most
scholars agree that a mudarib can take out monies to cover his expenses
such as travel and subsistence.
■■ The mudarabah can be arranged as ‘restricted’ or ‘unrestricted’. A restricted
mudarabah refers to an arrangement in which the activities of the mudarib
in terms of what he can do with the monies put in by the rabb-ul-maal
are defined and restricted to certain activities. An unrestricted mudarabah
does not establish any restrictions on what business activities the mudarib
can undertake.
Application of mudarabah
Business or project finance
Clearly, financiers such as banks can provide business finance to entrepre-
neurs through this technique. It is well suited to financing start-ups as the
entrepreneur has little or no initial capital but has the business idea, skill,
time and desire to undertake the business venture. In modern-day banking
providing business finance in this way would be seen generally as high
risk, but obviously would depend on the business idea and credentials. For
example, financing the expansion of a well-established business with a good
track record will usually be less risky than financing a start-up bringing a
completely new and untried product to the market.
Business/project finance Example
Qatar International Islamic Bank (QIIB) provides finance on a mudarabah

basis for construction/infrastructure and real estate projects. Mudarabah
from the perspective of the financier is a relatively high-risk way of
financing – the financier will get a return only if the project makes a
profit. It is clear, from the way the bank markets this finance (see below),
that QIIB’s focus is to provide finance based on mudarabah to projects that
have very high chances of succeeding because they are state-run or backed
by creditworthy large companies. In this way the bank is mitigating its
commercial risk.
The following is an extract from the QIIB website, marketing its
mudarabah financing:
QIIB provides project financing or mudarabah to customers in the
construction/project development business. The bank may finance
projects awarded to the contractor provided the project owner is a
government, semi-government entity, or other credit-worthy public
companies. Identical projects financed under mudarabah contracts are
63
usually state infrastructure projects such as roads, sewer lines, power

stations, beautification and landscaping of public areas, etc.
Mudarabah could also be utilized to finance the development of
real estate projects including residential compounds and commercial
properties including retail and office buildings. Details of the project
including feasibility studies, technical and financial analysis in addition
to analysis of the project owner and the contractor are performed by
the bank to determine viability. Once approved, the financing is granted
based on a profit-sharing formula.
Source: www.qiib.com.qa
Example Bank deposits

Islamic banks cannot reward depositors with interest. Many use mudarabah,
where the depositors as a collective are the arbab-al-maal (plural of rabb-ul-
maal, i.e. the owners of wealth), and the bank assumes the role of the mudarib
and invests the monies from the depositors. Profits generated from these invest-
ments are shared in a pre-agreed ratio between the bank and the depositors.
Sharjah Islamic Bank, for example, offers savings and deposit accounts
based on the concept of mudarabah. The Sharjah Islamic Bank website
describes its saving account as follows:
Sharjah Islamic Bank invests deposited funds and shares the profits
between the bank and the investor based on the bank’s declared profit rate
at the end of each month following the concept of mudarabah.
Source: www.sib.ae
MUSHARAKAH
Essentially there are two types of musharakah:

1. A business partnership/joint venture – referred to in Arabic as sharikah
al-’aqd.
2. A partnership of ownership, for example co-owning a property with other
parties – referred to in Arabic as sharikah al-mulk.
Business partnership into a joint venture (sharikah al-’aqd)

Within this type of musharakah, three different types of partnership can exist:
1. Partnership by capital (shirkah al-amwal).
2. Partnership by work (shirkah al-amal).
3. Partnership by face (shirkah al-wujooh).
The key features of each of these are as follows.
64
Partnership by capital (shirkah al-amwal)

■■ All partners must contribute capital to the project or business.
■■ The management of the joint venture can be undertaken by either or both
parties, or it can be outsourced to a third party. The element of work
and management is not integral to musharakah based on partnership by
capital.
■■ The capital contributed by each party must be valued with certainty at
the time of forming the partnership, so as to define the relative capital
contribution by each party. Any losses will be borne pro rata to capital
contributed.
■■ Profits will be shared according to the split agreed by the parties.
For those partners who do not contribute to the management of the
business/project, i.e. sleeping partners, their share of profits cannot
exceed their stake in the business – for example, if a sleeping partner
contributed 20 per cent of the capital, his profit share cannot exceed
20 per cent.
■■ The capital contributed by the respective parties can be in the form of
cash or other assets such as property or land. The important thing is that
an accurate valuation of the value contributed by each party is made at the
time of forming the partnership.
■■ All assets of the musharakah are owned by the partners in line with the
proportion of capital contributed by each partner.
Partnership by work (shirkah al-amal)

■■ Partners come together to provide services to their customers. For
example, two partners provide accountancy or consulting services such
that revenues generated go into one pool, from which profits are
distributed according to an agreed profit-sharing ratio.
Partnership by face (shirkah al-wujooh)

■■ Here the partners have no initial upfront investment. The usual scenario
is of the partners seeking to procure merchandise on credit which they can
then sell for immediate payment. From the proceeds, they will pay the
supplier(s) and share the profits in line with the pre-agreed profit-sharing
ratio.
There are key features applicable to all three types of sharikah al-’aqd:
■■ Profit distribution must reflect the actual profits earned and not be based
on a fixed sum of money or a percentage of the capital contributed.
■■ Profit-share ratios can be amended at a future date by mutual consent of
the partners.
65
■■ Each partner is entitled to terminate the partnership with prior notice or

when set conditions have been met, such as the partnership being set up
for only a limited time period, the purpose for which the partnership was
set up has been achieved, the partnership becoming insolvent, etc.
■■ If one partner wants to leave, the other partners can mutually agree to
continue the partnership, buying out the leaving partner’s share.
Partnership of co-ownership (sharikah al-mulk)

This kind of partnership comes into existence either by two or more parties
mutually agreeing to buy an asset together or through one or more parties
gaining an interest in an asset without positively buying a share in it, e.g.
inheriting property.
Diminishing musharakah
Before looking at the application and uses of musharakah, it is worthwhile
discussing a related concept called ‘diminishing musharakah’. Diminishing
musharakah applies to a scenario in which one party reduces their stake in a
business/asset/project gradually over time, while the stake of the other party
in the partnership grows in an equal and opposite way, such that by the end
of a known period one party fully owns the business/asset/project.
In the next section we will see the use of diminishing musharakah in the
market.
Application of musharakah
The most common application of the musharakah concept in the Islamic
finance industry is that of a business partnership based on capital contri-
bution (shirkah al-amwal):
■■ Business/project finance – here the financier, e.g. the bank, puts capital
into projects/business in partnership with other parties, each party’s
respective returns being dependent on the success or otherwise of the
project/business. This can be applied to a number of scenarios: finance for
a particular project, seed capital for a business, working capital finance,
import finance, export finance, etc.
■■ Asset finance – there are a number of practical examples of financiers
such as banks using the technique of diminishing musharakah to finance
the purchase of assets such as property. Indeed, sharia-compliant home-
purchase plans in the UK tend to be based on the diminishing musharakah
concept. This is best illustrated by looking at a scenario.
66
Let us say a couple wants to buy a house worth £300,000. They can put in
£100,000 but need £200,000 finance to buy the house. They apply to an
Islamic bank that provides home finance based on diminishing musharakah.
On the assumption that the bank agrees to provide the finance, the bank
and the couple will buy the property together such that the bank puts in
£200,000 and owns 2/3 of the property on day 1, and the couple will put in
£100,000 and owns 1/3 of the property on day 1. The bank then provides
the facility for the couple to buy the bank’s share over time through periodic
payments. Hence the term ‘diminishing musharakah’ as the bank’s share
diminishes over time.
The following is an extract from the website of Al Rayan Bank (formerly Example
known as Islamic Bank of Britain, IBB) advertising its Home Purchase
Plan based on diminishing musharakah. You will see the advert talks
about the finance based on diminishing musharakah and leasing (ijarah).
This is because once the property is purchased jointly with the bank, the
couple in our example will live in the house. The bank, as part owner of
the property, will charge the couple rent to live in the house. Hence the
monthly payment the couple will make to the bank will comprise a rental
element and an amount that goes towards purchasing the bank’s share of
the property.
Unlike a conventional mortgage where the purchaser borrows money
from a lender which is then repaid with interest, Al Rayan Bank’s
sharia compliant Islamic mortgage alternatives (Home Purchase Plans or
HPP) are based upon the Islamic finance principles of a Co-Ownership
Agreement (Diminishing musharakah) with Leasing (ijarah).
Your monthly HPP payment is made up of two elements, an acqui-
sition payment and a rental payment. When all acquisition payments have
been made and the finance has been settled, ownership of the property
transfers to you.
Our HPP mortgage alternatives are not exclusively for Muslims, Al
Rayan Bank provides competitive rental rates which are attractive to
everybody. Finance for your property is generated from ethical activities
considered lawful under sharia. Our administration fees are low and
there are no early settlement charges, giving you flexibility with your
finances.
Source: http://www.islamic-bank.com/home-finance/home-purchase-plan/
67
Differences between musharakah and mudarabah

At this juncture, it is worthwhile summarising the differences between these
two equity-based sharia-compliant modes of finance – see Table 5.1.
Table 5.1 The differences between mudarabah and musharakah
Mudarabah Musharakah
Investment From rabb-ul-maal All parties contribute

(‘owner of wealth’ or
passive investor)
Management Rabb-ul-maal has no All partners can

right to contribute to participate in the
management management
Capital appreciation While profits are shared, All partners benefit from
all capital appreciation of the capital appreciation
the investment goes to of the investment
the rabb-ul-maal
Liability Rabb-ul-maal is liable All partners bear losses

to the extent of his proportionate to their
investment and bears respective capital
financial loss, mudarib contributions
loses his efforts
Mudarabah may most closely be compared to a passive equity investor

(whether that is on a private equity basis or via public equity markets), while
musharakah may be most closely compared to a partnership model.
ASSET FINANCE
As we mentioned, in a world without interest, financiers can make a

return on their capital by buying goods or assets and then selling them for
a profit or leasing them. We will now look at the transaction types that
facilitate this.
Murabaha
Key features of murabaha transactions are as follows.
1. Murabaha refers to a sale transaction in which the seller discloses the
cost price of the items they are selling and the profit mark-up they are
applying to get to the sale price. However, disclosing the cost price and
profit mark-up is not a general requirement of the sharia, i.e. it is perfectly
legitimate for a seller to sell something without revealing the cost price
68
and his profit margin; this is something that applies to murabaha only. If
the cost price and profit mark-up are not disclosed, this type of sale trans-
action is called musawamah in Arabic.
2. Murabaha lends itself well to asset financing as the financier can buy
assets required by the seeker of finance and then sell them on for a profit.
This works because the financier can give deferred payment terms to the
recipient of the finance.
3. Deferred payment terms are a common feature of murabaha-based deals for
the obvious reason of facilitating finance for those seeking it; however, it
is not something required for a murabaha to be valid. It is worth noting
that it is permissible to sell items outside of a murabaha, i.e. where the
profit mark-up is not disclosed, on a deferred payment basis whereby the
goods are supplied now for payment later. In Arabic this is referred to as
a bay al mu’ajjal sale (in essence a musawamah transaction with deferred
payment).
4. Many assets can be the subject of a murabaha-based transaction, including
property, machinery, equipment and commodities. Murabaha is not
permitted in a transaction where both countervalues are items that can
be subject to riba. In Chapter 3, under the ‘Prohibition of interest (riba)’
section, we discussed that in addition to paper money, six commodities
(gold, silver, dates, barley, wheat and salt), and any commodity by extrap-
olation that could be sold by weight and had the natural ability to be used
as a medium of exchange, needed to be exchanged at spot, like for like,
otherwise the exchange would be construed as including riba. Hence such
items cannot be used in a murabaha.
Islamic banks will typically use a technique called ‘murabaha to the purchase
orderer’ when financing assets. This is a simple technique, whereby the party
requiring the financing identifies the asset it wants to purchase. The bank
then buys the asset and sells it on to this party at a profit mark-up known
to both parties on a deferred payment basis, i.e. on a murabaha basis. This is
best illustrated by an example:
■■ Company A wishes to buy a machine for £5 million and approaches an Example

Islamic bank for financing for this purchase.
■■ The Islamic bank agrees to finance the purchase of this machine on a
murabaha basis as follows:
■■ The Islamic bank will initially legally acquire the asset for £5 million.
■■ Before acquiring the machine, the bank will get Company A to sign a
promise that it will purchase the machine from the bank once the bank
has acquired it. This promise will be legally enforceable and protects
the bank from the risk that Company A will not go ahead with the
69
purchase. Note the bank at this stage of receiving the promise from
Company A is not selling something it does not own, it is simply
getting a one-sided undertaking from Company A that it will buy the
asset from the bank once the bank has acquired it.
■■ It will then sell the asset on to Company A for £5 million plus, say, £1
million profit, making a total of £6 million.
■■ The bank requires payment of the £6 million over 60 months (5 years),
i.e. £100,000 per month.
■■ While there are deferred payment terms, Company A will become the
legal owner of the machine when the sale is made from the bank to the
company.
■■ The bank essentially ends up with a credit risk, i.e. Company A owes it
£6 million.
Due to the fact that the financier invariably ends up with a debt owed
to it, i.e. a credit risk, it is common for the financier to seek collateral/
security in the form of recourse to the asset itself and/or another asset or
to a guarantee.
What happens if the client of the bank wants to pay the amount owed
earlier? Do they have the right to any discounts? While payment is usually
deferred, the price has been fixed and the seller is not obliged to give any
discounts for early settlement of any debt owed to it. The seller, at their
discretion, can give a discount in respect of early payment, but it should not
be a contractual obligation. This is the official ruling given by the Islamic
Fiqh Academy.
What happens if the client defaults on payment? Can the bank charge
more than the sale price agreed as a penalty? If the bank were to benefit by
charging more than what was agreed, this excess would be regarded as riba.
The mainstream practice is to charge a penalty for default that goes towards
covering extra costs incurred by the bank in recovering the debt owed to it
and/or the remainder/all of it to a charity.
At this point, it is worth comparing a murabaha transaction with a
conventional loan on interest, as both transactions end up with a debt owed
by one party to another, but one is based on a trade of real assets and the
other is a money-for-money exchange – see Table 5.2.
While ‘murabaha to the purchase orderer’ is a technique widely accepted
and practised in the Islamic finance industry, there have been some concerns
regarding the degree to which the transaction is controlled so as to almost
fully eradicate any risk to the financier, and therefore it very much mimics
the economic reality of a loan, namely:
70
Comparison of a murabaha transaction with a conventional loan Table 5.2
Murabaha Conventional loan
Underlying Sale of real asset, where seller Money for money transaction,
transaction (e.g. bank) must have actual bank does not need to take
ownership ownership of any asset
Late payment Financier cannot benefit from Usual feature – lender stands
any late payment penalty to benefit from any late
penalty charges
Early Seller not obliged to give any Usual feature of loan contracts
repayment discounts and should not be – early payment terms are
in sales contract – can give stipulated
early payment discounts out
of discretion
■■ The bank gets in place a legally binding promise from the recipient of the
finance to purchase the asset.
■■ In reality, the bank will own the asset for only seconds/minutes, as it
almost instantaneously sells on to the purchaser.
■■ The bank also protects its position by taking collateral/security as with a
conventional loan.
I mention these points because it is important to appreciate the sensitivities
around different types of Islamic finance instruments. Islamic finance is
ultimately a faith-based system of finance and its long-term future as an
industry is partly predicated on remaining true to the principles and values
taught by the faith. In this case, murabaha is built on the principle of
having an underlying trade of assets, whereby a seller has taken some risk in
procuring an asset and selling it on at known profit. If the substance of that
is undermined in any particular transaction, then it calls into account the
credibility of that transaction.
Commodity murabaha
The point being made in the previous paragraph is relevant to a particular
application of the murabaha concept, namely commodity murabaha (sometimes
referred to as tawarruq). Commodity murabaha has been widely practised in
the short history of the modern Islamic finance industry but has provoked
widespread criticism for its artificial nature; indeed, while the transaction
may technically represent a trade, the substance of the transaction has little
or no regard for the asset being transacted.
Commodity murabaha has been widely used to facilitate inter-bank liquidity
as well as providing personal and corporate finance. It works as follows:
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■■ Party A has excess liquidity of, say, £1 million and would like to earn a
return on it. Party B requires finance of £1 million.
■■ In a commodity murabaha, Party A and Party B strike a deal whereby
Party A will provide finance of £1 million to Party B, based on a
commodity trade as follows:
■■ Party A would typically buy metals – the London Metals Exchange is
used extensively for this – for £1 million. It would attain legal title to
these metals.
■■ It would then almost instantaneously sell these metals to Party B on a
murabaha basis, i.e. in this case for £1 million plus a mutually agreed
profit mark-up, let’s say £1.1 million, payable in one year’s time.
■■ Party B, at this point of acquisition of the metals from Party A,
becomes the legal owner of the metals and has a debt to Party A of £1.1
million payable in one year’s time.
■■ Party B, requiring the £1 million, sells the metals, again almost
instantaneously after acquisition, back into the market to realise the
£1 million in cash.
It can be seen that in reality the underlying metal in the trade has no real
commercial value to the parties but rather is used to legitimise the trans-
action from a sharia perspective. For many, this transaction is therefore
artificial and is not in line with the underlying spirit and substance of the
sharia.
Many sharia scholars have sanctioned the use of commodity murabaha on
the basis that the Islamic finance industry is young and needs mechanisms
to operate within the global banking and financial system – for example,
inter-bank liquidity needs to be facilitated. However, they have encouraged
practitioners and the industry to find other solutions so that its use can be
minimised.
In April 2009 the Jeddah-based Islamic Fiqh Academy, an international
body of scholars, issued a resolution criticising commodity murabaha/
tawarruq as described above as a ‘deception’, damaging its acceptability in
the industry.
In recent times Oman has launched its Islamic finance sector and a
policy document released by the Omani Central Bank pertaining to the
Islamic finance industry states: ‘Commodity murabaha or tawarruq, by
whatever name called, is not allowed for the licensees in the Sultanate as a
general rule.’ Instead inter-bank liquidity is facilitated through mudarabah,
musharakah and wakala structures (we will discuss wakala shortly).
However, AAOIFI has approved commodity murabaha and has issued a
sharia standard in relation to it (Sharia standard number 30). The sharia
standard contains certain conditions for the transaction to be valid, such as
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an auditable ownership of the commodity by each party and separation of

the purchase and sale arrangements. These conditions seek to promote as
much as possible a legitimate trade between two parties. However, the issue
of commodity murabaha being a ‘synthetic’ trade in which neither party is
interested in deriving any utility from the underlying commodity remains.
Ijarah
The translation of ijarah is ‘to give something on rent’ and refers to two
main scenarios:
1. Employment of a person whose services are purchased in exchange for
wages – known in Arabic as ijarah ’ala al-ashkash (hire of persons).
2. Transfer of the right to use an asset (referred to as usufruct) in exchange
for rent. This is synonymous with leasing an asset and in Arabic is called
ijarah al-a’yan.
The second scenario is more relevant when it comes to the Islamic finance
industry and the ijarah contract is used extensively in the market.
The key features of an ijarah contract are as follows.
1. The lessor must be the owner of the leased asset and must bear the
risks and costs associated with ownership, unless damage/costs occur
as a result of misuse or negligence on the part of the lessee. Hence the
major maintenance and insurance of the asset is the responsibility of
the lessor, while the minor maintenance and cost arising from the use of
the leased asset must be borne by the lessee. For example, the landlord/
lessor of a property would be responsible for ensuring the structure
of the property is sound and maintained – for instance, the roof, the
electricity and utilities are working – while the tenant/lessee would
be responsible for paying the utility bills and ensuring the property is
kept in good order in terms of hygiene and cleanliness.
2. The leased asset must be used for activities that are permitted by the
sharia. Either the lease agreement will stipulate what activities can be
undertaken by the lessee or the lessee needs to seek permission from the
lessor for a new activity not previously agreed.
3. The rental must be fixed and known to both parties. It is permissible
to have different rental levels for different periods of the ijarah at the
outset of the contract. For example, the rental of a cottage by the coast
may be set higher for the summer months. It is also permissible to have
a variable rental linked to a particular benchmark or other method,
if it is clear and agreed by both parties upfront. Where the rental is
variable, then from a sharia perspective it is desirable if the lessee has
the option to terminate the contract when the rent is revised, as the
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rental may increase significantly and/or there is a cap to any potential

increase. Both of these things help to mitigate the gharar (contractual
uncertainty) that can come in when the future rentals are not known.
4. It is also permissible to express the rental as a percentage of the costs
incurred by the lessor in purchasing the asset.
5. Rentals are payable whether or not the lessee uses the asset, e.g. if an
office is taken on rent by a lessee, the rental will be payable whether or
not they use the office.
6. The ijarah must be for a specified period.
7. Total damage, destruction or significant defect of the leased asset (for
example, due to fire) will give the lessee the option to void the ijarah
contract. To avoid this, the lessor could try to substitute the damaged
asset with another asset that gives the lessee the same benefits. Partial
damage to the asset will give an option to the lessee to continue with
the contract with or without a proportionate reduction of the rental
payments.
8. Apart from the ijarah contract becoming void due to asset damage or
destruction, the ijarah can be terminated by mutual consent of the
parties. If the lessee contravenes any of the lease agreement terms, the
lessor has the right to terminate the lease contract unilaterally.
9. It is not permissible for a lessor to charge the lessee a penalty on late
payment with a view to profiting from that penalty. Any such penalty
may be used to cover the costs of chasing/recovering the rentals from
the lessee and/or donated to charity.
10. The lessee, with the consent of the lessor, can sub-lease the leased asset
to a third party.
Ijarah wa iqtina (lease with acquisition)

This refers to an ijarah in which the lessee undertakes to purchase and
therefore take ownership of the leased asset at the end of the lease. Another
name for this type of lease is ijarah muntahia bitamleek (lease ending in
ownership).
These types of ijarah contracts are often compared to conventional
financial leases because financial leases will usually also involve ownership
passing to the lessee at the end of the lease period.
It is worth noting that the classification of conventional leases into
operating and finance leases does not exactly match the classification of ijarah
contracts into ‘plain’ ijarah contracts and ijarah wa iqtina contracts. Finance
leases are defined to be leases in which the risks and rewards of ownership
are substantially transferred to the lessee. Hence a lease can be classified as
74
a finance lease even if ultimately the lessee does not take ownership of the
asset. For instance, if a piece of equipment has a useful economic life of five
years and it is leased to a lessee for five years, this would be categorised as
a finance lease because the lessee will essentially use the asset for its total
economic life. From an ijarah perspective, this would be classified as a ‘plain’
ijarah.
In an ijarah wa iqtina, there is usually a unilateral purchase undertaking
by the lessee to buy the asset or a unilateral undertaking by the lessor to sell
the asset to the lessee at the end of the lease term. The transaction is struc-
tured in this way because the sharia prohibits one contract being contingent
on another – hence it would not be permissible to agree a sale contract at the
same time as the ijarah contract. The use of a unilateral promise overcomes
this prohibition. The other way of overcoming this issue is by the lessor
gifting the asset to the lessee once all required payments have been made.
Ijarah mawsoofa bil thimma (forward lease)

In a normal sales contract such as murabaha, it is not a valid sale to
agree something today for execution in the future. Linked to this is the
requirement of the seller to own what they are selling.
In an ijarah, where the lessor already owns the asset, it is permissible
to conclude an ijarah contract to provide the asset on a future date. For
example, a property owner can execute an ijarah contract today to rent his
property to someone in one month’s time.
Rental payments may relate only to the period in which the lessee uses
the asset, but it is permissible for the lessee to pay in advance, on the basis
that these advance payments are set off against the rentals due for the actual
use. So the property owner (the lessor) may request some of the rent due
in advance today (i.e. at the completion of the contract), which can then
be offset against the rent due for the actual use of the property in the first
month. (For instance, if the rent agreed in one month’s time was £1,000,
the property owner could request £500 to be paid now.) If, for whatever
reason, the lessor fails to provide the asset for use by the agreed date, then
the pre-paid rentals will be repayable by the lessor.
From the discussion of ijarah above, it can be seen that it is very similar
to the widespread practice of leasing we see in the world today. However,
in many modern-day leasing contracts, there will be terms of the leasing
contract that conflict with the principles of ijarah. For example, leasing a
car is a common scenario. Most car-leasing contracts will require the lessee
to procure and bear the cost of insurance for the car. Under ijarah, the lessor
as owner of the vehicle should bear this burden.
It is worth summarising the key potential differences between ijarah
contracts and conventional leasing contracts – see Table 5.3.
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Table 5.3 Potential differences between ijarah contracts and conventional leasing contracts
Conventional Ijarah
Rental payments Contract can stipulate Can only relate to period of use
rental payments for by lessee
periods even when No payment due if asset is not
asset is not useable useable
Risk of destruction/ Often transferred to Remains with lessor, except in the

loss lessee case of negligence or misuse by
the lessee
Insurance and Often on the lessee Has to be on the lessor

major maintenance
Pricing Variable or fixed Variable or fixed (first rental has to

be fixed)
Penalty for late Yes If enforced, has to be paid out

payment in charity less directly related
debt-recovery costs
Comparing murabaha to ijarah

We have now looked at murabaha and ijarah – both can be used by financiers
to make a return by financing assets. Both techniques are used extensively
in the Islamic finance industry. It is worth comparing the two techniques to
highlight the differences and relative features of each contract type. Table
5.4 summarises this comparison.
A central point at the outset is that in terms of pricing, ijarah is more
flexible. In a murabaha, once the price has been set, it cannot be changed and
Table 5.4 A comparison between murabaha and ijarah
Murabaha Ijarah
Financier will usually require client to Lessee often not required to make
make a prior promise to purchase promise to purchase asset
Sale of asset Sale of usufruct
Mark-up on the cost Profit realised from rent
Fixed profit rate and price Rent can be variable in each term
Often a short-term financing mechanism Often a long-term financing mechanism
Cost of asset must be disclosed Cost of asset does not need to be

disclosed
Need to disclose full profit mark-up Necessary to disclose rental
Ownership is transferred upon signing Ownership may be transferred later if

the contract ijarah wa iqtina
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the financier has to work with a fixed profit mark-up, often over a lengthy
deferred payment term. In an ijarah, the rental can be changed periodically
and hence offers more flexibility.
Application of ijarah
Asset finance
Ijarah has been used extensively to provide asset finance to individuals for
such things as cars and houses and to businesses for such things as machinery,
equipment and property finance.
Meezan Bank, an Islamic bank in Pakistan, provides car finance based Example
on ijarah wa iqtina, i.e. leasing ending in ownership for the lessee.
The following is an extract from Meezan Bank’s website marketing and
explaining its car ijarah product. It is an excellent real-life illustration of the
features of an ijarah contract and reinforces the rules pertaining to ijarah –
namely the respective rights of Meezan Bank as the lessor and the customer,
as the lessee; the fact that the lessee is not liable to pay any further rentals if
the car is a write-off or stolen; that Meezan Bank, as the owner of the vehicle,
has the responsibility to insure the vehicle in a sharia-compliant way; and
the fact that any late payment penalty is directed to charity.
As a step towards Meezan Bank’s mission to provide a one-stop shop for
innovative value-added shariah-compliant products, Meezan Bank’s Car
ijarah unit provides car financing based on the principles of ijarah and is
free of the element of interest.
Car ijarah is Pakistan’s first interest-free car financing based on the
Islamic financing mode of ijarah (Islamic leasing). This product is ideal
for individuals looking for car financing while avoiding an interest-based
transaction.
Meezan Bank’s Car ijarah is a car rental agreement, under which the
Bank purchases the car and rents it out to the customer for a period of 3
to 5 years, agreed at the time of the contract. Upon completion of the lease
period the customer gets ownership of the car against his initial security
deposit.
Car ijarah, designed under the supervision of Meezan Bank’s shariah
Supervisory Board, is unique to car leasing facilities provided by other
banks.
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Rights and liabilities of owner v/s user
An Islamic ijarah is an asset-based contract, i.e. the Lessor should have

ownership of the asset during the period of the contract. Under Islamic
shariah, all ownership-related rights and liabilities should lie with the
owner while all usage-related rights and liabilities should lie with the user.
A conventional lease contract does not distinguish between the nature of
these liabilities and places all liabilities on the user of the asset, which is
contradictory to Islamic shariah.
Under ijarah, all ownership-related risks lie with the Bank while all
usage-related risks lie with the user, thus making the Lessor the true
owner of the asset and making the income generated through the contract
permissible (halal) for the Bank.
Continuation of lease rentals in case of total loss or theft of vehicle
If the leased vehicle is stolen or completely destroyed, the conventional

leasing company continues charging the lease rent till the settlement of
the insurance claim. Under the Islamic system, rent is consideration for
usage of the leased asset, and if the asset has been stolen or destroyed, the
concept of rental becomes void. As such, in the above-mentioned eventu-
alities, Meezan Bank does not charge the lease rental.
Takaful instead of insurance
Legally (in accordance to Pakistan’s law and regulations), it is required

for all leasing entities to insure the leased assets. As such, Meezan Bank
insures its leased assets. Meezan Bank insured its assets through Takaful
only, which is the Islamic product for insurance.
Permissibility for penalty of late payment of rent under Islamic shariah
In most contemporary financial leases, an extra monetary amount is

charged, in their income, if the rent is not paid on time. This extra amount
is considered as riba and is haram [an activity/item which is not permitted
by Islam e.g. consumption of alcohol or gambling]. Under ijarah, the
Lessee may be asked to undertake, that if he fails to pay rent on its due
date, he will pay a certain amount to a charity, which will be administered
through the Islamic Bank. For this purpose the Bank maintains a charity
fund where such amounts may be credited and disbursed for charitable
purpose.
Source: www.meezanbank.com/islamiccarfinancing.aspx
Ijarah-based investments
Providing investors with the opportunity to invest in assets that are leased
out on an ijarah basis is an attractive option. It gives investors the prospect
of receiving a predictable income stream and, depending on the quality of
the assets and lessee, it can be seen as a relatively low-risk investment.
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The National Bank of Kuwait (NBK) provides investors with an ijarah Example
investment fund. Again it is interesting to see how this product is described
and marketed by the product provider. An extract from NBK’s website
referring to the fund says:
The Fund seeks to invest all of its assets in the purchase of equipment or
portfolios of equipment which, in turn, are leased to diversified lessees.
The Fund will select high quality lessees, with a particular focus on
‘Fortune 1000’ companies and companies that are found to be of high
credit quality. The equipment portfolios of the Fund will have a diverse
range of leases and equipment types, thus reducing overall Fund risk.
The entire portfolio will be invested in accordance to Islamic shariah
principles and overseen by a board of shariah scholars.
NBK goes on to depict the risk level as low on the chart shown in Figure 5.1.
National Bank of Kuwait’s ijarah investment fund – how the bank depicts its Figure 5.1
risk level
High
Low
Source: www.kuwait.nbk.com
Risk level
Ijarah is often used in conjunction with other sharia-compliant transaction
types. For example, we saw earlier Al Rayan Bank’s home finance advert (an
extract of which can be found under the ‘Musharakah’ section). It mentions
the following:
Al Rayan Bank’s sharia compliant Islamic mortgage alternatives (Home
Purchase Plans or HPP) are based upon the Islamic finance principles of a
Co-Ownership Agreement (Diminishing musharakah) with leasing (ijarah).
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Here, following the acquisition of the property by Al Rayan and the client
jointly, Al Rayan will lease the asset to the client on an ijarah basis.
Capital markets
In Chapter 6 we will be discussing an investment instrument called sukuk,
often referred to as an Islamic bond. These instruments facilitate raising
large amounts of capital for governments and companies. Many of these
sukuk will either be based on ijarah or will involve an ijarah contract. Key
reasons for this include the following:
■■ Ijarah usually corresponds to a predictable income stream, which investors
like.
■■ The issuer of the sukuk can legitimately commit to buying the asset back
from the sukuk investors at a future date at a predetermined price. Again
investors like this because it gives them greater certainty.
We will discuss this particular application of ijarah when we discuss sukuk
in the next chapter.
ISTISN’A AND SALAM – EXCEPTIONS TO THE NORM
In Chapter 4 we discussed the general conditions required for valid

commercial contracts as per the sharia. There were several conditions
pertaining to the ability of the seller to supply the purchaser with the object
of sale: namely that the object of sale must exist, the seller must own the
object that they are selling, and they must have the ability to deliver the
object to the purchaser upon executing the sale. All these conditions seek to
ensure that the sale can be completed as agreed and mitigate the risk of the
seller not being able to supply the items of sale.
While this represents the general situation, there are a couple of excep-
tions that apply in some specific circumstances – transactions that come
under the headings of istisn’a and salam. In sharia, there are the following
general principles/maxims:
■■ Hardship calls for simplification of the rules.
■■ Needs are to be treated as necessities.
The exceptions of istisn’a and salam are based on these principles in relieving
potential cash flow pressure for sellers. As we will see below, in both istisn’a
and salam, the sellers need time and resources to produce what they sell, and
so to make it easier for them they have been allowed to receive payment in
advance of supplying the items for sale.
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Istisn’a
Istisn’a means ‘to request a manufactured item’.
Istisn’a is a sale contract that applies to manufactured goods or constructed
items such as property. In such cases the purchaser is buying something that
does not currently exist. An istisn’a contract is executed with the seller
contracting to manufacture or construct a non-fungible item over a period of
time in return for a price agreed now, payable as agreed by the two parties.
One of the features of istisn’a contracts is that payment terms can be very
flexible – payment can be all upfront, in stages, all at the end or even after
the end of the manufacture/construction phase – it comes down to what is
mutually agreed by the two parties. Most istisn’a contracts in practice are
based on staged payments over the period of manufacture/construction.
It is not necessary to appoint a time for delivery. However, the purchaser
may appoint a maximum time for delivery beyond which it is not acceptable
for the manufacturer to delay.
AAOIFI has allowed the seller to request the purchaser, subject to
agreement from the purchaser, to pay a non-refundable deposit (called arbun
in Arabic). This would be forfeited by the purchaser if they cancelled the
contract after the manufacture process had begun.
Application of istisn’a
Finance for property developers and manufacturers
Financiers can purchase items that qualify for istisn’a such as property prior
to manufacture/construction, thereby providing finance for the constructers.
The financier will usually make a commercial return on this financing
through the onward sale of the manufactured item at a higher price than
what it paid. It usually will not wait until the asset is manufactured but will
enter into a ‘parallel istisn’a’ contract while the item is being manufactured.
In this ‘parallel istisn’a’ contract the financier switches role and becomes
the supplier of the asset. Often the financier will pay in advance or upon
delivery for the manufactured item in the first istisn’a and the customer
of the financier pays in instalments after receiving delivery in the second/
parallel istisn’a.
This is best illustrated by an example:
Islamic Bank A enters into an istisn’a contract to buy a house from a Example
property developer for £1 million. The bank will pay £500,000 upfront
and £500,000 on completion, with a maximum time frame of delivery for
the completed house in six months’ time. Islamic Bank A then enters into
another istisn’a contract (a parallel istisn’a) in which it sells the house to
Party A for £1.25 million. The bank contracts to supply the house to Party
81
A in a maximum time frame of six months, and agrees a payment schedule

with Party A such that Party A pays £250,000 on receiving the house and
then on an instalment payment basis of £125,000 per year for the next eight
years thereafter.
The bank in the second istisn’a contract must bear the responsibility of
ensuring the house is delivered to the specification as per the contract and
within the six-month time frame. If there is some kind of default on these
terms, this must be rectified at the bank’s expense, even though the default
was ultimately caused by the real manufacturer.
Other features of istisn’a contracts are as follows:
■■ The manufactured item itself is often taken as security by the financier
but it is permissible to take other items as collateral.
■■ If the manufacturer fails to produce the items agreed, the buyer may
terminate the contract and is entitled to receive a refund of the contract
price paid so far.
■■ If the manufacturer fails to deliver the goods on time, or to specification,
then the contract price may be reduced by a specified amount per day
unless an extension is mutually agreed.
■■ If the defaulting party is the financier or end customer of the financier, the
manufacturer may be relieved of any further responsibility to complete
the manufacture. The manufacturer will typically schedule payment
terms such that it mitigates the chance of losses due to non-payment from
the buyer.
■■ Penalties can be levied on the buyer for non-payment or late payment, but
as with other contract types, any excess collected above what was agreed
can go towards covering recovery costs and the rest needs to go to charity.
Example Sharjah Islamic Bank, a Gulf-based Islamic bank, provides istisn’a finance for
real estate development projects. The description given below by the bank
describes how the bank will sell the developed property/land to the customer
through an istisn’a contract in which payments are staggered and deferred
up to a maximum of 10 years, with a construction phase up to two years.
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Istisn’a
Istisn’a is a sharia mode of financing widely used by Islamic banks and

financial institutions to finance the construction of buildings, residential
towers, villas and related products, and manufacturing of aircrafts, ships,
machines and equipment, etc.
We adopt istisna’a mode of financing to fulfil your financing require-
ments in relation to properties, buildings, and villas, etc. Following is a
brief outline of this mechanism. If you own, or have a usufruct of, a plot
of land and want to construct a property on it and need financing for this
purpose, we will sign an istisna’a agreement with you to sell the property
and then construct the building as per your specifications at our own cost
and will get the sale price from you on a deferred payment basis.
Details of the terms under which this product is offered are outlined below:
Terms of Financing
Type of Property: Freehold. Cash Contribution: Minimum 40% to 50%

of total project cost. Finance Tenor: 10 years including up to two
years’ construction period. Mode of Repayment: Monthly, Quarterly,
Semi-annual or Annual terms are available. Sources of Repayment:
Primary: Rental income of the project. Secondary: Other incomes. Profit
Rate: Fixed throughout the financing period. Security: First degree regis-
tered mortgage on the plot and the building, in addition to the other terms
of approval. Insurance: Insurance policy covering the property under
construction to be assigned to the Bank. Qualified Assets: Residential,
office buildings and villa complexes.
Source: http://www.sib.ae
Project financing – istisn’a used in conjunction with ijarah

So far we have described a situation in which the financier enters into an
istisn’a contract and then enters into a parallel istisn’a to sell on the manufac-
tured items at a mark-up. Another possibility is for the financier to enter
into an istisn’a with the manufacturer to procure and finance the asset and
then enter into an ijarah with the party that wants to use the asset. In this
way the financier earns its return through the rentals. These transactions are
usually structured with the following two additional features:
1. The ijarah is usually an ijarah wa iqtina – that is, the lease usually ends
in the ownership of asset transferring from the financier to the lessee.
2. To give the financier some return during the construction phase (which
can be several years in very big projects), the ultimate lessee often pre-pays
rentals during this phase. Rentals under an ijarah can only correspond to
the period of use of the asset – hence any rentals pre-paid are effectively
offset against the rentals due once the lessee starts to officially have access
83
to and uses the asset. This type of ijarah (i.e. where there are pre-paid
rentals) is called an ijarah mawsoofa bil thimma (forward lease).
During the construction phase, there is often this ijarah mawsoofa bil thimma
and once the construction phase is over, there is an ijarah wa iqtina.
A good example of such a transaction was in 2008 when Qatar Islamic
Bank (QIB) financed three desalination units in the Ras Abu Fontas A1
(RAF A1) water desalination plant for Qatar Electricity & Water Company
(QEWC) for $150 million. The financing was structured as an istisn’a-
ijarah scheme spanning 20 years. QIB entered into an istisn’a with an
Italian manufacturer to build the plant over a 1.5-year period. During this
construction period there was a forward lease rental payable by QEWC to
QIB. Once the construction period was over, an ijarah wa iqtina was in place
for an 18.5-year period during which QEWC would use and pay rental to
QIB for the plant and become ultimate owner of the plant at the end of the
lease term.
Salam
Salam is the other exception to the general rule that an item being sold has
to be in existence at the time of sale. Istisn’a applies to non-fungible items
that need to be manufactured or constructed. Salam applies to fungible items
that also require time for production, such as agricultural produce; indeed,
the Prophet Muhammad sanctioned payment in advance to farmers before
their crops matured, so as to make it easier for them in the period in which
their crops were growing.
Salam can be defined as the sale of a defined amount of a fungible object
for full payment now for delivery in the future at an agreed time and place.
Key features of a sale based on salam are as follows:
■■ The object of sale must be specified in quality and amount.
■■ The object of sale must be fungible – that is, it must be substitutable and
therefore freely available in the market place from day one of the contract
to the date of delivery, or at least freely available at the time of delivery.
Hence salam cannot apply to a non-homogeneous item such as a precious
stone or rare painting. This condition is required to protect the buyer who
has paid upfront. In the scenario in which the seller fails to produce the
items or falls short of the required amount, they are required to procure
the items from the market and make good his commitment to deliver the
sale items at the specified time and place.
■■ The buyer can be further protected by requiring the seller to give some
form of security or guarantee that can be invoked if the seller fails to
supply the goods at the required time.
84
■■ In essence, by requiring the item to be fungible, it allows the obligation

of the seller to deliver the goods at a specified time in the future to be
treated like a debt. Whether the seller succeeds in producing the required
goods or not, they will have the ability to repay this ‘debt’ by procuring
the goods from the market.
■■ To trade debt at anything but par is tantamount to riba (interest) and
therefore disallowed. Hence a buyer of a commodity in a salam contract
cannot sell their right to receive the goods from the supplier they have
contracted with for anything but what they paid. Thus salam-based
investments are not very popular because of this restriction on their
tradability.
■■ It does not matter where the commodity is produced as long as the
requirement to supply the contracted quantity by a specific date is met.
Therefore a salam contract should not, for example, refer to the produce of
a particular farm or the fruit of a particular tree in case that farm or tree
fails to produce the required goods.
■■ The quality of the goods must be clearly stipulated to ensure there is no
ambiguity over what the buyer expects when the goods are delivered in
the future.
■■ Salam can be applied to the sale of fungible commodities that can be
measured by weight, volume, length or number – for example, metals
such as copper and zinc, grains, oil, sugar, etc.
■■ In a salam contract, delivery is deferred. Most scholars require the
minimum deferment period to be one month. However, the AAOIFI
standard on salam (Sharia Standard number 10) does not specify a
minimum.
■■ Payment is required in full upfront from the buyer. Some scholars have
allowed a maximum delay of three days. Delaying payment would mean
that both delivery of the commodity and the payment are delayed.
This would be tantamount to sale of a debt (the commodity) for a debt
(payment), which has been forbidden in the sharia. Moreover, the key
reason for allowing salam is to alleviate the cash needs of the seller, hence
delaying payment would be against this.
Salam cannot be applied to justify the short selling of shares because:
■■ the shares of a particular company are not necessarily fungible;
■■ salam is an exception to the normal rules of sale. In sharia, it is imper-

missible to apply analogy based on an exception to the normal rules.
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Application of the salam contract

Finance for producers of fungible items
Financiers such as banks can provide finance to farmers, miners, etc. by
paying them now for delivery in the future. They can make a return on
this purchase by selling the commodities procured for a higher price. To
minimise the risk of the commodities falling in price between paying for
them and delivery, the financier will usually seek to lock in a profit by
entering into a parallel salam contract, in which the financier enters into a
second salam contract, this time as the seller. It will seek to agree a higher
price than it paid in the first salam contract. This is best illustrated by an
example.
Example Islamic Bank A enters into a salam contract to buy 100 kg of copper for
£50,000 from Supplier B, to be delivered in 45 days. Islamic Bank A pays
£50,000 to Supplier B now.
Islamic Bank A then enters into another salam contract (a parallel salam
contract) with Party C, to deliver 100 kg of copper in 45 days for £55,000.
Party C pays £55,000 to Islamic Bank A now.
Islamic Bank A has made £5,000 profit out of these two transactions.
Note that the second salam contract needs to be independent of the first
and cannot be tied to or contingent on the first salam contract.
Islamic Bank A would not be allowed to buy from Party B and then sell
on to Party B, i.e. the counterparties on the buying and selling side need
to be different. Otherwise, this would open the door for transactions repli-
cating a loan on interest.
Conventional institutions would generally use forward contracts in these
situations, whereby the item of sale and the price paid are both deferred. In
sharia, this is not regarded as a valid sale. If an Islamic bank wants to use
this technique, it needs to use promises.
Export/import finance
Here the financier can act as the buyer, providing finance to the exporter for
the production and supply of the export merchandise. The financier then
sells on the export merchandise for a profit margin to the export customers.
Conversely, the financier can finance importers by buying the goods on a
salam basis from the suppliers and then selling them on to the importers for
a profit which could be on a murabaha basis.
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Personal finance
Salam has been used to provide finance to individuals. Here an Islamic bank
pays an individual money now in return for that individual supplying it
with a particular commodity of a certain amount at a particular time in the
future.
Dubai Islamic Bank (DIB) and Abu Dhabi Commercial Bank (ADCB)
provide personal finance on this basis. The following is an extract from DIB’s
website on the Frequently Asked Questions (FAQs) on this product. Note
the recipient of the finance is required to buy sugar and deliver it to DIB in
the future under the salam contract.
Frequently Asked Questions
1. Is there actual commodity buying and selling?

Yes, there is actual buying and selling of a real commodity.
2. Since commodity prices fluctuate over time, how can DIB justify fixing the
price over long tenures?
Salam is being practiced for 14 centuries and Muslims all over the world
have been entering into salam contracts and are aware of market fluctua-
tions. This means that by studying the market, one can predict the future
prices. This is not strange as ‘futures’ are being used in conventional
banking with both the considerations deferred. But sharia allows only the
delivery of goods to be deferred in case of salam with the price paid up
front.
3. How will the commodities be delivered to DIB?

Based upon your request, one of the suppliers will issue a Master Sale
Undertaking to you and once you purchase the commodity from the
supplier and take its possession, you (or the Agent acting on your behalf)
will send a notice to the Supplier to deliver the commodity to DIB (by way
of debiting and crediting the commodity accounts).
4. Who is the Supplier in case of Al Islami salam Finance?
The supplier, in case of Al Islami salam Finance, is Al Khaleej Sugar

Company and their principal business activity is processing of refined cane,
raw molasses and syrup sugar.
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5. What is the commodity that I will be required to sell to DIB?
The commodity required to be sold by you, to DIB, is Sugar.
6. Is there a profit that I am paying to DIB in Al Islami salam Finance?
In Al Islami salam Finance, DIB will pay you the purchase price in advance
and you will be required to deliver only the commodity on agreed future
dates.
7. How does the bank earn profit in Al Islami salam Finance?

Upon receiving delivery of the required quantity at the agreed delivery dates
from you, DIB may earn profit on the same post selling it in the market.
A similar type of arrangement can be used to provide working capital

finance for businesses.
It is worth comparing and contrasting the contracts of salam and istisn’a.
Both can be viewed as exceptions to the norm in sale contracts for the reasons
we have discussed, but apply and work in different ways – see Table 5.5.
Table 5.5 A comparison between istisn’a and salam
Istisn’a Salam
Applies to assets that are to be either Applies to fungible items such as

constructed or manufactured base metals, agricultural produce and
commodities such as sugar and oil
The contract is very flexible in terms Payment must be made in full at the
of payment timing – can be upfront, beginning of the contract
phased, at the time of delivery or
post-delivery
A maximum time frame can be set for The delivery time is fixed
the asset construction/manufacture and
delivery
The contract can be cancelled only The contract cannot be cancelled

before the work starts
We have now discussed six very important transaction types:

Equity-type transactions:
1. Musharakah.
2. Mudarabah.
Asset finance:
3. Murabaha.
4. Ijarah.
88
5. Istisn’a.
6. Salam.
These represent key structures that are used extensively in the Islamic
finance industry and a good grasp of these will enable you to comprehend
many of the transactions in the industry. We will now look at some other
important transaction types. These, together with the six structures we have
already looked at, will be an important part of your tool kit in analysing and
understanding sharia-compliant products and transactions.
OTHER KEY TRANSACTION TYPES
Wakala
Wakala means ‘agency’ and refers to a situation in which one party
appoints someone as their agent or representative to act on their behalf. It
is a simple concept and, as we will see, has gained widespread application
in the Islamic finance industry. Some of the key features of wakala are as
follows:
■■ The agent is acting on behalf of the principal and therefore in terms of
work carried out by the agent, the agent is not the contractual counter-
party in matters pertaining to the object of the agency. Therefore the
agent cannot be held liable for any loss, damage or liability arising from
the performance of the agency contract.
■■ The agent is required to carry out his duties in good faith, with due care,
attention and skill, and holds any property of the principal on trust. If the
agent is guilty of negligence, misconduct or breaching the terms of the
agency agreement, then the principal has recourse to the agent to recover
the losses they have suffered as a result.
■■ The remuneration to an agent can be structured in a flexible way. It can
be in the form of a wage (in which case the agency becomes a contract of
hire) and/or it can have a performance element to it.
■■ The scope of the activities delegated by the principal to an agent can be
restricted or unrestricted. If the activities are restricted and the agent acts
beyond the authority given to them, such transactions concluded by the
agent are not valid unless permission is given by the principal.
■■ Agency contracts can also be on the basis of a ‘disclosed agency’ and an
‘undisclosed agency’:
■■ Disclosed agency: this is the usual type of agency, where all parties
to a contract know that the agent is acting on behalf of the principal.
■■ Undisclosed agency: in this situation, the agent does not disclose that
89
they are acting on behalf of a principal. Consequently, the other party

to the contract has recourse to the agent only and not to the principal.
■■ The principal is responsible for all costs and expenses incurred by the
agent in performing the work agreed under the contract and must
therefore reimburse the agent accordingly.
Wakala contracts can be terminated through the mutual agreement of the
agent and principal, death of the principal or agent, completion of the task,
destruction of the object of the agency or loss of eligibility (e.g. a person
who undertakes the role of agent in managing a principal’s money in terms
of investment loses his regulatory licence to undertake such duties).
Application of wakala
There are a number of applications of Wakala.
Savings accounts
When we discussed mudarabah, we saw an example of how Sharjah Islamic
Bank had used the mudarabah contract to provide a savings account in which
the bank invested the monies of the depositors and shared the resultant
profit with the depositors in a pre-agreed profit ratio.
Other banks have instead used the wakala contract for savings accounts.
Here the bank acts as a wakil (agent) of the depositors in terms of investing
their monies on a sharia-compliant basis. In return the bank receives a fee
which can be a fixed amount, linked to the investment amount, and/or have
a performance element to it. The following is an extract from the website of
Al Rayan Bank (formerly known as Islamic Bank of Britain, IBB) explaining
how the bank uses the wakala contract for its savings products. It has a
useful FAQ section with it.
90
1. How do Islamic banking products such as savings accounts work? Will

I be paid interest? What will I earn and is it Halal for me to earn from my
savings?
Al Rayan Bank, and other Islamic banks, will not pay interest to customers
that open a savings account with them. However, it is permissible for
customers to earn a profit which is generated from the deposits they make
with their Islamic bank.
Al Rayan Bank’s savings accounts are based on Islamic finance principles
and pay profits. For example, the Al Rayan Bank Fixed Term Deposit Account
is based on the Islamic financial principle of Wakala (agency agreement).
Under the Wakala Agreement, a customer deposits their savings with Al
Rayan Bank and the Bank becomes their agent. Al Rayan uses the cash
deposit to invest in sharia compliant and ethical trading activities and generate
a target profit for the customer over a fixed term. The Bank manages and
monitors the performance of the investments on a daily basis to minimise the
risk and ensure that the customer receives the projected target (‘expected’)
profit rate.
Customers are given a guarantee that their funds will only be invested
in sharia compliant and ethical investments, which will exclude all interest-
bearing transactions and non-sharia compliant business activities such as
gambling, speculation, tobacco and alcohol. Currently investments take place
in trades of low risk commodities (metals) and in the Bank’s Home Purchase
Plans, whereby the rents received by the Bank for investing the customers’
funds are paid as profits, after deducting the Bank’s fees.
2. Is it permissible under the sharia to quote a profit rate for Fixed Term
Deposit savings accounts?
It is important to clarify that this sharia compliant savings product(s) is called

‘fixed term’ and not ‘fixed return’. It is usually offered under the Islamic
principle of Wakala (an agency agreement). With this product, the Islamic bank
provides an expected profit rate over a set period of time as a ‘target’ based
on the investment activity it will undertake with the deposits. The ‘Fixed’
element relates to the length of time the bank will undertake the investment
activity for the customer. For example, two years for the Two Year Fixed Term
Deposit Account.
These savings products do not offer a fixed return in the same way that
conventional banks that pay interest do. Under sharia, the bank cannot
guarantee a rate of return, because with investment there is always an element
of risk.
However, Islamic banks mitigate this risk for the customer in many ways, so
that the customer’s deposits and return do not suffer. To date, for this type of
savings product, Al Rayan Bank has always achieved the expected profit rate
offered to its customers.
Source: www.islamic-bank.com
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Wakala as a tool for facilitating inter-bank liquidity

When we discussed commodity murabaha, we noted the synthetic nature of
this transaction and the fact that it has been heavily criticised for this. We
also noted that Oman in recent times, for this reason, has prohibited the use
of commodity murabaha for inter-bank liquidity purposes. In recent years,
wakala has emerged as a widely used alternative – it has greater authenticity
from a sharia perspective. Banks with surplus liquidity contract with other
banks on wakala basis; that is, they engage the other bank(s) as an agent
to invest their monies on a sharia-compliant basis for a fee in return for an
expected profit return. The bank acting as the agent (wakil) could be doing
this role just to earn fees from it or also to facilitate monies it requires for
investment activities in which it wants to participate.
In June 2013, a standard wakala contract template was launched by the
Bahrain-based International Islamic Financial Market (IIFM), a non-profit
industry body which develops specifications for Islamic finance contracts.
The concept of wakala can be applied in:
■■ Fund management: this is a common application of wakala – the fund
manager acts as the agent of the investors in managing the fund and
charges a fee for his services.
■■ Brokering services: this is very common too, for example employing an
agent to sell an asset such as a property.
■■ Islamic insurance (takaful): the contract of wakala is often used within
the context of Islamic insurance businesses. The insurance business tends
to have two sides – the underwriting of risks and the investment of monies.
Both these functions can be delegated to agents by the policy holders. This
will become clearer when we discuss Islamic insurance in Chapter 8.
Security contracts
The following transaction types fall under the category of ‘contracts of
security’. These contracts are designed to protect creditors from debtors
defaulting on the payment terms agreed. These contracts are not primary
contracts with original rights and liabilities. Security contracts seek to
secure the rights and liabilities that originate from primary contracts such as
murabaha, salam, ijarah, etc. Hence security contracts must necessarily relate
to a primary contract and will seek to protect the interests of the principal
creditor in those primary contracts.
Hawalah
This refers to the transfer of a debt from the person who currently owes
the debt (the transferor) to the person named in the hawalah contract (the
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transferee). A key reason the sharia has sanctioned hawalah is so that debts
can be paid more easily, as evidenced by the following Prophetic teaching:
Procrastination in the payment of debts by a wealthy man is an injustice.
So, if your debt is transferred from your debtor to a rich debtor, you
should agree.
‘Collection of Prophetic sayings’ by Imam Bukhari
It is best to look at a couple of scenarios of how hawalah could work:

■■ Party A in the UK buys goods on credit from Party B in Malaysia and
now has a debt to Party B of £1,000.
■■ Party A could employ the services of a hawalah operator – Party C (many
Islamic banks offer this service) – and transfer the debt it owes to Party B
from itself to Party C. This is stipulated in the hawalah contract and now
repayment of the debt (£1,000) to Party B must be sought from Party C
and not Party A.
■■ Party C can charge Party A an administrative fee for this service, but this
fee cannot be proportionate to the debt transferred – otherwise it could
be construed as interest.
Hawalah can also be applied in a situation as follows:
■■ Party A buys goods on credit from Party B for £5,000. Party A has also
lent £5,000 to Party C. Hence you have the following position:
■■ Party A has a debt to Party B of £5,000.
■■ Party C has a debt to Party A of £5,000.
■■ A hawalah contract can be constructed so that Party C pays Party B

directly, without Party A having to collect monies from Party C and then
paying Party B. This serves to simplify matters and can be worthwhile
when creditors and debtors are separated geographically.
So far we have discussed hawalah in terms of debt transfer expressed in
monetary amounts. It can be applied to debt expressed in terms of fungible
assets such as metals (e.g. copper, aluminium, etc.) but not non-fungibles
(e.g. buildings). Hence you can transfer a debt expressed in terms of 100 kg
of sugar, in which 1 kg of sugar is identical to another, while this is not
possible with buildings as one building is different from another.
A number of products/services provided by the banking industry today
are forms of hawalah, such as cheques, drafts, pay orders, bills of exchange,
overdrafts, etc.
Rahn
Rahn in Arabic means to hold. In the context of providing security, it refers
to a contract in which the seller/creditor mitigates the risk of payment
93
default by the buyer/debtor by holding as security a physical asset, which

can be sold in the event that the buyer does not fulfil his commitment to
pay.
The security can be offered in the form of a mortgage or pledge against
an asset belonging to the debtor or the creditor can take physical possession
of the pledged asset itself. Any surplus proceeds in excess of the outstanding
debt realised from the sale of the pledged asset must be returned to the
debtor.
Taking security in this fashion is common in transactions such as
murabaha and salam, where essentially the outcome of the transaction is a
debt that is owed.
A key advantage of a rahn contract is that the pledged asset can continue
to be used by the debtor. Therefore, in practical terms it changes very little
– the debtor continues using the pledged asset, while the arrangement
enhances his creditworthiness and mitigates the risk of non-payment from
the perspective of the creditor. The pledge makes a creditor a secured
creditor who is normally ranked higher than other creditors who have no
pledge or security.
If the creditor holds the pledge asset in physical possession, they have to
exercise due care in looking after the asset as they are holding it on trust.
If the asset is damaged or destroyed while in their possession without any
negligence or fault on their part, the creditor does not suffer the consequent
loss on the asset.
Kafalah
Kafalah in Arabic means guarantee and is a contract between the guarantor
and the person they are guaranteeing. This can be in the form of a financial
guarantee (as most commonly found in the Islamic finance industry),
whereby if a creditor defaults on paying a debt, the guarantor will fulfil
the obligation on the part of the creditor. A guarantee can also be given in
respect of the actions of a person/organisation, e.g. I guarantee that a tutor
will be with you every Monday.
■■ A guarantee may be restricted, e.g. I guarantee £500 of a person’s debt,
or, unrestricted, e.g. I guarantee whatever is owed.
■■ The guarantee can be limited in terms of duration, e.g. I guarantee
payment of whatever is the outstanding balance at the end of the
month.
■■ The guarantee can be based on specific conditions, e.g. I guarantee paying
the debt of a person if they are made bankrupt.
■■ A guarantee may be deferred to a specified date in the future, e.g. a
guarantor provides a guarantee that they will pay whatever debt is
incurred over the next financial year if the creditor fails to do so.
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Traditionally, it has not been allowed to charge for guarantees from a sharia
perspective. This is because the one paying for the guarantee is uncertain
about what they will get in return, i.e. there is contractual uncertainty
(gharar) involved. Also they may get more than what they paid for as a fee,
hence this could be construed as riba/interest. However, scholars have recog-
nised that guarantees are necessary to give distant, unacquainted traders
the confidence to transact with each other. In this context, if the guarantors
cannot at least recover their costs of due diligence and processing these
guarantees, then they will not provide these guarantees.
Hence AAOIFI standards allow a charge to be made by the guarantor
when issuing a guarantee, so long as the amount of the charge is no greater
than the administration costs incurred. The guaranteed party is not excused
from his obligation because of the guarantee and is therefore still liable for
settlement either to the guarantor or to the original creditor.
What, if any, security contract is used to protect the interests of the
creditor in a transaction will depend on the suitability of these techniques
in a particular set of circumstances and what the parties are willing to agree.
It is possible for one obligation to be secured by more than one contract. For
example, to secure the debt owed by the buyer in a murabaha transaction it
is possible for the buyer to pledge an asset against the debt (rahn) as well as
putting a guarantor in place (kafalah).
CONCLUSION
In this chapter we have discussed the features of the key transaction types
found in the practice of Islamic finance and given examples of how these are
applied in the market. The first step is to understand these as standalone
concepts; the second step is to start understanding how these concepts differ
and compare, so you can appreciate what transaction type best meets the
objective of a particular transaction.
We have seen that a financier could finance the acquisition of an asset
such as a building or a machine using the techniques of murabaha, ijarah wa
iqtina and diminishing musharakah. What contract type is actually used will
depend on what is best suited. For example, if the duration of the finance is
a relatively long period, then ijarah may be preferred because of the fact that
the rentals can be revised periodically and hence it gives the financier more
flexibility, as opposed to fixing a particular price at the outset which cannot
be changed, as in a murabaha.
In the real world, financial products and transactions need to be struc-
tured to meet the demands and needs of customers. It is no use bringing
products to the market based on these contracts if there is no real demand
for such products. The contracts and transaction types we have discussed
95
represent key ‘tools’ which can be used to produce sharia-compliant financial

products that consumers want. Since the modern Islamic finance industry
is relatively new, the challenge is to innovate to bring products to market
that meet the needs of consumers and are sincere to the letter and spirit of
the Islamic teachings. The role of sharia scholars is very important here, in
that they not only understand the sharia rulings but they apply these in the
context of modern-day commercial, financial and regulatory realities, so they
enable products to be structured that have features that appeal to and meet
the needs of consumers and at the same time are commercially viable from a
risk, return and regulatory perspective.
An example of where a classical sharia concept has been augmented
to make it more commercially viable is that of murabaha to the purchase
orderer. In classical murabaha, it is assumed that the seller already owns
the assets they are selling on at a known profit mark-up. Scholars have
sanctioned the use of this concept with the additional requirement that the
seller (i.e. the financier) acquires the asset only once they have received a
promise from the ultimate purchaser that the purchaser undertakes to buy
the asset from the seller. This is to protect the financier from the negative
consequences of the purchaser not going ahead with the transaction and
hence makes the transaction more commercially viable.
In summary, this chapter gives you a large part of the tool kit you need
to navigate and understand sharia-compliant financial products and trans-
actions. The transaction types enumerated and discussed are by no means
exhaustive but will give you a substantial foundation for comprehending
Islamic finance market practice.
96
6
Sukuk
Introduction
Definition
Mechanics of a sukuk transaction
Types of sukuk
Asset-based versus asset-backed sukuk
Sukuk and the secondary market
A strong future for sukuk
Conclusion
6 · Sukuk
INTRODUCTION
In the last chapter, we went through the main types of commercial trans-
action found in Islamic finance. We now turn our attention to a particular
instrument known as sukuk. If one instrument from the Islamic finance
industry could be singled out for its positive impact in raising the inter-
national profile of the industry and sparking the interests of governments,
central banks, business and investors around the world, it would be sukuk.
It has been central to putting Islamic finance on the ‘global map’ and will
continue to play an important and central role in driving the industry
forward. We have therefore dedicated a whole chapter to this instrument.
Sukuk, often called ‘Islamic bonds’, have grown in popularity in recent
years as a sharia-compliant capital markets instrument enabling govern-
ments and companies to raise large amounts of capital. This growth has been
fuelled by various factors:
■■ There is growing demand for sharia-compliant investment instruments – a
recent survey1 revealed that 54 per cent of investors invest in sukuk because
they are sharia-compliant; these investors are mainly Islamic banks.
■■ Investors have been drawn to sukuk because of attractive yields and as a
way of diversifying their investment portfolios – 20 per cent2 of sukuk
investors invest for this reason; these investors are mainly conventional
banks.
■■ Issuers of sukuk have been attracted by the liquidity available in the
Islamic world and as a means of diversifying their funding base.
The sukuk market is a key driver of the global expansion of the Islamic
finance industry and is worth more than $237 billion.3 It has enjoyed
strong growth in the last decade and this looks set to continue as more
governments and businesses seek to tap into the liquidity and demand from
investors. Indeed, the UK successfully issued its first sovereign sukuk in
June 2014 for £200 million. This was the first sovereign sukuk outside of a
Muslim country and it was oversubscribed by almost 12 times. At the time
of writing, other countries such as South Africa, Oman, Tunisia, Morocco
and Nigeria were working towards issuing sukuk to support and fund infra-
structure projects.
This chapter describes how a basic structure works, the differences
between conventional bonds and sukuk, the different types of sukuk that can
be issued, and takes a look at some recent examples of sukuk issues in the
market.
1
Thomson Reuters Zawya, ‘Sukuk Perceptions and Forecast Study 2014’.
2
Ibid.
3
Ibid.
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DEFINITION
Sukuk in Arabic means certificates (plural of sakk, meaning certificate).

Sukuk is the term used in Islamic finance to refer to certificates representing
undivided shares in the ownership of:
■■ tangible assets; or
■■ the usufruct of an asset; or
■■ particular projects or investment activities.
The sukuk issuer raises capital by selling an asset (or a stake in a project or
business) to investors. These investors become the sukuk holders and, with a
stake in the asset or project, have a right to revenues and profits generated
in proportion to their ownership share.
Difference between sukuk and conventional bonds

While sukuk have been described as Islamic bonds, there are significant
differences between sukuk and conventional bonds, as summarised in
Table 6.1.
Table 6.1 A comparison between sukuk and conventional bonds
Sukuk Conventional bonds
Sukuk holders invest in ownership of an Bond holders essentially provide an

asset or project interest-bearing loan
Return is based on the performance of Return is interest, determined at

the asset or project owned by investors the outset and not linked to the
performance of any asset or investment
Sukuk holders, as beneficial owners Bond holders are not exposed to losses
of an asset/project, bear any losses borne by the bond issuer in the use of
generated by those assets/projects (to funds raised by the bond issue
the extent of their ownership)
Maturity of sukuk corresponds to an Bond term not necessarily linked to any

underlying project or activity underlying activity of bond issuer
Sukuk issue subject to sharia rules Bond issues not impacted by sharia
(e.g. sukuk proceeds must be used for rules
sharia-compliant purposes)
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6 · Sukuk
MECHANICS OF A SUKUK TRANSACTION
Figure 6.1 illustrates the mechanics of a typical sukuk transaction.
A typical sukuk transaction Figure 6.1
Arranger manages Manager manages

sukuk issue the SPV on behalf
process of the sukuk holders
Obligor raises finance by SPV

Obligor
issuing a sukuk through a SPV
Representing
Party raising
The relationship between the the sukuk
finance
Obligor and SPV can be holders
structured in a number of
different ways e.g. musharaka
mudarabah, ijarah, salam, istisn'a
The party seeking to raise finance from the sukuk issue (usually a government
or large corporation) is called the obligor. As we will see below, the
relationship between the obligor and the sukuk investors can take a number
of forms:
■■ A special-purpose vehicle (SPV) is normally established (often offshore
for tax reasons) to represent sukuk holders. The beneficial owners of the
SPV are the sukuk holders – sukuk certificates issued by the SPV represent
evidence of this ownership.
■■ Monies from the sukuk issue go into the SPV and are used to acquire an
asset or stake in a business or project. Similarly, returns from the sukuk
investment will be paid into the SPV; individual sukuk holders will then
be remunerated according to their individual investments from the SPV.
■■ A bank is usually engaged as a sukuk arranger. The arranger fulfils a
number of functions, including establishing the sukuk structure and SPV,
writing the prospectus for the sukuk issue, and underwriting, promoting
and marketing the issue.
■■ A manager of the SPV will normally also be engaged. Their role is to
manage the SPV on behalf of the sukuk holders and to be accountable to
them for the performance and delivery of the stated investment objectives.
Sukuk holders can change the manager if they are not satisfied with the
performance of the manager.
101
Sukuk can be structured using a number of different types of contract that

define the commercial relationship between the sukuk holders (as represented
by the SPV) and the obligor. Key factors influencing what structure is used
are:
■■ the underlying project, business or asset – for example, an ijarah contract
is suited to a sukuk where the underlying asset of the sukuk can be leased,
while a musharakah sukuk is more suited to a business venture;
■■ the risk/return profile of the sukuk – structures like ijarah lend themselves
better to a lower-risk, fixed-income type return profile as lease rentals
are predictable and the exit price can be determined at the outset, while
structures such as musharakah and mudaraba (i.e. equity instruments) are
generally more risky from an investor perspective, with less certainty as to
the returns and the exit price cannot be determined at the outset.
We will now look at the main types of sukuk based on different contract
types.
TYPES OF SUKUK
Sukuk al musharakah
The obligor contributes capital to the project and the sukuk holders, through
the SPV, also contribute capital to the project. The normal rules and condi-
tions of musharakah then apply to the obligor and sukuk holders as partners
in the project. This type of sukuk is suitable for business projects where
the obligor has capital to invest and wants to complement that by raising
further capital.
Example This type of sukuk has been used to provide working capital for power-
producing companies in Pakistan. The first sukuk of this kind was structured
for Kot Addu Power Company (KAPCO) by Meezan Bank Limited (MBL)
in 2011, and since then it has been a favourite among liquidity-strapped
power companies.
KAPCO’s six-month tenured sukuk was issued to meet the company’s
short-term working capital requirements for purchasing fuel for power gener-
ation. Under the structure the sukuk holders purchased an undivided share in
the ownership of an identified generation unit (which produces power) from
KAPCO for a purchase price equivalent to the sukuk issue amount. This
created a shirkat-ul-milk (joint ownership in property) between KAPCO and
the sukuk holders in the underlying generation unit. Subsequently the sukuk
holders and KAPCO executed a musharakah agreement to share the profits
and losses emanating from the underlying generation unit (shirkat ul aqd).
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6 · Sukuk
The musharakah was limited to the underlying generation unit and did not
extend to other generation units or business of the company. KAPCO acted
as the managing partner under the musharakah.
A two-tier profit sharing structure was agreed such that up to a certain
level profits were shared in line with investment proportions, and above this
level a different profit-sharing ratio was applied in favour of KAPCO – see
Figure 6.2.
Two-tier profit-sharing structure Figure 6.2
SPV
6-month
KAPCO
musharakah Representing
sukuk holders
Profit/Loss Profit/Loss
Share Share
Generation
unit
Capital contribution Cash

in kind, through part contribution
ownership of sukuk issue
generation unit proceeds
At the end of the six-month period, two things can happen:

1. KAPCO buys out the stake in the generation unit of the sukuk holders.
2. KAPCO and the sukuk holders enter into a new musharakah agreement.
In the case of KAPCO buying the stake of sukuk holders, this price cannot be
guaranteed at the inception of the sukuk; this would contravene the essence
of musharakah – profit and loss sharing. Indeed, a specific ruling by AAOIFI
in February 2008 expressly prohibited obligors from providing a purchase
undertaking to sukuk al musharakah investors in terms of a specific exit price.
A purchase undertaking can be provided at the outset, but the actual price
must be the market price at the time of exit.
103
Sukuk al mudarabah
The sukuk holders through the SPV provide the capital (as the rabb-ul-maal)
and the obligor undertakes to manage and run the project (as the mudarib).
Again the normal rules of mudarabah then apply to both parties as partners
in the project. This type of sukuk is suitable for financing a business project
or for providing asset management services, where the obligor does not want
to contribute capital but rather provide business/investment expertise and
resources. The only returns to both the obligor and sukuk holders are in the
form of profits generated from the project or assets.
Example In March 2013, Dubai Islamic Bank (DIB) issued a $1 billion sukuk on a
mudarabah basis to raise capital to support its growth plans. The issue was
oversubscribed by around 14 times. Features of this sukuk issue included the
following:
■■ The target profit rate to sukuk investors is 6.25 per cent per annum – until
this level is achieved, the profit-sharing ratio under the mudarabah has
been set at 99 per cent sukuk holders, 1 per cent DIB.
■■ Any surplus above this is retained by DIB and credited to a reserve.
This is an example of a perpetual sukuk – it does not have a fixed tenure,
rather it has the potential to go on indefinitely. In this particular case,
the minimum tenure was set at six years, after which DIB could, at any
time of its choosing, terminate the mudarabah and return the capital to
investors.
Sukuk al wakala
In this case an obligor can raise capital by selling assets to the sukuk holders;
an agent (wakil) is then appointed on behalf of the sukuk holders to manage
those assets under a wakala contract. The sukuk holders will typically look to
receive a target profit rate from the assets being managed by the wakil; the
wakil will charge a wakala fee for their services, which will usually include
a fixed element plus a performance-related element.
The main difference between a sukuk al mudarabah and a sukuk al wakala
is that in a mudarabah structure profit will be shared between the obligor
and sukuk holders in a pre-agreed ratio, while in a wakala structure the wakil
must receive a wakala fee for his services whether a profit is made or not. The
sukuk holders will typically just receive up to the target profit return, with
any surplus going to the wakil as a performance fee.
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6 · Sukuk
In October 2013, FWU Group, a German financial services firm, issued a Example
$20 million sukuk al wakala to fund a set of retakaful 4 transactions for its
Luxembourg-based unit Atlanticlux. Sukuk holders were sold the beneficial
rights to sharia-compliant insurance policies. A wakil, AON plc, was
appointed to manage this portfolio of policies and the target return to sukuk
holders is 7 per cent per annum.
The term of the sukuk is five years, is tradable and the FWU Group has
provided a purchase undertaking to buy the portfolio of insurance portfolios
at exit at a particular price.
Note here the wakil, AON plc, is independent of the obligor, FWU
Group. An agent cannot provide a purchase undertaking to buy the assets it
is managing on a wakala basis at a predetermined price; the wakil’s role is to
act on behalf of the principal and they do not bear the responsibility of any
profits or losses.
Sukuk al-ijarah
Typically, an asset owned by the obligor is sold by the obligor to the sukuk
holders (the SPV) and then leased back by the obligor from the SPV through
an ijarah wa iqtina (lease ending with acquisition).
The UK government used such a structure when it issued its first
sovereign sukuk in June 2014. It raised £200 million by selling beneficial
ownership rights in three buildings owned by central government to sukuk
holders. It then leased those buildings from the sukuk holders for a five-year
term at a rental yield of 2.036 per cent per annum. At the end of this
five-year term, the UK government will buy back the beneficial rights to
the building from the sukuk holders at par, i.e. at the price at which it sold
the assets to the sukuk holders originally.
The sukuk is listed on the London Stock Exchange and can be traded on
the market by investors.
In an ijarah structure of this kind, it is permissible to pre-agree the
buyout price; the obligor can provide a one-sided purchase undertaking to
buy the asset from the sukuk holders at a specified price at the end of the lease
term. As noted above, in a partnership/equity contract such as musharakah
it is not permissible to fix the exit price or the profit rate as this contravenes
the essence of profit/loss sharing. (Sukuk usually mature between three and
seven years.)
Retakaful is the mechanism by which takaful entities (Islamic insurance entities) mutually cover
4
each other for some of the risks they carry in their respective takaful entities. In essence it is very
similar to the concept of reinsurance as applied to conventional insurance.
105
Sukuk al murabaha
The sukuk holders, as represented by the SPV, buy an asset and sell it to the
obligor at a known mark-up. The obligor pays the SPV for this asset over
a deferred period of time. This has been a popular technique in helping
obligors raise asset finance; from a sukuk holder’s perspective it can be
attractive as the cash flows and returns are known at the outset, subject to
the obligor fulfilling his commitment to pay. Obligors also like it because
they have certainty as to the timing and value of their cash outflows.
The major drawback with this technique is that such sukuk cannot
be traded except at par. The sukuk certificates essentially represent debt
receivable from the obligor and to trade debt is seen as trading money;
therefore any trade except at par would be regarded as involving interest.
Indeed, this structure most closely resembles a conventional bond – like a
conventional bond a debt is the outcome of the murabaha transaction.
Sukuk al bai bithaman ajil (also called sukuk al bai muajjal)

Bai Bithaman Ajil or Bai Muajjal refers to a sale on credit, with payment
due at a future fixed date or within a fixed period. This is structured in the
same way as sukuk al murabaha, except in this case the profit mark-up to
the obligor is not disclosed. It therefore shares the same issue of not being
tradable other than at par.
Sukuk al istisn’a
The obligor could raise money through a sukuk based on an istisn’a contract to
finance the construction of property or infrastructure or the manufacture of an
asset. As we saw in Chapter 5, when we discussed the application of istisn’a, the
obligor could structure the istisn’a in conjunction with a leasing arrangement
which involves a forward lease element (ijarah mawsoofa bil thimma) during the
construction phase, and an ijarah wa iqtina in the post-construction phase. In
such an application, the sukuk holders (via the SPV) would buy the asset being
constructed through an istisn’a contract with the obligor (thereby providing
finance to the obligor to carry out the construction). Then the obligor would
contract to lease the asset from the SPV to provide returns to the sukuk
holders during the term of the sukuk, and then buy the asset from the sukuk
holders at the maturity of the sukuk at a stipulated price. The QEWC example
in Chapter 5 is essentially the structure we are referring to.
Sukuk al salam
The relationship between the obligor and SPV could be structured as a salam
transaction, in which the SPV through the sukuk issue raises monies to enter
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6 · Sukuk
into a salam contract with the obligor. Here the SPV pays monies now in
return for the obligor to supply a specified amount of a fungible commodity
at a particular time and place in the future. The SPV will then usually enter
a parallel salam (refer back to Chapter 5 under the salam section to remind
yourself of how this works), with a view to making a profit and generating
a return on investment to the sukuk holders.
Sukuk based on salam, like sukuk based on murabaha, cannot be traded except
at par. In a sukuk al salam, investors hold a certificate denoting that they are the
beneficial owners of a particular commodity to be delivered at a specified time in
the future. The sharia views the obligation of the seller to supply a commodity
in the future as a debt, therefore trading a salam sukuk certificate at anything
other than what the sukuk holder paid for it would be considered as riba.
The Central Bank of Bahrain, on behalf of the Government of Bahrain,
since June 2001 has been issuing short-term sukuk al salam (tenure of 91 days)
on a monthly basis. The commodity used has been typically aluminium. It
has been a mechanism of raising short-term finance for the government. The
sukuk holders make a return on the onward sale of the aluminium through a
parallel salam transaction.
The different types of sukuk described above represent the main struc-
tures used in the market, but this is not an exhaustive run-through of all
the different types of sukuk – there are other structures that are possible and
sometimes different structures are combined to produce ‘hybrid’ sukuk.
Figure 6.3 shows the relative amounts of capital raised through the main
sukuk structures between January 2010 and September 2013.5
Capital raised through the main sukuk structures, January 2010 to Figure 6.3
September 2013
Sukuk al liara
15% Sukuk al musharakah/

1% bai bithaman ajil
1% 23%
Sukuk al musharakah
4%
3% Sukuk al mudaraba
Sukuk al wakala
12%
Sukuk al istisn'a
41%
Sukuk al salam
Others
Thomson Reuters Zawya, ‘Sukuk Perceptions and Forecast Study 2014’.

5
107
ASSET-BASED VERSUS ASSET-BACKED SUKUK
When sukuk were first developed, the requirement was to have 100 per cent
tangible assets to provide full asset backing to investors. In asset-backed
securities, the sukuk holders enjoy the full backing of the underlying assets
as there is a true sale and legal transfer of the ownership of the assets to
sukuk holders. Sukuk holders thus enjoy the guarantee of having recourse
to the assets to recover their capital in the event that the obligor becomes
insolvent or faces difficulties in meeting payments. However, corporates and
governments faced challenges in finding suitable assets for the structuring
of such sukuk. The assets were not available, or were not sufficient, or were
already encumbered, or such sale of assets would be subject to transfer taxes.
On the part of governments, especially in countries of the Gulf Cooperation
Council (GCC), the law does not allow for the sale of public assets such as
land and property to foreigners, which made the structuring of asset-backed
sovereign sukuk difficult.
In 2002 Malaysia issued an asset-based sukuk al-ijarah in which there was
no true sale of the underlying assets to sukuk holders; rather, sukuk holders
would enjoy beneficial ownership of the assets throughout the life of the
sukuk. In this case, in the event of default, sukuk holders would have recourse
to the Federation of Malaysia (the obligor) instead of the sukuk assets. From
this first issuance of asset-based sukuk, this structure has become more
common than asset-backed sukuk throughout the world – although both
forms of sukuk are in the market and still being issued.
While asset-based sukuk still require 100 per cent physical assets which
are sharia-compliant to support the sukuk at the time of issuance, for those
issuers who do not have sufficient physical assets for structuring sukuk,
the concept of blended-assets sukuk was introduced. This type of sukuk
combines sharia-compatible receivables and physical assets, with the main
condition that the proportion of the physical assets has to exceed that of the
receivables for sukuk issuance and trading. In the beginning, some sharia
scholars required the majority portion to be at least 51 per cent or 66 per
cent of the portfolio. In 2003, the Islamic Development Bank (IDB) issued a
similar sukuk with a mixed portfolio consisting of 65.8 per cent ijarah assets
combined with 34.2 per cent of murabaha and istisn’a receivables. In 2005,
however, it was permitted to reduce the minimum physical assets to 30 per
cent in a mixed portfolio sukuk.
Eventually, the requirements for physical assets became further diluted
in order to meet the increasing demand of issuers who did not even have
the 30 per cent physical assets. This led to the development of asset-light
sukuk structures, which do not require any physical assets at the time of
sukuk issuance. These sukuk are based on the mudarabah (profit sharing) or
musharakah (profit and loss sharing) arrangements between the issuer and the
108
6 · Sukuk
sukuk holders and the proceeds raised from the sukuk holders are invested in
the business or project on a mudarabah or musharakah basis.
SUKUK AND THE SECONDARY MARKET
In our description of the different types of sukuk, we have commented on

the tradability of these sukuk. We have seen that sukuk that result in a ‘debt
obligation’, such as in the case of a sukuk al murabaha and sukuk al salam,
cannot be traded except at par. Sukuk that do not fall into this category, such
as sukuk al-ijarah and sukuk al musharakah, can be traded before maturity.
Clearly the ability to liquidate and trade an investment instrument at any
time is a positive feature when attracting potential investors. Hence while
sukuk al murabaha has been a popular instrument, many of the new issues in
the market are not using this structure due to the lack of tradability.
As the sukuk market has developed through the years with the issue of
tradable sukuk, a secondary market has emerged and developed for those
sukuk. A number of sukuk investments are now listed on major global stock
exchanges, facilitating efficient and transparent trading. As a result many
non-Muslim institutional and private investors have entered the sukuk
market. At the same time, sukuk investment funds such as those offered
by Emirates NBD and Qatar Islamic Bank UK (QIB UK) have emerged.
These funds trade and invest in a portfolio of sukuk listed on stock exchanges
around the world.
Another indication of the positive development of the secondary market
is the appearance of ‘Islamic bond indices’. These indices are compiled by
averaging the yield to maturity of selected sukuk and publishing this yield
with an underlying index value for a given maturity. Examples of such
indices are the Dow Jones Citigroup Islamic Bond Index and the Sukuk
Index by HSBC and Dubai International Financial Exchange (DIFX).
However, the tradability of sukuk is still not as efficient or liquid as the
bond market, the key reason being that the sukuk market is much smaller
and there is a lack of shorter-term sukuk for banks’ treasury departments to
invest to meet their short-term obligations. As the market matures, deepens
and becomes bigger – with more sukuk being listed on stock exchanges and
being rated – the secondary market for sukuk will get stronger and more
liquid.
A STRONG FUTURE FOR SUKUK
Sukuk issues are an increasingly popular way for governments and large
corporations to raise sharia-compliant capital for large infrastructure projects
109
such as energy plants, airports and roads, as well as real estate projects
and businesses. Similarly, sukuk issues provide banks with an investment
instrument that can facilitate treasury management and inter-bank liquidity,
deploying ‘excess’ capital to earn a sharia-compliant, predictable and
relatively low-risk return. For investors, too, sukuk can form a useful part
of a diversified sharia-compliant investment strategy, typically combining a
fixed-income profile and the ability to trade on recognised secondary markets.
As Figure 6.4 illustrates, the number of sukuk issued and the capital
raised have increased impressively over a number of years. In 2013 there
was a decline on 2012, driven by fewer large new issuances of sukuk in
2013 and the ‘fixed-income market’ overall slowing down due to investors
being uncertain/anxious about the monetary policy of the United States
in particular and the impact on interest rates. Despite this, the potential
growth of sukuk is significant, with more and more countries looking to use
this as a source of funding.
Figure 6.4 Global aggregate sukuk historical trend, 1996–2013
$ Billion No. of Issues

160 800
581
140 Amount issued 700
120 Number of issues 600
572
100 500
425
80 400
60 253 300
230 213
188 183
40 150
200
115
20 47 55 49 100
41
2 1 0 4
0 0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD
May
2013
Source: Thomson Reuters Zawya.
Economic growth and government spending commitments are likely to

boost sukuk issues in markets such as Malaysia, GCC and Turkey where
Islamic finance is relatively established and growing. Saudi Arabia and Abu
Dhabi have significant spending plans, while Dubai’s preparations for the
2020 World Expo and Qatar’s plans for the 2022 FIFA World Cup are all
likely to lead to new sukuk issues, either directly by the respective sovereign
governments or by related entities. Oman, which has not previously been a
major issuer, has also indicated it will use sukuk instruments to fund infra-
structure projects over the next few years.
110
6 · Sukuk
Following the successful launch of the first sovereign sukuk outside of

the Islamic world by the UK government in June 2014, Luxembourg and
Hong Kong have recently taken steps to legislate for sukuk deals, while at
the time of writing several Sub-Saharan African countries were reportedly
considering issuances.
Issuers are also likely to be attracted by evidence of increasing market
efficiency. Structuring costs have fallen significantly, while the time taken
to construct a deal has fallen from as much as six months to a few weeks.
CONCLUSION
All in all, the future for the sukuk market looks strong and its importance
to the Islamic finance industry is central. As mentioned at the start of this
chapter, sukuk have had a leading positive impact on the global expansion
and attraction of the Islamic finance industry, and can have a material impact
on the world economy. They are helping Muslim and non-Muslim nations to
raise capital to support infrastructure projects – in the process putting excess
liquidity to good use, creating more jobs and enhancing living standards.
111
7
Sharia-compliant investments and
wealth management
Introduction
Sharia-compliant investments
Zakat by Iqbal Nasim
Sharia-compliant estate distribution and Islamic wills by
Haroon Rashid
Conclusion
7 · Sharia-compliant investments and wealth management
INTRODUCTION
Islam has a profound effect on how Muslims invest and manage their wealth.
The following are key influencing factors:
■■ Investments must be sharia-compliant – the subject/activity under-
pinning the financial transaction has to be a permitted activity (e.g.
cannot relate to alcohol, gambling, etc.), it has to be free of interest, it
has to be free from contractual ambiguity/uncertainty and an investor can
seek a return only if they take some commercial risk in the investments
they are making.
■■ Contractual principles (as per Chapter 4) need to be adhered to.
■■ The sharia has comprehensive guidance on how one’s wealth should be
distributed on death, i.e. inheritance laws.
■■ It is obligatory for Muslims who possess a certain minimum level of
wealth to give a part of their wealth in charity every year (system of zakat).
■■ As we saw in Chapter 3, Islam has a distinctive perspective on wealth and
upholds certain principles and values with respect to wealth.
In this chapter, we will focus on:
■■ sharia-compliant investments – what are the key asset classes and key
principles underpinning each asset class;
■■ zakat – the obligatory charity due on wealth acquired. The chief executive
of the National Zakat Foundation in the UK, Iqbal Nasim, discusses the
key principles underpinning this important area;
■■ Islamic wills and estate planning – a leading practitioner in this field,
Haroon Rashid, gives an explanation of how important this area is from
an Islamic perspective, the key principles underpinning Islamic inher-
itance law, and the implications for practitioners in light of practical
issues such as taxes levied on inheritance. This area is a fundamental part
of sharia-compliant wealth management.
SHARIA-COMPLIANT INVESTMENTS
There is a need for investments that meet the requirements of the sharia –
invariably planning for life events such as university fees for our children or
having the best possible income in retirement, or simply putting surplus
monies to productive use requires investing money for the future.
There are now more than 1,000 sharia-compliant funds around the
globe (see Figure 7.1),1 with $56 billion invested. While this is only 4.7
1
Thomson Reuters, ‘Global Asset Management Report 2014’.
115
Figure 7.1 Number of sharia-compliant funds globally, 2007–13
1200
1000 No. of funds
800
600
400
200
0
2007 2008 2009 2010 2011 2012 2013
per cent of global Islamic assets, investment into sharia-compliant funds is

growing at an impressive rate and there is growing traction for such invest-
ments among non-Muslim investors. The range, depth and quality of sharia
compliant investments have improved over time.
Table 7.1 Islamic funds broken down by domicile, number and size
Domicile No. of funds Assets under management ($ million)
Malaysia 263 10,164
Saudi Arabia 163 6,056
Luxembourg 111 3,401
Pakistan 62 2,364
Indonesia 53 2,157
Ireland 53 1,742
Jersey 33 1,286
Kuwait 26 705
South Africa 21 663
Canada 19 248
United Kingdom 12 248
UAE 12 231
Other 91 248
116
Malaysia, Saudi Arabia and Luxembourg are recognised as the leading

hubs for Islamic funds, collectively playing host to 71 per cent of Islamic
funds globally.2 Table 7.1 shows the breakdown of funds in terms of their
domicile, number and size.
Key asset classes

Asset classes in the sharia space are similar to the mainstream conventional
market. Clearly interest-based investments are prohibited. Instead within
the sharia-compliant space, asset classes include categories referred to as
‘Islamic deposit accounts and money market funds’ and sukuk (as discussed
in Chapter 6 and often referred to as Islamic bonds). The broad asset classes
offered therefore are:
■■ Islamic deposit accounts and money market funds;
■■ property;
■■ equities;
■■ commodities;
■■ sukuk.
Some funds are structured to give exposure to more than one asset class and
as such are referred to as ‘mixed funds’.
Figure 7.2 is a classic depiction of the asset classes in terms of the risk and
Risk and return trade-off across different asset classes Figure 7.2
Private
equity
Ge
Equity and
ne
isk
commodity funds
ra
gr
lly
sin
gre
rea
ater
inc
Property funds
po
ly
ral
ten
ne
tia
Ge
l re
Sukuk funds
tur
n
Cash, deposit accounts and

money market funds
2
Thomson Reuters, ‘Global Asset Management Report 2014’.
117
return trade-off across different asset classes – this is very generic and may
not hold true for all investments.
In terms of the relative number of funds available in each asset class, the
Thomson Reuters ‘Global Islamic Asset Management Report 2014’ reported
the breakdown for data collected in 2013 shown in Figure 7.3.
Figure 7.3 Number of funds available in each asset class, 2013
1%
Equity
16%
Sukuk
3%
2% Money market
51% Property
12%
Commodity
Mixed assets
15%
Other
Source: Thomson Reuters, ‘Global Islamic Asset Management Report 2014’.
Islamic deposit accounts and money market funds

While money market funds, as in Figure 7.3, are not as common as equity
or sukuk funds, they are the largest asset class in terms of monies invested,
as outlined in the Thomson Reuters report. The report highlights that
this asset class accounted for more than $20 billion (over one-third of the
investment into Islamic funds) in 2013.
Islamic deposit/savings accounts tend to operate on either a wakala or
mudarabah basis, as illustrated in Chapter 5. Here the return is not interest
but a profit delivered to the depositor from investing in sharia-compliant
investments. The underlying investments will tend to be low risk with a high
level of certainty as to what the return to the investor will be. For example, Al
Rayan Bank’s deposit accounts offer returns to investors based primarily on
investments into its own property finance schemes. The rate of return on Al
Rayan Bank’s property finance schemes is known; the main risk to investors
is customers defaulting on making payments. The default rate tends to be
very low because of the relatively high entry requirements to secure property
finance, e.g. the upfront deposit required from customers by the bank tends
to be quite high – at the time of writing the minimum deposit required was
20 per cent. Hence the return to depositors is highly predictable and certain.
118
Some banks have in the past and some continue to provide Islamic deposit
accounts based on commodity murabaha. As discussed in Chapter 5 this
practice has come under quite a lot of criticism due to its synthetic nature
and countries such as Oman have not permitted its use.
Sharia-compliant money market funds tend to invest in a portfolio of
Islamic deposit accounts, sukuk and other ‘fixed-income’ type investments
such as ijarah-based investments. Such funds, through pooling and scale, can
command better returns than individuals investing on their own.
Here are two examples of sharia-compliant money market funds.
The Gulf-based bank Emirates NBD has an Islamic money market fund. A Example
description of the fund from Emirates NBD is as follows:
The Emirates Islamic Money Market Fund (the ‘Fund’) is a Shari’a
compliant open ended fund that aims to achieve a higher profit return
than traditional Shari’a compliant bank deposits of similar liquidity,
predominantly from a diversified portfolio of Shari’a compliant money
market instruments including the use of collectives investing in such
instruments. The Fund will seek over time to acquire a diversified
portfolio, including, but not limited to, instruments such as (or schemes
investing in) Islamic deposits, Shari’a compliant synthetic instruments,
murabaha, sukuk and international trade contracts.
Source: www.emiratesnbd.co.uk/en/
The reference to sharia-compliant synthetic instruments would suggest the

fund does invest in commodity murabaha-based investments.
The second example is from National Bank of Kuwait. Again this is an Example
extract from its website, providing information on the fund:
The Watani USD Money Market Fund According to Islamic shariah
principles is an open-ended fund, which aims to generate returns that are
in excess of the USD Fixed Deposit rates. This will be achieved through
investing in high-quality money market instruments such as murabaha
transactions and ijarah according to Islamic shariah principles.
Source: www.kuwait.nbk.com
In this case, ijarah is mentioned. Ijarah lends itself well to providing

investors a relatively low-risk, predictable income stream – which is in
keeping with the risk and return profile of this asset class. As we will see
below, ijarah also features strongly within the sukuk asset class.
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Sukuk
As we saw in Chapter 6, sukuk as a sharia-compliant capital markets
instrument has grown impressively for more than a decade. As an asset class
to invest in, they have become more accessible because:
■■ many sukuk are now listed on recognised stock exchanges around the
world;
■■ the growth and listings have enabled an active secondary market to
develop, which in turn has enabled sukuk funds to emerge. Indeed, sukuk
funds now account for 15 per cent of the total sharia-compliant funds
on the market, and around $4 billion is invested in sukuk-based mutual
funds (just under 10 per cent of the total investment into Islamic mutual
funds).3
The sukuk asset class is an important part of the Islamic investment universe
– it often provides a fixed-income investment instrument that is tradable
(hence the fact it is often referred to as an Islamic bond). Investors, whether
individuals or institutions such as banks, often want these types of instru-
ments as opposed to equities or property-based investments which tend to
be more risky and/or illiquid.
As we discussed in Chapter 6, ijarah is a popular investment technique
when structuring sukuk. This is because an ijarah usually allows a predictable
and defined income stream for investors with a known exit price at maturity
and the investor is able to trade the sukuk. All these features are appealing
to investors. Within the sharia-compliant investment universe there are a
number of leasing funds comprising assets that are purchased by the fund
and leased out. Investment into such funds will therefore often have a similar
risk profile to sukuk-based investments.
An example of a sukuk fund is the Global Sukuk Plus Fund provided by
QIB UK. An extract from a factsheet4 of the fund reads as follows:
The Fund’s assets are invested in sukuk issued by sovereign, quasi
sovereign and corporate issuers in accordance with the Fund’s investment
guidelines. Sukuk are sourced globally.
The tradability and liquidity of sukuk investments have improved over time
as the market has expanded and an increasing number of sukuk have been
listed on the major stock exchanges around the world. However, compared
with the relatively large and mature conventional bond market, the sukuk
market is not as liquid. This will improve as the market expands further.
3
Thomson Reuters, ‘Global Islamic Asset Management Report 2014’.
4
January 2014 factsheet.
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Property
Investment into property has been very popular across the globe for decades
and many investors have made significant returns as property prices generally
across the world have risen significantly.
As an asset class, it lends itself well to sharia-compliant investing because:
■■ the investment relates to a physical asset – hence is asset-backed;
■■ the returns to investors can be in the form of rentals and/or profit on sale
of properties – all of which is sharia-compliant.
As we saw earlier in the chapter, property funds accounted for only 2 per
cent of the total sharia-compliant fund universe in 2013. However, many
investors have and want to invest directly into property. The challenge they
often face is getting access to sharia-compliant finance to purchase property.
Access to sharia-compliant property finance has improved significantly in the
last decade as Islamic banks and international banks with an Islamic window/
offering have had quite a strong focus in this area. In a country like the
United Kingdom, where Islamic finance is very much a niche area, you can
now find sharia-compliant property finance for buying your home, buy-to-let
residential investments, commercial property finance and to some extent real
estate development finance. This will undoubtedly spur on the demand from
individuals looking to invest in the property sector in a sharia-compliant way.
Access to sharia-compliant funding is also an important factor for the
provision of sharia-compliant property investments from providers. An
example is an investment offered by a company called London Central
Portfolio Ltd (LCP). In recent years the company has started offering
investment opportunities into the prime central London residential market
on a sharia-compliant basis. A feature of its business model and investment
proposition is to fund the investments through sharia-compliant finance as
well as monies received from investors. Its latest investment memorandum5
says the following:
It is anticipated that shariah compliant leverage will be obtained on the
best terms offered. The terms below are indicative…:
Term: From drawdown for five years
Security: First legal charge over the portfolio
Leverage to refurbished value: Up to 50%
Profit rate cover ratio: 135% at all times
Profit rate periods: Six months and/or 5 years
The level of leverage is set at 60% of the purchase price, which is
estimated to represent 50% of the refurbished value at the beginning of
Investment Memorandum for investment into London Central Apartments II Limited, 5

5
February 2014.
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the Investment Period. Property values would therefore have to fall in the
region of 50% before negative equity would be reached.
Thus the availability of sharia-compliant finance has helped the provision of
such investment options in the property sector.
Equity
As we saw earlier, equity funds are the most popular type of fund, repre-
senting 51 per cent of the total sharia-compliant fund universe. Investing
into equities equates to buying a stake in a business. Naturally the issue
of whether or not an equity investment is sharia-compliant is broadly
dependent on the sharia permissibility of the activities that the business
engages in and the financial make-up of the company.
With so many sharia-compliant equity funds now in existence, the
criteria used to determine sharia compliance are relatively well established
and mainstream. Many of the major stock exchanges around the globe have
indices made up of equities that comply with the sharia criteria: for example,
there is the Dow Jones Islamic Market Index and the FTSE Shariah Global
Equity Index.
The criteria used to determine sharia compliance essentially come down
to two parts.
1. The industry screen. This looks at the industry in which the company is
involved. Businesses involved in activities prohibited by the sharia such as
drinking alcohol, eating pork, gambling and pornography would clearly
not qualify as eligible sharia-compliant investments. For example, the
Dow Jones Islamic Market Index screens out companies involved in the
following sectors:
■■ alcohol;
■■ pork-related products;
■■ conventional financial services;
■■ entertainment;
■■ tobacco;
■■ weapons and defence.
2. The financial screen. The current reality of investing in equities listed

on all the major stock exchanges is that very few companies will be fully
sharia-compliant. While there are plenty of companies that engage in
lines of business that are fully sharia-compliant (i.e. they avoid the type of
industries listed above), the overwhelming majority of companies will have
some involvement in interest – either through interest-based borrowings or
through interest accruing on monies held in a conventional bank account.
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The mainstream sharia scholars have opined to allow investment into

equities that have these ‘impurities’ as long as they are below certain
thresholds. They have justified this on the following grounds:
1. Any ‘impure income’ such as interest received must be calculated and
given to charity, so as to purify the return to investors. In this sense there
is zero tolerance on earning any interest.
2. Stock markets perform an important function in the economy in providing
the platform for businesses to gain equity funding. This funding facili-
tates the running and growth of businesses, which in turn creates jobs and
prosperity for others. Therefore at this stage in the development of Islamic
finance (relative to the established nature of global stock markets) it may
harm the public interest not to allow investment into equities listed on
the stock market.
3. Scholars have taken the view that they will allow stock market investment
as long the ‘impurities’ are below certain thresholds – ensuring that
the overriding core and majority of the investment is sharia-compliant.
Scholars have also stipulated that over time they will tighten these
thresholds so the tolerated level of impurity diminishes.
The financial screens used and approved by scholars are broadly similar
across different organisations and jurisdictions but are not uniform. This
is an example of where, in my opinion, standardisation would benefit the
industry, by having one set of criteria agreed by a central sharia board/
governing body presiding over the entire Islamic finance industry.
AAOIFI, the Bahrain-based standard-setting body for the Islamic finance
industry, has stipulated the following ratios for the financial screen in terms
of investing into equities (AAOIFI sharia standard 21):
■■ Conventional debt/Total market capitalisation <30%.
■■ (Cash + cash deposits)/Total market capitalisation <30%.
■■ (Total interest + income from non-compliant activities)/Revenue <5%.
Let us now look at the rationale underpinning these ratios.
Conventional debt/Total market capitalisation <30%

Clearly, many companies have taken on conventional, interest-bearing debt
to partly finance the business. From a sharia perspective, paying interest
as well as receiving interest is not permissible. For the reasons mentioned
above, scholars have generally permitted up to one-third (30 per cent in
the case of AAOIFI) of the capital structure of a company to be financed by
conventional interest-bearing debt.
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Two questions emanate from this.
What do you define as the capital structure of the company?

By this I mean, what do you measure conventional interest-bearing debt
against to see whether it exceeds 30 per cent or 33 per cent? In practice,
different measures are being used in the industry. For example, as we saw
above, AAOIFI has used ‘total market capitalisation’ as the value, the FTSE
Shariah Global Equity Index and the MSCI Islamic Index use ‘total assets’,
and the Dow Jones Islamic Market Index uses ‘trailing 24-month average
market capitalisation’ as the value.
There are pros and cons in using any of these measures – those that use
market capitalisation will tend to have a larger pool of eligible stocks as the
market value of a company tends to be greater than the value of its total assets.
However, market values of listed companies can be volatile and stocks may
end up fluctuating in and out of sharia compliance. Again a standard approach
to this issue would be welcome from both an industry and a consumer
perspective. It also highlights the point that although AAOIFI is the leading
standard-setting body within the industry, the guidance and standards it
produces are not mandatory and therefore organisations have produced their
own criteria which their own sharia scholars have endorsed and certified.
Why have scholars used one-third as the fraction they have allowed?
Prophet Muhammad is reported to have said: ‘One third is big or abundant’
(source: Imam Tirmidhi). So scholars have used this as a basis for setting this
particular threshold. This threshold is considerably more than the 5 per cent
threshold set for non-permissible income. Anything that affects the income
of the company is seen as a ‘greater impurity’ – thus not only is the threshold
lower but any impermissible income has to be given to charity.
(Cash + cash deposits)/Total market capitalisation <30%

Trading cash at anything but par would be regarded as interest. So if a
company’s asset base has a significant amount of cash, then the trading of
shares in that company is getting closer to trading cash. Based on the premise
that one-third is regarded as ‘abundant’ in the sharia, scholars have stipulated
that cash plus cash deposits must not exceed one-third of a company’s assets.
Sharia-compliant investing: more than just avoiding prohibitions

It is clear that for investments to qualify as sharia-compliant they must not
violate certain prohibitions and that the subject matter of the investment
must be permissible by Islamic law. However, there is a broader picture. The
rules of the sharia are designed to achieve certain objectives (referred to as
maqasid al sharia in Arabic).
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Renowned Muslim scholar Abu Hamid Al-Ghazali (1058 to 1111)

described the objectives of the sharia as follows:
The very objective of the shariah is to promote the well-being of the
people, which lies in safeguarding their faith (deen), their lives (nafs), their
intellect (ñaql), their posterity (nasl), and their wealth (mal). Whatever
ensures the safeguarding of these five serves public interest and is
desirable, and whatever hurts them is against public interest and its
removal is desirable.
Therefore there is clearly a call for sharia-compliant investments to be
in ventures and sectors that serve to enhance and protect the public
interest. In this broader context, the Islamic teachings would encourage
investment into areas such as renewable/green energy, social housing and
fair trade farming. Similarly, in addition to prohibiting investment into
areas considered haram, such as alcohol and gambling, the sharia in this
broader context would discourage investment into areas that serve to harm
the public interest, such as projects that harm the environment or exploit
‘cheap’ labour.
Sharia-compliant investments in substance have a broader mandate than
merely not violating certain prohibitions. Indeed, there is a strong affili-
ation with socially responsible investment (SRI) and ethical investments.
However, one has to be careful: the screening criteria used in the mainstream
SRI and ethical investment space are not usually totally in line with sharia
criteria. For example, such criteria will not look to screen out companies
with interest-bearing debt.
There has been a growing call and consensus that the Islamic finance
investment industry needs to increasingly position its value proposition in
the SRI/ethical space. This has a resonance with the overall objectives of the
sharia and with human beings of all faiths or no faith. This in turn will make
the proposition more inclusive and appealing to a much broader audience – a
‘win-win’ situation for all.
It is worth noting, too, that the sharia principles promote certain
investment and economic behaviours that are beneficial to the public
interest:
■■ Investors, to earn a legitimate return, must take some commercial and/
or asset risk in what they are investing in; they cannot merely take credit
risk as in the case of an interest-bearing loan. This in turn means investors
have to invest in real projects and businesses, which in the long run
means the economy’s foundation will be the production of real goods and
services. This is generally seen as healthy as opposed to an over-reliance
on the financial sector, dominated by interest-bearing transactions and
banks. The structure of the UK economy, for example, has been criticised
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for its over-reliance on the financial services sector and a relatively weak
manufacturing sector.
■■ Equity finance is promoted and debt instruments demoted relative to
conventional finance – this in turn promotes investors and financiers
investing in projects and businesses with the best business credentials
as opposed to those with the best collateral or credit rating. Again for
the long-term health of the economy this will be better, ensuring the
finance is allocated to the best business ventures. Unhealthy debt levels
and a recognition that small and medium-sized enterprises (SMEs), to
flourish, need access to equity finance are contemporary topical issues in
the mainstream.
As mentioned in the introduction we now go on to look at two very
important aspects of Islamic wealth management: the Islamic duty to give a
portion of one’s wealth to charity every year, and the clear and overt guidance
in the sharia on how to distribute one’s wealth on death.
ZAKAT BY IQBAL NASIM
The core obligatory acts of worship in Islam are five:

1. The testimony of faith (shahadah).
2. Five daily prayers (salat).
3. Annual alms-giving (zakat).
4. Fasting in the month of Ramadan (sawm).
5. The pilgrimage to Mecca (hajj).
Zakat is therefore the third of the five pillars and the only one that is intrin-
sically connected to one’s wealth. Specifically it involves an annual transfer
of fixed portions of certain types of one’s wealth to an eligible recipient,
provided that one’s net zakatable assets are above a given threshold (nisab).
As a core act of worship, there are strict rules that govern the calculation,
payment and distribution of zakat, all of which contribute ultimately to its
proper fulfilment and acceptance.
Given its importance, zakat is supposed to be administered at state level
and in many Muslim countries this is the case. Kuwait and Malaysia stand out
as two countries where the zakat systems appear to be the most developed. In
non-Muslim countries where Muslim communities exist, organisations and
charities that collect and distribute zakat have emerged, typically relying on
local Muslim scholars to guide their policies and procedures.
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Linguistic meaning and spiritual significance

The word zakat appears 32 times in the Qur’an and it is noteworthy that,
on 28 of these occasions, its mention is conjoined with reference to salat
(prayer), the second pillar. Indeed, the two concepts are mentioned in many
places as core pillars of pre-Islamic prophets and faiths, as if to remind us
that prayer and charity have always been utterly fundamental practices of
anyone who holds a belief in God.
Linguistically, the word zakat carries meanings of purification, growth
and blessing. These literal translations hold great significance when it
comes to the spiritual importance of zakat. By paying zakat, one is purifying
one’s soul from miserliness and greed, purifying one’s wealth and laying
the foundations for a more blessed and prosperous future. By contrast,
abstaining from paying one’s zakat is considered to be a way of inadvertently
sullying all of one’s wealth and possibly leading to a less fortunate outcome
in terms of financial prosperity.
Therefore, Muslims see zakat as a core part of sensible wealth management.
In fact, the zakat payer simply considers a certain portion of his or her wealth
every year as being the God-given right of someone who qualifies as an
eligible recipient. The zakat payer is a temporary guardian over this portion
until it is transferred to the rightful owner. Zakat is not considered in the
same way as conventional charity, whereby a donor may feel that he or she
is conferring a favour to the beneficiaries of a charitable initiative. Rather,
zakat is to be seen through a lens of duty, responsibility and honouring the
basic rights of others.
Other forms of charity

As mentioned, all aspects of the payment and distribution of zakat come with
specific parameters and zakat is considered to be an obligatory act. Outside
of zakat, however, voluntary charity (sadaqah) is heavily encouraged and has
few, if any, restrictions in terms of amounts given and causes supported.
It is important to understand that not all valid causes for support are
necessarily taken care of via zakat. It is simply the minimum requirement
and therefore addresses basic needs. Beyond zakat, voluntary giving, the
establishment of endowments and parallel fiscal systems (in a Muslim
country) would all need to exist for a well-rounded approach to fulfilling the
overall needs of a community.
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Paying Zakat
Who pays Zakat?
Muslim scholars agree that once someone meets the following criteria, he or
she must pay Zakat:
1. To be Muslim.
2. To have reached the age of physical maturity (and therefore personal
accountability from an Islamic perspective).
3. To be of sound mind.
4. To have been in possession, for the period of one lunar year, of net
zakatable assets whose value equals or exceeds a given threshold (nisab).
Where there is some disagreement is in relation to points 2 and 3 above. The
majority of Muslim scholars hold that even though they are conditions for
all other acts of worship, neither being of the age of physical maturity nor
being of sound mind are necessary conditions for zakat to be paid on one’s
wealth, i.e. if savings have accumulated in a child’s name or if someone who
is mentally incapacitated possesses the necessary quantum of wealth, then
zakat is due in both cases, with the parent or guardian being responsible for
fulfilling the calculation and payment.
The other important factor here is the definition of the nisab, or threshold
above which zakat becomes due. The first point to note is that the nisab
varies for different asset classes within zakatable wealth. So, for example,
cattle and agricultural produce are subject to zakat, with specific numbers
and measures to determine whether any zakat is due and if so, how much.
For most conventional assets today, i.e. cash, business stock and other
investments, the traditional measure of the nisab in gold and silver terms is
used to determine an equivalent value in today’s currency.
Since real gold and silver coins were effectively the cash of the day at the
time of Prophet Muhammad, he defined the nisab accordingly, equating to
approximately 85 g of gold and 595 g of silver. As of August 2014, using
live gold and silver prices, the nisab values are approximately £2,100 and
£240 respectively. Muslim scholars advocate that, where one’s only asset is
gold, the threshold of gold should be used. But where (as is far more likely)
one possesses a mix of assets, the silver threshold should be used. Therefore,
if one’s net zakatable assets are valued at £1,000, zakat should be calculated
at 2.5 per cent and £25 should be paid.
When should it be paid?

Zakat is paid once every lunar year. The zakat payer must have a fixed zakat
anniversary in the lunar calendar, this being the date that he or she will
analyse their financial situation and calculate the zakat they owe. Zakat
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is therefore very much a balance sheet calculation. Once calculated, zakat

should be paid immediately or as soon as possible. In most cases in the
United Kingdom, this is done directly to registered charities. However, in
some cases, a zakat payer may wish to pay their zakat directly by hand to a
needy person whom he or she may not meet for some time. In this case, it is
valid to delay the payment of zakat up to a maximum of one lunar year, i.e.
it must be paid before the next zakat becomes due.
Zakat can be paid in advance of the calculation date. In this case, one
might pay in monthly instalments or on one-off occasions, perhaps in
response to a particular charitable appeal. In this case, when it comes to
making the annual consideration of zakat, the calculation process remains
the same but whatever has already been paid can be subtracted from the
amount owed and the balance can then be discharged. If the zakat paid to
date ends up exceeding the amount owed, then unfortunately there are no
refunds. The surplus amount will simply be considered as supplementary
or voluntary charity. Finally, the intention of fulfilling one’s zakat at the
time of payment is critical. A person cannot retrospectively include general
charitable donations that were not intended as zakat as part of their zakat
fulfilment at a later date.
Where should it be paid?

Zakat should be paid either directly to an individual or cause that is known
to be eligible to receive zakat, otherwise to a credible organisation or state
body that is trustworthy when it comes to administering zakat funds.
How should it be calculated?

The basic principle of zakat calculation is that all items for personal use are
exempt from zakat except for cash and, in the opinion of some scholars, gold
and silver. A person’s house, car, clothes, etc. are not subject to zakat.
The essential steps of a zakat calculation are as follows:
■■ Add up the value of all of the zakatable assets.
■■ Calculate and subtract qualifying debts and liabilities.
■■ Compare the net value against the nisab (threshold).
■■ If the net zakatable assets equal or exceed the threshold then zakat is due
on the total net value at a rate of 2.5 per cent.
The conventional assets and liabilities for a zakat calculation are shown
below. For the sake of simplicity and relevance, zakatable assets such as
minerals, crops and cattle are excluded here.
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Zakatable assets
Cash and liquid investments
Cash and liquid investments are fully subject to zakat. This includes cash in all
types of bank accounts, in a person’s wallet and under the mattress. If interest
has been earned on liquid investments, then it should be given to charity
separately and only the principal amount should be noted for zakat purposes.
Gold and silver

Some scholars consider gold and silver to be intrinsically subject to zakat,
meaning that gold and silver jewellery, whether used as personal items or
simply stored, would be subject to zakat.
Most scholars are of the opinion that if such items are worn and are
held for personal utility, no zakat is due. However, if they are kept as an
investment or simply hoarded, then zakat would be due.
The value of gold and silver, whether in jewellery form or held as bars or
biscuits, can be calculated by a jeweller based on the selling price.
Business assets
These include cash and business assets for which the primary intention is to
sell them on at a profit, such as stocks of finished goods, work in progress and
raw materials. It also includes receivables, i.e. monies owed to businesses.
All business assets should be valued at their current market price. For
finished goods, this should be their retail sale price. For unfinished goods,
this should be whatever price one expects the unfinished good to fetch on
the zakat anniversary date.
Shares and equity investments

If shares are purchased with the express intention of resale then the entire
holding is subject to zakat at market value. If, however, shares are purchased
as an investment to generate dividends, then as zakat is due only on the
zakatable assets of the firm, a realistic attempt must be made to calculate the
percentage of the shareholding relating to zakatable assets.
Any dividends received should be added to one’s cash balance for zakat
purposes.
Property and other fixed assets

The house in which a person lives is not subject to zakat. If a property or
other fixed asset has been purchased with the express intention to resell, then
the entire value of the property/asset is subject to zakat. If there is any other
intention, it is not subject to zakat.
Any rental income from properties owned should be added to a person’s
cash balance for zakat purposes.
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Pension
For monies set aside for pensions prior to retirement, zakat is payable only if
the pension assets are being invested on behalf of the pension holder and the
value of a person’s investments/pension pot can be specifically determined.
If pension monies are being invested, the zakat liability will be determined
by the nature of the investment (property or shares, etc. as per the third and
fourth points above).
Debts owed to oneself

Zakat is payable on strong debts, i.e. money that is owed to somebody
that he or she is confident will be repaid. This may include personal loans
to friends and family. This does not include outstanding wages, dowry or
inheritance.
Debts and liabilities

Not all debts and liabilities are deductible for zakat purposes. For example,
the outstanding portion of long-term debts, such as a mortgage or a personal
loan from a bank that are repayable by instalments, should not be deducted.
Some scholars do allow for up to a year’s worth of the principal portion of
such debts to be subtracted, but this allowance should be taken only if one’s
ability to meet the repayments is likely to be adversely affected by excluding
them from one’s zakat calculation. That said, personal loans among friends
and family are deductible since they can be immediately recalled at any
time.
Upcoming bills and liabilities are not to be deducted. However,
outstanding or overdue liabilities can be subtracted, including those where
there is a legal/formal/signed commitment to an upcoming payment.
The principles apply to both personal and business situations.
Final calculation and payment

Once all the zakatable assets have been valued and all relevant debts/liabil-
ities have been subtracted, then the net value should be compared to the
nisab (threshold) and if the figure is above the threshold, 2.5 per cent of the
total net zakatable assets should be paid as zakat.
Abdullah has £10,000 of zakatable assets and £6,000 of outstanding debts Example
to friends and family. Net zakatable assets are therefore £4,000. Since this
figure is above the nisab, zakat is due at 2.5 per cent, i.e. £100 is payable.
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Distributing zakat
To whom is zakat distributed?
The Qur’an (Chapter 9, verse 60) specifies eight categories for the distri-
bution of zakat:
1. The poor.
2. The needy.
3. Those employed to administer zakat.
4. Those whose hearts are to be reconciled.
5. Those in slavery.
6. Those in debt.
7. In the way of God.
8. The destitute traveller.
Each of the above categories has distinct criteria, and discussions as to exact
definitions of some of the categories in today’s context continue among
scholars. Here, we will simply address the first two categories in a little
more detail.
Technically, the poor and needy are defined as those whose zakatable
assets are valued below the nisab level and whose surplus non-zakatable
assets are also valued below the nisab level. Surplus assets are defined as any
non-zakatable assets that are never used. Someone whose surplus assets are
valued above the nisab level, and who also has zakatable assets valued below
the nisab level, does not pay or receive zakat.
The distinction between the poor and the needy is typically that the
former represents absolute poverty (i.e. absence of food, clothing, shelter)
and the latter represents a sense of relative poverty (i.e. necessities of life are
in place but a person still struggles with some essentials on a regular basis).
When should it be distributed?

Zakat should be distributed within a lunar year of being calculated. If one is
giving zakat to a charity or organisation, then its policies should be reviewed
to ensure that zakat distribution is taking place on an annual cycle.
Where should it be distributed?

One of the core principles of zakat is for it to be distributed in the area in
which it is collected. The socio-economic impact of zakat and the binding
effect between the haves and the have-nots are supposed to occur within
localities and communities in which funds are collected.
Due consideration must also be given to areas of extreme poverty and/or
difficulty as a result of conflict or natural disaster, as well as to relatives who
may be eligible to receive zakat. The latter is considered important as a way
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of maintaining the ties of kinship but excludes one’s ordinary dependants as

well as direct ascendants and descendants.
How should it be distributed?

Zakat should be distributed through the most appropriate method that meets
the needs of recipients, as well as being practical, impactful and honouring
the trust of zakat payers. Methodologies may vary between communities
and situations, but the key to zakat distribution is the empowerment of the
beneficiary and ultimate transformation from a payer to a recipient.
Iqbal Nasim has been at the helm of the National Zakat Foundation
(www.nzf.org.uk) since November 2011. Prior to this, he worked for over
five years in the investment banking industry as an equity research analyst
in London. He is currently studying for an MSc in Voluntary Sector
Management at Cass Business School and holds an MA in Economics and
Management from Cambridge University.
Iqbal is passionate about unleashing the potential of Zakat in empowering
individuals and societies across the world. He believes Zakat is not just
about poverty alleviation, but that it can be integral to the development
of a community at every level.
He has spoken about Zakat and NZF extensively across the UK and
also at an international level. In 2011, he spoke on the topic of Zakat at
the Global Donors Forum, convened by the World Congress of Muslim
Philanthropists in Washington DC, and conducted the Zakat Masterclass
at the 10th World Islamic Economic Forum in Dubai.
SHARIA-COMPLIANT ESTATE DISTRIBUTION AND ISLAMIC WILLS

BY HAROON RASHID
Historical context
Islam is regarded as a complete way of life. This extends to rules relating to
the distribution of an estate following death. This is an important consider-
ation in the wider context of Islamic finance, as Muslims will often be looking
for professional advice in relation to financial planning at the same time as
dealing with affairs relating to their will and the inheritance of their estate.
In many Muslim jurisdictions the law relating to the distribution of
estates is based upon the Islamic rules set out in the Qur’an and Sunnah.
In all jurisdictions that do not adhere to Islamic principles it is therefore
necessary for the individual to plan and ensure that their estate is distributed
in accordance with their faith. The importance of Islamic inheritance can be
illustrated by a saying of the Prophet:
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Any Muslim who has anything to will should not let two nights pass
without writing a Will about it.
(Imam Bukhari)
Although this saying of the Prophet is categorised as being advisory by

scholars, it is particularly pertinent in non-Muslim jurisdictions as the will
can be used to ensure the estate is distributed in the correct Islamic manner.
This part of the chapter will deal with some of the key issues that need to
be considered by a practitioner advising a Muslim client. It is important
to have a grasp of these issues, even when not directly advising in relation
to wills, in order to ensure that the key issues are identified and clients are
directed correctly.
Waqfs (permanent endowments)

Historically the Islamic inheritance rules have provided for substantial good
within Muslim society. It is worth noting that prior to the revelation of
inheritance rules, women had no share in the estates of their close relatives
– all assets would pass to male relatives and generally to the eldest son. As a
result of the Islamic inheritance rules, women received a guaranteed share in
the estate from all their closest relatives for the first time, something which
was unthinkable in much of the world, even within the last century.
An additional, much overlooked benefit of the rules of inheritance was in
the widespread establishment of waqfs. A waqf can be equated to a modern-
day trust, the essential elements being that an asset leaves the ownership of
the waqif or settlor and enters into the possession of muttawallis or trustees,
whose responsibility it is to manage the trust in accordance with the wishes
of the waqif. Because Islamic inheritance rules provide that one-third of the
estate can pass to charity, there is wide utilisation of this provision, such
that at its height waqfs accounted for a huge proportion of public buildings
and utilities such as roads, hospitals, schools and shelters for the needy. The
whole system of waqf was managed by central government and registers were
kept of all waqf property, such that there are still examples of waqf property
that was settled nearly 1,000 years ago being utilised for its original purpose.
Waqfs can also be established in one’s lifetime and can provide useful
opportunities for tax planning and asset-protection purposes.
Forced Heirship and Testamentary Freedom

Inheritance systems around the world generally fall in between two polar
categories: forced heirship versus complete testamentary freedom. The two
regimes have conflicting policy considerations and these can be summarised
as follows.
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Forced heirship
A forced heirship regime is one where the distribution of a deceased’s estate
is not within the individual’s control but rather is decided by government
or the law of the land. The primary concern in such jurisdictions is to ensure
that the surviving family are adequately provided for. In particular, this
avoids a situation where a testator is allowed to maliciously disinherit his
close family for personal and vindictive reasons or simply because they felt
that others would benefit more from their wealth. This model (in part) can
be seen in countries such as France and Spain.
Testamentary freedom
The alternative model commonly in use is that testators are given absolute
freedom in relation to the distribution of their estate. This is the position
in the United Kingdom and the policy consideration at the heart of this
decision is that an individual should be able to dispose of his or her wealth
as they see fit, and it is not for the government to dictate who or what is
the correct distribution for individuals. This does, however, inevitably lead
to situations where families have been left in great difficulty as a result of a
will, and therefore it is also common that legislation has been enacted that
allows a surviving family member or dependant to challenge the will of the
deceased (a control on the ‘complete’ testamentary freedom).
The Islamic system

The Islamic system of inheritance of the estate combines elements of both
forced heirship and testamentary freedom.
The testamentary freedom element allows a testator freedom to distribute
up to one-third of their estate in any manner they see fit, provided they
do not benefit the primary inheritors, who must benefit from at least the
remaining two-thirds of the estate. This one-third is known as the ‘wasiyyah’
(literally ‘the will’ as this is the only part a Muslim can ‘will’ – the balance
is not within their jurisdiction, it is God’s Will). The wasiyyah can be used
for charity or to benefit other family, friends or relatives, or anyone who does
not benefit from the two-thirds.
At least the remaining two-thirds (it can be more if the one-third is not
used in full) represents the forced heirship element in that this must pass in
accordance with the Islamic law, which provides a comprehensive system of
calculation and distribution of the shares, which will be considered in more
detail later in this chapter. Importantly, the surviving spouse, parents and
children will usually always benefit from at least two-thirds of the estate,
provided they survive the deceased. If one or more of these relatives is not
alive at the time then wider family, such as brothers, grandparents, nieces
and nephews, etc., may be brought into the distribution.
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Therefore the Islamic system ensures that the closest family relatives are
provided for as well as allowing the testator freedom over up to one-third of
the estate to provide for others who may be in need and/or charitable objects.
Major principles of Islamic inheritance law

An overview of Islamic inheritance
Islamic inheritance is a complex subject, and books have been written about
the topic in its own right. There are a few key concepts that are essential for
advisers to be aware of when advising clients.
First, they should know there are three main types of inheritors under
Islamic law: zawil furood, asabah and zawil arhaam (see Figure 7.4).
Figure 7.4 The three main types of inheritors under Islamic law
Zawil Furood
Asabah
Zawil Arhaam
Zawil furood
The zawil furood, or the obligatory inheritors, are those inheritors who are
mentioned in the Qur’an and Sunnah and they total 12 in number. There are
eight female relatives: the wife, mother, grandmother, daughter, granddaughter,
full sister, paternal sister and maternal sister. The four male relatives mentioned
are the husband, father, paternal grandfather and maternal half-brother.
Although it is not crucial to know all these relations, what is important is
to note that the zawil furood are those relations who receive a specified share
of the deceased’s estate. From the 12 relations mentioned only the spouse,
parents and daughter receive a share of the estate as of right, assuming there
are no barriers to inheritance (see later).
Asabah
The asabah are residuary beneficiaries of the deceased and are those relatives
who receive the remainder of the estate after the zawil furood, or fixed-share
inheritors, have received their proportion. In simple terms this is usually
the son(s) of the deceased or, if the deceased does not have a son, then the
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deceased’s father, failing which his grandfather, brother, paternal uncles and
then paternal nephews.
Zawil arhaam
In the vast majority of cases the inheritors will be divided among the zawil
furood and the asabah and there will be nothing remaining for the final
category of inheritors, the zawil arhaam. This category contains the more
distant relatives of the deceased (for example, this includes the maternal
grandfather, aunts and sister’s children) and it is sufficient for most circum-
stances just to know that this category exists.
A basic distribution
As can be gathered from the above, the Islamic system of inheritance is
not straightforward and any practitioner looking to fully advise in this
area should seek to gain proper training on the full implementation of how
the distributions are calculated. However, most clients will have a fairly
straightforward distribution, which, given some practice (and utilising the
tools mentioned below as checks), can quickly be calculated.
Some rules of thumb to bear in mind are as follows:
1. Immediate family will always inherit (assuming no bars on inheritance
– see below). This means clients should be advised that their parents,
children and spouse are always entitled to receive a share of the estate. The
exact proportion will depend on who survives the deceased.
2. Where a son survives and parents also survive, the mother’s and father’s
shares will always be 1/6th each.
3. Where the deceased leaves behind a husband, the husband will receive
either 1/2 or 1/4th of the estate. If the deceased was survived by a child
then the husband will receive 1/4th, otherwise he will receive 1/2. (It
should be noted it is whether the deceased had a surviving child or not
that is the key question – the child does not necessarily have to be the
surviving spouse’s child as well.)
4. Similarly, where the deceased leaves behind a wife, the wife will receive
either 1/4th or 1/8th of the estate. If the deceased was survived by a child
then the wife will receive 1/8th, otherwise she will receive 1/4th.
5. Where a son or sons alone (or together with daughter(s)) survive the
deceased, the children as a whole will receive the balance of the estate (in
accordance with point 6 below) after the parents and spouse have been
allocated their respective shares.
6. Where sons and daughters survive the deceased, each son will receive
twice the share of each daughter. As an example, where the deceased is
inherited by two sons and three daughters, each son will receive a 2/7ths
share of the amount passing to the children as a whole and each daughter
will receive a 1/7th share. 137
Example You meet with a new client in relation to tax planning and sharia-compliance
advice. She confirms that her close family is as follows:
■■ Husband.
■■ Mother.
■■ Father.
■■ Two daughters and one son.
■■ Three brothers.
Applying the rules above, you can advise that the current distribution of her
estate in accordance with sharia law is as follows:
1. Her brothers will not inherit as she is survived by a son.
2. Her husband, parents and children are all entitled to a share of her estate.
3. As she has a son, her parents will each receive 1/6th (or 4/24ths each) of
her estate.
4. As she has children, her husband will receive 1/4th (or 6/24ths) of her
estate.
5. The children will receive the balance of the estate, 10/24ths. This will be
divided into four equal shares and each daughter will be entitled to one
of these shares, with her son receiving the remaining two shares.
Ten key issues

There are some key issues that occur on a regular basis and it is therefore
important that advisers have the background to these. Although you may
not be preparing the will or advising directly in this regard, it is important
to be able to pass this information on to a specialist in the preparation of
Islamic wills for them to advise you accordingly. A summary of the key
issues is provided below.
1. Funeral expenses
The deceased’s estate is primarily responsible for funeral expenses and this
is the first expense that must be deducted from the estate before any of the
inheritors can be given their share or any other liabilities can be satisfied. In
the majority of cases the deceased’s family will cover the expense; however,
Islamically there is no obligation that they do so, and therefore this can be
claimed back as part of their share of the estate as appropriate.
2. Debts
Islamically, an individual is responsible for all debts that he or she has
accrued during their lifetime and there is strong encouragement for
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individuals to ensure debts are paid as soon as possible. Where this has not
been possible during one’s lifetime, the debts must be cleared from the estate
even if this exhausts all funds. The payment of liabilities will obviously be a
matter that is also considered during the estate administration under the law
of the appropriate jurisdiction, and therefore advice should be taken from a
suitably qualified probate lawyer in this regard, particularly when dealing
with insolvent estates.
3. Wasiyyah
As mentioned above, Islamic inheritance law incorporates elements of both
forced heirship and testamentary freedom. An individual has freedom to
‘will’ up to one-third of his estate to any beneficiaries who do not automati-
cally inherit. Quite often this is used to benefit charity and may also be used
in conjunction with other tax-planning options to reduce any estate duty/
inheritance tax that may be payable by the estate.
4. Non-Muslims as inheritors
Where the deceased has a non-Muslim relative(s) who would otherwise
inherit, Islamic inheritance law states that they will not inherit as of right.
(The deceased can, however, leave a share of the estate to them from the
wasiyyah.)
5. Male versus female shares

In some cases, but not all, where a male and female relative of the same
relation (such as sons and daughters) inherit together, the male will be
entitled to twice the share of the female. By way of example, if there are two
sons and one daughter of the deceased then the share passing to the children
will be divided into five equal shares, and each son will be entitled to 2/5ths
and the daughter will receive the remaining 1/5th.
This, however, is not always the case and quite often male and female
relatives will inherit equally, such as the mother and father of the deceased
inheriting equally when the deceased leaves a son. There are also a number
of scenarios where a female of the same degree inherits more than her male
equivalent heir. For example, where a deceased leaves behind a mother, a
father, a husband and two sons, each son is entitled to 5/24ths of the estate.
In exactly the same scenario, but this time where there are two daughters
instead of two sons, each daughter receives 4/15ths or approximately 6 per
cent more each of the estate than if the deceased had left two sons.
Islamic scholars have commented on some of the wisdoms behind the
difference in shares received by male and female heirs of the same degree.
Sharia law operates on the maxim of equity. In relation to inheritance, this
means that where individuals have received a greater share of inheritance,
such as in the case of a son over a daughter, the son has at the same time
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been given greater responsibilities for the maintenance of his family. The
daughter, however, has no such responsibilities and is free to utilise her
inheritance in any way she sees fit. As an example, if a brother and sister have
both received inheritance from a deceased father, it is the brother’s respon-
sibility to maintain his sister if she is unmarried and has no adult son (who
would first be responsible). This system therefore ensures an equilibrium
is established between rights and responsibilities of individuals in society.
6. Pensions
Unlike other assets, pension death benefits do not usually form part of the
estate for sharia purposes, provided the individual has no right to encash the
pension death benefit during their lifetime. In such cases any pension lump
sum or continuing payments can be allocated to an individual or multiple
individuals as the testator sees fit. Where such pensions are available this can
often be used to provide greater financial security for the surviving spouse
of the deceased.
7. Life policies
Life insurance is generally considered to be impermissible for Muslims (see
Chapter 8 on Islamic Insurance – Takaful). However, where a life policy has
been taken out, a testator can be advised that the proceeds of such a policy
may in certain circumstances be utilised to pay the estate duty/inheritance
tax that the estate is liable for, it being incumbent that the balance of any
life policy proceeds be given to charity. There are differences of opinion on
this issue among scholars and therefore clients should be advised to take
appropriate advice considering their individual circumstances. The life
insurance is regarded as ‘the lesser of two evils’ compared with taking the
rights of the rightful heirs.
8. Charity and obligations

Muslims are obligated to complete certain acts such as daily prayers, zakat,
fasting and pilgrimage. Where some or all of these obligations have not
been fulfilled, clients should be advised that they can utilise their wasiyyah
to make payments to charity as a recompense.
9. Non-inheritors
As a rule, adopted, illegitimate and stepchildren do not inherit as of right
from the deceased, although again these inheritors can receive a share from
the wasiyyah.
10. Different schools of thought

For Sunni Muslims there are four main schools of thought. Helpfully,
however, there is a consensus among them in practically all common family
scenarios.
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There are a number of inheritance tools that can be utilised to ascertain the
distribution of the deceased’s estate or the potential distribution. These include:
■■ I Will Solicitors app (available on mobile devices).
■■ IRTH calculator – this is software designed to calculate the inheritance
due to the various inheritors as defined by Islamic law. (www.islamic-
software.org/irth/irth.html)
Haroon Rashid is perhaps the leading specialist on Islamic Wills in the
UK. He has worked as a solicitor for some of the top law firms in the
country and also lectures on Wills and probate matters. Currently in the
process of writing a book on Islamic Wills he qualified as a lawyer in
2000. In 2003 he wrote his own Islamic Will in what was perhaps the
beginning of professionally drafted Islamic Wills in England and Wales.
In 2007 he founded I Will Solicitors, the first and perhaps still the only
firm in the country that solely specialises in Islamic Wills, Haroon has
overseen the preparation of well over 2,000 Wills to date and has lectured
up and down the country on the topic of tax efficient Islamic Wills.
ISLAMIC WILLS AND PLANNING
Tax planning
Taxation of estates
Although there are variations around the world, most jurisdictions have
some form of estate duty/inheritance tax. The basic principle behind such
taxes is that where an individual has passed away with significant assets they
should be required to recontribute to wider society, particularly as they have
received the benefits during their lifetime. Further, it is generally agreed
that the wealthier an individual, and therefore the larger an estate, the more
of a tax hit the estate should take (one of the policy objectives effectively
being that wealth is redistributed rather than continually being hoarded).
In the United Kingdom, inheritance tax is charged on wealth, usually at
the time of death. Inheritance tax applies to estates (and gifts made in the
seven years prior to death) exceeding £325,000 (as at 2014/15). Above the
threshold of £325,000 inheritance tax is chargeable at 40 per cent. Therefore,
in simple terms, an estate of £425,000 will be liable to tax on £100,000 at
40 per cent, resulting in a tax bill of £40,000 (all else remaining equal).
Tax-planning opportunities for Muslim clients

It can be seen from the above that it is important that practitioners and
advisers are aware of the tax implications for their clients when advising
about wills and Islamic finance products generally. This can be particularly
pertinent for Muslim clients, as shown in the examples below.
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Example In the United Kingdom, where a Muslim woman passes away leaving
behind a husband, children and parents and an estate worth £6 million, the
Islamic distribution would be as follows:
■■ Husband receives 1/4th of the estate, or £1.5 million.
■■ Mother receives 1/6th of the estate, or £1 million.
■■ Father receives 1/6th of the estate, or £1 million.
■■ Children receive the balance of the estate, or £2.5 million.
In the United Kingdom, taxation on the estate, in simple terms, would be
worked out as follows:
■■ Estate is £6 million.
■■ Deduct share passing to surviving spouse* – £1.5 million.
■■ Deduct non-taxable portion of the estate – £325,000.
■■ Balance £4,175,000.
■■ This is taxed at 40 per cent, equating to tax of £1,670,000.
*This is considered to be free of tax.
There are various tax-planning measures that clients in similar situations

should be advised about: this will obviously vary significantly between
jurisdictions and therefore advisers will need to take different measures in
different jurisdictions. Some of these measures are considered in more detail
below.
Life interest trust will

UK legislation provides that all assets passing between spouses pass free of
tax (provided that certain domicile rules are met) – this is known as spouse
exemption. Additionally, the spouse exemption is available where one spouse
leaves their entire estate into a trust fund whereby the surviving spouse is
entitled to the income from that trust. In the United Kingdom, such trusts
are known as life interest trusts, where the spouse is a life tenant (the one
entitled to the income). It is important to note that although the surviving
spouse has a right to the income, the trustees of the trust have discretion to
appoint capital to any beneficiary.
The use of a life interest trust will with the surviving spouse as a life
tenant in a will for wealthy Muslim clients can ensure significant inheritance
tax or estate duty savings, and this is best illustrated by looking again at our
example above.
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Where the same Muslim woman passes away leaving behind husband, children Example
and parents and a £6 million estate, but having a life interest trust will with the
surviving husband as the life tenant, the tax position is significantly improved.
In the United Kingdom, the taxation on the estate would be calculated as
follows:
■■ Estate is £6 million.
■■ Entire estate is deemed to pass to spouse – £6 million.
■■ Balance £0.
■■ Resulting in tax saving on first death of £1.67 million.
As this example shows, the entire estate is treated as being that of the
surviving husband, although he is entitled to income only for as long as
there are assets within the trust. The trustees can distribute, after the death
of the wife, the capital to any named beneficiary and where an Islamic
will is required, the trustees would invariably distribute the capital to the
beneficiaries in the appropriate way. Wills usually have a side letter of wishes
requesting that the trustees ensure an Islamic distribution is effected.
As with any tax-planning measures, each jurisdiction must be considered
on its own terms to ascertain the most appropriate planning option.
Lifetime giving
Often an appropriate tax-planning strategy, especially for older wealthier
clients, would be for them to gift assets outright to their children, to
their grandchildren or to charity as appropriate. Islamically, an individual
is allowed to make gifts during their lifetime as they please. Generally
speaking, gifts to children should be made equally (or according to some
views, in accordance with the sharia distribution on death). This can be
varied, however, if the individual has good reason to favour one child over
another, such as one child being in greater financial need.
Making gifts during one’s lifetime is also a way of reducing the size of an
estate for inheritance tax or estate duty purposes. However, advisers should
be aware of any provisions within a jurisdiction that limit an individual’s
ability to do so for tax-planning purposes. As an example, in the United
Kingdom an individual’s estate is considered to be the assets they own at
death, together with any gifts over £3,000 that have been made in the seven
years preceding death. The aim of this legislation is to avoid a situation
where an individual gifts his whole estate to a beneficiary on his deathbed,
thus avoiding the tax that would otherwise have been payable. Similarly, in
the United Kingdom, where an individual makes a gift but continues to
benefit from that gift, this will still be considered to be part of his estate
irrespective of how long ago they actually made the gift.
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Under Islamic law there is a concept of marawdul maut or deathbed illness.

Where an individual is in the final illness that actually leads to his death
and is bedridden as a result of this illness, his usual freedom of discretion
in relation to gifting is curtailed. The limit of the deathbed illness is one
lunar year prior to death. In such a state, where an individual makes a gift
to a beneficiary of his estate, this is valid only if the other beneficiaries all
agree (all individuals must be adult). Where an individual makes a gift
to another beneficiary of his estate, it will be treated as being a part of his
wasiyyah and therefore only a maximum of one-third of the estate value can
be given. Appropriate advice should always be sought in situations where an
individual is in his final illness.
Lifetime trusts (waqfs)

Rather than making an outright gift to an individual a client may prefer to
retain control of the asset. In such circumstances a waqf or trust would be an
appropriate vehicle in which to provide for tax planning as well as allowing
the client to retain control of the asset as trustee. Provided that the trustee
could no longer benefit from the asset, and the control of the asset is not
solely in the hands of the person making the gift, it is likely to be deemed
valid for Islamic law purposes as well as in the jurisdiction in which the asset
is gifted into trust.
Protecting assets for beneficiaries

By making a gift into a trust a client can obtain another benefit, in that the
asset can be protected for the use of a vulnerable beneficiary. Trusts are an
excellent vehicle where a beneficiary is young, elderly or mentally or physi-
cally disabled. The trustees appointed to the trust can utilise the assets of
the trust and invest the same for the benefit of the vulnerable beneficiary.
Advisers should be able to identify situations in which a trust fund would
be appropriate and advise clients accordingly.
The Islamic law of inheritance is a complex subject and practitioners,
when advising on the same, will need to be aware of the local jurisdiction
and any conflict with the Islamic position, as well as having a thorough
understanding of the Islamic law of inheritance.
CONCLUSION
This chapter has looked at three very important topics:

■■ sharia-compliant investments;
■■ the obligatory duty to give a proportion of one’s wealth to charity (zakat);
■■ sharia-compliant estate distribution and Islamic wills.
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All these areas have a profound impact on how Muslims manage their wealth
and as this chapter has shown, there is a set of principles and a framework
that have developed for each of these areas.
At the very least it is useful for practitioners to have an appreciation
of these areas. In particular, asset managers interacting with the Islamic
space need to know about sharia-compliant asset classes and the criteria
used to determine sharia compliance. Lawyers and other professionals
advising Muslims on estate planning, wills and inheritance tax need to
have a working knowledge of Islamic inheritance laws. Wealth managers
need to know about all three of these areas to advise their Muslim clients
on effective wealth-management strategies that ensure wealth is earned in a
permissible way, the obligatory duty to give to charity is factored into the
annual planning, and an estate plan is in place that is sharia-compliant and
tax-efficient.
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8
Takaful – Islamic insurance
Introduction
Sharia perspective on conventional insurance
Takaful – the Islamic alternative
Takaful models
Types of takaful policy
The future of the takaful industry
Conclusion
8 · Takaful – Islamic insurance
INTRODUCTION
Human beings have long recognised the need to protect themselves against
the impact of risks they face, such as natural disasters, travel accidents,
unemployment, sickness or dying at a young age and leaving a vulnerable
young family behind.
Islam teaches its followers to put their trust in God; at the same time, it
also encourages them to use the resources, skills and abilities bestowed on
them by God to act responsibly and protect their wealth and property.
In this chapter we will look at the reasons why conventional proprietary
insurance is not regarded as sharia-compliant and explore the Islamic alter-
native called takaful.
SHARIA PERSPECTIVE ON CONVENTIONAL INSURANCE
In conventional proprietary insurance schemes, a commercial entity seeks

to provide insurance cover for a particular risk by charging an insurance
premium and make a profit net of any claims and other costs. This model is
at odds with the sharia in three key respects:
Gharar (excessive uncertainty)

Insurance aims to provide protection against an event that could happen
but is uncertain in terms of if or when it might happen. Actuaries model
the probability of events occurring and seek to set insurance premiums at
a level that both compete effectively in the market and maximise profit for
the insurance company. These attempts to model the future will invariably
be imperfect. Some uncertainty will exist in almost all commercial dealings
(for example, when a consumer buys fruit, there is a chance that it will not
be ripe). This level of uncertainty is seen as natural and accepted in the
market. However, the sharia does not tolerate ‘excessive’ levels of uncertainty
(gharar) and most scholars are of the opinion that the uncertainty found in
commercial insurance contracts falls into this category.
Maysir (betting)
Related to the fact that the occurrence of certain events is uncertain,
sharia scholars are generally of the opinion that the premium charged by
commercial insurance companies is similar to placing a bet (maysir) on
whether a particular event will happen. So this is another sharia objection to
conventional proprietary insurance.
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Riba
In conventional insurance schemes, either the policy holder will receive more
than they pay as a premium (if a successful claim is made) or the insurance
company will receive more in premiums than it pays out in claims. Given
that the ultimate outcome is a money-for-money exchange, i.e. a premium
paid in money is exchanged for a potential payout in money later, and that
these two values will invariably be different, in a commercial context this
would amount to riba. Riba can also arise if the insurance company invests
in interest-bearing instruments such as gilts.
TAKAFUL – THE ISLAMIC ALTERNATIVE
Takaful means mutual cooperation or joint guarantee. It refers to a not-for-

profit set-up in which individuals club together by contributing into a
common pool. The monies in this fund are used to pay out to members of
the pool who have been afflicted by certain events that the members have
mutually agreed to cover each other for – travel accidents, for example. The
monies left in the pool after paying claims belong to the members.
The Takaful Act enacted by Malaysia in 1984 defines takaful as follows:
A scheme based on brotherhood, solidarity and mutual assistance, which
provides for mutual financial aid and assistance to the participants in case
of need whereby the participants mutually agree to contribute for the
purpose.
The sharia violations of riba, gharar and maysir that are prevalent in conven-
tional commercial insurance contracts do not occur in such a system. Instead
of a premium payable in a commercial insurance contract, pool members
donate (tabarru means donation) a sum of money to the pool. If a member
is paid compensation from the pool, this payment is regarded as a form of
mutual assistance rather than as a countervalue paid under a contract of
exchange. Hence the issue of riba does not arise in such a system.
Similarly, the non-commercial nature of the arrangement means that the
prohibitions of gharar and maysir do not apply. It is in a commercial context
that the sharia demands as much certainty as possible in the exchange
between the two parties to a transaction (i.e. absence of gharar) and forbids
gambling/betting (maysir) by either party.
Takaful also differs from commercial proprietary insurance with regard
to who bears the risk. In commercial proprietary insurance the risk is
transferred to the insurance company, which takes on the risk(s) covered
in the insurance policy in exchange for the insurance premium. Under the
takaful system, risk is not transferred to any third party but is borne by and
distributed among the members of the pool.
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The relationship between the pool members and the pool is framed in
terms of two binding promises: the members promise to contribute to the
fund, and the pool promises to pay out in the event of a claim.
The takaful system is virtually identical to the concept of mutual
insurance, which is still alive today and has a deep heritage in the United
Kingdom, rooted in local communities putting money into a common pool
to protect members from certain misfortunes.
It is worth noting at this point that in markets such as the United
Kingdom, the provision of takaful products is limited. Where the law
demands protection (for example, car insurance is required to drive a car in
the United Kingdom) and there is no sharia-compliant alternative available,
scholars have permitted the use of conventional insurance products. This is
based on the fact that it is a legal requirement of the country and Islamically
it is of paramount importance to be law abiding and maintain social order
and harmony in society. Where there is no legal imperative but there is no
sharia-compliant alternative available, scholars are reluctant to permit the
use of conventional insurance products, but depending on the circumstances
of a particular case, may endorse it if it is deemed that the potential loss to
the person/entity will be very hard to recover from.
TAKAFUL MODELS
Takaful could in theory be established by governments or by privately

organised groups and communities. In reality, given the range of risks
that potentially requires covering and the fact that different risks apply
to different groups of people, it is difficult for governments to provide the
necessary range and depth of coverage. Therefore takaful solutions have
tended to be established by private organisations.
Single entity structure

A single non-profit entity can be set up on a mutual or cooperative basis.
This is almost identical to a mutual organisation in the United Kingdom,
in which the entity is owned by members and there are no external share-
holders seeking to make a profit from its activities. Members appoint a board
or management to run the operation. The cost of management and other
expenses are funded through member contributions and other activities
such as profits earned from investments. Any surplus, net of claims paid
and expenses, belongs to members. Any shortfall needs to be covered by
increased contributions from members.
151
Double entity structure

An alternative and more common approach to takaful operations is to
establish a two-tier structure (see Figure 8.1):
■■ Entity 1: a takaful mutual fund/pool operating on a non-profit basis to
collate members’ funds and pay out to them on the incidence of certain
events covered by the fund. The monies in the pool, including any
surplus, belong to the members.
■■ Entity 2: a commercial entity, usually referred to as the takaful operator
(TO), engaged by the takaful fund to manage activities such as claims
handling and investments in accordance with sharia principles. The
commercial entity is motivated by the revenues it can earn for share-
holders from services provided to the takaful non-profit-making entity.
The TO has no direct liability in respect of any takaful policies issued
by the fund – it is merely entrusted to manage the takaful entity and its
investments.
A common feature of the relationship between the TO and the takaful fund
is that the operator agrees to provide an interest-free loan (qard hassan) to the
fund in the event of a shortfall in the fund due to claims exceeding member
contributions.
Figure 8.1 Takaful models: single entity structure versus double entity structure
SINGLE ENTITY STRUCTURE DOUBLE ENTITY STRUCTURE
TAKAFUL POOL TAKAFUL POOL
Non-profit-making Non-profit-making entity

entity
Monies in the pool
Managed by board belong to members
appointed by takaful
members
Monies in the pool TAKAFUL OPERATOR

belong to members
A commercial entity
engaged by the takaful
members to manage the
takaful pool’s underwriting
activities and possibly
investments too
152
Possible pitfalls of the double entity structure

Most takaful operations around the world have been set up based on the
double entity structure, and have usually been initiated by takaful operators
who have identified a commercial opportunity in providing sharia-compliant
protection.
There are some potential pitfalls with this structure:
1. Takaful is in essence a non-profit-making activity, set up for the mutual
protection and benefit of its members. The takaful fund must ensure that
its original purpose and values are not undermined by the involvement
of a commercial entity focused on maximising profit. Close attention
needs to be paid to how the commercial entity is remunerated, so that its
interests are fully aligned to those of the takaful fund. We will look at this
more closely when discussing how the relationship between the TO and
the takaful fund can be structured.
2. Some commentators have argued that the agreement by the TO to provide
an interest-free loan to the takaful fund in the event of a shortfall is
tantamount to transferring risk from the takaful fund to the TO. Such
a transfer would be fundamentally at odds with the concept of takaful
– that risk needs to be shared and distributed among members of the
takaful fund and not transferred to a third party.
Relationship between the takaful pool and the takaful operator

As described above, the operator provides services to the pool. These services
fall into two broad categories:
1. Underwriting – this includes issuing new takaful policies and claims
handling. These services are typically provided by the operator to the pool
through a wakala contract (principal–agent relationship). The operator
acts as the agent (wakil) of the pool members (the principal) and receives
a fee for its underwriting services on this basis. This can be structured as
a fixed fee or as a percentage of the contributions paid into the pool.
2. Investment management – this refers to investing the monies of the
takaful pool on behalf of the pool members. A mudarabah contract for the
investment management services is typically provided by the operator.
The operator acts as the mudarib, providing investment management
services to the pool members, who collectively form the rabb-ul-maal
(providers of capital). Under such a contract, the operator does not
receive any fixed remuneration, instead sharing in any profit generated
through the investment activity, while any losses are borne solely by pool
members.
153
The wakala contract for underwriting services and the mudarabah contract
for investment management services is the most common model used
to define the relationship between the TO and the takaful pool and its
members. There are a number of reasons for this:
■■ The wakala contract lends itself well to the provision of underwriting
services as a management fee is charged to the pool by the TO. This is
usually either a fixed fee or a percentage of the value of contributions
received by the pool (this can be justified on the basis that the greater the
value of contributions, the more work the operator needs to do).
■■ Applying a mudarabah (profit-sharing) contract to underwriting would
not work as well for the following reasons:
■■ The essence of takaful is that any underwriting surplus should belong
to the pool members, as they are and should be the ‘risk takers’. If the
operator shares in the surplus, its role as a ‘risk manager’ starts to merge
wrongly into ‘risk taking’.
■■ An underwriting surplus is not the aim of the takaful pool and is not
the same as a profit – it is in fact an undistributed surplus from the
tabarru. Hence to apply a contract of profit sharing is something of a
mis-fit.
■■ Similarly, if the operator is remunerated according to the value of the
underwriting surplus, the operator will be motivated to maximise the
surplus. This is not aligned to the interests of the pool members, nor is
it compatible with the aims and values of takaful.
Yet the mudarabah contract is well suited to the investment management
activities of the TO. The operator receives a share of any profits from the
investments and hence the operator’s interests are generally aligned to those
of the pool members – to make the best possible return. However, there is
the potential misalignment of interests if the operator wants to take more
risk than is suitable for the pool members. Such issues need to be addressed
in the governance applied to takaful operations.
Nevertheless, it is also possible to use a wakala contract for investment
management services, instead of the mudarabah contract. The fee payable
to the operator (wakil) can be structured to contain a performance-related
component. The mudarabah contract is generally more risky from the
operator’s point of view as no remuneration will be received unless a profit
is made on the investments. Hence either wakala or mudarabah contracts
could be used for investment management services: the contract chosen
depends on the preferences of, and agreements between, the TO and the
pool members.
154
Use of the waqf (endowment) concept in takaful

A waqf is an endowment created by a person who donates an asset that they
own to an endowment vehicle, with the intention of benefiting specified
beneficiaries. The donor can still manage the asset or may pass management
responsibility to other specified persons. In the United Kingdom and other
jurisdictions, where specific waqf legislation does not exist, trusts can work
well as an endowment vehicle.
The use of the waqf concept has been increasingly applied within the
takaful arena. In Pakistan, for example, a waqf takaful model has been used.
The waqf founder initiates a takaful operation by donating a sum of money
to the waqf. Participants then contribute to the waqf with the objective of
paying out and helping participants who are affected by specified events or
risks.
In this kind of scheme, all investment returns and any underwriting
surplus remain within the waqf and are not shared with the contributors.
The participants at the outset agree that any surplus should be kept and used
by the charitable waqf. A waqf may appoint external providers to supply
services such as investment management.
A more common model is to combine a waqf with a wakala contract, and
in some circumstances with mudarabah as well. For example:
■■ A takaful operator provides underwriting services on a wakala basis.
■■ The operator also provides investment management services on a
mudarabah basis.
■■ Any surplus generated by the takaful pool is donated to a waqf, instead of
being redistributed back to pool members.
Using a waqf in this way can help to mitigate a practical issue of redistrib-
uting surpluses back to members. Insurance is a dynamic activity with a
continuous stream of joiners and leavers and new claims. Moreover, claims
can sometimes be made some considerable time after the incident giving
rise to the claim has occurred. As a result, accurately ascertaining what
proportion of the surplus a member is entitled to can be difficult. This issue
is resolved if all members agree that any surplus should be paid to a chari-
table waqf.
TYPES OF TAKAFUL POLICY
Conventional insurance is broadly categorised into life insurance and general

insurance. In a similar way, takaful can be broadly categorised into general
and family/life takaful.
155
General takaful
General takaful, like general insurance, seeks to cover losses suffered by
replacing value equivalent to that prior to the damage or loss. The risks
covered are generally short-term in nature, such as protection against car
accidents, travel problems, fire, damage to property and so on. Within this
space, protection for businesses such as professional indemnity, employer
liability and public liability cover are all possible. General takaful policies
usually last one year and focus almost entirely on protection as opposed to
investment return and growth. Hence the activities of the TO or the mutual
takaful pool are centred around underwriting.
Family/life takaful
Takaful can cater for all risks, including death – to provide assistance to the
family of the deceased is very much in line with Islamic values. Family/life
takaful plans are generally schemes that provide cover to an individual who
wishes to save a sum of money for dependants, should the participant die
prematurely. This cover is effectively a long-term savings plan, typically of
10–30 years’ duration. Given the long-term savings nature of these policies,
contributions by participants are usually split into an underwriting pool
and an investment pool. If the participant dies during this period, the
policy provides some financial protection for the family and dependants left
behind; otherwise the policy matures at the end of the contracted period.
Such policies can also usually be redeemed at any time up to maturity.
Family/life takaful therefore goes beyond simply insuring against the event
of death; it also enables the participant to save a capital sum on survival.
There are three typical scenarios:
1. Death before plan matures: heirs to the deceased’s estate receive all of
the monies accumulated in the investment pool based on the deceased’s
contributions into the pool and the returns earned on those contributions.
In addition, the heirs will receive from the underwriting pool an amount
of money equivalent to all remaining or outstanding total donations that
would have been made if the participant had survived until maturity of
the takaful plan.
2. Benefits at maturity: if the participant survives until maturity of the
plan, he or she will typically receive the monies accumulated in the
investment pool (as above) plus a proportion of the surplus, if any, arising
in the underwriting pool.
3. Surrender benefit: this arises when a participant decides to terminate his
policy before maturity. Typically he or she receives monies accumulated in
156
the investment pool on his behalf, but does not receive any monies from
the underwriting pool.
It is possible to provide takaful such that a person’s family receives a payout
on death, whenever that occurs, i.e. like a conventional whole-of-life policy.
This is rare because life cover is invariably a long-term policy; in takaful,
the monies in the pool belong to the members and hence this is suited to
a plan in which the member benefits from investment and underwriting
services.
Takaful Malaysia is a leading takaful provider in Malaysia. It provides Example

both family and general takaful products. On the family side it provides
protection for health problems (paying for medical fees, etc.), protection
against the risk of not being able to pay for home finance payments, and
protection against death before a certain age.
On the general takaful side it offers protection against fire, damage to
property, motor accidents and personal injury, and a multitude of protection
products for businesses/organisations.
Retakaful
As with conventional insurance, the takaful pool needs to be able to
redistribute some of the risk outside the pool if it is to remain viable and
sustainable. Otherwise, very large claims resulting from catastrophic events
(such as heavy storms or flooding) could cause the pool to become insolvent.
Consequently, retakaful has developed in a similar way to reinsurance.
The takaful pool redistributes some of the risk in the pool by passing a
portion of the contributions in the takaful pool to the retakaful pool. The
retakaful pool works on the same principles as takaful: the members of the
retakaful pool (other takaful pools/funds) make contributions into the pool
to mutually guarantee each other (see Figure 8.2). The participants in a
retakaful contract are the takaful operators, acting on behalf of the respective
takaful pools they represent.
The retakaful pool Figure 8.2
RETAKAFUL POOL
Members are other takaful pools, often

represented by the takaful operators of
those pools
157
THE FUTURE OF THE TAKAFUL INDUSTRY
A report by Ernst & Young in 20131 commented that ‘there is a dearth of

takaful operators who are capable of providing leadership to the growing inter-
nationalisation of the industry. There is a need for large, regional champions to
lead growth in regional markets and to participate in international markets’.
There are signs of change. In this 2013 publication, Ernst & Young
reported that global gross takaful contributions are estimated to be around
$15 billion in 2014, growing at more than 15 per cent per annum.
Momentum seems to be building in takaful’s three key markets – Saudi
Arabia, Malaysia and UAE. Saudi Arabia accounts for approximately half
of the Islamic insurance industry, partly due to the fact that conventional
proprietary insurance is not permitted in the country. The growth lever for
strong growth in Saudi Arabia and UAE (specifically Abu Dhabi) was the
implementation of the compulsory national health insurance policy. Qatar
is also legislating to make it mandatory to hold a national health insurance
policy, which will drive demand of its takaful industry. Malaysia, with a
relatively developed Islamic finance industry, has actively supported the
growth of its takaful sector. In fact, Malaysia has emerged as the world’s
largest family takaful market. With a proven model and regulatory clarity,
the country is set to further build on this leadership position. Family and
medical takaful are the major business lines across all markets.
Scale in the protection space is very important and this has been a
challenge outside of Saudi Arabia and Malaysia. Regulatory enhancements
are also presenting new opportunities in rapid growth markets such as
Turkey and Indonesia. The challenge is to build on the lessons learned from
core Islamic ﬁnance markets to address rising demand expeditiously.
CONCLUSION
Takaful is in many ways the ‘sleeping giant’ of the Islamic finance industry.
As highlighted at the beginning of this chapter, protection against the risks
we face as human beings is a basic need. With the significant and growing
Muslim demographic across the world, a tremendous opportunity exists
to provide sharia-compliant protection solutions. Conventional insurance
still dominates across the Muslim world (in a report by Swiss Re in 2011,
83.1 per cent of premiums went to conventional insurance providers in
Muslim countries2) and in most of the non-Muslim world there is very little
provision of takaful.
1
Ernst & Young (2013) ‘Global Takaful Insights 2013: finding growth markets’.
2
Islamic Finance News (2012) Supplement, May.
158
For the takaful industry to compete with conventional proprietary

insurance, it needs to achieve scale, a more accessible regulatory framework,
have suitable long-term investments for the family/life takaful market and
attain operational efficiency. Scale is important to overcome significant
start-up costs, provide competitive pricing and mitigate the risk of insol-
vency. Regulation in individual jurisdictions and the regulatory framework
across borders need to be simplified to allow larger, regional players to
develop. A lack of relatively stable, long-term sharia-compliant investments
has been an issue – these are needed to match the long-term nature of family/
life takaful plans and the fact that these plans have a strong investment focus.
Instruments such as longer-term sukuk are required to support the growth
of the takaful industry. World-class standards of operational efficiency are
required to compete effectively with the well-established conventional
insurance market.
An oasis of opportunity exists in the takaful market, but if the growth
potential is to be realised, a significant number of challenges need to be
overcome.
159
9
The future of Islamic finance
Introduction
Recommendations for success by IFSB and IDB/IRTI
Opinion pieces
The Christian view of usury by Robert Van de Weyer
The future of Islamic finance by Dr Sayd Farook
The secret to long-term success: get the direction of travel right by
Faizal Karbani
9 · The future of Islamic finance
INTRODUCTION
In coming to this last chapter of the book, it is my hope that the reader has
grasped the key principles, concepts and practices underpinning the Islamic
finance industry. Furthermore, that it is clear that the industry in its modern
form is at a very exciting stage – the growth potential is impressive, with
plenty of opportunity for expansion and progress across the world. Indeed,
penetration levels are fairly low in Muslim-majority countries. However,
many challenges remain for an industry that is barely 40 years old if it is to
compete effectively against a conventional financial system that is mature,
well established and enjoys the benefits of scale.
As a practitioner myself and having been actively involved in the industry
for the past decade, it feels as though we are no more than 10–15 per cent
of the way through the journey that the industry needs to go through to
establish itself as a viable and credible alternative to conventional finance.
The purpose of this chapter is to give the reader some powerful insights
and perspectives on where the industry is and what are some of the key
challenges, opportunities and imperatives for the future if it is to achieve
its potential.
RECOMMENDATIONS FOR SUCCESS BY IFSB AND IDB/IRTI
To start with I want to cite a credible report published in May 2014 which
seeks to provide a blue print for the development of the Islamic finance
industry. The report was produced by two important organisations in the
Islamic finance industry – the Islamic Financial Services Board (IFSB) and
the Islamic Research and Training Institute (IRTI).
1. IFSB: in addition to AAOIFI, the IFSB is the other most recognised
regulatory body in the Islamic finance industry. The IFSB serves as an
international standard-setting body which has the objective of ensuring
the soundness and stability of the Islamic financial services industry. The
work of the IFSB complements that of the Basel Committee on Banking
Supervision, the International Organization of Securities Commissions
and the International Association of Insurance Supervisors.1
2. IRTI: the institute was established by the Islamic Development Bank
1
At April 2014, the 184 members of the IFSB comprised 59 regulatory and supervisory
authorities, 8 international inter-governmental organisations, 111 financial institutions and
professional firms as well as 6 self-regulatory organisations (industry associations and stock
exchanges) operating in 45 jurisdictions. Malaysia, the host country of the IFSB, has enacted
a law known as the Islamic Financial Services Board Act of 2002, which gives the IFSB the
immunities and privileges that are usually granted to international organisations and diplo-
matic missions.
163
(IDB – a supranational bank committed to the economic and social devel-

opment of Muslim member countries) as the research and training arm of
the bank.
In March 2007, the IDB and the IFSB published a document on the
state and future of the Islamic finance industry. The report, entitled
‘Islamic Financial Services Industry Development: Ten-Year Framework
and Strategies’ (Ten-Year Framework), sought to lay out a roadmap for the
development of the industry.
The Ten-Year Framework provided an overview of the industry,
highlighting key opportunities and challenges. The document also offered
13 core recommendations for the development of the industry. In May
2014, the IFSB and the IRTI published a mid-term review of the Ten-Year
Framework (Mid-Term Review)2 as more than half of the period had passed.
The report assessed the impact of macroeconomic events, monitored progress
in implementing the original recommendations, and proposed additions or
modifications to the recommendations to guide the industry.
The Mid-Term Review presented 16 recommendations (3 additional
recommendations to the original set), classified into 3 themes, as a blueprint
for the industry to develop:
1. Enablement: fostering conditions for the industry to thrive.
2. Performance: enhancing the effectiveness of institutions active in the
industry.
3. Reach: expanding the set of potential beneficiaries of the industry.
The recommendations are summarised and categorised according to these
themes in Table 9.1.
These 16 recommendations are an excellent reflection of the challenges
facing the industry and what it needs to do to successfully progress. A
number of the areas mentioned in the recommendations were highlighted
in Chapter 1, namely the need for:
■■ a regulatory environment that allows the industry to develop and flourish;
■■ scale to compete effectively with conventional finance;
■■ human capital – if Islamic finance is to reach its growth potential, it
needs significant human capital – appropriately educated and trained – to
facilitate and drive this growth;
■■ sharia authenticity – remaining true to the spirit and objectives of the
sharia;
■■ making Islamic finance more inclusive – as a value proposition it can and
should appeal to more than just Muslims.
2
IFSB and IRTI (May 2014), ‘Islamic Financial Services Industry Development: Ten Year
Framework & Strategies – A Mid Term Review’.
164
The 16 Mid-Term Review recommendations Table 9.1
Enablement
Facilitate and encourage the operation of free, fair and transparent markets in the
Islamic financial services sector.
Develop the required pool of specialised, competent and high-calibre human

capital.
Promote the development of standardised products through research and

innovation.
Develop an appropriate legal, regulatory and supervisory framework, as well as an

IT infrastructure that would effectively cater for the special characteristics of the
Islamic financial services industry (IFSI) and ensure tax neutrality.
Develop comprehensive and sophisticated inter-bank, capital and hedging market

infrastructures for the IFSI.
Foster collaboration among countries that offer Islamic financial services.
Develop an understanding of the linkages and dependencies between different

components of Islamic financial services to enable more informed strategic planning
to be undertaken.
Performance
Enhance the capitalisation and efficiency of institutions offering Islamic financial

services to ensure that they are adequately capitalised, well performing and
resilient, and on par with international standards and best practices.
Enhance sharia compliance, effectiveness of corporate governance and

transparency.
Enhance the implementation of the international prudential, accounting and auditing

standards applicable to the IFSI.
Strengthen and enhance collaboration among the international Islamic financial

infrastructure institutions.
Foster and embrace innovative business models, including new technologies and
delivery channels, in offering Islamic financial services.
Reach
Enhance access by the large majority of the population to financial services and
enhance access to funding for SMEs and entrepreneurs.
Promote public awareness of the range of Islamic financial services.
Conduct initiatives and enhance financial linkages to integrate domestic IFSI with
regional and international financial markets.
Strengthen contributions to the global dialogue on financial services, offering

principles and perspectives to enhance the global financial system.
165
These recommendations are aimed at influencing key stakeholders in the

industry, particularly policy makers, regulators and industry bodies/players.
With the IFSB and IDB’s membership of central banks, governments and
regulators and prominence in the industry, the report has a good chance of
positively influencing the way forward. As part of this Mid-Term Review,
the IFSB and IDB/IRTI have set down some more specific and detailed
criteria with which to assess progress against the recommendations made
and it will be interesting to review these results post-2017, once the overall
10-year period has elapsed.
OPINION PIECES
I now want to share some insightful and interesting opinion pieces on the
relevance and future of the Islamic finance industry. These contributions are
from Robert Van de Weyer and Dr Sayd Farook.
Robert Van de Weyer – Robert is an economist and was previously a
lecturer at Cambridge University. He is a practising Christian priest and
has written a book called Against Usury. It is interesting to get Robert’s
perspective as someone outside of the Islamic finance industry – an
insight into how Christianity has viewed interest over time and how he
believes an interest-free economy could produce more equitable and stable
economic outcomes. This feeds into the aspiration that the values and
principles underpinning Islamic finance can appeal to an audience wider
than just Muslims.
Dr Sayd Farook – Dr Sayd is the Global Head of Islamic Capital
Markets at Thomson Reuters. Previously he was a consultant for a leading
Islamic finance consultancy, Dar Al Istithmar, and gained his doctorate
in Islamic finance from the University of Technology in Sydney. Dr Sayd,
by virtue of his experience, his global role and the fact that Thomson
Reuters is continually conducting world class research and analysis of the
Islamic finance industry, is in an excellent position to offer an insightful
perspective on the progress, opportunities and challenges facing the
Islamic finance industry. Dr Sayd shares his views on how the industry
has developed to date and offers his wisdom as to what the industry needs
to do going forward to achieve its potential.
I finish the chapter with an opinion piece from myself: what I regard as the
ingredients critical to the long-term success of the Islamic finance industry.
166
THE CHRISTIAN VIEW OF USURY BY ROBERT VAN DE WEYER
Modern Christianity has no distinctive message about financial and economic

matters. Occasionally Christian leaders condemn particular financial practices.
Thus, for example, Rt. Rev. Justin Welby, the Archbishop of Canterbury, has
strongly criticised the high interest rates charged by ‘pay-day’ lenders, and
he has indicated his preference for credit unions as a means of providing
loans to the poor. But, like all Christian pronouncements on finance, this is
merely an ad hoc view on an issue that has received widespread publicity; it
does not derive from any specific Christian teaching.
Yet for the first 15 centuries of the Christian history, the Christian church
promulgated two particular economic principles, and the church regarded
breaking those principles as criminal, to be severely punished. The Christian
writer who expounded these principles most clearly was Thomas Aquinas.
But they were reiterated time and again at meetings of Christian bishops.
The first principle was the ‘just price’. This stated that the price charged
for any good or service should reflect the labour expended in producing it.
In normal circumstances market forces will ensure the just price. If, for
example, people can earn more money from producing X rather than Y, then
some of those producing Y will shift to X in pursuit of a higher reward, and
this will continue until earnings are roughly equal.
But the ancient Christian leaders were concerned with circumstances where
market forces fail and hence where moral force must ensure compliance. One
such circumstance is a temporary shortage of a good, perhaps owing to a
poor harvest or warfare. Dealers in that good will be tempted to raise their
price to exploit the shortage, but Christian leaders taught dealers to resist
this temptation, instead leaving the price unchanged. Another circumstance
is where a particular producer has some local monopoly power, giving them
the ability to push up their price; again the Christian leaders taught such
producers to charge a price based only on labour costs.
The second principle was the prohibition on usury, defined broadly as
the charging of interest on loans. The basis for this prohibition came from
various verses in the Old Testament (for example, Leviticus 25:35–7). The
kind of lending envisaged in these verses is to families who have fallen
into poverty, so charging of interest was seen as taking advantage of other
people’s misfortune.
As the European economies became more sophisticated in the medieval
period, merchants needed money from others in order to finance trade, and
one way of raising money was to borrow at interest. Since the lenders and
the merchants alike were typically quite wealthy, there was no question
of exploitation. Nonetheless the Christian church continued to condemn
interest. Those providing finance for trade should have a share of the profits
rather than an amount fixed in advance.
167
The argument centred on the allocation of risk. If a passive investor lends

money to a merchant at interest, in order to finance a trading expedition,
then the financier has first call on any returns from the expedition. Thus
the merchant carries a disproportionate share of the risk. If the expedition is
disappointing, the investor will receive their interest, while the merchant may
receive little or nothing. Conversely, if the expedition is very successful, the
merchant will enjoy high returns, while the investor’s returns are unchanged.
The Christian leaders said this was inequitable. They recognised that
every industrial and trading enterprise involves a degree of risk. So they
taught that everyone providing funds for an enterprise should share the risk
by means of sharing both the profits and the losses.
By the sixteenth century the Christian condemnation of usury was
becoming more muted and a century later all the mainstream churches had
accepted usury as an inevitable element of successful commercial activity.
The main reason for this doctrinal retreat was the rise of banks. As banks
rapidly came to occupy a central place in European economies, Christian
leaders felt they had little choice but to bless them – and since banks depend
on lending at interest, Christian leaders in effect also had to bless usury.
Of course, in condemning usury prior to the seventeenth century,
Christianity was firmly allied to Islam, and if Christianity is again to engage
in financial matters, it must renew that alliance. Yet in focusing on the
allocation of risk, Christianity has a distinctive contribution, and an analysis
of the nature of banking reveals this.
The essence of banking, from the sixteenth century onwards, is ‘maturity
transformation’. Banks receive money from the public in the form of
deposits, and depositors have the right to take out their money at any time,
or at short notice. Depositors may receive a small amount of interest or, more
often, the banks reward them by administering their deposits for little or no
charge. The banks in turn lend out those deposits to businesses and private
individuals, for periods that may vary from a few weeks or months to 25 or
30 years, and they charge substantial interest. The banks’ profits come from
the difference between the high interest they charge borrowers and the low
interest they pay depositors.
Banks undoubtedly serve two important functions vital to modern
economies. First, bank deposits, accessed through debit cards, bank transfers
and the like, comprise the main form of money, and they are far more secure
than cash. Secondly, banks are the main channel through which people’s
savings find their way to productive investment.
Yet banks are prone to periodic crises, of which the credit crunch of
2007–8 is the most recent, and possibly the worst – and the reason for these
crises is the inequitable allocation of risk.
In principle, depositors carry no risk whatever. They are lending
their money to the banks at low interest, with the right of immediate
168
withdrawal. Conversely, businesses borrowing money from the banks carry

all the risk. Regardless of how well or badly a business performs, it must
pay the interest to the bank. Of course, some businesses fail altogether, so
the bank receives little or nothing. But in normal times it can predict the
rate of such failures and it sustains the losses through the high interest it is
charging others.
A crisis comes when lots of borrowers fail at the same time and then
suddenly the allocation of risk shifts. Banks find themselves unable to pay
depositors when they wish to withdraw funds. As rumours of this start to
circulate, depositors rush to the banks in order to withdraw funds, making
the crisis worse. Thus banks are no longer able to perform their primary
social function of providing money, so the entire economy is in danger of
seizing up. At this point the government has no choice but to intervene,
effectively guaranteeing bank deposits. So the risk ends up in the lap of the
taxpayer, and the knowledge of this ultimate outcome may have prompted
banks in the previous few years to make unduly risky loans – the problem
of ‘moral hazard’.
This prompts the question of whether it would be possible to have
an efficient banking system without usury, in which risks were allocated
equitably. What would such a banking system look like? Would it perform
the dual functions of providing money and channelling funds to productive
investment? Moreover, would it be free of periodic crises?
A non-usurious banking system would have two sorts of banks. The first
would be deposit banks, in which people deposited their money for the
banks to administer. The banks would hold their deposits either as cash
or in some other safe form, such as a government bond that held its real
value. By their nature deposit banks would be perfectly safe, in that people
could be certain, even in the direst economic circumstances, of being able to
withdraw their money on demand.
The second would be investment banks. People would entrust their
savings to investment banks, which would use the savings to acquire equity
in businesses or buildings. Thus the banks would help businesses to expand
and the banks would then receive returns depending on the success of the
businesses. Those entrusting funds to the investment banks would receive an
annual return, depending on how well the various investments performed.
The investment banks would also retain some liquidity to enable people to
withdraw on a first-come-first-served basis.
Thus the social functions of banks would be split. The deposit banks
would uphold the system of money, while the investment banks would
marry savings with investment. Of course, investment banks would not
be the only channel for savings. Different types of investment banks
would spring up, with different specialities. But the important point is
that risks would be transparent and fair. Deposit banks would be totally
169
safe, while investment banks would provide the means whereby savers
and investors shared risk equitably.
While this model for non-usurious banking accords with traditional
Christian teaching, it may appeal to those without faith. Indeed, since the
credit crunch several commentators, with minor variations, have advocated
it, the most prominent being John Kay of the Financial Times. The idea
of ‘ring-fencing’, advocated by the Independent Commission on Banking
appointed by the government (known as the Vickers Commission), is a weak
version of the separation of banks. It would be unlikely to work successfully
because it retains important elements of usury, but it perhaps indicates the
way the tide of opinion is moving.
The prohibition of usury would have other important implications
beyond the sphere of banking, of which two are especially prominent. First,
companies would not be able to finance their operations through issuing
debentures (bonds); the only form of finance would be ordinary shares,
where investors receive a share of profits. High ‘gearing’ or ‘leverage’, where
businesses depend heavily on bonds, is a major cause of commercial failure,
even where the businesses are basically sound. All businesses go through
difficult patches and if they are so highly geared that they cannot pay the
bond interest, they go under. So requiring all business finance to be in the
form of equity would create a more stable commercial environment.
Secondly, families would no longer buy their homes through mortgages
but instead would share the purchase with an investment bank or other
specialist provider. If the investment bank provided, say, 60 per cent of the
funds, the family would pay to the bank an amount equal to 60 per cent of
the market rent. When the family sold the house, the bank would receive 60
per cent of the proceeds. Thus the bank would share with the family the risks
attaching to home ownership. One major consequence would be the end of
housing bubbles, which are caused by people borrowing at interest to buy
homes in the belief that the rising value will more than cover the interest.
The present writer, as a Christian, would not presume to comment on
the underlying theology of Islamic finance. But undoubtedly most people
regard the principles of Islamic finance as applicable only to Muslims. The
present writer, by contrast, believes that if God has taught that a particular
financial principle is righteous, it is universally applicable. The prohibition
of usury in all its forms is a righteous financial principle, divinely ordained
– and Muslims and Christians alike should preach that message to the world.
Without doubt the world would be a fairer and happier place if the message
were heeded.
Rev. Van de Weyer is an economist and a priest in the Church of England.
The ideas expressed in this article are explored more thoroughly in his book
Against Usury (SPCK, 2010).
170
THE FUTURE OF ISLAMIC FINANCE BY DR SAYD FAROOK

You should learn from your competitor, but never copy. Copy and you die.
Jack Ma, Founder of the Alibaba Group
Three-quarters of the world’s adult population, or 2.5 billion people, are

unbanked and Muslims are more likely to be financially excluded because
a significant proportion avoid interest-based financial services.3 While
Islamic finance continues to grow in leaps and bounds it has the potential
to gain even more traction if it can reach those left behind by conventional
finance. However, Islamic financial institutions (IFIs) are facing serious
challenges with respect to satisfying customers and reaching the unbanked
demographic across both their native markets such as the GCC and new
markets such as North Africa and Central Asia.
Customers are no longer happy to accept Islamic financial services as a
sub-par alternative to conventional finance and the Islamic banking model
has not proven to be inclusive. With an aggressive and competitive landscape
where IFIs have to compete head on with conventional financial institutions
for market share, IFIs now have to come up with a differentiated approach
that increases barriers of entry and enhances stickiness of customers. The
question is, how? In this opinion piece we explore the evolution of the
strategic direction of IFIs in the last couple of decades, to assess what needs
to be done to ensure they can compete effectively to retain and grow market
share in an increasingly inclusive way.
Potential universe of Islamic finance customers

Studies during the late 1990s and early 2000s identified three broad
segments that make up the potential universe of Islamic finance customers.
The first are the religiously strict ‘sharia loyalist’ customers who can occupy
anywhere between 10 per cent and 30 per cent of the potential customer
base of IFIs. These customers demand and prefer sharia compliance above
all else and are willing to pay a premium price or sacrifice profits in order
to align their financial dealings with Islamic principles. This customer
segment is the most inelastic and is considered a captive customer base of
IFIs, in the absence of competition. The second customer segment is defined
as ‘floaters’ and they occupy anywhere between 40 per cent and 70 per cent
of the market for Islamic financial services. These customers are charac-
terised by a preference towards Islamic financial products only when they
are deemed to be competitive with conventional products. Finally, the last
3
World Bank (2012) ‘Three quarters of the world’s poor are “unbanked”’, http://econ.worldbank.
org/WBSITE/EXTERNAL/EXTDEC/0,,contentMDK:23173842~pagePK:64165401~piPK:6
4165026~theSitePK:469372~isCURL:Y,00.html
171
broad customer segment is termed ‘secular’ and occupies anywhere between

15 per cent and 30 per cent of the customer universe. These customers do
not have any preference for Islamic financial products and care only about
the relative value of the offering.
Phases of Islamic finance growth

Appealing to Muslims with sub-par products: 1990–2010
From the early days of modern Islamic finance into the post-financial
crisis era, IFIs were struggling just to offer basic services – from banking
and insurance to asset management and capital market products – to
their captive customer base, the strict sharia-sensitive customer segment.
With sparse product offerings, diverse practices and little consumer
understanding of Islamic products, IFIs were insulated from competitive
pressures by the strict Muslim consumer segment’s demand for sharia-
compliant products; this was the case even where Islamic banks offered
similar economic outcomes at higher cost than conventional banking
products.
Appealing to all with competitive products: 2010 onwards

More recently, IFIs have realised that appealing just to the sharia-sensitive
customer segment will result in a very limited market. To expand the pie,
IFIs needed to look farther afield to all customers of financial services,
and try to appeal to them with equivalent services at equal costs with
conventional financial institutions, which share relatively price-elastic
customers unwilling to accept higher cost for what they consider equiv-
alent products.
This phase is likely to enable IFIs to grab a bigger slice of the financial
services pie by appealing to floaters, but it is not likely to yield a significant
jump in market share. In these instances, multinational and regional banks
with a strong product offering and strong brand loyalty will continue to
command an ever-increasing share of the customer’s pocket.
Standalone Islamic banks and sharia-compliant windows or subsidi-
aries of conventional banks that have developed a full product suite and a
highly competitive offering can compete with other banks, and in many
instances, win over customers. In many mature markets such as UAE,
Bahrain, Malaysia, Kuwait and Saudi Arabia, this is where Islamic banks are
gradually gaining market share.
Local banks that do not have Islamic products will continue to see their
market shares decline, and Islamic banks will be the beneficiaries, but only
up to a certain level as there will always be a user base for conventional
products so long as there is a part of the population that is secular in
character or agnostic to the type of bank that is offering the services.
172
The success of Islamic banks in this phase is based on an assumption

that they can compete head-to-head on technology solutions (branchless
banking, online), product breadth and depth (wealth, trade and financial
markets) and quality service.
Appealing to all with a differentiated set of products: 2015 onwards
Most IFIs will come to realise that banking on ethics is not so much of a
differentiator when conventional institutions with a strong franchise, loyal
customer base and wider breadth of products are marketing themselves on
the same premise. In this phase, the real game changer will be when IFIs can
craft new, differentiated products that can appeal to everyone, while offering
at the same time a best-in-class product suite that can win customers over to
switch from their existing financial institutions. This step necessitates that
the previous step of competing with conventional financial institutions on
their own game is completed successfully.
To this day, there are no markets that have really reached this phase of
evolution. With the exception of Grameen microfinance, the reality is that
very little innovation actually originates out of the Muslim world.
That is not to say that the Muslim world will not innovate but that
chances are very unlikely in the near future, given the brain drain that has
occurred in the Muslim world over the past century. While Muslim societies
wait for their brain gain, they have little left of an ecosystem necessary for
innovation to occur.
However, there are many products that the Islamic finance industry could
champion from the developed world, take as their own and run with: these
products need to have a strategic fit with IFIs’ core ethos and operating
model. Right now, nothing else from the developed financial markets fits
with the underlying ethos and strategic perspective of Islamic finance, other
than products that are ethical, increase access to banking and finance services
for those who have limited access and/or aim to provide a purposeful reallo-
cation of capital from those who have it to those who need it.
New and differentiated product offerings for Islamic finance

As such, if one were to look at what could be adopted wholesale with minor
adjustments for local preferences and regulatory issues, the products are:
■■ crowdfunding for SMEs (small and medium-sized enterprises);
■■ socially responsible investments;
■■ community banking services.
All of these lend themselves to the Islamic financial services’ core ethos.
The question is whether or not IFIs – which would include banking and
non-banking institutions – can move the needle and really champion these
173
causes in a scalable manner that enables them to grow their market share
profitably.
Crowdfunding for SMEs

Many bankers in the Muslim world dismiss crowdfunding as a fringe
movement or a phenomenon to be ignored. They do so at their peril. In the
space of five years, crowdfunding has grown from a mere handful of sites
to nearly 1,000 platforms operating on every continent except Antarctica.
Experts predict that crowdfunding grew between 60 per cent and 80 per
cent in 2012 and was likely to have grown more than 100 per cent in 2013.4
Crowdfunding breaks away from the normal banking model by enabling
individuals through social networks to decide which businesses deserve
funding – and these individuals do not think like bankers. They fund the
smallest businesses, they expect success but not massive profits, and they
view creativity and innovation as positive signs rather than warning flags.
This inclusive, social justice-based innovation ethos aligns very well with
Islamic finance, which emphasises access to finance for those who need it.
Experts such as Richard Swart from the University of California, Berkeley,
suggest that the crowdfunding market will likely hit $95 billion by 2025,
and that too without considering institutional investors.5 That would
represent a similar growth trajectory to Islamic financing itself, which hit
$150 billion in assets (75 per cent of which were banking assets) in the
mid-1990s, 20 years after the Islamic Development Bank and Dubai Islamic
Bank began operations.6
Socially responsible investments

A much-touted wedding of the $1.6 trillion Islamic financial services
industry and the $3.74 trillion socially responsible investment sector has
been in the making for years, yet has not seen the light of day. With the
exception of a few fund managers such as SEDCO Capital, which uses dual
Islamic and environmental, social and governance (ESG) screening strategies
for some of its funds, the two have yet to meet on common ground and
agree upon strategies to consolidate their approach to the market to capture
the largest market share. Islamic asset and fund management lag behind
the scale of conventional socially responsible investment (SRI) funds and
hence in most cases cannot justify the higher costs to include SRI or ESG
screening. The potential for this marriage is tremendous and inevitable, yet
its occurrence will depend on concerted efforts by sharia-compliant fund
4
Swart, R. (2013) World Bank: Crowdfunding investment market to hit $93 billion by
2025. MediaShift, 10 December [online]. Available at: www.pbs.org/mediashift/2013/12/
world-bank-crowdfunding-investment-market-to-hit-93-billion-by-2025/
5
Ibid.
6
Islamic Financial Services London (2008) Islamic Finance 2008.
174
managers to court SRI fund managers and ask them to consider offering
their services to customers, and vice versa. We are already seeing trends of
this occurring, with some sharia-compliant fund managers shifting their
strategies to appeal to SRI investors also.
It is only a matter of time before IFIs figure out this might be the magic
wand to gain critical mass in the wealth segment and start courting SRI
fund managers aggressively.
Community services banking

A niche trend arising in some of the more community-oriented regions of
the United States is the advent of community service-based banking. This
approach goes against the conventional wisdom that branches need to be
scaled down in a bid to move towards more cost-effective and technology-
intensive branchless banking. Instead, community service-based banking
emphasises the role of the modern bank branch as a centre of community
rather than just banking services.
Customers are able to use the bank’s branches for a variety of community
activities, which repositions the bank as a key stakeholder in the overall
well-being of the community, akin to the role of the masjid in the early
days of Islam. These banks are not just modern versions of Bailey Building
& Loan, serving just a marginal role in the financial system. Some of the
banks embracing this approach include those with multi-billion-dollar asset
portfolios and are aggressively expanding (organically and through mergers
and acquisitions).
Instead of adopting the conventional wisdom, Islamic banks that attempt
to differentiate themselves through values of community service, something
indigenous to the Islamic conception of business, may do better in retaining
and attracting new customers.
Conclusion
Within the next few years, IFIs will be reaching a point of saturation in their
home markets. With customers becoming savvier and more demanding, it
will no longer be sufficient just to offer an ‘Islamic’ alternative, even if it is
competitive with the conventional financial industry’s offerings. IFIs need
to offer a value proposition that is fundamentally distinguished. This may
mean returning to the roots of empowering entrepreneurs, increasing access
to finance and serving as a real stakeholder in the community. However, this
time it needs to be with a fresh twenty-first-century twist.
175
THE SECRET TO LONG-TERM SUCCESS: GET THE DIRECTION OF

TRAVEL RIGHT BY FAIZAL KARBANI
You may have heard people using the analogy: it is useless running fast
if you are running in the wrong direction. I passionately believe that the
Islamic finance industry will achieve long-term success only if it is sincere to
its faith-based and ethical roots. Only then will it bring a distinctive, value-
based alternative to conventional finance. Otherwise, despite the hype, the
impressive growth potential and the lure of billions of pounds of business
from the Muslim world, the substance behind the offering will be weak and
the industry, in my view, will fail to gain credibility and ultimately will not
succeed.
The industry thus far can be likened to a child going into high school. It
has learned to talk, write, look after itself, but has been very much copying
the adults around it, namely the conventional financial institutions, in how
it conducts itself. As it transitions into high school and adulthood, it will
increasingly want to assert its own personality – it will discover its true
self and what it stands for. This emerging adult will command respect and
credibility if it is seen to be sincere to the faith and values it represents, it is
honest and transparent with those it engages with, it is seen to be benefiting
society (the overall objective of sharia), if it serves people with profession-
alism and it charges people fairly for what it offers.
Central to achieving this vision of a successful ‘adult’ and ensuring the
industry is running in the right direction are, in my view, two critical issues.
Focus on achieving the objectives of sharia

As I have mentioned already in this book, the rules and principles of the
sharia are designed to protect and enhance the interests of individuals and
society at large, as articulated by a renowned Islamic scholar, Imam Ghazali:
The very objective of the sharia is to promote the well-being of the
people, which lies in safeguarding their faith (deen), their lives (nafs), their
intellect (ñaql),their posterity (nasl), and their wealth (mal). Whatever
ensures the safeguarding of these five serves public interest and is
desirable, and whatever hurts them is against public interest and its
removal is desirable.
In my view, focusing on the objectives of sharia instead of a narrow, dogmatic
perspective of just looking at the detailed rules has a number of advantages:
■■ For Muslims – it helps them engage with and buy into the industry
and its practices; currently a lot of scepticism exists in the Muslim world
about the practices of the Islamic finance industry fuelled by practices
such as commodity murabaha that are very synthetic in nature. An
176
approach grounded in expounding the objectives of the sharia such as

investing in socially responsible investments and providing protection
through true mutuality and cooperation inspires credibility and confi-
dence in the industry.
■■ For non-Muslims – in the absence of a religious imperative to follow
the injunctions of the Qur’an and the Prophetic teachings, the narrative
of protecting and enhancing the interests of society is something that
resonates from an ethical perspective. This in turn opens up the Islamic
finance industry to a much larger audience. As the piece by Robert Van de
Weyer advocates, there is a case to be made for equity finance as opposed
to interest-based finance purely on rational grounds.
■■ Substance over form – surely ensuring the substance of transactions is
sound from an ethical point of view and meeting the noble objectives of
the sharia is more important than structuring transactions to meet the
letter of sharia law. Focusing on the objectives of sharia when coming up
with new products will ensure substance is given precedence over legal
form.
Being true and bold enough to be different

As Dr Sayd Farook’s piece has highlighted, it is fair to say many of the
products to date in the Islamic finance industry have sought to mimic the
economic effect of conventional financial instruments – examples include
commodity murabaha mimicking the economic effect of interest-bearing
loans and Islamic home purchase plans mimicking closely the economic
effect of conventional mortgages. This is understandable to some extent, as
the industry has been in its infancy, copying the ‘adults’ around it.
Furthermore, there is nothing wrong with looking to see whether there
is a sharia-compliant means of providing financial products in a way that
gives the same or similar benefits as conventional products; the problem
arises when it is done in an artificial way (as in the case of commodity
murabaha) or the transaction is so closely controlled that while in theory
the transaction exhibits certain characteristics required by the sharia, in
reality these characteristics are practically non-existent because of the way
the transaction is structured. For example, as described in Chapter 5, the
diminishing musharakah technique is widely used for home financing.
In a musharakah, both parties share in the profit and loss. Typically, in a
diminishing musharakah home finance plan, the bank protects itself from
the property falling in value by requiring the buyer to sign a legally
enforceable promise that the buyer will buy the property from the bank at
the original cost price. Hence, the bank ends up not sharing in any upside
of the property price going up but it also does not share in the downside of
177
the property price going down. Many have criticised this on the basis that
it is not faithful to the true spirit of musharakah.
In the above example, it is clear that the diminishing musharakah and
other sharia-compliant home purchase plans that have been in the market
to date have been designed to compete head-to-head with conventional
mortgages. Indeed, partly driven by banking legislation, the pricing of
these sharia-compliant products has been with reference to LIBOR (London
Interbank Offered Rate) and compared directly to conventional mortgages.
My recommendation is for product providers to come up with products
that are faithful to the sharia principles and be bold enough to bring
products that are different to the conventional space. For example, in terms
of sharia-compliant home financing, to bring a scheme that means both
parties share in the upside and the downside, the pricing in terms of rent is
not in reference to LIBOR but real rental rates, the buying of shares in the
property is not pre-ordained or forced on either party, and further shares are
sold to either party at the market price at the time of selling. Yes, this is a
very different proposition to the way the diminishing musharakah financing
scheme from Islamic banks currently works – but it is more authentic and
gives consumers a real, more flexible alternative to conventional finance.
Faced with this alternative, I can see bankers retorting that my suggestion
would contravene banking legislation in that the bank is taking on property
price risk and crossing the line of merely providing finance. But that is
exactly the point: the whole Islamic finance philosophy is anti-debt and
wants financiers to take on real asset and commercial risk in the way they
deploy their capital.
This brings me on to a related point, namely that I am an advocate of
Islamic finance expanding as much as possible outside of the banking model.
This is for two reasons:
1. The banking framework is built around the fractional reserve system. As
discussed in Chapter 3, the fractional reserve system is inextricably linked
to interest. Hence it is difficult for Islamic banks, and more so for Islamic
windows in conventional banks, to completely extricate themselves from
this system.
2. Banking regulation is biased towards interest-bearing debt-based transac-
tions (as was alluded to in the diminishing musharakah example), while
Islamic finance is biased towards equity finance and financiers taking on
real asset risk. Hence banking regulation does not naturally lend itself to
the ethos and philosophy of Islamic finance.
Instead of banks, investment houses, funds, private equity firms, venture
capital firms and cooperatives are some of the vehicles that might be more
suitable.
178
Concluding comments
I am a firm believer that if the Islamic finance industry can achieve the above
two objectives, it will set the foundation for a long-term successful future.
The industry will then present a fresh and authentic value proposition to
the world: Muslims fuelled by the religious imperative to follow their faith
will more readily buy into what the industry offers; and all human beings,
Muslims and non-Muslims, will potentially be attracted by the ethics and
values. At the very least, the industry will command respect and credibility.
All the other issues cited for the industry to develop, such as an accom-
modating regulatory framework, attracting the right amount and quality
of human capital, etc., are very important but secondary, in my view, to
the above two issues. I would compare the two issues I have highlighted to
setting the industry in the right direction – the infrastructure around this
direction will naturally build and flourish as the market expands. Yet if
the industry does not get these fundamentals right, it may fail to provide a
convincing and compelling proposition to Muslims at large and to bringing
anything new to the non-Muslim market. Indeed, the worst-case scenario,
in my view, is that Islamic finance is seen as little more than a system that
copies the economic effect of conventional transactions underpinned by
complex structures that keep to the letter of sharia law with little ethical
substance to them. If this kind of situation develops, the current hope and
buoyancy about the future of the industry will undoubtedly be replaced by
a lacklustre and disappointing performance over the next few decades.
Therefore, the challenge to product providers, regulators, sharia scholars,
academics and educators of Islamic finance and those working in the industry
is to create an environment, a culture, a mindset where the objectives of
sharia and building a distinctive, authentic value proposition are put at the
forefront. This requires vision, bravery and a commitment to the long-term
success of the industry. If this can be achieved, there is little doubt in my
mind that the Islamic finance industry can enjoy substantial, sustainable
growth for many years to come, and can occupy a credible and sustainable
long-term place within the global financial system as a real alternative to the
conventional, interest-based financial system.
179
Index
AAOIFI see Accounting and Auditing deposit accounts 118

Organization for Islamic home finance 67, 79–80
Financial Institutions (AAOIFI) savings accounts 90–1
Abu Dhabi 110, 158 alcohol and alcohol trades, prohibition
Abu Dhabi Commercial Bank (ADCB) 32, 35–6, 122
87 allocation of finance 38
Abu Hanifa (Imam) 24 allocation of risk, Christian view
acceptance in sharia-compliant contracts 168–70
49–50, 52 ambiguity see gharar (excessive
accountability to God 32–3 uncertainty/ambiguity)
Accounting and Auditing Organization angels, belief 20
for Islamic Financial Institutions AON plc 105
(AAOIFI) aqd (contract) see contracts
approval of commodity murabaha 72 Aquinas, Thomas 167
on contract combination 51–2 Arabian Gulf region 25
on guarantees 95 arbab-al-maal (owners of wealth) 64
on impermissible industries 36 arbun (non-refundable deposit) 49, 81
on istisn’a 81 artificial transactions 72
as leading self-regulatory body 53–4 asabah (residuary beneficiaries) 136
rates for financial screen 123–4 asset classes, sharia-compliant
on short selling 49 investments 117–8
on sukuk al musharakah 103 asset finance 66–7, 68–80
accounts application of ijarah 77–8
bank 64, 130 asset-backed versus asset-based sukuk
Islamic deposit 117–9 108–9
savings 90–1 asset-light sukuk 108–9
acquisition, leasing with 74–5, 77–8, assets
83–4, 105, 106 protection in trust funds 144
action, pillars of 21–2 zakatable 130–1
Adam, first human being 19 AT Kearney 10
adult entertainment, prohibition 36 Atlanticlux 105
affluence, rise of Muslim 8, 10–2
Africa, sukuk launch 111 back-to-back sales, prohibition 51
‘Against Usury’ (Van de Weyer) 166, 170 Bahrain 92, 172
agency see wakala (agency) bai al-inah (back-to-back sales) 51
agricultural produce, use of salam 84–5 bai bithaman ajil, sukuk al 106
Al Rayan Bank (formerly Islamic Bank of bai muajjal, sukuk al 106
Britain (IBB)) bank deposits 64, 119, 168–9
181
Index
Bank of International Settlements (BIS) financial screen 123, 124

39–40 subject to zakat 130
banks and banking Central Bank of Bahrain 106
community services 175 challenges for Islamic finance industry
fractional reserve model 34–5, 39–40, 13–6
178 change of mind, option 51
Islamic 7, 10 charities, estate distribution 140
liquidity 71–3, 92 charity giving see also zakat
models 168–70 obligatory 21, 32, 115
prohibition of conventional 36 voluntary 127
regulation 178 Christianity
barter, prohibition of interest 37–8 percentage of world population 8
bay al mu’ajjal (transaction with deferred view of usury 167–70
payment) 69 view on interest 37
beneficiaries commercially driven Islamic finance 27
residuary 136 commodities
trust funds 144 number of Islamic funds 118f
betting, conventional insurance 149–50 salam finance 86–8
Bible 19, 20 commodity murababa 14, 71–3, 92
on interest 37 copying interest-bearing loans 177
on usury 167 deposit accounts 119
bilateral contracts 47–51 scepticism fuelled by practice 176
blended-assets sukuk 108 community services banking 175
bonds competitive products 172–3
conventional compared with sukuk conflict of interest, sharia-compliant
100t products 27
Islamic see sukuk congregational prayer 22
prohibition of usury 170 consistency, sharia-compliant products 27
brokering services, and wakala contract construction finance
92 istisn’a 81–4
Bukhari (Imam) 92–3 projects 63–4
business assets, subject to zakat 130 contingent contracts, prohibition 51–2
business finance 63–4, 66 contracting parties 48
business partnership, into a joint venture contracts
64–6 contingent 51–2
ijarah 73–4
calculation of zakat 131 promises 52–3
Canada 116t Qur’an on 47
capital appreciation, differences between rahn 93–4
musharakah and mudarabah 68t sharia-compliant commercial 47, 53–5
capital markets, based on ijarah 80 validity 47–51
capital structure of a company 124 contractual arrangements, integrity 51–2
capitalism 31–2 conventional banking, prohibition 36
cars conventional debt ratio, financial screen
finance, based on ijarah wa iqtina 77–8 123–4
insurance 77–8, 151 conventional financial services,
leasing 75 prohibition 122
cash and cash deposits conventional insurance 36
182
Index
dominance in Muslim world 158–9 economic models 31

prohibition 36 Islamic 31–5
sharia perspective 149–50 economic principles of Christian church
crowd funding for SMEs 173–4 167
Cuba 31 Egypt 25
customers, potential Islamic finance Emirates NBD 109, 119
171–2 endowments
permanent 134
Damascus, Syria 25 takaful 155
Day of Judgement 19, 20 entertainment industries, prohibition
death, belief in accountability after 19 122
deathbed illness 144 equities
debts finance system 40
conventional, financial screen 123–4 investment 122–4
dangerous levels 39–40 subject to zakat 130
deductible for zakat 131 number of Islamic funds 118f
estate distribution 138–9 equity-type transactions 61–8
defect, option 51 Ernst & Young 10–1, 158
defence companies, prohibition 122 estates
deliverability, item or service 49 sharia-compliant distribution 133–41
deposit accounts 118–9 taxation 141–4
deposit banks 169–70 ethical investments 125
deposits, non-refundable 49, 81 existence, item or service 48–9
differentiated products 173 export/import finance, salam 86
diminishing musharakah 66–7
home finance 79, 177–8 faith see also Islam
disclosed agency 89–92 six pillars of 19–20
disposable income 16 testification 21
distribution family, inheritors 137
estates 133–41 family takaful 156–7
zakat 132–3 Farook, Dr Sayd 166
dividends, subject to zakat 130 on the future of Islamic finance 171–5
divine decree, belief 20 fasting 21
el-Diwani, Tarek 34 fatwa (opinion/certification) 26
donation, takaful 150 female versus male inheritance shares
double entity structure of takaful 152–4 139–40
Dow Jones Citigroup Islamic Bond Index financial planning
109 estate distribution 133
Dow Jones Islamic Market Index 122, Islamic wills 141–4
124 financial screen, sharia-compliant
Dubai 110 investments 122–4
Dubai International Financial Exchange financial services, conventional,
(DIFX) 109 prohibition 122
Dubai Islamic Bank (DIB) 10, 104, 174 fiqh (interpretation of Qur’an and Sunnah)
personal finance 87–8 24
five pillars of action 21–2
economic development, countries with fixed assets, subject to zakat 130
large Muslim populations 8 forced heirship, estate distribution 134
183
Index
forward contract 53 guarantee, contracts 94–5

forward leasing 75, 84, 106 Gulf Cooperation Council (GCC) 108
fractional reserve banking model sukuk growth 110
debt 39–40
inflation 40 hadith (sayings of Prophet Muhammad)
linked to interest 178 23–4
prohibition of interest 34–5 Halim, Nazneen 15
France 134 Hanafi school of thought 24–5
Friday, importance as holy day 22 Hanbal (Imam) 25
FTSE Shariah Global Equity Index 122, Hanbali school of thought 25
124 hawalah (transfer of debt) 92–3
fund management, wakala contract 92 heirship, forced 134–5
funeral expenses, estate distribution 138 hire of persons 73
fungible items, salam finance 49, 84–6, holy scriptures 19, 20
88t, 106 home finance 52–3, 66–7, 121, 177–8
futures contracts 53–4 Hong Kong 111
FWU Group 105 human capital 15–6
gambling, prohibition 32, 35–6 ijarah (leasing)

GDP, world growth rate 11t with acquisition 77–8, 83–4, 106
general takaful 156, 157 application 77–80
gharar (excessive uncertainty/ambiguity) compared with conventional leasing
bilateral contracts 48 76t
conventional insurance 36, 149–50 compared with murabaha 76–7
ijarah 74 in conjunction with istisn’a 83–4
kafalah contracts 95 contracts 73–4
prohibition 35, 41–2 forward 75, 84, 106
unilateral contracts 47 hire of persons 73
al-Ghazali, Abu Hamid (Imam) 54 home finance 67
on the sharia 15, 125, 176 investments 78–9
global debt 39–40 money market funds 119
‘Global Islamic Asset Management sukuk 102, 105, 108, 109, 120
Report 2014’ (Thomson Reuters) transfer of right to use asset 73
118 ijarah ‘ala al-ashkash (hire of persons) 73
global share in Islamic finance industry ijarah al-a’yan (transfer of right to use
6–7 asset) 73
global sukuk issuance 13f ijarah mawsoofa bil thimma (forward lease)
Global Sukuk Plus Fund 120 75, 84, 106
‘Global Takaful Insights 2013’ (Ernst & ijarah muntahia bitamleek (lease ending in
Young) 158 ownership) 74
God, belief in the one 19 ijarah wa iqtina (lease with acquisition)
gold, subject to zakat 128, 130 74–5, 77–8, 83–4, 105, 106
Gold Standard 34 Ijma (consensus of the scholars) 25
Grameen microfinance 173 illness, deathbed 144
growth immediate family as inheritors 137
Islamic finance industry 5–7 impact, assessment 32
potential 11–2 import finance, salam 86
reasons 8–13 INCIEF university 26
184
Index
income, disposable 16 sharia-compliant 115–26

Independent Commission on Banking Iran 25
170 Iraq 24–5
Indian sub-continent 24–5 Ireland 116t
indices, Islamic bond 109 Islam
Indonesia 116t, 158 belief system 19–20
industry screen, sharia-compliant importance of Qur’an and Sunnah
investments 122 22–4
inflation 40 importance to Islamic finance industry
infrastructure projects finance 63–4 7–8, 14, 19, 27–8
inheritance 131–41 interpretation of the sharia 24–5
taxation 141–3 key practices 21–2
inheritors 136–40 percentage of world population 8–9
inspection, option 51 view on wealth 31, 115
insurance Islamic assets 5
cars 77–8, 151 Islamic Bank of Britain (IBB)
conventional deposit accounts 118
dominance in Muslim world 158–9 home finance 67, 79–80
prohibition 36 savings accounts 90–1
sharia perspective 149–50 Islamic Banking Act 1983 (Malaysia) 26
ijarah compared with conventional Islamic banks 7, 10
leasing 76t Islamic bond indices 109
Islamic see takaful (insurance) Islamic bonds see sukuk
life 140 ‘Islamic commercial law: an analysis of
mutual 151 futures and options’ (Kamali)
integration of Muslim and non-Muslim 53–4
economies 8 Islamic deposit accounts 117–9
integrity, contractual arrangements 51–2 Islamic Development Bank (IDB) 163–4,
inter-bank liquidity 71–3 174
wakala for facilitating 92 blended-assets sukuk 108
interest Islamic economic model 31–5, 43
conventional insurance 150 Islamic finance
prohibition 35, 36–41, 43 challenges and opportunities 13–6,
fractional reserve banking model 163
34–5 distinguished value proposition 175,
reasons 38–41 179
the Qur’an on 7–8 future 171–5, 176
International Islamic Financial Market growing market 8–13
(IIFM) 92 growth of industry 5–7, 172
investment banks 169–70 key principles 35–42
investments reasons 7–8
differences between musharakah and recommendations for success 163–6
mudarabah 68t Islamic financial institutions (IFIs),
equity, subject to zakat 130 future 171–5
ijarah-based 78–9 Islamic Financial Services Board (IFSB)
impurities 123–4 163–6
liquid, subject to zakat 130 ‘Islamic Financial Services Industry
management in takaful 153–5 Development: Ten-Year
185
Index
Framework and Strategies’ (IDB life takaful 156–7

and IFSB) 164–6 lifetime giving 143–4
Islamic Fiqh Academy 25 lifetime trusts 144
on commodity murabaha 72 liquidity
on murabaha transactions 70 inter-bank 71–3, 92
on promises in commercial dealings 52 Muslim nations 12–3
Islamic inheritance law 136–41 loans
Islamic law see sharia conventional compared with murabaha
Islamic Research and Training Institute 70t
(IRTI) 163–6 personal, subject to zakat 131
Islamic wills 141–4 location of zakat distribution 132
ISRA government research institute 26 London Central Portfolio Ltd (LCP) 121
istisn’a (request for manufactured item) London Metals Exchange 72
48–9, 80–1 loss, risk, ijarah compared with
application 81–4 conventional leasing 76t
compared with salam 88t Luxembourg 111, 116–7
sukuk al 106–7
maintenance, ijarah compared with
Jaafar (Imam) 25 conventional leasing 76t
Jaafri school of thought 25 Malaysia
Jabir ibn Abdullah 33, 36 asset-based sukuk al-ijarah 108
Jersey 116t gaining market share 172
‘just price,’ Christian principle 167 Islamic finance industry 26–7
sharia-compliant funds 116–7
kafalah (guarantee) 94–5 sukuk growth 110
Kamali, Mohammad Hashim 53–4 takaful 150, 157, 158
Kay, John 170 zakat system 126
al-Khudri, Abu Sa’id 37 male versus female inheritance shares
Kot Addu Power Company (KAPCO) 139–40
102–3 Malik (Imam) 25
Kuwait Maliki school of thought 25
gaining market share 172 management
sharia-compliant funds 116t differences between musharakah and
zakat system 126 mudarabah 68t
investments in takaful 153–5
late payment penalties maqasid al sharia see sharia
ijarah car finance 78 marawdul maut (deathbed illness) 144
ijarah compared with conventional ‘maturity transformation’ 168
leasing 76t maysir (betting) 149–50
istisn’a 81 Mecca, Saudi Arabia 21
leasing see ijarah (leasing) Medina, Saudi Arabia 25
liabilities Meezan Bank Limited (MBL) 77–8, 102
deductible for zakat 131 mixed assets, number of Islamic funds
differences between musharakah and 118f
mudarabah 68t Mohamad, Mahathir 34
estate distribution 139 money market funds 118–9
life insurance 140 number of Islamic 118f
life interest trust will 142–3 money production
186
Index
conventional and Islamic finance 34–5 Muslims

Islamic perspective 38 focus on the objectives of the sharia
monotheistic faith, Islam 19 176–7
mortgages, prohibition of usury 170 percentage of Sunnis and Shias 24
MSCI Islamic Index 124 population growth 8–10, 16
mudarabah (profit-sharing transaction) muttawallis (trustees) 134
62–4 mutual insurance 151
differences between musharakah and
68 Nasim, Iqbal, on zakat 126–33
Islamic deposit/savings accounts National Bank of Kuwait
118–9 ijarah investment fund 79
sukuk 101, 104, 108–9 Islamic money market fund 119
takaful investment 153–5 new products, importance of sharia-
mudarib (project manager) 62–3, 64, 104, compliant 14
153 nisab (threshold) 128, 131
Muhammad, Prophet 20 non-inheritors, estate distribution 140
on accountability to God 32–3 non-Muslims
on barter 37 focus on the objectives of the sharia
on definition of nisab 128 177
on equity-type transactions 61 inheritors 139
example and teachings in the Sunnah North Korea 31
23–4
on interest 36 obligations, estate distribution 140
on Islamic inheritance 133 obligatory inheritors 136
on one-third 124 offer and acceptance, sharia-compliant
sanction of payment in advance to contracts 49–50
farmers 84 oil, wealth 10
on wealth 31, 33 Old Testament, on usury 167
Mundell, Robert 34 Oman 92
murabaha (asset finance transaction) Islamic finance industry 72
68–71, 75, 96 prohibition of murabaha 92, 119
commodity 14, 71–3, 92, 119, 176, sukuk growth 110
177 Omani Central Bank 72
compared with ijarah 76–7 one-third threshold, investment
rahn 94 impurities 124
security contracts 94, 95 OPEC (Organization of the Petroleum
sukuk al 105–6, 109 Exporting Countries) 10
musawamah (asset finance transactions) options, contracts 51
69 Organisation of the Islamic Conference
musharakah (profit and loss sharing (OIC) 25
transaction) 62, 64–8 ownership, item or service 49
application 66–7 Oxfam International 38
differences between mudarabah and 68
diminishing 66–7, 79, 177–8 Pakistan
sukuk 101, 102–3, 105, 107f, 108–9 car finance 77–8
Muslim countries sharia-compliant funds 116t
Islamic finance assets 7 sukuk al musharakah 102–3
tapping into the liquidity 12–3 waqf takaful 155
187
Index
parallel istisn’a 81 istisn’a in conjunction with ijarah

parties to a contract 48 83–4
partnership promises
co-ownership 66 sharia-compliant contracts 52–3
ijoint venture 64–6 takaful 151
payments 128–9 property
late penalties 76t, 78, 81 investment 121–2
zakat 128–9 istisn’a for development 81–4
penalties, late payment 76t, 78, 81 number of Islamic funds 118f
pensions project finance 63–4
estate distribution 140 subject to zakat 130
subject to zakat 131 prophets, belief 19–20
permanent endowments 134 public interest, protection 31–5
permissible, item or service 48
personal finance, salam 86–8 Qatar 110, 158
personal loans, deductible for zakat 131 Qatar Electricity & Water Company 84
pilgrimage to Mecca, obligatory act 21 Qatar International Islamic Bank (QIIB)
pillars of action 21–2 63–4
pillars of faith 19–20 Qatar Islamic Bank (QIB) 84, 109, 120
planning see financial planning Qiyas, hierarchical order 25
poor and needy, distribution of zakat 132 Qur’an 19, 20
pork and pork-related products, on distribution of zakat 132
prohibition 32, 35–6, 122 hierarchical order 25, 26
pornography consumption, prohibition importance of the 22–4
32 on inheritance 141
power-producing companies, sukuk al on interest 7–8, 36
musharakah 102–3 on sharia-compliant contracts 47
prayer on teachings of Prophet Muhammad
obligatory act 21–2 23
zakat 127 on wealth 33
predestination, belief 20 on zakat 127
pricing
ijarah compared with conventional rabb-ul-maal (owner of wealth) 62–3, 68t,
leasing 76t 104
option 51 investment management in takaful
uncertainty 42 153
principles of Islamic finance 35–42 rahn (to hold) contracts 93–4
products Ramadan 21–2
evolving 172–3 rapid growth markets 10–1
new offerings 173–5 Rashid, Haroon
prohibited activities on Islamic wills 141–4
commercial transactions 35 on sharia-compliant estate distribution
Islamic economic model 32 133–41
prohibition of interest 36–41 real estate projects finance 63–4
Islamic economic model 34–5 istisn’a 81–4
reasons 38–41 real service or asset 35
prohibition of uncertainty 41–2 risk incurred 42
project finance 63–4, 66 regulation 14, 178
188
Index
relatives as inheritors 137 SEDCO Capital 174

rental 73–4 settlors 134
ijarah car finance 78 Sha’afi school of thought 25
ijarah compared with conventional Shafi (Imam) 25
leasing 76t shares, subject to zakat 130
income, subject to zakat 130 sharia
residuary beneficiaries, inheritors 136 importance of authenticity 14
resources, productive use 40–1 inheritance laws 115
resurrection after death, belief 20 interpretation and meaning 24–5
retakaful 157 objectives 15, 176–7
riba (interest) 35 permitted activities 35–6
conventional insurance 150 ‘sharia- loyalist customers’ 171
debt trading 85, 93, 95 sharia supervisory boards 26–7
penalty payments 70, 78 sharia-compliant estate distribution
prohibition 36–41, 69 133–41
sukuk al salam 107 sharia-compliant products 14–5
risk copying conventional financial
Christian view on allocation 168–70 instruments 177
destruction/loss 76t importance of faith perspective 19
level under ijarah 78, 79–80 investments 115–26, 144–5
return trade-off 117f numbers of funds 7
Robertson, James 34 objectives 124–6
role of scholars in verifying 26
sadaqah (voluntary charity) 127 sharikah al-amwal (partnership by capital)
salam (sale of fungible object for full 65
payment now) 49, 80, 84–5 sharikah al-’aqd (business partnership in a
ahn 94 joint venture) 64–8
application 86–9 sharikah al-mulk (partnership of
compared with istisn’a 88t co-ownership) 64, 66
sukuk al 106–7 Sharjah Islamic Bank 64, 81–2
salat (five daily prayers), zakat 127 Shias 24–5
Saudi Arabia shirkah al-amal (partnership by work) 65
Friday as day off 22 shirkah al-wujooh (partnership by face)
gaining market share 172 65
Hanbali school of thought 25 shirkal al-amwal (partnership based on
Maliki school of thought 25 capital contribution) 66–7
sharia-compliant funds 116–7 shirkat ul aqd 102
sukuk growth 110 shirkat-ul-milk (joint ownership in
takaful 158 property) 102
savings accounts, wakala contract 90–1 short selling, prohibition 49
scale, challenge faced by Islamic finance silver, subject to zakat 130
14–5 single entity structure of takaful 151–2
scholars six pillars of faith 19–20
role in Islamic finance 26–7 socialism 31
sharia, needed 15–6 socially responsible investment (SRI)
secondary market, sukuk 109 125, 174–5
‘secular’ 172 South Africa 116t
security contracts 92–5 Spain 134
189
Index
start-ups finance 63 testification of faith, obligatory act 21

subject matter of a contract 48–9 Thomson Reuters 16, 118, 166
uncertainty 41–2 time period, uncertainty 42
sub-par products 172 timing 128–9
sukuk (Islamic bond) distribution of zakat 132
asset-based versus asset-backed 108–9 zakat payment 128–9
capital markets 80 tobacco and tobacco trades, prohibition
capital raised through 107f 35–6, 122
compared with conventional bonds Torah 19, 20
100 transactions
definition 12, 100 artificial 72
growth 12–3, 99, 110–1 asset finance-type 68–80
mechanics of transaction 101–2 equity-type 61–8
secondary market 109 istisn’a 80–4
strong future 109–11 key types 61, 95–6
types 102–7 other key 89–95
sukuk al bai bithaman ajil 106 trustees 134
sukuk al bai muajjal 106 trusts, lifetime 144
sukuk al istisn’a 106 Turkey
sukuk al mudarabah 104 Hanafi school of thought 24–5
sukuk al murabaha 105–6, 109 takaful 158
sukuk al musharakah 102–3
sukuk al salam 106–7 UAE
sukuk al wakala 104–5 gaining market share 172
sukuk al-ijarah 102, 105, 108, 109, 120 sharia-compliant funds 116t
sukuk asset class takaful 158
investment 120 UK
number of Islamic funds 118f government sukuk 105, 111
Sukuk Index (by HSBC) 109 Islamic finance assets 7
Sunnah issue of sovereign sukuk 13
hierarchical order 25, 26 sharia-compliant funds 116t
importance 22–4 testamentary freedom 135
Sunnis 24–5 uncertainty see gharar (excessive
Swart, Richard 174 uncertainty/ambiguity)
Swiss Re 158 underwriting, service provided by takaful
operator 153, 155
tabarru (donation), takaful 150 undisclosed agency 89–90
takaful (insurance) 149, 158–9 unilateral contracts 47
car insurance 77–8 uqud (contracts) see contracts
future of the industry 158 usury
Islamic insurance alternative 150–1 Christian view 167–70
models 151–5 prohibition 167–1670
types of policy 155–7
wakala contract 92 validity of contracts, key conditions
Takaful Act 1984 (Malaysia) 150 47–51
tawarruq see commodity murabaha value
taxation of estates 141–4 Islamic finance industry 5–7, 16
testamentary freedom 135 item or service 48
190
Index
Van de Weyer, Robert 166 owners see arbab-al-maal (owners of

on the Christian view of usury wealth)
167–70 pursuit, Islamic values 33–4
weapons, prohibition 122
wa’d (promise) see promises Welby, Justin 167
wakala (agency) 72, 89–92 welfare state, dictated by Islamic
Islamic deposit/savings accounts principles 32
118–9 wills
sukuk al 104–5 Islamic 135, 141–4
underwriting 153–5 life interest trust 142–3
wakil (agent) 90, 92 women, inheritance rules 134
waqfs (permanent endowments) 134
takaful 155 zakat (giving percentage of wealth to
taxation 144 charity) 32
waqif (settlor) 134 calculation 129
wasiyyah, estate distribution 140 distribution 132–3
wasiyyah (will) 135 linguistic meaning and spiritual
estate distribution 139 significance 127
Watani USD Money Market Fund 119 one of five pillars of Islam 126–7
wealth paying 128–9
distribution zakatable assets 130–1
inequality 38–9 zawil arhaam, inheritors 137
Islamic system 38–9 zawil furood 136
management 144–5 zukat, obligation 115
191

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PRAISE FOR MASTERING ISLAMIC FINANCE

‘A comprehensive introduction that demystifies Islamic finance by clearly

About the author xi

1 The Islamic finance phenomenon 3

2 Islam – key beliefs, principles and practices 17

3 How Islamic finance differs from conventional banking 29

4 Valid commercial contracts in Islamic finance 45

Status and use of promises 52

Part 2 ISLAMIC FINANCE IN PRACTICE 57

5 Key transaction types in Islamic finance 59

7 Sharia-compliant investments and wealth management 113

8 Takaful – Islamic insurance 147

Sharia perspective on conventional insurance 149

9 The future of Islamic finance 161

We are grateful to the following for permission to reproduce copyright material:

Extracts on pages 67, 79 and 90–1 from Al Rayan Bank (formerly

I am indebted to several people in helping me to write this book. My dear

of Islamic Finance to date and what he believes the industry needs to do

1. The Islamic finance phenomenon

Islamic finance is estimated to be an industry worth over a staggering $1.7

THE ISLAMIC FINANCE PHENOMENON

Figure 1.1 Global assets of Islamic finance

Share of global Islamic finance industry Figure 1.2

UK 2.3% Saudi Arabia,

Source: ‘Global Islamic Finance Report 2013’, Edbiz Consulting.

WHY DOES ISLAMIC FINANCE EXIST?

WHY IS ISLAMIC FINANCE A SIZEABLE AND

Key growth factors

Muslim population by region, 2010 and 2030 Figure 1.3

Muslim population by region

billion people, accounting for approximately 23 per cent of the world’s

Figure 1.4 Top 10 Muslim countries by population

Algeria Population - million

0 50 100 150 200 250

Rising affluence among Muslims

Ernst & Young, ‘World Islamic Banking Competitiveness Report 2012–13’.

Rapid growth markets Table 1.1

Russian Federation 5.3%

Republic of Korea 4.6%

South Africa 3.6%

Saudi Arabia 3.4%

The Ernst & Young ‘World Islamic banking competitiveness report

Table 1.2 Potential for growth

CAGR % Growth Size of % market

Qatar 31% 1.8× faster $54bn 24%

Indonesia 42% 3.1× faster $20bn 4.6%

Saudi Arabia 11% 3.6× faster $245bn 53%

Malaysia 20% 2.1× faster $125bn 20%

UAE 14% 3× faster $83bn 17%

Turkey 29% 1.6× faster $39bn 5.6%

Tapping the liquidity of Muslim nations

UKIF, ‘Islamic Finance Report – March 2012’.

Global aggregate sukuk historical trend, 1996−2013 Figure 1.5

Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.

Sukuk issuance: breakdown by country ($m, 2013 YTD) Figure 1.6

Source: ‘Islamic finance gateway’, Thomson Reuters Zawya.

KEY CHALLENGES FACING THE INDUSTRY

insurance. In both of these areas, sharia-compliant providers have struggled

Islamic finance for all

The human capital challenge

In summary, the religious imperative for Muslims to follow the teachings

To understand Islamic finance it is important also to understand a little

The six pillars of faith