Unit – 5 Unit 5: Emerging Issues in Finance and Financial

Management
Topic: Islamic Finance

Islamic finance
Islamic finance has the same purpose as other forms of business
finance except that it operates in accordance with the principles of
Islamic law (Sharia). The basic principles covered by Islamic finance
include:
 Sharing of profits and losses.
 No interest (riba) allowed.
 Finance is restricted to Islamically accepted
transactions. i.e. no investment in alcohol, gambling
etc.

Therefore, ethical and moral investing is encouraged. Instead of interest being

charged, returns are earned by channelling funds into an underlying investment
activity, which will earn profit. The investor is rewarded by a share in that profit,
after a management fee is deducted by the bank. The main Islamic finance
products are:
 Murabaha (trade credit)
 Ijara (lease finance)
 Sukuk (debt finance)
 Mudaraba (equity finance)
 Musharaka (venture capital)
 Salam and Istisna (forward contracts).

More details on Islamic finance

The Islamic economic model has developed over time based on the rulings of
Sharia on commercial and financial transactions. The Islamic finance framework
seen today is based on the principles developed within this model. These include:
 An emphasis on fairness such that all parties involved in a transaction can
make informed decisions without being misled or cheated. Equally reward
should be based on effort rather than for simple ownership of capital.
 The encouragement and promotion of the rights of individuals to pursue
personal economic wellbeing, but with a clear distinction between what
commercial activities are allowed and what are forbidden (for example,
transactions involving alcohol, pork related products, armaments, gambling
and other socially detrimental activities). Speculation is also prohibited (so
instruments such as options and futures are not allowed). Ethical and moral
investing is encouraged.
The strict prohibition of interest (riba). Instead interest is replaced with cash
flows from productive sources, such as returns from wealth generating
investment activities

How returns are earned

Riba is defined as the excess paid by the borrower over the original capital borrowed
i.e. the equivalent to interest on a loan. Its literal translation is 'excess'. Within the
conventional banking system, a bank get access to funds by offering interest to
depositors. It will then apply those funds by lending money, on which it charges interest.
The bank makes a profit by charging more interest on the money it lends than it pays to
its depositors.
This process is outlawed under Islamic finance. In an Islamic bank, the money provided
by depositors is not lent, but is instead channelled into an underlying investment activity,
which will earn profit. The depositor is rewarded by a share in that profit, after a
management fee is deducted by the bank. For example, in an Islamic mortgage
transaction, instead of loaning the buyer money to purchase the item, a bank might buy
the item itself from the seller, and resell it to the buyer at a profit, while allowing the
buyer to pay the bank in instalments. However, the bank's profit cannot be made explicit
and therefore there are no additional penalties for late payment. In effect, the interest is
replaced with cash flows from productive sources, such as returns from wealth
generating investment activities and operations. These include profits from trading in
real assets and cash flows from the transfer of the right to use an asset (for example,
rent).
Sharia boards (SBs)
Sharia Boards (SBs) ensure that all products and services offered by Islamic banks and
other Islamic financing institutions (IFIs) are compliant with the principles of Sharia
rules.
They review and oversee all new product offerings made by the IFIs and make
judgments on an individual case-by-case basis, regarding their acceptability with
Sharia rulings. Additionally, SBs often oversee Sharia compliant training programmes
for an IFI’s employees and participate in the preparation and approval of the IFIs'
annual reports.
SBs are normally made up of a mixture of Islamic scholars and finance experts to
ensure that fair and reasonable judgments are made. Where necessary, the finance
experts can explain the products to the Islamic scholars. The Islamic scholars often sit
on several SBs of a number of different IFIs. SBs are, in turn, supervised by the
International Association of Islamic Bankers (IAIB).
Specific Islamic financing methods
Islamic sources of finance

In Islamic Banking there are broadly 2 categories of financing techniques:

 'Fixed Income' modes of finance – murabaha, ijara,
sukuk, salam, istisna
 Equity modes of finance – mudaraba,
musharaka. Each of these is discussed in
more detail below.

Murabaha
Murabaha is a form of trade credit or loan. The key distinction between a
murabaha and a loan is that with a murabaha, the bank will take actual
constructive or physical ownership of the asset. The asset is then sold onto the
'borrower' or 'buyer' for a profit but they are allowed to pay the bank over a set
number of instalments. The period of the repayments could be extended but no
penalties or additional mark-up may be added by the bank. Early payment
discounts are not welcomed (and will not form part of the contract) although the
financier may choose (not contract) to give discounts.

Ijara
Ijara is the equivalent of lease finance; it is defined as when the use of the
underlying asset or service is transferred for consideration. Under this concept,
the Bank makes available to the customer the use of assets or equipment such
as plant, office automation, or motor vehicles for a fixed period and price. Some
of the specifications of an Ijara contact include:
 The use of the leased asset must be specified in the contract.
 The lessor (the bank) is responsible for the major maintenance of
the underlying assets (ownership costs).
 The lessee is held for maintaining the asset in good shape