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ISLAMIC FINANCE

BASICS AND OVERVIEW RAHIB JASKANI

Definitions

An Islamic Economy is an economy that is regulated by a set of rules based on outlines set by the Islamic Sharia. Sharia is the set of guidelines mentioned in the Quraan. The use of the word Economy is some what too big for these rules, they dont add up to a full economical theory but they organize some aspect of an economy such as trade manners, partnership methods, and of course money matters or in other words Islamic Financing.

Islamic Financing is a concept

Islamic Financing is a concept that emerged in scientific manners in the second half of the past century. With the expanding role that the banking system and money handling, many Muslim communities were faced with a problem over the concept of INTEREST. lIn this presentation we will look at this problem and the solutions that have evolved. Of course this is just an introduction to the topic.

Why no interest?

In Islamic Sharia, there is a straight forward and definite rule that has to be obeyed, NO RIBA. So what is Riba? Riba-defined

By definition, Riba is an Arabic word that literally means extra. In regards to Islamic Sharia, Riba means the lending of money for a specific time whereupon the lender receives his money with an EXTRA amount agreed upon.

Riba = interest

Sound familiar? It should. It was what most people in finance call interest!! This rule of no interest This rule of no interest causes some difficulties for believers. lWestern banks, which dominate world banking, are based on interest paying accounts and interest bearing loans. lBased on the rule and definition mentioned above, Moslem people must not use any of the facilities or services that the above banking system provides.

So a new form of banking methodology emerged,

Islamic Banks.
Islamic Banks do not charge or pay interest. Islamic Banks are built on relationships

Banks with no interest?


A bank that neither charges nor pays a interest is an intriguing concept. Especially if we consider the existing (and dominate) global banking system (that is interweaved with all the daily aspects of our life) is based on interest.

How do Islamic banks make money? Islamic banks rely on other methods to generate income. These methods are approved forms of Islamic Financing and are mentioned in Islamic Sharia Three forms of Islamic Financing

Modaraba (Participation Financing) Morabaha (Financing Resale of Goods) Ijara (Lease financing)

In all three methods a customer receives a commodity/product or rights and benefits. When customers deposit money with a bank, they receive it back with profit, depending upon the type of relationship. Because the relationship is based on profits it is very common to hear Islamic Banks refer to their investment

MODARABA
Modaraba (Participation Financing) falls under three categories Demand Deposits Mutual Investment Deposits Special Investment Deposits

Demand Deposits
These deposits are not restricted. They are payable on demand and do not share in any profits.

Mutual Investment Deposits


Mutual Investment Deposits are somewhat like mutual funds except that they do not invest in traded equity. An Islamic Bank will combine these deposits with the Banks money in order to participate in mutual investment transactions conducted by the bank. Under these deposits, the percentage of profit is fixed at the end of the banks financial year

Special Investment Deposits

An Islamic Bank will invest these deposits in a specific project or investment upon the request or the approval of the depositor. The depositor in this case will be entitled to receive profit and is liable for the losses, provided that the bank is not negligent or in default. At the end of the deposit period, the bank receives its share of profit against its contribution of experience and management, while the depositor receives his share of profit as a capital share contributor.

Modaraba
All these deposit transactions are based an Islamic Sharia concept called Modaraba (Participation Financing), where one party (the depositor) provides the cash and the other party (the Bank) provides the experience and management.

MORABAHA
Another form of a relationship between a customer and an Islamic bank is that of buyer and seller. This contract is known as Morabaha (Financing Resale of Goods). The bank buys goods or products from its owner directly on the request of the customer and then resells it to the customer, at a selling price higher than the purchase price. The customer then pays any consideration to the goods he purchased on an installment basis, as per an agreed repayment schedule. Similar to a installment sales in traditional Western finance

IJARA
The third method, or Ijara (leasing), requires an Islamic bank to purchase equipment and lease them to the customer for a specific period of time. At the end, in most cases, the Bank will transfer the title to the customer either by executing a sale agreement for a normal value or by way of donations.

Ijara = leasing
More specifically, Ijara (Lease) is an agreement whereby the bank (the Lessor) conveys to the customer (the Lessee), in return for a specific rent, the right to use a specific asset for a specific period of time.

Ijara = leasing
Under this contract, the bank (Lessor) purchases the asset and rents it to the customer (Lessee). The contract specifies the leasing party and the amount and timing of rent payment and responsibilities of both parties during the period of the lease. The Lessee provides the bank with an undertaking to settle the rental amount as per the agreed schedule Of course just because we are dealing with Islamic Finance, it does not change the regular rules that govern leases. For example under this financing method there are two types of lease, the Finance Lease and the Operating Lease

Finance Lease
A lease is classified as a Finance Lease if it ends with the transfer of ownership of the property to the Lessee. Finance leases have to be capitalized and are also called capital leases.

Operating Lease
The Operating Lease does not provide for the transfer of ownership at the end of the lease term, which is normally for a short period of time, and rentals are calculated on the basis of the usage of the assets to provide for wear and tear plus profit.

Socially responsibility
It is important to note that the bank must be satisfied with the nature of the usage of the leased assets, as their use must be permitted under Sharia. For example, an Islamic Bank would not allow an asset to be used in producing a product such as alcohol drinks. This aspect of social responsibility also plays a key role in investments.

Ulama = Expert
Since Islamic Banking can be rather complex, Sharia principles are governed by Islamic experts or Ulama. It is always essential to obtain the approval of the Sharia advisor of the bank on the forms of the financing contracts, in order to ensure their compliance with the principles of Islamic Sharia.

Islamic Finance is growing in importance


Any of you who read the Financial Professor newsletter, as youd better do, you must have noticed an item regarding Islamic financing, and this item is the following:

The Central Banks of 8 Islamic countries have agreed to have a common regulator that will oversee financial institutions in all of the nations in an effort to improve accountability and transparency. This could be huge. While Islamic financing (which is based on both religious teachings and business incentives), is still a small segment of the market, it is growing rapidly and the standardization can only be good for further growth.