The basics of Islamic banking and finance

A financial system based on principles of trust, ethics and partnership can become a partner in the development of your business.

The Islamic banking and finance industry has developed from what was once a niche exotic product to take its place as part of the mainstream in a matter of just 40 years. Naturally the curiosity associated with this alternative financial system has also intensified. In this article, we explain its basics.

Islamic banking and finance is intended to serve the same underlying purpose as any other conventional bank or financial institution: to intermediate funds from those who have capital (capital rich) to those who need it (capital deficient). However, as the saying goes, 'God is in the details'.

To put it simply, 'Islamic banking' refers to a system of banking that is consistent with the principles of Islamic law (sharia) and guided by an Islamic perspective on economics. Common with the three Abrahamic faiths, the principal prohibition relates to the giving or taking of interest (usury or riba). Other elements include avoiding investments in businesses that are considered unlawful or harmful to society (e.g. businesses dealing with alcohol, pork, gambling), avoidable ambiguity or uncertainty in the provisions of contracts.

Because a fixed or variable rate of interest on a loan is not allowed, Islamic financial institutions support companies and individuals in need of financing either through selling them the required equipment or property on a deferred installment basis, or by entering into some form of profit and loss sharing partnership. We define some of the key products used by Islamic banks below:

Funding the purchase of inventory or assets (such as trade finance): Islamic banks use themurabaha (mark-up or cost-plus) product to help companies purchase inventory or assets. Upon receiving a request from the customer, the Islamic bank will purchase the products or inventory from the supplier and then sell to the customer at a margin above cost, payable in specified installments in the future. The key difference here between Islamic finance and conventional bank lending is that the financing is always linked to the sale of an asset and the amount payable never increases beyond the amount agreed, as the cost plus price.

Expansion of business enterprise: When a company wants to expand its business (without necessarily purchasing a specified asset or inventory), Islamic banks help it grow by partnering with it on a profit and loss sharing basis. Two principle contracts are used, both of which are derivatives of a core partnership principles. In the musharaka financing approach, both the Islamic bank and the customer provide some contribution (cash or in kind) to the project. They then share profits according to whatever formula they agree upon and share losses according to their contribution. The mudaraba contract is similar, only that the bank is the sole contributor of capital, while the customer manages the investment project to receive a profit share as investment manager.

Assisting in purchase of homes: When customers want to purchase homes, Islamic banks can assist them with a 'lease-to-own' product under the general family of 'lease' or ijara instruments. After the customer has identified the house he wants to purchase and the necessary credit checks are completed, the Islamic bank will purchase the house in the bank's name, then lease it to the customer for a defined period of time. Upon the fulfillment of certain conditions (such as the payment of all rental payments), the Islamic bank will sell the house to the customer either for a token amount or based on a pre-agreed price.

From some of these examples, one may wonder what the real distinctions are between Islamic finance and conventional finance. Upon careful examination, you will notice that in each of these examples, the customer never just receives money that he would have to return with an additional amount of interest. Instead, all of the financing is either linked to the sale of asset, partnership in a project or the purchase and lease of an asset.

Hence, one of the key differences between Islamic finance and conventional finance is that sharia-based banking is tightly linked to the real economy. This means that all financing transactions are asset-based or asset-backed, manufacturing or producing real, tangible assets. One of the reasons why this industry was semi-impervious to the financial crisis was due to the requirement of asset-linkage to any sale or lease contracts. This concept of asset-backed transactions protects the financial rights of the institutions as the real asset is always present as collateral, and in most cases covers the financing transaction's obligations toward the parties involved.

Since most of the products of Islamic finance involve asset-based financing, direct investment or partnerships, there is a natural fit between Islamic finance and SME needs.

(Zawya / 06 March 2013)

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Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com