Chapter 28

Islamic Finance

Holy Quran SunnaShariah - “Sacred Law”

Islamic Finance

Riba - UsuryInterest-based lending

where borrower repays more than amount borrowed to reflect

time delay in repayment

GhararExcessive uncertainty

and ambiguity about an outcome

Gambling and Insurance

HaramForbidden practices

No interestNo selling what you do

not ownNo selling of debts

Interest Prohibited

Profit and Loss SharingPermitted

Haram - Prohibited Interest

Halal - PermittedProfit and Loss Sharing

Avoid RibaNo interest elements

Null and void

Different cultures have different definitions of fairness and justice and

what is unfair and unjust

Islamic definition of fairness and justice

MoneyProfitRisk

Interest

Argument1. Can only charge rent on something that is a commodity

2. Therefore, it is unfair to charge rent on something that is not a commodity

3. Money is not a commodity.

4. Therefore money cannot be rented

5. Rent on money is called interest

6. Therefore cannot charge interest

Avoid Gharar

Gambling - Zero Sum Game

Seller should own what they intend to sell

Objectives

Maximize profit and wealth

Spread prosperity

Islamic FinanceMoney does not have

intrinsic value

Just a measure of value or medium of exchange

Islamic FinanceMust have an asset

involved in the exchange

No money for money

Participatory-type finance

Share profit and lossShare risk

Equity positionDebt position

Zakat - Religious Tax

2.5 Percent on profits

Poor, orphans, charityFinance projects

Operations

IslamicShariah - Interpreted

Non-IslamicSecular - Elected

Interest ChargingIslamic

Not allowedProfit and loss sharing

Non-IslamicAllowed

Fixed and variable

Interest on DepositsIslamic

Not allowedMay share in profits

Non-IslamicAllowed

Interest plus principal

Risk Sharing

IslamicMust share risk

Non-IslamicMay share risk

Penalty on Default

IslamicNot allowed to charge

Non-IslamicMay charge

Gharar

IslamicForbidden

Non-IslamicAllowed

Customer Relationship

IslamicPartner and Investor

Non-IslamicCreditor and Debtor

Shariah Supervision

IslamicRequires Board

Non-IslamicNo Board

Islamic Banks

Maximize shareholder wealth

Develop society

Source of Funds

ShareholdersDepositors

Deposits

Current Savings

Investment

Hiba

A non-predetermined return paid

Gift

Current Deposit Accounts

Receive funds on demandIssue checks

No guarantee of returnBank may give Hiba

Savings Deposit Accounts

WadiahMust get permission to

use for loans Bank may give Hiba

Investment Deposit AccountsMudarabah

Specific time periodProfit and loss sharing based

on predetermined ratioCould lose deposit

IslamicProfit and loss sharing system

Non Islamicinterest-based system

Equity Financing

Musharakah

Mudarabah

MusharakahPartnership

All contribute capitalProfit shared on prior agreement

Only lose invested capitalCharge a fee if manage

Project pays profit share to bankEntrepreneur pays bank capital

MudarabahPartnership

Bank contributes capitalEntrepreneur contributes work

Profit shared on prior agreementBank bears all capital losses

Asset Financing

Must own before reselling

MurabahahSalem

Ijarah Leasing

Murabahah

Bank buys the assetResells to customer

Price includes cost plus markup profit

Full disclosure transparencyCustomer pays installments or lump

sum at the end

SalemBank buys the asset today for

delivery in the future

Agriculture

Buyer responsible for delivery

Ijarah LeasingUsufruct: temporary use and enjoyment

of a property

Bank (Lessor) buys the asset and rents to client (lessee)

Client may return or receive asset at the end of the term

Sukuk - Islamic BondsRegular bonds not permitted

Interest and reselling debt prohibitedInvestor owns a proportionate

undivided share of the asset

Ownership equity position not a debt position

No guarantee or fixed return

Takaful - Islamic InsuranceDistribute losses among participants

Participants pool fundsNo insurer-insured relationship

Operator manages account fundParticipants pay premiums to create fund

Operator pays damages out of funds

Operator can charge an administrative fee

FutureDifferent views and interpretations

EvolvingNo uniform consensus

Four schools of thoughtShafi’i, Maliki, Hanafi, and Hanbali