PRAISE FOR MASTERING ISLAMIC FINANCE

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

Edinburgh GateHarlow CM20 2JEUnited KingdomTel: +44 (0)1279 623623Web: www.pearson.com/uk

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.

Pearson Education is not responsible for the content of third-party internet sites.

ISBN: 978–1-292–00144–9 (print) 978–1-292–00146–3 (PDF) 978–1-292–00145–6 (ePub) 978–1-292–00817–2 (eText)

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10 9 8 7 6 5 4 3 2 119 18 17 16 15

Print edition typeset in 11.5pt Garamond by 3Print edition printed in Great Britain by Henry Ling Ltd, at the Dorset Press, Dorchester, Dorset

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.

vii

Contents

About the author xi

Publisher’s acknowledgements xii

Author’s acknowledgements xiii

Part 1 BACKGROUND 1

1 The Islamic finance phenomenon 3Introduction 5The Islamic finance phenomenon 5Why does Islamic finance exist? 7Why is Islamic finance a sizeable and growing market? 8Key challenges facing the industry 13Conclusion 16

2 Islam – key beliefs, principles and practices 17Introduction 19Belief system 19Key practices – the five pillars of action 21Importance of the Qur’an and the Sunnah 22Interpretation of the sharia 24The role of scholars and sharia supervisory boards in Islamic finance 26Conclusion 27

3 How Islamic finance differs from conventional banking 29The Islamic economic model 31Key Islamic finance principles 35Conclusion 43

4 Valid commercial contracts in Islamic finance 45Introduction 47Key conditions for validity of contracts 47Integrity of contractual arrangements 51

viii

Contents

Status and use of promises 52Conclusion 53

Part 2 ISLAMIC FINANCE IN PRACTICE 57

5 Key transaction types in Islamic finance 59Introduction 61Equity-type: transactions 61Mudarabah (Partnership – one party contributes capital) 62Musharakah (Partnership – all parties contribute capital) 64Asset finance: 68

Murabaha (Sale of an asset at a known profit mark-up) 68Ijarah (Leasing of an asset) 77Istisn’a (Sale of an item to be constructed or manufactured) 80Salam (Sale of fungible item yet to be produced) 84

Other key transaction types: 89Wakala (Agent providing services to a Principal) 89Hawalah (Transferring a debt) 92Rahn (Providing security) 93Kafalah (Providing a guarantee) 94

Conclusion 95

6 Sukuk 97Introduction 99Definition 100Mechanics of a sukuk transaction 101Types of sukuk 102Asset-based versus asset-backed sukuk 108Sukuk and the secondary market 109A strong future for sukuk 109Conclusion 111

7 Sharia-compliant investments and wealth management 113Introduction 115Sharia-compliant investments 115Zakat by Iqbal Nasim 126Sharia-compliant estate distribution and Islamic wills by Haroon Rashid 133Conclusion 144

8 Takaful – Islamic insurance 147Introduction 149

ix

Contents

Sharia perspective on conventional insurance 149Takaful – the Islamic alternative 150Takaful models 151Types of takaful policy 155The future of the takaful industry 158Conclusion 158

9 The future of Islamic finance 161Introduction 163Recommendations for success by IFSB and IDB/IRTI 163Opinion pieces 166The Christian view of usury by Robert Van de Weyer 167The future of Islamic finance by Dr Sayd Farook 171The secret to long-term success: get the direction of travel right by Faizal Karbani 176

Index 181

xi

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.

xii

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.

xiii

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

xiv

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.

Part

1BACKGROUND

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

1The 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

5

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’.


6

Global assets of Islamic financeFigure 1.1

2006

18001600140012001000800600400200

0

509

2007

$ Bn, assets end-year

677

2008

861

2009

933

2010

1130

2011

1289

2012

1631

2013

1700

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’.


7

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:

Share of global Islamic finance industry Figure 1.2

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

Bangladesh, 1.0%

Indonesia, 1.3%

Egypt, 1.3%

UK 2.3%

Turkey 2.5%

Qatar 4.2%

Bahrain, 4.4%

Kuwait, 46.3%

UAE, 7.4%Malaysia, 9.5%

Saudi Arabia,9.5%

Iran,25.5%

Others, 21.2%


8

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


9

Muslim population by region, 2010 and 2030 Figure 1.3

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.

WorldAsia-PacificMiddle East-North AfricaSub-Saharan AfricaEuropeAmericas

1,619,214,0001,005,507,000

321,869,000247,544,00044,138,0005,256,000

Estimated Muslim

population

Population estimates are rounded to thousands. Percentages are calculated from unrounded numbers.Figures may not add exactly due to rounding

ProjectedMuslim

population

Estimated percentage

of globalMuslim

population

Projectedpercentage

of globalMuslim

population

2,190,154,0001,295,625,000

439,453,000385,939,00058,209,00010,927,000

100%62.119.915.02.70.3

100%59.220.117.62.70.5

2010

Muslim population by region

2030


10

Top 10 Muslim countries by population Figure 1.4

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

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

0 50 100 150 200 250

Morocco

Algeria

Turkey

Iran

Nigeria

Egypt

Bangladesh

India

Pakistan

Indonesia

Population - million


11

Rapid growth markets

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%

Table 1.1

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


12

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

10 UKIF, ‘Islamic Finance Report – March 2012’.

Potential for growth

CAGR % of Islamic finance – 5 years (2008–12)

Growth rate vs. conventional finance

Size of Islamic assets $bn

% market share of Islamic finance

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%

Table 1.2


13

Global aggregate sukuk historical trend, 1996−2013 Figure 1.5

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTDMay2013

160

140

120

100

80

60

40

20

0

Amount issued

$ Billion # Issues

Number of issues

213

800

700

600

500

400

300

200

100

0

581

572

425

253230

183150

188

115

495541474012

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.

33,869

7,274

5,166

2,5891,756

Malaysia

Saudi Arabia

UAE

Indonesia

Turkey

Bahrain

Pakistan

Brunei Darussalam

Other

– 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.


14

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/


15

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.


16

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.

2Islam – 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

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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


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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.

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.

Six pillars of beliefFigure 2.1

Belief inone God

Belief inthe prophets

of God

Belief inthe holy

scriptures

Belief inthe Day ofJudgement

Belief inthe angels

Belief inthe Divine

Decree


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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

Testificationof faith

Five dailyprayers

Fasting in Ramadan

Payingcharityyearly

Pilgrimage to Mecca


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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’anThe 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


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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 SunnahThe 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


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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’.


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■ 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.


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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).


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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.


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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.

3How Islamic finance differs from

conventional banking

The Islamic economic model

Key Islamic finance principles

Conclusion

3 · How Islamic finance differs from conventional banking

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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


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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


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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’


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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


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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 shariaThere 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


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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.


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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:


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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.


39

■ 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

Q1’01Q3’01

Q1’02Q3’02

Q1’03Q3’03

Q1’04Q3’04

Q1’05Q3’05

Q1’06Q3’06

Q1’07Q3’07

Q1’08Q3’08

Q1’09Q3’09

Q1’10Q3’10

Q1’11Q3’11

Q1’12Q3’12

Q1’13

110

100

90

80

70

60

50

40

30

20

10

0

Total

Government

Financial corporations

Non-financial corporations


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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

2 Source: Evans-Pritchard, A. (2014) BIS chief fears fresh Lehman from worldwide debt surge. The Telegraph, 14 July.


41

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


42

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.


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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.

4Valid 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

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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.


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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


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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


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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.


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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:


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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.


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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


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(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


55

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).

Part

2ISLAMIC FINANCE IN

PRACTICE

5. Key transaction types in Islamic finance

6. Sukuk7. Sharia-compliant investments and wealth

management

8. Takaful – Islamic insurance

9. The future of Islamic finance

5Key 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

61

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.


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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.


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■ 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 mudarabahBusiness 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

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

Example


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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.

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

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

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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.


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■ 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 musharakahBefore 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 musharakahThe 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.


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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 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/

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Differences between musharakah and mudarabahAt this juncture, it is worthwhile summarising the differences between these two equity-based sharia-compliant modes of finance – see Table 5.1.

The differences between mudarabah and musharakah

Mudarabah Musharakah

Investment From rabb-ul-maal (‘owner of wealth’ or passive investor)

All parties contribute

Management Rabb-ul-maal has no right to contribute to management

All partners can participate in the management

Capital appreciation While profits are shared, all capital appreciation of the investment goes to the rabb-ul-maal

All partners benefit from the capital appreciation of the investment

Liability Rabb-ul-maal is liable to the extent of his investment and bears financial loss, mudarib loses his efforts

All partners bear losses proportionate to their respective capital contributions

Table 5.1

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.

MurabahaKey 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


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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 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

Example


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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:

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.


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■ 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 murabahaThe 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:

Comparison of a murabaha transaction with a conventional loan

Murabaha Conventional loan

Underlying transaction

Sale of real asset, where seller (e.g. bank) must have actual ownership

Money for money transaction, bank does not need to take ownership of any asset

Late payment Financier cannot benefit from any late payment penalty

Usual feature – lender stands to benefit from any late penalty charges

Early repayment

Seller not obliged to give any discounts and should not be in sales contract – can give early payment discounts out of discretion

Usual feature of loan contracts – early payment terms are stipulated

Table 5.2


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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.

IjarahThe 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


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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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Comparing murabaha to ijarahWe 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

Potential differences between ijarah contracts and conventional leasing contracts

Conventional Ijarah

Rental payments Contract can stipulate rental payments for periods even when asset is not useable

Can only relate to period of use by lesseeNo payment due if asset is not useable

Risk of destruction/loss

Often transferred to lessee

Remains with lessor, except in the case of negligence or misuse by the lessee

Insurance and major maintenance

Often on the lessee Has to be on the lessor

Pricing Variable or fixed Variable or fixed (first rental has to be fixed)

Penalty for late payment

Yes If enforced, has to be paid out in charity less directly related debt-recovery costs

Table 5.3

A comparison between murabaha and ijarah

Murabaha Ijarah

Financier will usually require client to make a prior promise to purchase

Lessee often not required to make 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 the contract

Ownership may be transferred later if ijarah wa iqtina

Table 5.4


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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 ijarahAsset 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 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.

Example


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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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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).

The National Bank of Kuwait (NBK) provides investors with an ijarah 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.

Source: www.kuwait.nbk.com

Example

National Bank of Kuwait’s ijarah investment fund – how the bank depicts its risk level

Figure 5.1

High

Low


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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’aIstisn’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’aFinance 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 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

ExampleExample


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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.

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.

Example


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Project financing – istisn’a used in conjunction with ijarahSo 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

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


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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.

SalamSalam 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.


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■ 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.

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 financeHere 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.

Example


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Personal financeSalam 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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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.

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 comparison between istisn’a and salam

Istisn’a Salam

Applies to assets that are to be either constructed or manufactured

Applies to fungible items such as base metals, agricultural produce and commodities such as sugar and oil

The contract is very flexible in terms of payment timing – can be upfront, phased, at the time of delivery or post-delivery

Payment must be made in full at the beginning of the contract

A maximum time frame can be set for the asset construction/manufacture and delivery

The delivery time is fixed

The contract can be cancelled only before the work starts

The contract cannot be cancelled

Table 5.5

We have now discussed six very important transaction types:

Equity-type transactions:

1. Musharakah.

2. Mudarabah.

Asset finance:

3. Murabaha.

4. Ijarah.


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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

WakalaWakala 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


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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 wakalaThere 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.


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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.

HawalahThis 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.

RahnRahn 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


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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.

KafalahKafalah 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


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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.

6Sukuk

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

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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.

A comparison between sukuk and conventional bonds

Sukuk Conventional bonds

Sukuk holders invest in ownership of an asset or project

Bond holders essentially provide an interest-bearing loan

Return is based on the performance of the asset or project owned by investors

Return is interest, determined at the outset and not linked to the performance of any asset or investment

Sukuk holders, as beneficial owners of an asset/project, bear any losses generated by those assets/projects (to the extent of their ownership)

Bond holders are not exposed to losses borne by the bond issuer in the use of funds raised by the bond issue

Maturity of sukuk corresponds to an underlying project or activity

Bond term not necessarily linked to any underlying activity of bond issuer

Sukuk issue subject to sharia rules (e.g. sukuk proceeds must be used for sharia-compliant purposes)

Bond issues not impacted by sharia rules

Table 6.1

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MECHANICS OF A SUKUK TRANSACTION

Figure 6.1 illustrates the mechanics of a typical sukuk transaction.

A typical sukuk transaction Figure 6.1

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.

Arranger managessukuk issueprocess

Obligor raises finance byissuing a sukuk through a SPV

The relationship between theObligor and SPV can bestructured in a number ofdifferent ways e.g. musharakamudarabah, ijarah, salam, istisn'a

Obligor

Party raisingfinance

SPV

Representingthe sukukholders

Manager managesthe SPV on behalfof the sukuk holders


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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 musharakahThe 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.

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).

Example

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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.

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.

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.

Two-tier profit-sharing structure Figure 6.2

6-monthmusharakah

Capital contributionin kind, through partownership ofgeneration unit

Cash contributionsukuk issueproceeds

Profit/Loss

Share

Profit/Loss

Share

KAPCO

SPV

Representingsukuk holders

Generationunit


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Sukuk al mudarabahThe 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.

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.

Example

Sukuk al wakalaIn 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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In October 2013, FWU Group, a German financial services firm, issued a $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-ijarahTypically, 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.)

4 Retakaful is the mechanism by which takaful entities (Islamic insurance entities) mutually cover 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.

Example


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Sukuk al murabahaThe 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’aThe 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 salamThe 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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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

5 Thomson Reuters Zawya, ‘Sukuk Perceptions and Forecast Study 2014’.

Capital raised through the main sukuk structures, January 2010 to September 2013

Figure 6.3

23%

15%

41%

12%

3%

4%

1%1%

Sukuk al liara

Sukuk al musharakah/bai bithaman ajil

Sukuk al musharakah

Sukuk al mudaraba

Sukuk al wakala

Sukuk al istisn'a

Sukuk al salam

Others


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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

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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


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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.

Global aggregate sukuk historical trend, 1996–2013 Figure 6.4

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.

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTDMay

2013

160

140

120

100

80

60

40

20

0

Amount issued

$ Billion No. of Issues

Number of issues

213

800

700

600

500

400

300

200

100

0

581

572

425

253230

183150

188

115

495541474012

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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.

7Sharia-compliant investments and

wealth management

Introduction

Sharia-compliant investments

Zakat by Iqbal Nasim

Sharia-compliant estate distribution and Islamic wills by Haroon Rashid

Conclusion

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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’.


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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.

Number of sharia-compliant funds globally, 2007–13 Figure 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

Table 7.1

1200

1000

800

600

400

200

02007 2008 2009 2010 2011 2012 2013

No. of funds

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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

2 Thomson Reuters, ‘Global Asset Management Report 2014’.

Risk and return trade-off across different asset classes Figure 7.2

Privateequity

Gen

eral

ly in

crea

sing

risk

Generally greater potential return

Equity andcommodity funds

Property funds

Sukuk funds

Cash, deposit accounts andmoney market funds


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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.

Number of funds available in each asset class, 2013 Figure 7.3

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.

Equity

Sukuk

Money market

Property

Commodity

Mixed assets

Other

2%

3%

1%

51%

15%

12%

16%

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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 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.

Example

The second example is from National Bank of Kuwait. Again this is an 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.

Example


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SukukAs 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 yearsSecurity: First legal charge over the portfolioLeverage to refurbished value: Up to 50%Profit rate cover ratio: 135% at all timesProfit 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

5 Investment Memorandum for investment into London Central Apartments II Limited, 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 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.

Example


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Distributing zakatTo 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).

The three main types of inheritors under Islamic law Figure 7.4

Zawil furoodThe 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).

AsabahThe 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

Zawil Furood

Asabah

Zawil Arhaam

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deceased’s father, failing which his grandfather, brother, paternal uncles and then paternal nephews.

Zawil arhaamIn 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.


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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

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.

Example

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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. WasiyyahAs 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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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.

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.

Example

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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.

Where the same Muslim woman passes away leaving behind husband, children 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.

Example


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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.

8Takaful – 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

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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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RibaIn 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.


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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.

Takaful models: single entity structure versus double entity structureFigure 8.1

SINGLE ENTITY STRUCTURE

TAKAFUL POOL

Non-profit-making entity

Monies in the pool belong to members

DOUBLE ENTITY STRUCTURE

TAKAFUL POOL

Non-profit-making entity

Managed by board appointed by takaful members

Monies in the pool belong to members

TAKAFUL OPERATOR

A commercial entity engaged by the takaful members to manage the takaful pool’s underwriting activities and possibly investments too

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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.


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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.

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Use of the waqf (endowment) concept in takafulA 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.


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General takafulGeneral 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 takafulTakaful 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

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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.

RetakafulAs 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.

Takaful Malaysia is a leading takaful provider in Malaysia. It provides 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.

Example

The retakaful pool Figure 8.2

RETAKAFUL POOL

Members are other takaful pools, often represented by the takaful operators of

those pools


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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.

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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.

9The 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

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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.


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(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’.


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The 16 Mid-Term Review recommendations

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.

Table 9.1


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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.


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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.


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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


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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


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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).


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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:64165026~theSitePK:469372~isCURL:Y,00.html


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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.


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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


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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.


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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.


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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 shariaAs 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


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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


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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.


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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.

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Index

AAOIFI see Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

Abu Dhabi 110, 158Abu Dhabi Commercial Bank (ADCB)

87Abu Hanifa (Imam) 24acceptance in sharia-compliant contracts

49–50, 52accountability to God 32–3Accounting and Auditing Organization

for Islamic Financial Institutions (AAOIFI)

approval of commodity murabaha 72on contract combination 51–2on guarantees 95on impermissible industries 36on istisn’a 81as leading self-regulatory body 53–4rates for financial screen 123–4on short selling 49on sukuk al musharakah 103

accountsbank 64, 130Islamic deposit 117–9savings 90–1

acquisition, leasing with 74–5, 77–8, 83–4, 105, 106

action, pillars of 21–2Adam, first human being 19adult entertainment, prohibition 36affluence, rise of Muslim 8, 10–2Africa, sukuk launch 111‘Against Usury’ (Van de Weyer) 166, 170agency see wakala (agency)agricultural produce, use of salam 84–5Al Rayan Bank (formerly Islamic Bank of

Britain (IBB))

deposit accounts 118home finance 67, 79–80savings accounts 90–1

alcohol and alcohol trades, prohibition 32, 35–6, 122

allocation of finance 38allocation of risk, Christian view

168–70ambiguity see gharar (excessive

uncertainty/ambiguity)angels, belief 20AON plc 105aqd (contract) see contractsAquinas, Thomas 167Arabian Gulf region 25arbab-al-maal (owners of wealth) 64arbun (non-refundable deposit) 49, 81artificial transactions 72asabah (residuary beneficiaries) 136asset classes, sharia-compliant

investments 117–8asset finance 66–7, 68–80

application of ijarah 77–8asset-backed versus asset-based sukuk

108–9asset-light sukuk 108–9assets

protection in trust funds 144zakatable 130–1

AT Kearney 10Atlanticlux 105

back-to-back sales, prohibition 51Bahrain 92, 172bai al-inah (back-to-back sales) 51bai bithaman ajil, sukuk al 106bai muajjal, sukuk al 106bank deposits 64, 119, 168–9

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Index

Bank of International Settlements (BIS) 39–40

banks and bankingcommunity services 175fractional reserve model 34–5, 39–40,

178Islamic 7, 10liquidity 71–3, 92models 168–70prohibition of conventional 36regulation 178

barter, prohibition of interest 37–8bay al mu’ajjal (transaction with deferred

payment) 69beneficiaries

residuary 136trust funds 144

betting, conventional insurance 149–50Bible 19, 20

on interest 37on usury 167

bilateral contracts 47–51blended-assets sukuk 108bonds

conventional compared with sukuk 100t

Islamic see sukukprohibition of usury 170

brokering services, and wakala contract 92

Bukhari (Imam) 92–3business assets, subject to zakat 130business finance 63–4, 66business partnership, into a joint venture

64–6

calculation of zakat 131Canada 116tcapital appreciation, differences between

musharakah and mudarabah 68tcapital markets, based on ijarah 80capital structure of a company 124capitalism 31–2cars

finance, based on ijarah wa iqtina 77–8insurance 77–8, 151leasing 75

cash and cash deposits

financial screen 123, 124subject to zakat 130

Central Bank of Bahrain 106challenges for Islamic finance industry

13–6change of mind, option 51charities, estate distribution 140charity giving see also zakat

obligatory 21, 32, 115voluntary 127

Christianitypercentage of world population 8view of usury 167–70view on interest 37

commercially driven Islamic finance 27commodities

number of Islamic funds 118fsalam finance 86–8

commodity murababa 14, 71–3, 92copying interest-bearing loans 177deposit accounts 119scepticism fuelled by practice 176

community services banking 175competitive products 172–3conflict of interest, sharia-compliant

products 27congregational prayer 22consistency, sharia-compliant products 27construction finance

istisn’a 81–4projects 63–4

contingent contracts, prohibition 51–2contracting parties 48contracts

contingent 51–2ijarah 73–4promises 52–3Qur’an on 47rahn 93–4sharia-compliant commercial 47, 53–5validity 47–51

contractual arrangements, integrity 51–2conventional banking, prohibition 36conventional debt ratio, financial screen

123–4conventional financial services,

prohibition 122conventional insurance 36

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Index

dominance in Muslim world 158–9prohibition 36sharia perspective 149–50

crowd funding for SMEs 173–4Cuba 31customers, potential Islamic finance

171–2

Damascus, Syria 25Day of Judgement 19, 20death, belief in accountability after 19deathbed illness 144debts

conventional, financial screen 123–4dangerous levels 39–40deductible for zakat 131estate distribution 138–9

defect, option 51defence companies, prohibition 122deliverability, item or service 49deposit accounts 118–9deposit banks 169–70deposits, non-refundable 49, 81differentiated products 173diminishing musharakah 66–7

home finance 79, 177–8disclosed agency 89–92disposable income 16distribution

estates 133–41zakat 132–3

dividends, subject to zakat 130divine decree, belief 20el-Diwani, Tarek 34donation, takaful 150double entity structure of takaful 152–4Dow Jones Citigroup Islamic Bond Index

109Dow Jones Islamic Market Index 122,

124Dubai 110Dubai International Financial Exchange

(DIFX) 109Dubai Islamic Bank (DIB) 10, 104, 174

personal finance 87–8

economic development, countries with large Muslim populations 8

economic models 31Islamic 31–5

economic principles of Christian church 167

Egypt 25Emirates NBD 109, 119endowments

permanent 134takaful 155

entertainment industries, prohibition 122

equitiesfinance system 40investment 122–4

subject to zakat 130number of Islamic funds 118f

equity-type transactions 61–8Ernst & Young 10–1, 158estates

sharia-compliant distribution 133–41taxation 141–4

ethical investments 125existence, item or service 48–9export/import finance, salam 86

faith see also Islamsix pillars of 19–20testification 21

family, inheritors 137family takaful 156–7Farook, Dr Sayd 166

on the future of Islamic finance 171–5fasting 21fatwa (opinion/certification) 26female versus male inheritance shares

139–40financial planning

estate distribution 133Islamic wills 141–4

financial screen, sharia-compliant investments 122–4

financial services, conventional, prohibition 122

fiqh (interpretation of Qur’an and Sunnah) 24

five pillars of action 21–2fixed assets, subject to zakat 130forced heirship, estate distribution 134

184

Index

forward contract 53forward leasing 75, 84, 106fractional reserve banking model

debt 39–40inflation 40linked to interest 178prohibition of interest 34–5

France 134Friday, importance as holy day 22FTSE Shariah Global Equity Index 122,

124fund management, wakala contract 92funeral expenses, estate distribution 138fungible items, salam finance 49, 84–6,

88t, 106futures contracts 53–4FWU Group 105

gambling, prohibition 32, 35–6GDP, world growth rate 11tgeneral takaful 156, 157gharar (excessive uncertainty/ambiguity)

bilateral contracts 48conventional insurance 36, 149–50ijarah 74kafalah contracts 95prohibition 35, 41–2unilateral contracts 47

al-Ghazali, Abu Hamid (Imam) 54on the sharia 15, 125, 176

global debt 39–40‘Global Islamic Asset Management

Report 2014’ (Thomson Reuters) 118

global share in Islamic finance industry 6–7

global sukuk issuance 13fGlobal Sukuk Plus Fund 120‘Global Takaful Insights 2013’ (Ernst &

Young) 158God, belief in the one 19gold, subject to zakat 128, 130Gold Standard 34Grameen microfinance 173growth

Islamic finance industry 5–7potential 11–2reasons 8–13

guarantee, contracts 94–5Gulf Cooperation Council (GCC) 108

sukuk growth 110

hadith (sayings of Prophet Muhammad) 23–4

Halim, Nazneen 15Hanafi school of thought 24–5Hanbal (Imam) 25Hanbali school of thought 25hawalah (transfer of debt) 92–3heirship, forced 134–5hire of persons 73holy scriptures 19, 20home finance 52–3, 66–7, 121, 177–8Hong Kong 111human capital 15–6

ijarah (leasing)with acquisition 77–8, 83–4, 106application 77–80compared with conventional leasing

76tcompared with murabaha 76–7in conjunction with istisn’a 83–4contracts 73–4forward 75, 84, 106hire of persons 73home finance 67investments 78–9money market funds 119sukuk 102, 105, 108, 109, 120transfer of right to use asset 73

ijarah ‘ala al-ashkash (hire of persons) 73ijarah al-a’yan (transfer of right to use

asset) 73ijarah mawsoofa bil thimma (forward lease)

75, 84, 106ijarah muntahia bitamleek (lease ending in

ownership) 74ijarah wa iqtina (lease with acquisition)

74–5, 77–8, 83–4, 105, 106Ijma (consensus of the scholars) 25illness, deathbed 144immediate family as inheritors 137impact, assessment 32import finance, salam 86INCIEF university 26

185

Index

income, disposable 16Independent Commission on Banking

170Indian sub-continent 24–5indices, Islamic bond 109Indonesia 116t, 158industry screen, sharia-compliant

investments 122inflation 40infrastructure projects finance 63–4inheritance 131–41

taxation 141–3inheritors 136–40inspection, option 51insurance

cars 77–8, 151conventional

dominance in Muslim world 158–9prohibition 36sharia perspective 149–50

ijarah compared with conventional leasing 76t

Islamic see takaful (insurance)life 140mutual 151

integration of Muslim and non-Muslim economies 8

integrity, contractual arrangements 51–2inter-bank liquidity 71–3

wakala for facilitating 92interest

conventional insurance 150prohibition 35, 36–41, 43

fractional reserve banking model 34–5

reasons 38–41the Qur’an on 7–8

International Islamic Financial Market (IIFM) 92

investment banks 169–70investments

differences between musharakah and mudarabah 68t

equity, subject to zakat 130ijarah-based 78–9impurities 123–4liquid, subject to zakat 130management in takaful 153–5

sharia-compliant 115–26Iran 25Iraq 24–5Ireland 116tIslam

belief system 19–20importance of Qur’an and Sunnah

22–4importance to Islamic finance industry

7–8, 14, 19, 27–8interpretation of the sharia 24–5key practices 21–2percentage of world population 8–9view on wealth 31, 115

Islamic assets 5Islamic Bank of Britain (IBB)

deposit accounts 118home finance 67, 79–80savings accounts 90–1

Islamic Banking Act 1983 (Malaysia) 26Islamic banks 7, 10Islamic bond indices 109Islamic bonds see sukuk‘Islamic commercial law: an analysis of

futures and options’ (Kamali) 53–4

Islamic deposit accounts 117–9Islamic Development Bank (IDB) 163–4,

174blended-assets sukuk 108

Islamic economic model 31–5, 43Islamic finance

challenges and opportunities 13–6, 163

distinguished value proposition 175, 179

future 171–5, 176growing market 8–13growth of industry 5–7, 172key principles 35–42reasons 7–8recommendations for success 163–6

Islamic financial institutions (IFIs), future 171–5

Islamic Financial Services Board (IFSB) 163–6

‘Islamic Financial Services Industry Development: Ten-Year

186

Index

Framework and Strategies’ (IDB and IFSB) 164–6

Islamic Fiqh Academy 25on commodity murabaha 72on murabaha transactions 70on promises in commercial dealings 52

Islamic inheritance law 136–41Islamic law see shariaIslamic Research and Training Institute

(IRTI) 163–6Islamic wills 141–4ISRA government research institute 26istisn’a (request for manufactured item)

48–9, 80–1application 81–4compared with salam 88tsukuk al 106–7

Jaafar (Imam) 25Jaafri school of thought 25Jabir ibn Abdullah 33, 36Jersey 116t‘just price,’ Christian principle 167

kafalah (guarantee) 94–5Kamali, Mohammad Hashim 53–4Kay, John 170al-Khudri, Abu Sa’id 37Kot Addu Power Company (KAPCO)

102–3Kuwait

gaining market share 172sharia-compliant funds 116tzakat system 126

late payment penaltiesijarah car finance 78ijarah compared with conventional

leasing 76tistisn’a 81

leasing see ijarah (leasing)liabilities

deductible for zakat 131differences between musharakah and

mudarabah 68testate distribution 139

life insurance 140life interest trust will 142–3

life takaful 156–7lifetime giving 143–4lifetime trusts 144liquidity

inter-bank 71–3, 92Muslim nations 12–3

loansconventional compared with murabaha

70tpersonal, subject to zakat 131

location of zakat distribution 132London Central Portfolio Ltd (LCP) 121London Metals Exchange 72loss, risk, ijarah compared with

conventional leasing 76tLuxembourg 111, 116–7

maintenance, ijarah compared with conventional leasing 76t

Malaysiaasset-based sukuk al-ijarah 108gaining market share 172Islamic finance industry 26–7sharia-compliant funds 116–7sukuk growth 110takaful 150, 157, 158zakat system 126

male versus female inheritance shares 139–40

Malik (Imam) 25Maliki school of thought 25management

differences between musharakah and mudarabah 68t

investments in takaful 153–5maqasid al sharia see shariamarawdul maut (deathbed illness) 144‘maturity transformation’ 168maysir (betting) 149–50Mecca, Saudi Arabia 21Medina, Saudi Arabia 25Meezan Bank Limited (MBL) 77–8, 102mixed assets, number of Islamic funds

118fMohamad, Mahathir 34money market funds 118–9

number of Islamic 118fmoney production

187

Index

conventional and Islamic finance 34–5Islamic perspective 38

monotheistic faith, Islam 19mortgages, prohibition of usury 170MSCI Islamic Index 124mudarabah (profit-sharing transaction)

62–4differences between musharakah and

68Islamic deposit/savings accounts

118–9sukuk 101, 104, 108–9takaful investment 153–5

mudarib (project manager) 62–3, 64, 104, 153

Muhammad, Prophet 20on accountability to God 32–3on barter 37on definition of nisab 128on equity-type transactions 61example and teachings in the Sunnah

23–4on interest 36on Islamic inheritance 133on one-third 124sanction of payment in advance to

farmers 84on wealth 31, 33

Mundell, Robert 34murabaha (asset finance transaction)

68–71, 75, 96commodity 14, 71–3, 92, 119, 176,

177compared with ijarah 76–7rahn 94security contracts 94, 95sukuk al 105–6, 109

musawamah (asset finance transactions) 69

musharakah (profit and loss sharing transaction) 62, 64–8

application 66–7differences between mudarabah and 68diminishing 66–7, 79, 177–8sukuk 101, 102–3, 105, 107f, 108–9

Muslim countriesIslamic finance assets 7tapping into the liquidity 12–3

Muslimsfocus on the objectives of the sharia

176–7percentage of Sunnis and Shias 24population growth 8–10, 16

muttawallis (trustees) 134mutual insurance 151

Nasim, Iqbal, on zakat 126–33National Bank of Kuwait

ijarah investment fund 79Islamic money market fund 119

new products, importance of sharia-compliant 14

nisab (threshold) 128, 131non-inheritors, estate distribution 140non-Muslims

focus on the objectives of the sharia 177

inheritors 139North Korea 31

obligations, estate distribution 140obligatory inheritors 136offer and acceptance, sharia-compliant

contracts 49–50oil, wealth 10Old Testament, on usury 167Oman 92

Islamic finance industry 72prohibition of murabaha 92, 119sukuk growth 110

Omani Central Bank 72one-third threshold, investment

impurities 124OPEC (Organization of the Petroleum

Exporting Countries) 10options, contracts 51Organisation of the Islamic Conference

(OIC) 25ownership, item or service 49Oxfam International 38

Pakistancar finance 77–8sharia-compliant funds 116tsukuk al musharakah 102–3waqf takaful 155

188

Index

parallel istisn’a 81parties to a contract 48partnership

co-ownership 66ijoint venture 64–6

payments 128–9late penalties 76t, 78, 81zakat 128–9

penalties, late payment 76t, 78, 81pensions

estate distribution 140subject to zakat 131

permanent endowments 134permissible, item or service 48personal finance, salam 86–8personal loans, deductible for zakat 131pilgrimage to Mecca, obligatory act 21pillars of action 21–2pillars of faith 19–20planning see financial planningpoor and needy, distribution of zakat 132pork and pork-related products,

prohibition 32, 35–6, 122pornography consumption, prohibition

32power-producing companies, sukuk al

musharakah 102–3prayer

obligatory act 21–2zakat 127

predestination, belief 20pricing

ijarah compared with conventional leasing 76t

option 51uncertainty 42

principles of Islamic finance 35–42products

evolving 172–3new offerings 173–5

prohibited activitiescommercial transactions 35Islamic economic model 32

prohibition of interest 36–41Islamic economic model 34–5reasons 38–41

prohibition of uncertainty 41–2project finance 63–4, 66

istisn’a in conjunction with ijarah 83–4

promisessharia-compliant contracts 52–3takaful 151

propertyinvestment 121–2istisn’a for development 81–4number of Islamic funds 118fproject finance 63–4subject to zakat 130

prophets, belief 19–20public interest, protection 31–5

Qatar 110, 158Qatar Electricity & Water Company 84Qatar International Islamic Bank (QIIB)

63–4Qatar Islamic Bank (QIB) 84, 109, 120Qiyas, hierarchical order 25Qur’an 19, 20

on distribution of zakat 132hierarchical order 25, 26importance of the 22–4on inheritance 141on interest 7–8, 36on sharia-compliant contracts 47on teachings of Prophet Muhammad

23on wealth 33on zakat 127

rabb-ul-maal (owner of wealth) 62–3, 68t, 104

investment management in takaful 153

rahn (to hold) contracts 93–4Ramadan 21–2rapid growth markets 10–1Rashid, Haroon

on Islamic wills 141–4on sharia-compliant estate distribution

133–41real estate projects finance 63–4

istisn’a 81–4real service or asset 35

risk incurred 42regulation 14, 178

189

Index

relatives as inheritors 137rental 73–4

ijarah car finance 78ijarah compared with conventional

leasing 76tincome, subject to zakat 130

residuary beneficiaries, inheritors 136resources, productive use 40–1resurrection after death, belief 20retakaful 157riba (interest) 35

conventional insurance 150debt trading 85, 93, 95penalty payments 70, 78prohibition 36–41, 69sukuk al salam 107

riskChristian view on allocation 168–70destruction/loss 76tlevel under ijarah 78, 79–80return trade-off 117f

Robertson, James 34

sadaqah (voluntary charity) 127salam (sale of fungible object for full

payment now) 49, 80, 84–5ahn 94application 86–9compared with istisn’a 88tsukuk al 106–7

salat (five daily prayers), zakat 127Saudi Arabia

Friday as day off 22gaining market share 172Hanbali school of thought 25Maliki school of thought 25sharia-compliant funds 116–7sukuk growth 110takaful 158

savings accounts, wakala contract 90–1scale, challenge faced by Islamic finance

14–5scholars

role in Islamic finance 26–7sharia, needed 15–6

secondary market, sukuk 109‘secular’ 172security contracts 92–5

SEDCO Capital 174settlors 134Sha’afi school of thought 25Shafi (Imam) 25shares, subject to zakat 130sharia

importance of authenticity 14inheritance laws 115interpretation and meaning 24–5objectives 15, 176–7permitted activities 35–6

‘sharia- loyalist customers’ 171sharia supervisory boards 26–7sharia-compliant estate distribution

133–41sharia-compliant products 14–5

copying conventional financial instruments 177

importance of faith perspective 19investments 115–26, 144–5

numbers of funds 7objectives 124–6

role of scholars in verifying 26sharikah al-amwal (partnership by capital)

65sharikah al-’aqd (business partnership in a

joint venture) 64–8sharikah al-mulk (partnership of

co-ownership) 64, 66Sharjah Islamic Bank 64, 81–2Shias 24–5shirkah al-amal (partnership by work) 65shirkah al-wujooh (partnership by face)

65shirkal al-amwal (partnership based on

capital contribution) 66–7shirkat ul aqd 102shirkat-ul-milk (joint ownership in

property) 102short selling, prohibition 49silver, subject to zakat 130single entity structure of takaful 151–2six pillars of faith 19–20socialism 31socially responsible investment (SRI)

125, 174–5South Africa 116tSpain 134

190

Index

start-ups finance 63subject matter of a contract 48–9

uncertainty 41–2sub-par products 172sukuk (Islamic bond)

asset-based versus asset-backed 108–9capital markets 80capital raised through 107fcompared with conventional bonds

100definition 12, 100growth 12–3, 99, 110–1mechanics of transaction 101–2secondary market 109strong future 109–11types 102–7

sukuk al bai bithaman ajil 106sukuk al bai muajjal 106sukuk al istisn’a 106sukuk al mudarabah 104sukuk al murabaha 105–6, 109sukuk al musharakah 102–3sukuk al salam 106–7sukuk al wakala 104–5sukuk al-ijarah 102, 105, 108, 109, 120sukuk asset class

investment 120number of Islamic funds 118f

Sukuk Index (by HSBC) 109Sunnah

hierarchical order 25, 26importance 22–4

Sunnis 24–5Swart, Richard 174Swiss Re 158

tabarru (donation), takaful 150takaful (insurance) 149, 158–9

car insurance 77–8future of the industry 158Islamic insurance alternative 150–1models 151–5types of policy 155–7wakala contract 92

Takaful Act 1984 (Malaysia) 150tawarruq see commodity murabahataxation of estates 141–4testamentary freedom 135

testification of faith, obligatory act 21Thomson Reuters 16, 118, 166time period, uncertainty 42timing 128–9

distribution of zakat 132zakat payment 128–9

tobacco and tobacco trades, prohibition 35–6, 122

Torah 19, 20transactions

artificial 72asset finance-type 68–80equity-type 61–8istisn’a 80–4key types 61, 95–6other key 89–95

trustees 134trusts, lifetime 144Turkey

Hanafi school of thought 24–5takaful 158

UAEgaining market share 172sharia-compliant funds 116ttakaful 158

UKgovernment sukuk 105, 111Islamic finance assets 7issue of sovereign sukuk 13sharia-compliant funds 116ttestamentary freedom 135

uncertainty see gharar (excessive uncertainty/ambiguity)

underwriting, service provided by takaful operator 153, 155

undisclosed agency 89–90unilateral contracts 47uqud (contracts) see contractsusury

Christian view 167–70prohibition 167–1670

validity of contracts, key conditions 47–51

valueIslamic finance industry 5–7, 16item or service 48

191

Index

Van de Weyer, Robert 166on the Christian view of usury

167–70

wa’d (promise) see promiseswakala (agency) 72, 89–92

Islamic deposit/savings accounts 118–9

sukuk al 104–5underwriting 153–5

wakil (agent) 90, 92waqfs (permanent endowments) 134

takaful 155taxation 144

waqif (settlor) 134wasiyyah, estate distribution 140wasiyyah (will) 135

estate distribution 139Watani USD Money Market Fund 119wealth

distributioninequality 38–9Islamic system 38–9

management 144–5

owners see arbab-al-maal (owners of wealth)

pursuit, Islamic values 33–4weapons, prohibition 122Welby, Justin 167welfare state, dictated by Islamic

principles 32wills

Islamic 135, 141–4life interest trust 142–3

women, inheritance rules 134

zakat (giving percentage of wealth to charity) 32

calculation 129distribution 132–3linguistic meaning and spiritual

significance 127one of five pillars of Islam 126–7paying 128–9

zakatable assets 130–1zawil arhaam, inheritors 137zawil furood 136zukat, obligation 115

PRAISE FOR MASTERING ISLAMIC FINANCE

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