A Primer on Islamic Finance & BankingFebruary 2015

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1. The Islamic law which came from various sources – the Qur’an, the Hadith, the Sunnah, Ijma’ (views collectively agreed by Muslim scholars), Qiyas (analogy) and Ijtihad (personal reasoning) of the Muslim jurists.

2. An Islamic window is part of a conventional financial institution (which may be a branch or a dedicated unit of that institution) that provides both fund management (investment accounts) and financing and investments that are Sharia-compliant.

INTRODUCTION

Islamic banking refers to a system of banking that complies with Islamic law also known as Sharia1. The underlying principles that govern Islamic banking are mutual risk and profit sharing between parties, the assurance of fairness for all and that transactions are based on an underlying business activity or asset.

These principles are supported by the core values of Islamic banking whereby activities that cultivate entrepreneurship, trade and commerce and bring societal development or benefit is encouraged. Activities that involve interest (riba), gambling (maisir) and speculative trading (gharar) are prohibited.

Through the use of various Islamic finance concepts such as ijarah (leasing), mudarabah (profit sharing), musharakah (partnership), financial institutions have a great deal of flexibility, creativity and choice in the creation of Islamic finance products. Furthermore, by emphasising the need for transactions to be supported by genuine trade or business related activities, Islamic banking sets a higher standard for investments and promotes greater accountability and risk mitigation.

There are over 350 Islamic financial institutions worldwide across 75 countries and the global Islamic finance industry is experiencing average growth of 15-20% annually. The Islamic finance industry is at an early stage of development in Mauritius. The Banking Act 2004 allows banks to be incorporated as fully-fledged Islamic Banks or Islamic Windows2.

This booklet is an attempt to provide an understanding on the basic concepts and principles of an Islamic financial system as well as the process of Islamic deposit-taking and Islamic financial products. It also deals with some of the most commonly asked questions about Islamic banking.

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THE BASICSIslamic Finance v/s Conventional Finance

Conventional finance relates to a loan (money) granted for the purchase of assets on which a rate of interest is charged. In contrast, Islamic finance does not, and should not, deal with money directly as money cannot earn more money by itself. Money must be put into real business activities to earn extra money. This is the whole basis of trading. In other words, Islamic financial institutions facilitate the financing needs of customers by becoming sellers, lessors or partners as the case may be. The function of money has been transformed from a commodity into an enabler to facilitate trading, leasing and investment as illustrated in Figure 1 below.

Figure 1: The function of money in Islamic finance (Source: CIMA, An introduction to Islamic finance)

What is Islamic Banking?

As per the Banking Act 2004 (Bank of Mauritius), Islamic banking business means: “any financial business, the aims and operations of which are, in addition to the conventional good governance and risk management rules, in consonance with the ethos and value system of Islam”.

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Shareholders’ Fund

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Islamic Financial Institution

Purchase of an asset at ‘X’ from

the vendor

‘X’ money

‘X’ money

‘Y’% profit sharing‘X’% profit

sharing

Sell the same asset to

Customer at (X+Y)

Lease the same asset to Customer at

(X+Y)

Customer / Partner

Capital Investment in

‘X’ projectIslamic Deposit

Accounts

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3 PRINCIPLES OF ISLAMIC FINANCIAL SYSTEM3

A) PROHIBITION OF INTEREST (RIBA) Riba literally means “an excess”. In Islamic finance, riba is defined as the “premium” that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity. The principle of Sharia encourages the earning of profits but forbids charging of interest because interest accrues irrespective of the performance of the investment and is guaranteed.

B) MONEY AS “POTENTIAL” CAPITALMoney is treated as “potential” capital-that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. This means that money, by itself, cannot earn more money (riba-interest). The principle of Islamic finance defines money as a medium of exchange that must be put into real business activities to earn extra money. Islamic financial institutions meet the financial needs of clients by either selling, leasing or becoming a partner as the case may be.

C) RISK SHARINGDue to the prohibition of interest, the providers of funds become investors instead of creditors. The relationship between the investors and the Islamic bank is based on profit-and-loss sharing principles and both parties share business risks in return for a share of the profits.

D) PROHIBITION OF SPECULATIVE BEHAVIORIslamic finance principles discourage hoarding and commands that all transactions made by Islamic financial institutions must be free from elements of excessive uncertainty (gharar) and gambling (maisir).

3. Source: World Bank Publication 2008

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3 PRINCIPLES OF ISLAMIC FINANCIAL SYSTEM3 - cont’d

E) SANCTITY OF CONTRACTSIn Islam, contractual obligations and the disclosure of information are regarded as a sacred duty. Upholding such a principle certainly reduces the risk of asymmetric information and moral hazard.

F) SHARIA COMPLIANT ACTIVITIES In Islamic business and finance, investments are restricted to ethical and social responsible investments and industries approved by the Sharia advisor. Business activities which violate the rules of Sharia do not qualify for investment such as investments in alcohol (consumption), conventional financial services, tobacco, gambling, pork, amongst others.

G) SOCIAL JUSTICEAny transaction leading to injustice and exploitation is prohibited by Sharia. Islamic finance upholds information symmetry between the different parties to a contract as a preventive measure to the exploitation of any one party to the transaction.

The provision of Sharia compliant financial products and services entails adherence to the above fundamental principles. Islamic financial institutions rely on an external or in-house Sharia committee or board comprising of Sharia scholars to ensure compliance with Sharia rules & principles. In this respect, jurists have unanimously agreed upon the adoption of a number of Islamic financial instruments.

ISLAMIC BANKING V/S CONVENTIONAL BANKING DEPOSITS

Mobilization of deposits in an Islamic bank significantly differs from that of a conventional bank as shown in Figure 2 (page 5). Conventional banks guarantee an interest rate to depositors in advance. Depositors know beforehand the return accruable to them on a future date as a reward for keeping their money with the bank without any risk. It is worth noting that “Savings Deposit Accounts” in conventional banks are not guaranteed in the event of collapse of the banks.

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3. Source: World Bank Publication 2008

Figure 2: Deposits in a conventional bank

Conversely, Islamic banks mobilize funds through Mudarabah-based investment accounts as illustrated in Figure 3 below. Under this concept, the client is an investor (Rab-ul-Maal) and the bank is the manager (Mudarib) of the funds invested by the client. The Islamic bank invests the funds in a pool of Sharia compliant assets and income generated is shared between both parties at a predetermined profit sharing ratio.

According to Islamic finance principles, in a Mudarabah contract, the principal amount is not guaranteed by the bank but, is considered protected. Protected capital means that the investments used to finance the facility are collateralized, that is, the recipient of the financing provides collateral which secures the facility in case of default. Thus, depositors’ funds are protected by the collateral.

Figure 3: Deposits in an Islamic bank

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CO N V E N T I O N A L B A N K

Depositors BANK Advances

Client deposit money

Bank guarantees returns ( interest )

Bank loans out money

Clients repay principals and interests

I S LA M I C B A N K

Depositors Pool of Investments

ISLAMIC BANK (IB)

Advances

Client invests in the BankBank as a Manager creates

a pool of investmentsBank buys and sells or buys

and leases

Clients pay for financing facility

Bank takes its shares of profit

IB shares profit and loss with clients as dividends as per its proportion

of the contribution

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ISLAMIC FINANCIAL INSTRUMENTS

Various Islamic instruments are available to meet the financial needs of clients.

MUSHARAKAH (JOINT VENTURE)Musharakah is a contract whereby an Islamic bank and a client jointly contribute capital to an enterprise, whether existing or new, or to ownership of a real estate or moveable asset, either on a temporary or permanent basis. Profits generated by that enterprise or real estate/asset are shared in accordance with the terms of the Musharakah agreement whilst losses are shared in proportion to each partner’s share of capital.

MUDARABAH (PROFIT-SHARING CONTRACT)Mudarabah is a contract between an Islamic bank and a client whereby the Islamic bank would contribute capital to an enterprise or activity which is to be managed by the client as the Mudarib (manager). Profits generated by the enterprise or activity are shared in accordance with the terms of the Mudarabah agreement, while losses are to be borne solely by the Islamic bank unless the losses are due to the client’s misconduct, negligence and breach of contracted terms.

SALAM (FORWARD PURCHASE OF COMMODITY)A Salam contract is an agreement to purchase, at a predetermined price, a specified kind of commodity not available with the seller at the point of sale, which is to be delivered on a specified future date in a specified quantity and quality. The Islamic bank as the buyer, makes full payment of the purchase price upon execution of a Salam contract and the client takes delivery of the commodity thereafter.

ISTISNA (CONSTRUCTION FINANCE)An Istisna contract refers to an agreement to sell to a client a non-existent asset, which is to be manufactured or built according to his specifications and is to be delivered on a specified future date at a predetermined selling price. Istisna financing is made in phase payments and the client takes possession or delivery of the asset upon its completion.

IJARAH (LEASING)Under Ijarah or Islamic lease, the Islamic bank (lessor) acquires the asset required by its client upon the latter’s request for financing. The Islamic bank will lease the asset to the client subject to stipulated conditions agreed upon by both parties at the time of contract. Upon completion of the lease period or early purchase, the asset will be transferred to the client by way of a separate sale agreement.

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MURABAHA (MARK-UP FINANCING)A Murabaha contract refers to a sale contract whereby the Islamic bank sells to a client at an agreed selling price (cost price including a profit margin) a specified kind of asset that is already in their possession and transfers its ownership to the client. The client repays the marked-up price on deferred term basis over known time periods agreed upon by both parties at the time of contract.

SUKUK (CERTIFICATES OF INVESTMENT)A Sukuk (certificate) represents the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset.

QUESTIONS & ANSWERS (Q&A)

Q: Is Islamic banking meant for Muslims only?A: No. Islamic banking is for all individuals regardless of their religious beliefs.

Q: How do Islamic banks reward their depositors since payment of interest is not allowed?A: In Sharia, there are many ways to share profits or returns between an Islamic bank and its customers. For example, in Mudaraba-based deposit products, profits from a deposit arrangement will be shared between an Islamic bank and its depositors based on an agreed profit-sharing ratio and paid as profits. The Sharia also allows an Islamic bank to pay or give a sum of money to its clients in the form of Hibah (gift) as it deems fit. The latter may be available for holders of current account.

Q: Are Islamic banks allowed to take securities (deposits, pledge, third party guarantees, etc)?A: According to Islamic finance principles, it is permissible for an Islamic bank to request the client to provide lawful security. This collateral may take the form of a third party guarantee or the pledge of an investment account of the client or the pledge of any item of real or moveable property, or the pledge of the subject matter of the contract as a fiduciary pledge (or registered charge), either without taking possession of the pledged asset, or by taking possession of the pledged asset and then releasing the pledge progressively according to the percentage of the total payment received.

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QUESTIONS & ANSWERS (Q&A) - cont’d

Q: Do Islamic banks charge penalty fees for any late or partial payments?A: In a conventional bank, the client is charged additional interest (which is considered as income for the financial institution) if repayment is not made as scheduled. Such an additional amount is considered as interest under Islamic law and is not permitted. In an Islamic bank, the client undertakes to pay the Bank a penalty charge in case of default. This penalty charge, after deducting any administrative charges incurred by the Islamic bank, will be donated to the Islamic bank’s Charity Fund and distributed to the respective charitable/welfare institutions, with prior approval from the Sharia Advisor. Such charges are imposed to discourage moral hazard from clients.

Q: How do Islamic banks calculate their fees and charges?A: Islamic finance principles provide strict guidance regarding fees and expenses charged depending upon the Islamic contracts used. Islamic banks will charge only actual expenses incurred or a fee for providing the required services, whether such fees are in the form of a lump sum or a certain percentage of the facility amount.

Q: What are the products and services offered by Islamic banks?A: Some equivalent products & services offered by Islamic banks include the following:

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On the Liabilities SideSavings Accounts - MudarabahCurrent Accounts - QardInvestment Accounts - MudarabahWealth & Assets Management - Wakala Agreement

On the Assets SideTrade Finance - Murabaha / Musharakah Leasing - IjarahForward Sale (Manufacture) - SalamConstruction - Istis’na

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