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Structuring Islamic
Finance Transactions

Edited by Abdulkader Thomas, Stella Cox and Bryan Kraty

Published by Euromoney Books
Structuring Islamic Finance Transactions
Structuring Islamic Finance Transactions

Edited by
Abdulkader Thomas, Stella Cox and Bryan Kraty

Published by Euromoney Books

Published by
Euromoney Books
Nestor House. Playhouse Yard
London EC4V 5EX
United Kingdom

Tel: +44 (0) 20 7779 8999 or USA + I 800 437 9997

Fax: +44 (0) 20 7779 8300
www.euromoneybooks.com
E-mail:hotline@euromoneyplc.com

Copyright O 2005 Euromoney Institutional Investor PLC. Abdulkader Thomas and individual
contributors

ISBN 1 84374 213 6

This publication is not included in the CLA Licence and must not be copied without the permission of
the publisher.

All rights reserved. No part of this publication may be reproduced or used in any form (graphic, elec-
tronic or mechanical, including photocopying, recording, taping or information storage and retrieval sys-
tems) without permission by the publisher.

This publication is designed to provide accurate and authoritative information with regard to the sub-
ject matter covered. In the preparation of this book, every effort has been made to offer the most cur-
rent, correct, and clearly expressed information possible. The materials presented in this publication
are for informational purposes only. They reflect the subjective views of individual contributors and do
not necessarily represent current or past practices or beliefs of any organisation. In this publication,
none of the contributors, their past or present employers, the editor, or the publisher is engaged in
rendering accounting, business, financial, investment, legal, tax, or other professional advice or serv-
ices whatsoever and is not liable for any losses, financial or otherwise, associated with adopting any
ideas, approaches, or frameworks contained in this book. If investment advice or other expert assis-
tance is required, the individualised services of a competent professional should be sought.

Printed by Hobbs the Printers

Contents

David E. Upton
Recent history of lslamic finance xii
Faith, ethics. law and finance xiii
Compatibility xv
Shari'a boards and fatawa xvi
Intellectual curiosity and personal growth xvii
Internationalisation of finance xviii
Conclusion xix

Introduction: the origins and nature of the lslamic financial market

Abdulkader Thomas, based upon the work of Bryan Kraty, Stella Cox and
Lawrence Oliver with Mustafa Hussain
lntroduction
The growth of the lslamic finance industry
lslamic finance principles
Core mechanisms
lslamic finance instruments
What is money?
What does this mean for banking and finance?
Systemic challenges
Notes about the book

Examining the role of lslamic law

Abdulkader Thomas
lntroduction
Maqasid a1 Shari'a
Sources of law
lslamic schools of law
The concerns of Shari'a
Contracts
Contents The rule of possession (qabd)
Forbidden contracts and accountability
Conclusion

U n d e r s t a n d i n g the Shari'a p r o c e s s
Abdulkader Thomas
lntroduction
Shari'a boards
Preparing for the process
Two case studies: exceptions t o the rule

Equity f i n a n c e vehicles: m u d a r a b a a n d m u s h a r a k a
Abdulkader Thomas with M. lkram Thofeek
lntroduction
Limited liability and corporate personality
Mudaraba
Syndication by mudaraba
Retail fund aggregation
Non-bank financial institutions
Musharaka
Musharaka deposits
Deposit profit distribution methods .
Other forms of bank account
Declining-balance partnership
Shares and certificates
Pre-emption
Conclusion

4 The m u r a b a h a a n d simple sales transactions

Abdulkader Thomas and Bryan Kroty, with Sudin Haron, Musfafa Hussain,
and Stella Cox
lntroduction
Murabaha
Murabaha and cash management
Murabaha in a banking context
Murabaha in trade financing
Murabaha versus bai' bithaman a1 muaJal
 The case of Malaysia Contents

Less widely applied sales concepts

Problematic sales types
Letters of credit
Conclusion
Checklist: rnurabaha transaction steps

5 Lease finance and iiarah

Abdulkader Thomas and Bryan Kraty, with Mustafa Hussain, and Stella Cox
introduction
Lease finance and Darah
Islamic lease structure

Project finance applications

Main differences between Islamic and conventional leases
Conclusion

6 Salam
Abdulkader Thomas and Bryan Kraty, with Mustafa Hussain, and Stella Cox
Introduction
Salarn
Checklist: Salarnhstisna'a financing transaction steps
Parallel salam and liquidity management
Commodity financing
Working capital applications
Conclusion

7 Complex transactions: istisna'a, pre-export or manufacturing

finance working capital and proiect finance
Abdulkader Thomas with Bryon Kraiy
lntroduction
lstisna'a
Ju'ala as a sub-set of istisna'a
Securitised and syndicated project finance transactions
Syndicated and securitised pre-export and export finance transactions
Syndicated and securitised corporate finance transactions vii
vii B
Contents
Real estate
Abdulkader Thomas with appreciation to Mohammed Asario
lntroduction
Mudaraba and rnusharaka
lstisna 'a and intifa'a
Murabaha
Musharaka and declining-balance partnership
ljarah and leveraged ijarah
Securitisation of real estate
Conclusion

lslamic asset management

Stella Cox and lawrence Oliver with Abdulkader Thomas
Introduction
lslamic principles
Creating an lslamic asset base
lslamic fund management
Structure, marketing and distribution
Jurisdiction of registration and regulation
Disclosure
lslamic global asset management
Addressing the issues
Conclusion

10 Opportunities with sukuk and securitisations

Abdulkader Thomos, with appreciation to Mohammad Asaria and
Tamara Box
Sukuk - legal structure
Sukuk securitisation
Receivables securitisation
Rating Shari'a securitisations
Historical data and rating risk
Legal and regulatory issues with Shari'a-compliant securitisations
Tax and accounting issues
Jurisdiction and trustee issues
Shari'a securitisation opportunities
l@
B viii
viii
viii Conclusions and challenges for sukuk and lslamic securitisations
 Contents
11 Liquidity management: developing the lslamic capital market
and creating liquidity
Stella Cox with Abdulkader Thomas
introduction
Liquidity management and mainstream financial services
Challenges of lslamic liquidity operations
Murabaha as a liquidity management tool
Murabaha - asset or liability?
Salam
Tawarruq
lslamic 'debt' securities
Defining liquidity strategies
ljarah lease finance
Short-term investment programme
lslamic investment asset base
Disclosure, regulation and rating
The International lslamic Financial Market
lslamic capital market - multinational institutions
Conclusion

Risk management and derivatives

Abdulkoder Thomas
Introduction
Takaful and insurance
Derivatives
Principal
Synthesising derivatives or the effects
Derivative market risks
Hedge funds
Legal
Conclusion

13 The regulatory constellation and challenges

Abdulkoder Thomas, with special thanks to Helmi TaEb, Rifaat Abdel Karim,
Umer Chapra and Tariqullah Khan
Introduction
General supervisory standards
Emerging lslamic network
Contents Risk monitoring and measurement
The analytical challenge of profit-sharing deposits
The regulatory capital equation
Securitisation
Approaches governing Muslim minorities
Conclusion

14 Changes and challenges

Abdulkader Thomas
Introduction
Key developments
New opportunities
Standardisation
New markets
Conclusion

Glossary
Foreword
David E. Upton, Virginia Commonwealth University, Richmond, Virginia

Is there a need for this book on lslamic finance? If so, why should a non-Muslim be interested in reading
such a book? These would seem to be reasonable questions to many. even to finance professionals. The
typical reaction to a mention of lslamic finance is that it is an arcane topic involving dogmatic religious
pronouncements, incompatible with finance as generally practised and possibly an obstacle to economic
growth. After all, hasn't lslamic finance resulted in a stultified Mid-East economy, a business backwater
except for the oil sector? Isn't lslamic finance just a side-show. hemmed in by religious strictures? Isn't it
often based on conflicting fatawa (legal opinions) issued by rival clerics that result in archaic rules and
procedures? To the casual observer it seems to be a topic of interest to religious Muslims or socioiogists,
perhaps, but of little interest elsewhere. Surprisingly, these views can sometimes be found even among
secular Muslims, especially among finance professionals who have been trained in western finance. Such
attitudes are, of course, largely misinformed and exaggerated. The actual situation is very different. In
fact, lslamic finance has emerged from a period of inertia, and is undergoing a period of renewal and vig-
orous growth. It has become a dynamic field that will change the face of finance everywhere. As with any
change, there are opportunities to grasp and adjustments to make. But grasping opportunity, and making
the right adjustments, requires an understanding of the reasons for and nature of the change.

One of the motivations for this book arises from the need t o overcome outmoded and uninformed
impressions. But there is also a need to provide a more realistic picture of lslamic finance as it exists
today and how it will evolve in the future. Structuring Islamic Finance Transactions provides the back-
ground and understanding necessary for the reader t o find the opportunities and to make informed
proactive adjustments.

Even for those who manage to get past their early misconceptions and begin a study of Islamic finance,
however, the going can be difficult. The reasoning may seem cryptic, especially to those used to the thought
processes of western finance. Unfamiliar concepts are described by unfamiliar words, such as riba and
gharar, making the topic seem impenetrable. Much of the problem lies in the fact that comprehensive,
straightforward explanations of lslamic finance have been scarce and sometimes incomplete. The revival
of interest in lslamic finance has been comparatively recent, and many of the instruments and procedures
are new or have a relatively short history. lslamic scholars who first attempted to bridge the cultural gap
were struggling with western financial concepts that, to them. were as difficult to grasp as lslamic concepts
are for those approaching the problem from the West. This is no longer the case, and boundary-spanning
Foraword expertise now exists in both groups. The recent growth and development of the field has been rapid, how-
ever, and the literature has not been able to keep pace with the changes. As a result, much of the material
that is available tends to be overly simplified. The more sophisticated treatments that provide an advanced
knowledge level usually assume some previous background, and are often too specific and esoteric in
nature. Lacking a comprehensive source, readers were forced to link together scattered treatments, men-
tally switching gears among different authors. This has also contributed to misunderstandings. One exam-
ple is the oversimplified description of riba as 'no interest.' The subsequent explanation that this only
applies to a return on money, and not to a return on assets, may go unheard or even not be offered. To
many, the meaning of 'interest' is much broader than intended, and the description is mistakenly taken as
'no rate of return.' This misinterpretation usually evokes an incredulous 'Then how can they make any
money?' and the suspicion that the requirement is a sham that is ignored in practice. Another example is
the explanation of gharar (roughly. avoidable uncertainty), which often includes hadith (quotes) that are in
the formal and indirect form of expression found in religious writings. This leaves the mistaken impression
that 'It's a Muslim thing,' and not meant for outsiders.

How can a novice get past these obstacles? Both the rapid development of new techniques, and the mis-
conceptions which have arisen over time, have created a pressing need for a clear and concise treat-
ment of the conceptual underpinnings and state of the art in lslamic finance and an indication of possible
future developments. Structuring lslamic Finance Transactions fills that need. drawing on many diverse
sources to provide a treatment that is thorough and understandable, without resorting to oversimplifi-
cation or becoming bogged down in detail.

Recent history of lslamic finance

lslamic finance is not new, and actually rests on over 1.500 years of philosophical and legal reasoning.
During its classical period, Islam made great contributions to science and industry, including the concept
of zero and the concept of an algorithm. Trade in the Mediterranean region was strong and flourishing
under the lslamic commercial law of the time. Unfortunately, this system became stagnant, and withered
after the rise of colonialism and the emergence of large. sophisticated international companies. Together
these powers created an environment that led to western financial concepts and techniques being super-
imposed over the existing financial structures. Under this pressure, while the traditional lslamic financial
structures continued to exist, they were relegated to a minor role. For many, this resulted in an impression
that the only real business in the Mid-East was supported by and conducted through western finance. The
disconnect and clash between western practices and the underlying lslamic practices of traditional business
sectors made access to capital difficult, discouraged innovation and entrepreneurship, and obscured the
existence of the more traditional sectors. It is not surprising that smaller domestic business failed to flour-
ish and that growth of lslamic financial solutions was inhibited.

Perhaps nature abhors a vacuum. but certainly finance abhors unemployed resources and frustrated entre-
l@ xii
xii preneurship. Demand for financing techniques acceptable to the lslamic faith began to increase. Some
attempts were made to mobilise capital in an lslamic fashion that was more acceptable to domestic busi- Foreword

ness owners, but it was not until the 1960s that these attempts became widespread and began to bear fruit.
Since that time, there has been a continued and accelerating development of Islamic finance, resulting in
a growing number of increasingly sophisticated instruments and procedures compatible with Islamic pre-
cepts. New ways to reconcile lslamic and western thought in solving shared business problems have been
discovered. These new techniques are providing acceptable alternatives to western finance and permit
greater flexibility in problem solving. making it possible to free up previously untapped sources of capital.
The financial effect of many of these instruments is virtually identical to the financial effect of western
instruments, but they remain within the bounds of Shari'a (Islamic law). The close similarity of financial
effects is not a t all surprising; it is simply a function of the similarity of the problems being solved. While
there remain areas in which lslamic alternatives are not yet available or are still somewhat difficult to use,
lslamic finance has proven itself flexible and applicable to the modern business world. This growth process
is continuing, with solutions to many remaining problem areas already under development.

The benefit of these developments is not restricted t o Muslims. The new instruments and procedures
are available to, and have already been employed by, western business and governments. Not surprisingly.
the renaissance of lslamic finance has actually reduced the formerly perceived discord with western
finance. This book provides a realisation that the gulf between lslamic and western finance is not as
wide as originally thought, and that in fact there is a surprisingly large area of agreement between the
two approaches to mutual problems.

Faith, ethics, law and finance

lslamic finance is, of course, inextricably bound with religious thought and teaching. In western business
the concepts of religion, law, and ethics only loosely overlap. In Islamic finance, on the other hand, these
concepts approach congruency. Without a t least a basic knowledge of lslamic faith, a grasp of lslamic
finance can only be a t best a superficial collection of specific memorised cases. Readers of this book will
find that explanations of financial applications are accompanied by explanations of their relationship t o
lslamic reasoning. It is not necessary t o become an lslamic scholar (most Muslim businessmen are not
scholars eitherl), but a working knowledge of the basic thought process behind various financial fatawa is
necessary to provide perspective and allow extension of the guidelines to similar but different situations.
If this seems unfair, realise that for an lslamic scholar an understanding of western financial principles
would require a working knowledge of western law and ethics - and of their underlying religious basis.
Further, the closeness of religious, legal and ethical bases of lslamic finance often results in a relatively
more explicit statement of guidelines. The looser connection of the religious, legal and ethical basis of
western finance, on the other hand, results in a less explicit statement of guidelines, unfortunately often
assumed or only implied without exact specification. In the United States this is reflected in the recent
emphasis in business schools on adding courses in ethics to curricula that already contain courses in busi-
ness law. Without an appreciation of the differences in the two systems, there is the danger of mistakes
resulting from reliance on unconscious habit. xiii
xiii B
Foreword The acceptability of lslamic financial practices and instruments is based on lslamic law. Shari'a in turn
has three sources. The Qur'an, or received word of God, is the most basic source, but usually does not
deal directly with commercial problems. A second source is the Sunnah, or authenticated sayings and
reported actions of the Prophet Mohammed (PBOH), which provides more direct guidance for com-
mercial problems. The third source is ijtihad, scholarly interpretation and extension of the Qur'an and
the Sunnah. ljtihad is based on analogical reasoning and takes account of personal preferences, custom,
and impact on the welfare of society.

While this may a t first seem inflexible to the western mind, the interpretive and extensive nature of ijti-
had allows innovation and growth in response to the complexity and change of life. Once some under-
standing of the reasoning is achieved. similarities to more familiar concepts emerge. Many differences
from western finance can then be seen as a matter of degree rather than of kind. The religious conditions
placed on financial activities have goals that might come from the speeches of captains of industry in the
United States or Europe or, for that matter, anywhere in the world. The use of resources for the good of
all, a staple in those speeches, is a basic tenet of Islam. Riba is not presently strictly forbidden in west-
ern finance, but it was forbidden in the past and is at present certainly proscribed and often limited as
usury. Gharar is certainly reflected in western concepts of the fairness of, and requirements for, a valid
legal contract and in consumer protection laws. Both concepts deal with shared problems that are not
solely lslamic or solely western. offering solutions that are different but understandable to both groups.

Absolute differences do exist, but in many cases it is not hard for those trained in western finance to
understand the nature of the differences when the basic intentions are considered. It is often said that
lslamic finance is asset based, while western finance is currency based. The underlying lslamic concept
is that money has no value in and of itself, but is only a measure of value. This concept is involved in
the prohibition of riba, since if money has no intrinsic value there should be no charge for use of money.
However, this does not preclude a rate of return on asset-based investments, since those assets do have
an intrinsic value. Many find this emphasis on an asset base clumsy, inefficient, and unnecessary. They
would argue that money simply reflects a claim on some underlying assets anyway, so that they con-
sider money to be an asset in itself. While this argument is widely accepted. it is interesting to note the
repeated references to the 'money illusion' and the associated requirement to 'pierce the veil of money'
in the economic and financial analysis found in western texts. Clearly there is some difference between
assets and money. Not all would reconcile this difference in the same way.

It would be a mistake to think of lslamic finance as a rigidly prescribed set of dogmatic procedures set
by clergy without reference to the realities of business practice. Although Islam does set boundaries and
general guidelines for compliance with Shari'a. there is great flexibility within those boundaries. There
are three ideas that reinforce this flexibility. The first is that those things that are not forbidden are per-
mitted. As long as a procedure or instrument does not constitute a forbidden action, it is acceptable. This
leaves wide latitude for the design of instruments, contracts, and procedures. The second idea is that
material possessions are the property of God, and that we are but stewards of our possessions who are
required to use those possessions in an unselfish manner for the good of all (an idea also professed by Foreword

many other faiths). This indicates that there is a duty to engage in an ongoing search for better and more
efficient methods, within the limits set by Shari'a. Development and refinement of lslamic finance. rather
then reliance on fixed techniques. is considered a religious obligation. Closely related is the third idea
that the intent and emphasis of ijthad is not in limiting or forcing compliance with rules. The intent and
emphasis is rather to assist people in seeking a happier life. of making life easier, of removing hardship
and obstacles to a better life within the boundaries of Shari'a. Extending the consideration of riba, for
instance, the argument for prohibition of interest is notjust that money has no intrinsic value. The exten-
sion to prohibition arises because under this viewpoint, interest would result in the lender becoming
unfairly enriched without providing anything of value t o the borrower. Such unjust enrichment would be
a source of conflict and detrimental to society. This indicates that the intent is not to forbid a particular
type of contract, but rather to avoid a wrongful action in the interest of the common good.

The reader will find that the emphasis on removing obstacles to a better and happier life gives rise to a
practical attitude among lslamic scholars. an attitude that tends to focus less on form or esoteric philo-
sophical arguments and more on substance and impact on daily life. A result of this practical attitude is that
some deviations from strict conformance are permitted under @had. based on the concepts of istihsan (per-
sonal preferences), istislah (public welfare) and 'urf (custom). As with Christian theology, necessity may
cause certain acts to become permitted, even if discouraged in general or prohibited in other circumstances.
As an example, given a lack of alternatives, Muslims are allowed to invest in corporate stock, even though
the firm may participate in riba through leveraging. The investment is certainly not encouraged. but is per-
mitted as a practical and temporary solution to the lack of acceptable alternatives. This is not, however, a
'free pass.' The permissible amount of corporate borrowing and lending is limited - and the portion of
investor return attributable to interest must be purified, usually by donating that amount to charity.

Compatibility
Given the practical nature of lslamic law in the area of finance, it is not surprising that the reader will dis-
cover that lslamic methods can be quite compatible with western practices, and the practical result of
instruments and procedures is sometimes virtually identical despite what may a t first seem to be very dif-
ferent forms. This is to be expected -both systems are dealing with the same practical problems, and thc
substance of finance is the solution of those problems. Whether a mortgage is currency-based borrowing
of money or is an asset-based musharakah (roughly, partnership) in which one partner (the purchaser of
the home) buys out the other (the financial institution) over time, once we 'pierce the veil of money' we
are presented with the same solution to the same problem. The purchaser buys a home through a series
of payments, while the provider of capital - the financial institution -receives a rate of return on its invest-
ment in the home (remember that riba does not preclude a rate of return on assets). The fact that in one
case the underlying asset is money, and in the other case is the house, has great religious difference but
virtually no financial difference. The underlying philosophical basis may be different in many ways. and
the contract may seem strange to western ears and eyes. The two solutions are clearly not identical. Islam
Foreword and western financiers may disagree about which approach is fairer or more just (or more acceptable in
the eyes of God). But in the end, both the mortgage and the musharakah contract solve the same prob-
lem - and business gets done to the satisfaction and benefit of both parties.

It must be clearly understood that this compatibility and similarity of results is not the result of an effort
to circumvent Shari'a. Rather. it is an indication of the flexibility and inventiveness of mankind and a
reflection of our common problems. To be sure that lslamic principles are not violated. each new proj-
ect is submitted to a Shari'a board. The board is a group of Shari'a scholars that will consider whether
the project is compatible with Islamic teachings. It is important that the members of the board be widely
accepted as scholars in the lslamic religious community. At times the investigation and conclusion of the
board may be straightforward. as when the project makes use of previously accepted techniques or
instruments. If the project uses new techniques and instruments, or applies a previously accepted solu-
tion in a new manner, a deeper investigation of the acceptability of the proposed solution may be
required. If an acceptable solution is found and approved by the board, the approval takes the form of
a fatwa. or declaration of the acceptability of the project.

Compatibility, and the fact that the financial consequences are virtually identical in some cases, is some-
times misinterpreted to mean that there is no substantive difference between lslamic and western financial
solutions. The differences are interpreted as definitional 'tricks with words.' The reader should not make
this error. For instance. a repurchase agreement - selling an asset while a t the same time entering into
a contract to repurchase it later a t a higher price - is simply a financing device and is construed as riba.
While differences in allowable or disallowed practices may be subtle, especially to western finance prac-
titioners, they must be substantive in the eyes of the religious community. An identity of financial impli-
cations should not be considered as a lack of philosophical differences.

What seems identical to the uninformed may be in fact quite different; what seems different to the unin-
formed may actually be quite similar. While actual experience in lslamic finance is a necessary teacher,
experience can be a hard and incomplete teacher. Anyone who relies solely on experience may well miss
subtleties or less visible opportunities or make mistakes that someone who has a background of under-
standing will be able to use t o their advantage.

Shari'a boards and fatawa

Mention of Shari'a boards sometimes brings forth a criticism of lslamic finance: there does not exist a
single, overall authority that sets forth a uniform set of rules. Rather, there are various groups of schol-
ars or schools, and fatawa may be issued based on the differing interpretations of these schools. Thus,
a fatwa in Malaysia might approve of an instrument that would be considered riba and not approved in
Saudi Arabia. A reaction of those used to western finance may be that this system seems chaotic and inef-
ficient. The process is viewed as one ofjumping religious hurdles in a slow and painstaking process. with
an uncertain outcome. This results in an apprehension of great risk, which discourages curiosity in lslamic
finance. There is also the accusation that a fatwa can be obtained for almost anything if only the right Foreword

set of scholars can be assembled as a Shari'a board. In the face of conflicting fatawa, how can one pro-
ceed, and how is it possible to be sure that an instrument or process will be universally accepted?

This criticism overstates both the difficulties of using lslamic finance and the extent of disagreement. It may
be aggravated by the fact that lslamic finance has been recovering from a period of neglect, so that many
projects require exploration of new financial ground. Any area of rapid growth will result in differences of
opinion that will be worked out over time. While individual projects may be swiftly developed in areas where
a body of law is established through widely accepted fatawa, development of new law can be a slower
process. The process may also seem more cumbersome to western eyes simply due to a lack of familiarity
with the process and the underlying legal structure. If we compare the process of dealing with a Shari'a
board with that of dealing with the Sarbanes-OxleyAct, a problem currently faced by business in the United
States, we might get a more realistic picture. The uncertainty of compliance with (and reams of articles on)
the Sarbanes-Oxley Act seems to a t least parallel (and to judge from the outcry. exceeds) the uncertainty
surrounding obtaining a fatwa. The objection that a fatwa can be obtained for almost anything is exagger-
ated. A fatwathat is not accepted by the body of lslamic scholars will not become an accepted part of Shari'a.
True, there exist fatawa that have not become accepted, and there are differences over the acceptability of
other fatawa. On the other hand, it is not unusual for a lawyer in the United States to 'shop' for a juris-
diction favourable to a particular type of case - and jury trials often return surprising verdicts! The uncer-
tainty of the present day battle to influence the composition of the United States Supreme Court. and
perhaps to reverse prior decisions, is another case in point. One need only look a t the diversity of religious
thought among Christian denominations for a similar example of differing conclusions on the same topics.

intellectual curiosity and personal growth

The discussion has established: a) that several of the original questions are simply based on misconcep-
tions, b) that lslamic finance has become a dynamic and practical field that can function well in the mod-
ern business world and a t the same time serve lslamic society well, and c) that there is a definite need
for a book that sums up the state of the art. An understanding of the re-emergence of lslamic finance
is, of course, imperative for Muslims who deal with western firms. The importance of the re-emergence
is. however, not limited to the points of interaction with western finance. The increasing flexibility and
efficiency afforded by new techniques, and the innovative spirit created by new possibilities, is also a driv-
ing force for Muslims who wish to see their economies grow and flourish. By spreading an awareness of
these new techniques, this book will do much to encourage a dynamic lslamic business culture and con-
tinue the process'of growth. it is this type of environment that will produce the lslamic entrepreneurs
and business leaders of tomorrow. Certainly, this book is important in providing guidance and assistance
to those entrepreneurs who wish to remain within the tenets of their lslamic faith.

This, however. explains only part of the need for this book. Why should I be interested in lslamic finance?
1 am not Muslim, and I do not live in a predominantly Muslim country. What's in it for me? mii
xvii
B
Foreword Perhaps the first motivation to come to mind is that of intellectual curiosity. Islamic finance is intrinsi-
cally interesting. It is interesting to learn of different areas of finance even if the area is not of imme-
diate concern. This is my profession. and I should seize the opportunity t o increase my knowledge base
and encounter new ideas. For those not in the finance area, the intertwining of financial and religious
concepts in lslam provides insight and a fuller understanding of lslamic thought. While this does not
seem a practical or compelling reason a t first consideration, or on an individual level, after a moment's
reflection it is clear that, in a broader sense, providing and nurturing such understanding will be one
of the most important, if less practical, contributions of this book. Given the strained state of the world
today, an increase in understanding among all of us is of major importance.

Closely associated with intellectual curiosity is personal growth. lslamic finance is a change, and change
has both challenge and opportunity. Those who do not venture from the confines of the usual are. sadly.
likely to realise a t some point that they have been bypassed and become obsolete. One often hears that
learning does not stop a t the schoolhouse door. It is equally true that it does not stop a t the edge of
today's usual way of doing things. The inspiration that recognises opportunity does not arise from a
vacuum; it is what our subconscious does when it struggles to fit new concepts in with existing con-
cepts. Inspiration will not come to us; we must rather seek it out and cultivate it. Genius has been
described as the ability t o see things differently. Forcing yourself to think 'outside the box' by explor-
ing how others view things is one way of achieving this ability. The re-emergence of lslamic finance as
a dynamic force encourages a dialogue with western finance. Those who are aware of the dialogue and
are listening to it are the ones who will develop the personal edge that is found in business leadership.

We may not be the one t o recognise and seize an opportunity, but someone eventually will. We may not
be a t the start of the wave, but we certainly do not want to have it pass us by altogether. The question
is not whether it will be us or someone else who will eventually seize the opportunity. The question is
whether we will be ready when that happens.

The contributions of this book are not limited to the immediate financial context - they also include the
intellectual growth of individuals and of society.

Internationalisation of finance
Beyond intellectual curiosity and growth, there are more practical reasons why an understanding of lslamic
finance. and of lslamic thought. will have important benefits. We now live in the interdependent 'global
village.' where the impact of what happens in other countries is rapidly transmitted around the globe. As
a result, the days of business in general, and finance in particular, as a regional discipline are long gone.
Even if 1 am not Muslim, and even if I do not live in a predominantly Muslim country. I will come into con-
tact with lslam and lslamic finance. This need not be a direct contact. It is estimated that 20 per cent of
the world population is Muslim. The economic impact of a group of this size cannot be ignored - it is both
B xviii an opportunity and a force that affects the entire world. The pool of resources held by Muslims is substantial.
and there is a search for outlets to apply those resources to worthwhile projects. lslamic finance is now Foreword

international in scope, and issues of lslamic instruments now occur throughout the world. Both western
firms and western governments offer lslamic instruments (often combined with western instruments in
the same offering). The size and number of such offerings will increase as lslamic finance grows in sophis-
tication and offers a wider range of instruments. In short, there is potential to be tapped, and it cannot
be tapped without a working understanding of lslamic finance and its underlying concepts.

The impact and importance of lslamic finance extends well beyond those who deal in international under-
takings. Although the Muslim population may be concentrated in the Middle East and in southern Asia,
it is by no means absent from the rest of the world. Substantial Muslim populations are found through-
out the world, and Muslims are no longer unusual neighbours. Within the United States, there is a size-
able Muslim population that is, on average, more affluent, better educated and more sophisticated than
the national average. This population has an increasing demand for investment vehicles and for lslamic
mortgages and insurance. Interestingly. this has actually resulted in a great deal of the innovation in
lslamic finance occurring in the United States. rather than in traditionally Muslim countries. Fully-
fledged Islamic banking is now chartered in the United Kingdom, another leader in innovation.

Conclusion
This book. then, does fill a need. My brief discussion should make it clear that lslamic finance is not the
esoteric topic it was a decade or so ago. It is not something that will affect us a t some time in the future.
It is something that is already affecting us, an opportunity that is here now. The impact and the oppor-
tunity will continue to grow. Written a t a level that avoids oversimplification but is accessible to pro-
fessionals, this book provides in one source a background on the development of lslamic finance, a
comprehensive explanation of the state of the a r t of both lslamic finance techniques and the underly-
ing lslamic concepts, and a prognosis for the future. It will become a staple for anyone interested in
the area: those who make the effort of a careful reading will be well rewarded.

29 June 2005
Introduction: the origins and nature of the lslamic
financial market
Abdulkader Thomas, based upon the work of Bryan Kraty, Stella Cox and Lawrence Oliver with Mustafa ~ussain'

Introduction
The Qur'an, the revealed text of Islam, provides general advice about wealth. Not only does the pious
Muslim have an obligation to spend wisely, and for the benefit of others. but he finds direction in the
Qur'an relating to the accumulation of wealth. As the lslamic faith took root in sophisticated cities such
as medieval Cairo and Baghdad, the precursors of today's banks took shape. These rules-based inter-
mediaries provided an important source for the modern activity that we now call 'Islamic banking and
finance'. Our challenge in this book is to work with these same rules, their modern applications, and
cases exemplifying contemporary lslamic commercial contracts.

During the colonial area, the attention of Muslim governments, merchants. scholars and jurists to the
particular rules of Islam relating to commerce withered. Only in the 1960s did new thinking about the
subject become widespread, leading to multi-state and commercial experiments during the mid 1970s.
These experiences have evolved into lslamic financial practice as we understand it today.

Early experiments
Classical lslamic expressions of commerce are found in the juristic and theological literature of the Middle
Ages, when lslamic empires led the world in commerce. Yet many of the principles perfected both in the
classical period and their modern applications pre-date Prophetic Islam. Chapter 1: Examining the role
of lslamic law, looks a t the methods applied by Muslims to adapt or modify existing tools and invent new
ones in order to engage in commerce. To follow the evolution, we must first understand that the mod-
ern, emerging business of Islamic finance began with an experiment in micro-credit in the Nile Delta town
of Mit Ghamr. The persistence of the project's primary sponsor. Dr Ahmad Elnaggar, to define key meth-
ods of lslamic finance led to the founding of a number of today's leading lslamic institutions including
the islamic Development Bank, Dubai lslamic Bank and t h e ' ~ a rAl Mal group of financial institutions.

Dr Elnaggar's project was ultimately terminated and he went into exile. He endured often hostile pub-
lic debate in his quest to establish lslamic banking. Nonetheless, Dr Elnaggar was able t o forge a con-
sensus for the formalisation of lslamic banking by reaching out t o important political, social and
Introduction:
Exhibit 1 Traditional lslamic constma
the origins and
nature of the
lslamic financial
market ISLAM

(faith and belief) (practices and activities)

(man-tmgod worship) (man+omanactivities)

Political aciivities Social activities

Other economic activities Banking and financial activities

Source: Bahrain Monetary Agency, Islamic Bwking & Finance in the Kingdom of Bahrain (Bahrain: Bahrain Monetary Agency, 2002),p. 15.
Adapted from Islamic Bonking Practice (Bank lslam Malaysia Berhord, 141 5H/1994).

commercial leaders in the Arabian Peninsula and Malaysia. These personalities included King Faisal of
Saudi Arabia. Tengku Abdul Rahman of Malaysia, and Saeed Lootah of Dubai.

Dr Elnaggar persuaded these leaders that riba. something similar to interest. is explicitly forbidden in
the Qur'an. If there is no other reason orjustification, the devote Muslim must find a way to lead a life
free from riba. And this means that contract forms, deal substance and approaches to commerce must
be adjusted to comply with the injunction against riba. Dr Elnaggar's achievement was to raise the con-
sciousness among Muslim opinion leaders and businessmen that modern alternatives to riba were fea-
sible and realistic.

Prior to Dr Elnaggar's efforts. most Muslims had ignored the role of fiqh al mu'amalat, or the jurispru-
dence of commerce, in their financial arrangements. The traditional lslamic construct (see Exhibit 1 ) is to
build upon belief and manners with the Shari'a. or lslamic law, the way to organise worship and human
affairs, in ways that are consistent with the revealed text of lslam and the traditions of the Prophet
Mohammed (PBOH).2 Fiqh, which means 'understanding', and mu'amalat. which means 'works', combine
to define the understanding of Muslims relating to social, political and commercial activities. Although the
field has been well honoured in the social sphere, and less so in the political realm, it was widely ignored
between the late 1700s and 1960s. When one considers the above classical depiction of the priorities driv-
en by an individual's profession of Islam, it becomes clear why some may consider banking and finance a
relatively low priority in the management of one's life. Dr Elnaggar, however, provided a reminder of the
severity of the punishment for contracting with riba and lslamic scholars and opinion leaders began to view
the diagram not as a prioritisation, but as a means of highlighting and organising faith-driven obligations.

The early pioneers of lslamic finance were driven by the overall tenet of sustaining an ethical and equi-
table mode of conducting financial affairs. Governed by Shari'a, lslamic finance derives its principles
from the Qur'an and Sunnah. Although the Shari'a prohibits interest and similar forms of income. this Introduction:
the origins and
does not mean that capital is cost free in an Islamic System. Islam recognises capital as a factor of pro- nature o f the
lslamic financial
duction, but it does not allow the factor to make a prior or pre-determined claim on the productive sur- market

plus in the form of interest.

The core principles of lslamic finance are founded on the 'productive' use of money for community ben-
efit. These will drive us to an asset-based system where money is not a commodity in itself, merely
reflecting a value linked to the passage of time, interest, for a return. Because of this. financiers are
party to the underlying transactions, which must be transparent with all details ascertainable, if not
agreed, in advance with undisputed ownership. Preventable uncertainty. undue risk or systemic specu-
lation is prohibited as well.

This book will show that lslamic finance is very flexible, despite its apparent limitations. When struc-
turing in line with isiamic principles. financing may be provided to: private, public or sovereign entities:
lslamic or conventional entities. Funding may come from lslamic or conventional investors. Although
funds may be commingled, a point explained in Chapters 1 and 9, no lslamic funds may be used in con-
ventional financings or governed by a contract that is impermissible according to lslamic rules. During
the course of this book and its related cases, these points and related elements will be demonstrated.

For a financier to comply with lslamic ethics, the financier is not allowed to finance any activity or entity
related t o the manufacture, distribution or any facilitation of those things which are explicitly forbidden
by lslamic law, namely: alcohol. pork products. illegal and intoxicating drugs, gambling, pornography,
arms, and so on. Although business speculation in the ordinary course is understood, undue speculation
akin to gambling and 'unjustified enrichment', as we will discuss in the next chapter, are forbidden.
Furthermore. a primary value for Muslims is that money is not a 'commodity' and no receipt or payment
of interest is allowed.

The growth of the lslamic finance industry

These concept points matter because as much as 2 0 per cent of the world's population adheres to Islam. The
estimated 1.3 billion Muslims are one of the fastest-growing global communities. As we saw above, Islam
is one of the most active religions in its efforts to provide comprehensive life guidance to its adherents.

The Islamic finance business is an industry which has known gradual and broadening success. The lslamic
banking and finance business is undergoing remarkable growth. Between 2000 and 2004. the number
of lslamic banks increased by 70 per cent with a comparable growth in both shareholder equity and
asset^.^ Within this universe. money managers estimate that there is an active market for liquid funds
looking for quality assets in the range of USS30-50 billion a t any given time. This growing, but opaque,
market includes trade finance within the Organization of the lslamic Conference (OK) members, global
trade flows, investment activity, and consumer finance and investment.
Introduction:
the origins and
Geographic
1 dispersion
nature of the
Islamic financial The grc)wth is driven by an accelerating shift to lslamic finance in all Muslim societies. Retail investors
market
are conlmitted and surveys in Saudi Arabia have shown that as much as 76 per cent of the population
desires lslamic banking.4 Consumers, retail and corporate, are making themselves better informed about
lslamic financial opportunities. Conventional bankers, too, are growing their knowledge and competitive
positiorI in this business segment. Both conventional bankers and lslamic bankers are improving their
coopenition, increasing product offerings and enhancing the drive for improved lslamic finance infra-
structure in Muslim countries. Demand is diversified by product and is experiencing geographic disper-
sion: more than two-thirds of lslamic funds are from the Middle East, with the bulk of the rest from
south-east Asia and an emerging number from Africa. North America and Europe.

As mucli as the modern expression of Islamic values in finance has been centred in the Arabian Peninsula
and Ma laysia, London has been a global capital market centre for lslamic finance. For example, many
transna tional lslamic deals are governed by English law. And, with English as an important language for
lslamic finance, we find logical expansions of lslamic finance in North America, South Africa and grow-
ing corrifort with the concepts in a growing number of global jurisdictions. The client universe includes
both Muslim consumers and global corporations. Indeed, with the sukuk (Islamic bonds, see Chapter
10: O p portunities with sukuk and securitisations) issuance by the German state Saxony Anhalt, lslamic
financiall vehicles are showing themselves to be useful tools for public finance.

This ev~olution is captured in Exhibit 2 which shows the distribution of institutional establishment of
lslamic financial institutions around the globe.

Since tlie mid-1970s. lslamic finance has followed in the wake of innovations in the global financial
service: j industry. First, this has a strong connection t o the importance of London as a global

Exhibit 2 1ivolution of lslamic finance - marketsoverview

Source: Stella Cox and Lawrence Oliver.

lslamic finance centre. Secondly, global developments have guided the shift among lslamic financial insti- Introduction:
the origins and
tutions from simple commercial banking products to more sophisticated capital market products with nature of the
lslamic finoncial
longer tenors. Although London is a premier centre providing capital market services t o the global market

lslamic market, only Malaysia and Bahrain have fully integrated Islamic capital markets which offer vir-
tually all of the capital markets resources found in highly developed conventional markets. Stage 3 and
4 countries are enjoying rapid development and may well be expected to leap rapidly to Stage 5. The
number of Stage 1 countries is likely to increase with significant migration to Stage 2.

Curiously, Stage 2 is the most difficult space from which to graduate. Countries such a s Algeria, Sri
Lanka and the United States have been Stage 2 countries for a number of years and do not look likely
to graduate to Stage 3 in the near future. Stage 2 is often the space in which ad hoc accommodations
are made from a regulatory perspective. But, the commitment has not been made to formalise or grow
specific regulatory regimes that accommodate the evolution of the business domestically.

From a product perspective, the developing lslamic financial markets have shown t h e following pro-
gression (see Exhibit 3).

When lslamic banking took form in the 1970% the first-generation investors were familiar with such
banking role models as Citibank, Barclays. Credit Lyonnais (now CALYON) and similar commercial banks.
The typical chief executive of a new lslamic bank was drawn from such commercial banks or their
branches in the lslamic world. Along with the commercial banks, the lslamic banks undertook longer
tenors and entered syndicated and project finance in the 1980s. Only in the 1990s did lslamic finance
proponents begin to manage a shift to capital markets activities. These have flourished and this book
will document the techniques that have been perfected by lslamic banks over these past 40 years, as
well as many of the cutting-edge lslamic concepts now gaining a foothold in the lslamic market and its
interactions with the global capital markets.

Exhibit 3 Product timeline

Source: Stella Cox and Lawrence Oliver.

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