Where do we go from here?

Islamic Finance Principles

Professor Habib Ahmed
Durham University
January 22, 2009

Bankers’ Association for Finance and Trade

 Agenda
• Introduction to Islamic Law and Principles
– Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector

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 Sources of Islamic Law
Two sources of law in Islam
• Shari’ah—Revealed knowledge
– Quran
– Hadith/Sunnah (Sayings/doings of the Prophet)
• Fiqh– Derived knowledge through ijtihad
(exertion)
• Four major schools of thought in the Sunni
tradition

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 Basic Approach to Islamic Law
• Islamic laws can be broadly classified into
two types
– Ibadat (devotional acts) – Any act which is not legalized
by Shari’ah is void
– Muamalat (dealings or transactions)—All transactions
are permitted unless explicitly prohibited by Islamic law
(principle of permissibility)
• In muamalat, new transactions can be
accommodated through ijtihad as long as
they do not contain the prohibited
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 Contracts-Islamic Nature
• Freedom of contracts—provided the prohibited
elements are avoided
• Some aspects of the contractual relationship
determined by Shari’ah/Fiqh to avoid
– Injustice
– Conflicts/Misunderstandings
– Exploitation
• The prohibitions in transactions include:
– Riba
– Gharar

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 Riba
• Riba (literal meaning ‘increase’) is prohibited
“...they say: trading is only like riba, whereas God has permitted
trading and forbidden riba…” (Quran 2:275)
• Various interpretations of riba
• Implications of riba:
–Interest is forbidden
–Selling debt (at a discount) is not allowed

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 Gharar
• Gharar–Excessive risk, hazard, or ambiguity
• Gharar can exist in the object or terms of the
contract
• Implications of gharar:
– Existence of the object (& ability to deliver)
– Two sales in one
– The future sale

Bankers’ Association for Finance and Trade

 Agenda
• Introduction to Islamic Law and Principles
– Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector

Bankers’ Association for Finance and Trade

 Major Islamic Contracts used in
Financing

1. Sale (Exchange) Contracts

1. Deferred trading contracts
• Price deferred sale (murabahah)
• Object deferred sale (salam, istisna)
• Leasing-sale of usufructs (ijarah)
• Partnerships – musharakah or mudarabah
• Interest free loans (qard hassan) or loans at
service charges

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 Murabahah
Traditional Murabahah/Bai al-Muajjal
Productspot

Pricefuture

Financing Mode in Islamic Banks—Debt

• The financial institution buys and then sells a good to the
client at a mark-up
• Price paid at a later date
• The bank must own and posses the good
• The profit rate and other terms should be clearly specified in
the contract
• The bank can ask for guarantees or collateral
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 Salam
Traditional Salam

Pricespot

Commoditiesfuture

Financing Mode in Islamic Banks—Debt

• Used to finance the agricultural sector
• The price has to be fixed and paid when the contract is
concluded
• Commodities delivered at a later date
• The delivery time should be fixed

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 Istisna
Traditional Istisna

Paymentinstallments

Assetfuture

Financing Mode in Islamic Banks—Debt

• A pre-production sale used when an item/asset needs to be
manufactured/constructed
• The price of the asset should be known and time of payment
can be negotiated among the parties
• The seller of the asset (bank) can either manufacture it or
sub-contract it
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 Ijarah
Traditional Ijarah
Asset (for rent)fixed period

Rental Payments

Financing Mode in Islamic Banks—Leasing

• A hire-purchase leasing contract
• Ownership is transferred to lessee at the end of the contract
period
• Fiqhi objections—two contracts in one; purchase contract
cannot be binding
• Banks give away the asset at nominal value or as a gift at the
end of the lease period
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 Mudarabah
Traditional Mudarabah

Service/labour Fundsspot

Profit sharefuture Profit sharefuture

Financing Mode in Islamic Banks—Equity
• Partnership between bank and clients
• Used on the liability and asset sides
• Profit shared among parties at an agreed upon ratio
• Loss borne by financier only
• Financier cannot ask for a guarantee of capital or return
• Mudarabah can be restricted or unrestricted

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 Musharakah
Traditional Musharakah

Funds & labour Funds & labour

Profit sharefuture Profit sharefuture

Financing Mode in Islamic Banks—Equity

• A partnership contract in which bank contributes capital and
managerial services
• Like a mudarahah, but all partners manage the project
• The profit share among the partners at an agreed upon ratio
• Loss shared according to share of capital

Bankers’ Association for Finance and Trade

 Agenda
• Introduction to Islamic Law and Principles
– Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector

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 Ideal Islamic Banking Model
• Two-tier mudarabah model
– Profit-loss sharing modes of financing on both the asset and
liability side
Assets Liabilities and Equity
• Equity financing •Profit-sharing investment
(Mudarabah/musharakah) accounts (PSIA-Mudarabah
based)
•Demand Deposits (qard
hasan)
•Capital

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 Islamic Banking Practice:
2nd Best Model
One-tier Mudarabah with Multiple Investment Tools
• Liability Side—PSIA (Mudarabah based)
• Asset Side—multiple investment tools, dominated by fixed-
income contracts (murabahah, ijarah, istisna, etc.)
Assets Liabilities and Equity
•Debt-based financing •PSIA-Mudarabah based
(Murabahah, Istisna, salam) •Demand Deposits (Qard
•Leasing-based financing hasan)
(Ijarah) •Capital
•Equity-financing •Reserves
(Mudarabah/musharakah)

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 Tawarruq
2

Broker
Client 1 Bank
3

The client wants a personal loan and approaches the bank

1. Bank buys commodity from a broker paying spot (for £100)
2. Bank sells the commodity to client payable at a future date (for £110)
3. The client sells commodity to broker spot (for £100)
[Organized tawarruq: The client appoints the bank as agent to sell the
commodity. The bank sells the commodity spot to the broker for £100 on
behalf of the client and deposits the money in client’s account.]
At the end of the transaction, the client gets £100 and owes the bank £110
payable in the future

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 Implications of Tawarruq
• Tawarruq and Gresham’s Law (bad money
drives away good money)
• Tawarruq is driving all other modes away
• Tawarruq replicates a loan transaction
• The result—third best model of Islamic banking

Bankers’ Association for Finance and Trade

 Islamic Banking Practice:
3rd Best Model
Fixed Liability with Multiple Investment Tools
• Liability Side—Fixed-income investment accounts (using
tawarruq)
• Asset Side—multiple investment tools, dominated by fixed-
income contracts (tawarruq, murabahah, ijarah, istisna, etc.)
Assets Liabilities and Equity
•Debt-based financing •Fixed income investment
(Tawarruq, Murabahah, accounts (Tawarruq)
Istisna, salam) •Demand Deposits (Qard
•Leasing-based financing hasan)
(Ijarah) •Capital
•Equity-financing
•Reserves
(Mudarabah/musharakah)
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 Islamic Modes of Financing
Modes Sudan Pakistan Bahrain UAE
Murabahah 42.45 50.96 51.73 49.29
Musharakah 17.77 2.52 0.89 2.59
Mudarabah 3.10 - 1.96 4.36
Ijarah 0.87 20.41 5.56 18.90
Istisna 0.95 - 0.63 3.22
Salam 0.55 0.23 - -
Others 34.31 25.88 39.23 21.65
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions

Bankers’ Association for Finance and Trade

 Islamic Modes of Financing
Modes Iran Malaysia Jordan Saudi Arabia
Murabahah 21.02 41.04 15.41 15.81
Musharakah 0.97 0.24 2.99 0.65
Mudarabah 1.51 0.27 11.36 0.05
Ijarah 2.18 9.40 13.80 0.04
Istisna 0.07 1.72 1.20 3.74
Salam 0.03 - - -
Others 74.22 47.33 55.25 79.71

Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions

Bankers’ Association for Finance and Trade

 Agenda
• Introduction to Islamic Law and Principles
– Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector

Bankers’ Association for Finance and Trade

 Role of Shari’ah Scholars
• Most Islamic banks initially created by private
initiatives by pious Muslims
• Shari’ah compliance important feature of IF
organizations
• Authenticity, credibility, and public confidence of
products/services required
• Establishment of Shari’ah bodies at different levels
• Re-emergence of legal authority Shari’ah scholars

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 Different Types of Shari’ah Bodies
• Shari’ah bodies exist in different forms
 Shari’ah Department (in the bank)
 Advisor (external to the bank)
 Supervisory Board (in the bank)
 Supervisory Board (national)
 Professional Shari’ah Advisory Firms
 International Fiqh Bodies
• Depending on the regulations and size of the
organization, different models of Shari’ah
governance exist.

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 Shari’ah and Legal Risks
• No unified Shari’ah rulings
• Application of Islamic contracts in non-Islamic
jurisdictions
– ‘Choice of law’ and ‘dispute settlement clauses’
included in contracts
– Usually English law is preferred
– If Shari’ah is the governing law—disputes settled
by commercial arbitration

Bankers’ Association for Finance and Trade

 Agenda
• Introduction to Islamic Law and Principles
– Riba and Gharar
• Islamic Contracts
• Islamic Banking Models
• Shari’ah Governance
• Islamic Financial Sector

Bankers’ Association for Finance and Trade

 Evolution of Islamic Financial Sector
s’1970 s’1980 s’1990 2000’s
Islamic Banks Islamic Banks Islamic Banks Islamic Banks
Takaful Takaful/Retakaful Takaful/Retakaful Takaful/Retakaful
Mutual Funds Mutual Funds Mutual Funds
Mudarabah Co. Mudarabah Co. Mudarabah Co.
Leasing Co. Leasing Co.
Investment Banks Investment Banks
Islamic indices Islamic indices
Sukuk
Private Equity &
Venture Capital
Hedge Funds
Infrastructure/
project finance
Islamic REITs
Trust/Waqf
Management

Bankers’ Association for Finance and Trade

Size of Islamic Financial Industry
• Islamic financial sector is significant and
expanding at a fast rate
– More than 500 Islamic financial institutions in
over 75 countries
– Over 706 Shari’ah compliant mutual funds
– Total outstanding sukuk issues—USD 83.7
billion
• Estimated total Islamic financial assets
under management-$1 trillion
• Islamic financial Industry estimated to
reach up to $2.8 trillion by 2015

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 Questions?

habib.ahmed@durham.ac.uk

Bankers’ Association for Finance and Trade