The basic principles around the framework on Islamic Finance:
- strict prohibition of interest on debt i.e., earning interest (riba) is not allowed. It is strictly prohibited to use money for the purpose of making money.
- Instead of a loan the money provided in the form of deposits channelled into an underlying investment activity, which will earn profit. And the depositor rewarded with a share on such profit after deduction of management fees by the bank. (i.e., the finance flows between investor and borrower through a profit-sharing arrangement instead of interest).
- The income to Islamic banks is not in the form of interest income but are returns in the form of cash returns from productive source, e.g., profits from selling assets or let-out income (rent) from assets etc.
- The financing through a stakeholder-type partnership (mutual interest, trust and co-operation) that are engaged in deriving benefits from ethical, fair business activity.
- Wealth must be generated from legitimate trade and asset-based investments.
- Risk should be shared.
- Speculations are prohibited
- Sharia Board ensures all the product and services offered by the IFIs (Islamic Finance Institutions) are compliant with Sharia rules.
- The global Islamic financial market was worth $~2bln in 2021 and is expected $~3bln by 2027.
Islamic banking financing techniques could be categorised into following two heads:
Equity modes of financing:
- Mudaraba:
- A special kind of partnership where investment comes from first partner (100% provider of capital=owner of capital) and another party (agent) brings business expertise.
- Profits shared @ pre-agreed ratio.
- But only the lender (investor) of the money has to take losses (although provisions could be made where losses can be written off against future profits).
- Mudaraba in comparison with debt: It would not require commitment to pay interest that loan finance would involve.
- Mudaraba in comparison with conventional equity funding: Mudaraba would offer a method of obtaining equity funding without the dilution of control which an issue of shares to external shareholders would bring.
- Musharaka: (like VC)
- A partnership to invest in a business (two or more contribute capital).
- Profits shared @ pre-agreed ratio.
- But losses shared @ capital ratio.
Debt modes of financing (fixed income modes):
- Murabaha: (like trade credit, credit sales or loan)
- The bank will take actual ownership of the asset. The asset is then sold to the ‘borrower’/ ‘buyer’ @ profit with payment over a set number of instalments.
- No penalty or additional mark-up by bank is allowed, but repayments period can be extended.
- Early payment discounts are not within the contract.
- Ijhara: (like lease finance)
- The use of the underlying asset or service is transferred for consideration.
- The bank gives right-to-use asset to customer for a fixed period and price.
- The contract must specify: the use of underlaying asset, lessor (the bank) is responsible for the ownership cost (major maintenance of the underlying assets), the lessee is held for maintaining the asset in proper order.
- Sukuk: (like bonds)
- Sukuk bonds could have been based on underlaying securitised Islamic contracts like Ijhara and Mudaraba as well as on physical assets.
- Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukuk holder (investor) is a partial owner and profit is linked to the performance of the underlying asset.
- For example: the financial institution purchases a property financed by Sukuk certificates and rents it out at fixed rent. The certificate holders receive a share of the rent (instead of interest) and a share of the eventual sale proceeds. The Sukuk manager is responsible for managing the assets on behalf of the Sukuk holders (and can charge a fee). The Sukuk holders have the right to dismiss the Sukuk manager.
- A sukuk holder will participate in the ownership of the company issuing the sukuk and has a right to profits (but will equally bear their share of any losses).
- Asset based sukuk– raising finance where the principal is covered by the capital value of the asset but the returns and repayments to sukuk holders are not directly financed by these assets.
- Asset backed sukuk– raising finance where the principal is covered by the capital value of the asset and the returns & repayments to sukuk holders are directly financed by these assets.
- A key difference between Sukuk and Murabaha is that Sukuk holders have ownership over the cash flows but not the assets themselves.
- Salam contracts:
- Salam contracts are similar to forward contracts where a commodity (or service) is sold today for future delivery with quantity, quality, and the future date & time of delivery determined immediately. The sale would be at a discount so that bank can make profit.
- Salam vs Futures:
- Salam contracts are designed based on Islamic principles where uncertainty and speculation are avoided by fixing/making the payment at the starting of the contract and both parties aware of the price, quantity and quality along with date of future delivery.
- On the other hand, Futures are MTM daily and could lead to uncertainty in the amounts. Furthermore, Futures have fixed expire dates and pre-determined contract sizes which could mean the underlaying position is not hedged completely. Lastly, the price movement in Futures may not be completely in line with the price movement in the underlaying assets.
- Futures are traded in organised exchange markets which is not applicable for Salam contracts.
- Istisna contracts: are used for large turnkey projects where bank funds the construction and on completion the project is delivered to the customer of the bank who pays initial deposit, instalments to bank.
Benefits of Islamic finance:
- Stakeholder-type partnership based on mutual interest, trust and cooperation.
- Deriving benefits from ethical, fair business activity.
- Benefiting the community as a whole.
- Prohibit speculations and short-term opportunism.
- Focus on all party attention on successful outcome of the venture.
Drawback and challenges of Islamic finance:
- Increased cost of capital e.g., difficult to demonstrate the repayments for Mudaraba and debt instruments like Sukuk etc. may not attract tax-shield. Hence, companies raising finance through conventional ways may be able to achieve lower cost of capital and increased value of its investment.
- Lack of sufficient flexibility
- Principal-agent issues
- Cost of developing new financial product could be higher IFIs (hence, lack of innovation).
- Stages of compliance and layers of complications are higher which takes time.
- Expensive for customers due to cost of developing and many compliances involved.
- Valuation of Islamic products and its benchmarking is unique.
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