Understanding Islamic finance

Islamic finance is founded on Shariah principles which express an explicit intention to meet the financial needs of participants with integrity and in a manner that is just, fair, trustworthy and honest, while ensuring a more equitable wealth distribution.

 

Shariah principles in Islamic finance

Islamic finance encourages business and trade activities that generate fair and legitimate profit in which the business transaction must be accompanied by an underlying genuine trade and business-related activity. This requires a close link between financial and productive flows which underpin Islamic finance. This is to ensure the funds are being channelled into real economic activities and will thus entail the appropriate due diligence. This has the effect of insulating the Islamic financial system from risks associated with excessive financial leverage and speculative activities.

 

Riba (Interest)

The central feature of the Islamic financial system is the prohibition of the payment and receipt of riba (interest). Riba refers to an increase or excess which accrues to the owner in an exchange of sale of a commodity, or, by virtue of a loan arrangement, without providing any equivalent value to the other party. Money in Islam is not a commodity. The prohibition of interest arises from the fact that money is only perceived as a medium of exchange, stored value and unit of measurement.

 

Gharar (Speculation)

Another feature of Islamic finance is the prohibition of economic transactions involving speculations that is gharar. Gharar signifies ambiguity, uncertainty or lack of specificity in the terms of a financial contract. Under this prohibition, any transaction entered into should be free from uncertainty, risk and speculation.

 

No profit sharing without risk sharing

There is also the essence of no profit sharing without risk sharing.

 

No transactions in forbidden products and services

In Islamic finance, products and services that are forbidden by Shariah cannot be transacted in. Examples are pork, pornography, casino (gambling), interest (riba).

 

You cannot sell what you do not own

In Islamic finance, there is the rule of “you cannot sell what you do not own”. However, it has two exceptions by way of Salam (used for agric financing) and “Istisna”.

 

Islamic finance is divided into three groups, namely, Islamic Banking, Islamic Capital Market (Sukuk-Islamic Bonds) and Islamic Insurance (Takaful).

 

Islamic banking

Deposit framework of Islamic banks  Deposit taking is one of the sources of funds of an Islamic bank: Wadiah (safekeeping), Mudarabah (profit sharing) and Qard an hassana (benevolent loan).

 

There are various forms of financing that an Islamic bank can apply. These include Murabaha (cost plus mark up), Ijara (lease), Musharaka (partnership), Mudaraba (profit and loss sharing), Salam (deferred delivery sale), Istisna (deferred delivery contract), and Sukuk (Islamic bonds).

 

Tawarruq

This is a transaction where one party buys some goods on credit at a marked-up price and sells the same at a lesser value for the purpose of getting cash (i.e., the spot value of the goods). It is used for inter-bank transactions for Islamic banks. Trader 1 and 2 must be different except in Malaysia where “Bai Inah” (buying and selling to the same party) is allowed. There have been a lot of criticisms on Tawarruq, but no alternative to it, and thus it is overlooked.

 

Islamic capital market  Sukuk (Islamic bonds)

Sukuk are certificates of equal value representing common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.

 

Types of sukuk include Mudaraba Sukuk (joint venture), Ijara Sukuk (lease), Istisna Sukuk (construction/ manufacturing financing), Musharaka Sukuk (partnership), Salam Sukuk (sale with spot payment but defer delivery), and Murabaha Sukuk (cost plus profit margin sale). Sukuk represent proportionate beneficial ownership. For a defined period the risk and returns associated with the cash flows generated from the assets belong to the Sukuk holder.

 

Characteristics of a Sukuk are similar to a conventional bond with the difference being that they are asset backed. While Sukuk is a certificate of ownership, conventional bonds are certificates of indebtedness.

 

Islamic insurance (Takaful)

Takaful derived from kafala which means to guarantee. Takaful system is derived from Tabarru system which means donation, gift, and contribution. It is a mutual fund where all participants contribute to support one another in difficulties.

 

Conclusion

The people not conversant with the principles of Shariah and its economic philosophy sometimes believe that abolishing interest from the banks and financial institutions would make them charitable, rather than commercial, concerns which offer financial services without a return. The above submission negates this belief.

 

Jibrin is of the Islamic Financial Advisory unit, Ahmed Zakari & Co (chartered accountants), Kano.

 

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