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Islamic Finance: Creating social value from ethical banking

Islamic Finance: Creating social value from ethical banking

“The object of the Islamic economic system is to secure the widest and most beneficent distribution of wealth through institutions set up by it and through moral exhortation. Wealth must remain in constant circulation among all sections of the community and should not become the monopoly of the right.” – Sir Zafrullah Khan, first Muslim Judge at the International Court of Justice

Although mandated since the seventh century, Islamic banking and finance has only formalised gradually over the last 50 years. In that time, however, it has grown from a very niche asset class to a global one, with Islamic banking assets expected to grow at an annual rate of 19.7% to 2018, while valuing at £1.3 trillion (and counting).

In this introduction to our Islamic Finance series, we will explain the conceptual roots and benefits of Islamic finance.

Each subsequent part of the series will illustrate the applicability of specific Shari’ah compliant financial facilities. The four-part series will comprise of the following topics:

Part I: Profit-sharing (mudarabah)
Part II: Partnership and joint venture (musharaka)
Part III: Shari’ah loans (murabaha)
Part IV: Agency (wakala)

Islamic finance is guided by the teachings of Islam, which in itself are the compilation of ethical principles the Prophet Muhammad communicated as a messenger for the word of God and the documented precedent of his own life.

Dealing without interest

The central differentiator of Islamic finance is in the concept and use of money. Money is intended only as a measuring tool for value and, as such, medium of exchange, not a commodity to be traded or an asset that grows over time.

This is why interest (riba) is prohibited, as money itself has no intrinsic value, but only the real assets it is supposed to measure. Islamic finance proscribes that one should not be able to benefit from lending with interest payments as it is considered exploitative at the expense of the borrower.

To be Shari’ah compliant, financial transaction must have an underlying attachment to the “real economy” – tangible assets that can be bought and sold.

One of the first questions Islamic finance raises is, “If there is no interest, how then do banks make money?”

While Shari’ah compliant banking prohibits interest, the banks can still receive profit for their involvement in providing services and assisting their customers to raise capital. Essentially, Islamic banking is structured so that banks are more involved and share in the risk of their customers. Banks are rewarded for this by having a share in the resulting profits of the enterprises and trading activity they help finance.

Risk and profit

To put Islamic finance into context on a wider scale, when looking retrospectively at the Global Financial Crisis, much of the crisis occurred because the money that was traded, through the buying and selling of financial products such as mortgage-backed securities and credit default swaps, had no asset backing and was largely based on speculation.

This culture of passing risk from one party to another created a domino effect where the first hints of economic decline spread as a wave, bringing down large financial institutions such as Lehman Brothers and Northern Rock (now Virgin Money).

In contrast, Islamic finance theoretically offers a blueprint for a stable global economy, one that can also bring long-term societal benefits such as through an obligation to give charity by the well-to-do and the encouragement of wealth circulation within communities. When operated correctly, Islamic finance is effectively a bridge between non-profit organisations and commercial businesses, as it encourages the core values of each.

Islamic finance focuses on the relationship between risk and profit, using facilities that are based on ‘risk-sharing’ as opposed to ‘risk-transfer’, the latter being typically associated with conventional banking.

The concept of risk-sharing and principle that no party should profit purely from the exchange of money leads to a shift in perspective away from short-term transactions and towards longer-term relationships and their rewards.

Islamic financing arrangements

To example the way in which Shari’ah compliant finance benefits parties by encouraging practices of sharing risk and reward, our commercial team at Saracens has provided a brief overview of the financing arrangements that will be discussed in later instalments of this series.

Profit-sharing (mudarabah)

This type of partnership provides for one partner to invest capital into a commercial enterprise, while the other partner provides expertise and management skill. In consideration for the joint investment of capital and skill, the partners share in the generated profits at a pre-agreed ratio.

Partnership and joint venture ownership (musharaka)

Intro - Sub ImageSimilar to a Mudaraba, a Musharaka arrangement is more akin to a joint venture between two parties. Predominantly used by financial lenders and their business clients, this relationship calls for contribution of capital from both parties with an aim to share in any proceeds generated as a result of the joint financing.

Lending at cost-plus profit (murabaha)

With this type of Shari’ah loan, the lender buys (with its own money) and sells a specified commodity on behalf of the borrower and transfers the proceeds (loan amount) to the borrower. The borrower then repays the lender in instalments for the loan amount as well as a pre-agreed profit. The profit stems from the bank’s involvement in the trading of the commodities, which yielded the loan monies.

Agency (wakala)

In its simplest sense, a Wakala arrangement is one whereby a principal appoints an agent to act on its behalf. This arrangement has become prevalent in investment funds whereby the wakeel (agent) lends its expertise and manages the principal’s investments to generate a profit return. For example, if a customer enters into a Wakala agreement with a bank, then the bank can use their cash investment to invest in Shari’ah complaint trading activities with an aim to generate a target profit return for them. The customer would also have an ownership interest in any of the investment assets as security for the investment until the end of the Wakala arrangement.

In continuation of this series, the Saracens commercial team will be illustrating the profit-sharing, joint venture, Shari’ah loan and agency facilities in later segments. Our aim is to provide both borrowers and lenders interested in Islamic finance with a working understanding of the mechanisms and legal considerations of these products to ensure there is fair dealing between all parties.

If you are interested in Shari’ah compliant products, you may telephone our London office on +44 (0) 20 3588 3500 to speak directly to one of our advisors on your lending / borrowing needs.

Have you ever used an Islamic finance product? How did you find it different? We would love to hear about your experience. Please leave a comment or any questions in the section below.

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