Key concepts in Islamic Finance
In global terms, the Islamic financial services market is estimated to be worth around one trillion dollars (US). The potential for future growth means that investors are looking for further opportunities presented by Shari’a compliant financial products and services.
Islamic principles are known as Shari’a. They are based on a number of sources including the Holy Qu’ran and Sunna, the living tradition of the Prophet Mohammed. Over time, Islamic financial structures have been developed in line with Shari’a. These are some of the key concepts:
Shari’a holds that money has no value itself, which is to say it holds no intrinsic value. It only facilitates an exchange of things that do have value. The payment and receipt of interest (riba) under Islamic law is prohibited and any obligation to pay interest is considered to be void. Shari'a stipulates that any return to a financier be earned by way of profit.
According to Shari’a, any contract that involves speculation is void. This does not forbid the general commercial uncertainty which is a facet of most commercial transactions. Instead, Shari’a forbids speculation which is in the nature of gambling. The question is whether something arises from productive effort or force rather than chance. In commerce, the distinction may often be a fine one. Each transaction will need to be considered on its own merits.
Shari’a is concerned with any fundamental aspect of a contract which is not agreed with sufficient certainty. This will render is void. Fundamental terms are the usual suspects of subject matter, time for delivery, or price. The English legal approach of ascertaining whether there is some kind of machinery by which the uncertainty can be cured is not taken.
Another relevant aspect is that Shari'a does not permit uncertainty in the subject matter of a contract. A insurance arrangement in its standard form is prohited on the basis of, amongst other factors, uncertainty (gharrar) as to whether the relevant insured event will happen or not.
A contract where one party is deemed to have made an unjust gain at the expense of another is also considered to be void. It is not always clear what may amount to unjust enrichment of this kind and each transaction must be considered individually. The principle of unjust enrichment includes undue influence by one party over another.
To comply with Shari'a law a number of financing techniques have been developed. These include:
Murabaha (cost plus financing)
This is evident in trade financing contracts. The financier will purchase the asset from the supplier (either directly or indirectly via an agent) and will then on-sell the asset to the client at an agreed marked-up price. The financier may hold title to the asset for only a short period. The profit generated by the financier is nonetheless thought of as a profit derived from a sale of goods transaction. It is not therefore prohibited as interest paid on monies lent (riba).
This may be thought of as a medium between a conventional operating and finance lease.
Rental payments under an ijara will reflect an agreed profit element and comparisons with rentals on conventional leases can be made easily. Different a finance lease contract, obligations such as insurance or undertaking maintenance to the leased asset remain with the lessor. The lessee will only remain responsible for the payment of rent for as long as the asset is being used. If the lessee is no longer able to use the asset – if it is destroyed, for example – then the obligation to pay rent will end.
Mr. Ruhel Alom