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Basic of Islamic Finance

Basics of Islamic Finance

Islamic Finance is based on Shariah principles (a set of rules and regulations prescribed to lead a dignified life), which is primarily based on the below sources.

  1. Quran – Holy book revealed by Almighty Allah for the guidance of humanity on his beloved Prophet Muhammad peace and blessings upon him,
  2. Sunnah / Hadith – Sayings or acts of Holy Prophet or even his silence on something as a form of approval,
  3. Ijmah – The consensus of competent scholars on an issue of juridical importance and
  4. Qiyaas – The principle of analogy applied in the interpretation of points of Islamic law not clearly covered in the Quran, Sunnah or Ijmah.

That is why for all Islamic finance institutions be it a Islamic bank, finance company, mutual funds etc. a dedicated and independent Shariah advisory board or audit firm is required who will be guiding them on the basis of Shariah principles, whether to invest in some kind of ventures or not, whether to indulge in some kind of business or not, and how the whole mechanism should be governed etc. everything would be under a very strict supervision of these shariah advisors. For example Shariah did not allow to invest or promote the businesses in which riba/interest is involved in any form, as per Shariah one can’t invest or promote alcohol, gambling, drugs, hazardous chemicals, weapons of mass destruction etc. So these Shariah advisors will keep a close watch on any venture who claim to be Shariah compliant that they shouldn’t involve in any kind of these activities.

The whole purpose of Islamic finance is that one should not indulge in any un Islamic, illegitimate business and the wealth should not be kept in the hands of few but it should be proportionately divided among the people. And to attain this goal it prohibits riba/interest which exploits the needy and benefits the rich. While conventional banking and finance is wholly depends on interest and allied kind of businesses, Islamic finance provides the alternatives to be away from interest. That is why Islamic finance is getting popular being a very good ethical and responsible form of financing which is based on people centric approach and not profit centric only.

Below are few products and services which Islamic finance offers and are now getting popular in the global financial market on the basis of their performance.

Musharakah is a contract where parties come together for a partnership agreement based on pre agreed profit ratios on the other hand loss is shared on the basis of the amount of capital invested by each party. It can be a permanent contract or diminishing, in the permanent one there will be no mention about the time period and they can carry on the business as far as they are wish to continue and in the diminishing the financier will be getting their part of profit as well as the principal over a period of time and the ownership of that financier will be getting reduced over the time. It is usually used for a joint venture firm.

Mudarabah is a contract in which two parties agrees to start a business or project in which one party bring the capital needed and the other one brings the expertise or managerial skills required to run the business or fulfill the project. The net profits will be shared among both of them on a mutually agreed ratio whereas the loss will be borne by the financier only. In such type of contract, it is very important that financier should do a thorough research about the expertise of the second party who will be managing the business, because if it results in the loss it has to be borne by the financier and not the manager. Due to this fact there is very less percentage of Mudarabah contracts taking place in the Islamic banking as it’s a high-risk business contract.

The one who invest the fund is known as Rab-ul-Maal, and the one who manages or run the business is known as Mudharib.

Murabaha is a very popular contract among the Islamic banking industry which is taking place. It is a sale contract in which the bank or the financier is approached by the client with a request to purchase an asset on behalf of the client and then sell it back to the client with a margin of profit and the client will be paying this cost-plus profit in the installments over a period of time to the bank or financier. Here the need of the client is fulfilled and the fund of the bank is mobilized in an islamically permissible manner as there is no interest charged, and the margin of profit held by the bank is known to the client well in advance.

This kind of contracts can be used to finance the need of raw materials, agriculture, capital goods, consumer durables, machinery etc. All the information about the products to be purchased will be given by the client with detailed specifications so that there should not be any conflict once the product is purchased and the client refused to buy it therefore a “promise to buy” is taken from the client. And both parties are bound to oblige as they are motivated by the Islamic norms of keeping a promise in any case.  The bank or the financier can have independent research about the specifications given by the client is correct or not and then only go for a purchase.

Takaful or Islamic insurance is a mutually agreed insurance scheme in which policyholders agree to assist or aid the other policyholder in case of a loss or damage. In this insurance scheme there will be a takaful fund in which all policyholders put their money instead of paying the premiums as in the case of a conventional insurance scheme. This fund will be managed by the takaful operator who will undertake the roles and responsibilities of managing and administering the fund who will be paid a fee for this professional service. This fund will be utilised to meet the loss claims raised by any policyholder and any surpluses left will be distributed back to the policyholders which is a distinct feature of takaful and is gaining popularity in the insurance industry due to this feature as there is no such provision available in the conventional insurance industry.

Ijarah is nothing but a lease agreement in which Islamic bank or financier will be purchasing an asset be it a land, building, property, heavy machines, industrial units etc and lease it to the client. The ownership remains with the bank but the possession and right to use is transferred to the client against a pre agreed rent be it monthly or annually. This agreement must fulfill all the basic requirements of a valid contact such as the time period of the contract, the agreed rent etc. Once the contract expired the possession will be given back to the bank or financier and then they can lease the same to anyone else and earn the rent. The rent should be decided based on the cost of the asset and useful expected life should also be calculated to get the proper rent.

There is a one more possibility named as lease purchase transaction in which the client agrees to purchase the asset over a period of time at an agreed price and then the ownership will also be transferred to the client at the end of stated time period and payment of final amount. This may include the rentals also depending upon the nature of agreement and consent of agreed parties.

Sukuk or Islamic Bonds were introduced to prevent investors from indulging in unislamic conventional bonds which is based on interest payments as it is not allowed in Islam to invest in any such interest-based product. Sukuk are the certificates issued to the Sukuk holder as the ownership of an underlying asset in which the money collected from Sukuk holders are invested and they will be getting rent or profit depending on the nature of the contract they entered. There is a possibility of loss as well in the equity based Sukuk so the returns are not fixed as in the case of conventional bonds hence this fulfills the requirement of profit and loss sharing as per Islamic law.

Qard-e-Hasan is the purest form of Islamic loan where a needy person can get the loan without paying any interest. It serves the noble Islamic law of mutual assistance without any expected or fixed extra returns. The whole concept and its practice depends upon the trust between the lender and borrower. Hence the Islamic banks should also encourage this kind of loans which is the basis of Islamic finance but as there will be few maintenance and other administrative costs need to be fulfilled they can have the option of getting a management fee, or any extra amount paid by the borrower out of his own will without any pre arrangement or compulsion to pay, that is also permissible.

Wadiah is nothing but safe keeping, it can be seen an Islamic form of conventional current or saving account where the bank is obliged to pay back on demand by the account holder whole or part of amount deposited. There will be no fixed interest payment as in the case of conventional saving bank account, but bank may pay a token of appreciation known as “Hibah” or gift. Depending upon the bank and account holder agreement this amount can be used for investments as well but again the distribution of profit and risk of loss depends upon nature of agreement and banking laws accepted by the account holder. Few account holders do not agree for their amount to be utilized as they fear of a loss in this case bank can utilize it on their own risk as they have to pay it back when demanded, some account holders agree for investment and also agree to bear out of control losses if any.

Salam is a contract between a producer and a merchant where the amount of sale is paid in advance and the delivery of goods will be done in a future date. This facilitates the producer of getting financed his produced and then sold out as soon as it’s ready. The bank or the financier can dictate the specifications about the produce like quality, quantity, date of delivery, place of delivery etc in details so that no conflict will come up at the time of execution of contract. This type of contracts is usually made in the agricultural produces where the farmers get the advanced amount to produce his crops. This can also be applied to similar kind of industry as well where there will be a manufacturing process and then at a future date the final goods will be delivered. Once the bank or the financier got the physical possession of the goods then they can sell it out in the market and get a profit being the difference of purchase price and market price. There could be a possibility of decrease in price which may result in loss to the bank due to market fluctuations hence they have to be very vigilant on what they are agreeing to buy and how market behaves.

Istisna is bit similar to salam contracts where two parties agree to buy or sell something manufactured or processed at a future date. But there are few exceptions to it like the buyer can request the way he want his product/building/machinery to be manufactured/constructed or processed. The payment can be made in installments to purchase the raw materials, labor payments etc even it can be paid at the time of delivery. There is flexibility in regards to the time of delivery there is no compulsion to fix one date in future, and even the contract can be cancelled before the work get started. The Islamic bank can enter in such type of contract being a buyer as well as a seller. They can buy such assets and re sell it in the market or even they can make a contract with the manufacturer or builders and then sell it on deferred payments.

Waqf is an endowment given voluntarily by Muslims for religious purposes without an intention to reclaim it get any sort of income or return for themselves anything earned from such endowment properties can be utilized for community services like constructing masjids, graveyards, schools, hospitals etc. and the maintenance of such institutions will be fulfilled from the income generating from such endowment properties like revenues from a village, revenue from a mill, rent from a commercial shop or complex etc. Usually, these endowments are not maintained properly hence the Islamic banks can take care of it and fulfill the needs of community by providing interest free loans, assistance to build community institutions etc. Waqf properties cannot be sold, or transfer to anyone once it is Waqf for the community cause to please Almighty Allah.

Similar but not same to any other mutual fund, Islamic funds are the shariah compliant funds in which funds are collected from people and invested in shariah compliant securities where there will be no non shariah business being carried out. There will be shariah auditors who keeps a close watch on the investments of the Islamic funds to ensure if they are following the shariah norms which prohibits investments in companies indulging in the business of alcohol, pork, weapons, conventional interest-based businesses, gambling etc. They are allowed to invest in the holdings which are approved as shariah compliant by the shariah auditors. This gives the investors an alternative to invest their money in the Islamic way. The number of such Islamic funds are growing rapidly and many people are showing interest in such funds and it leads these fund’s asset under management to more than $50 billion. They can invest in equities, Sukuk, money market, real estate, healthcare etc.

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