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Home > Capital Markets Checklists > Key Principles of Islamic Finance

Capital Markets Checklists

Key Principles of Islamic Finance


Checklist Description

This checklist outlines the basics of Islamic finance, one of the fastest-growing areas in financial services.

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Definition

The principles of Islamic law derive from interpretations of two sources: the Qur’an and the Sunna. The central pillars of Islamic finance are that wealth must be generated from legitimate trade and asset-based investment, while the use of money for the purposes of making money is expressly forbidden. Crucially, the latter means that Islamic finance does not permit the charging or paying of interest (riba). Under Islamic principles, investment must have a social and an ethical benefit to wider society, with short-term speculative investments (known as masir) strictly forbidden. Islamic finance also prohibits investment in sectors classified as inappropriate on moral grounds by shariah law. These include industries involving alcohol, gambling, or drugs, but can extend well beyond these narrow boundaries. Each Islamic bank’s adherence to the principles of shariah law is governed by its own shariah board, a body charged with the responsibility of overseeing all processes of the bank. While some aspects of shariah law may be subject to individual interpretation, the board also has the responsibility to decide which proposed deals are acceptable to the bank on shariah grounds, and which are not.

Given that Islamic finance forbids the charging of interest, banks must earn their profits through the provision of fee-based services, or through a kind of partnership with clients in which both the risk and the profits or losses are shared between the bank and the customer, according to pre-agreed conditions. Such arrangements typically allow the client to draw a salary from the business, which is then deducted from profits. Shariah law permits a range of leasing-style agreements under which the bank can buy an asset on behalf of a customer, then charge a regular, pre-agreed rental fee. As in mainstream Western banking, these agreements can be fixed-term operating leases or lease purchases, with the latter obliging the client to buy the asset at the end of the period, at a predetermined price. While some leasing arrangements can be relatively straightforward, others can become more complex, depending on how the asset is originally purchased by the bank. Given that Islamic finance does not permit the charging of interest, a bank originally buying the asset on the basis of a variable interest rate may seek an arrangement by which the rental charge is increased, to effectively compensate any increase that it faces in financing costs. However, some shariah boards may refuse to sanction such agreements, potentially leaving the bank with exposure to interest rate risk.

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Advantages

  • Islamic finance provides a basis for commercial transactions for followers of Islam to enter into, which would be impossible on conventional banking terms.

  • The adoption of Islamic finance principles gives banks access to a substantial new customer base.

  • The partnership basis on which some Islamic businesses are established with banks ensures that the bank has a direct stake in the success of the venture.

  • The rejection of deals involving short-term, speculative activity encourages businesses to invest for the longer term.

  • Islamic finance contracts offer flexibility in terms of the applicable legal jurisdiction.

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Disadvantages

  • Some financial aspects of shariah law can be open to interpretation, with the result that some Islamic banks may agree transactions that would be rejected by other banks.

  • These “grey” areas, resulting from inconsistencies in interpretation, can create more uncertainty for clients than under conventional banking arrangements.

  • Some leasing arrangements can become appreciably more complicated when trying to ensure conformity to Islamic principles.

  • Given that the banks are the legal owners of assets under rental or leasing agreements with clients, issues such as liability for insurance and risk can be complications.

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Action Checklist

  • Non-Muslims should consider how Islamic finance can provide them

  • with access to financial backing from those seeking shariah-compliant funds.

  • As more institutions launch products compliant with shariah principles, investors should take time to assess their best choice of potential banking partners.

  • Understand that adherence to interpretations of Islamic principles can create complications over the medium term.

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Dos and Don’ts

Do

  • Recognize that the ethical considerations and long-term partnership advantages offered by Islamic finance can come with the price of greater complexity and uncertainty.

  • Take professional advice as to the tax treatment of Islamic finance transactions within your particular jurisdiction.

  • Appreciate that the prohibition of activities perceived as speculative could limit the business’s scope to capitalize on potentially lucrative short-term opportunities.

Don’t

  • Don’t regard Islamic finance as purely “specialty” banking; the market is fast becoming mainstream with a rapidly expanding range of products available.

  • Don’t look at Islamic banking in isolation, as deals can be structured with a combination of conventional and shariah-compliant finance.

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Further reading

Book:

  • Usmani, Muhammad Taqi. An Introduction to Islamic Finance. The Hague: Kluwer Law International, 2002.

Article:

  • Dar, Humayon A., and John R. Presley. “Islamic finance: A Western perspective.” International Journal of Islamic Financial Services 1:1 (April 1999). Online at: www.iiibf.org/journals/journal1/art1.pdf

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