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Home > Financing Best Practice > Islamic Modes of Finance and the Role of Sukuk

Financing Best Practice

Islamic Modes of Finance and the Role of Sukuk

by Abdel-Rahman Yousri Ahmad
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Table of contents

Executive Summary

  • Islamic finance modes are based on profit/loss sharing because of riba (interest) prohibition.

  • Murabaha has been responsible since the 1970s for the employment of about 80–90% of Islamic banks’ resources. The bank provides commodities on a “cost plus profit” price formula to customers who pay back their debt in installments.

  • Ijara ranks next in importance after murabaha and implies a promise by the bank (lessor) to gift or sell the leased asset at a nominal price to the lessee by the end of the leasing period.

  • Diminishing musharaka is a new product whereby the bank provides capital to a customer or partner whose share in partnership is increased gradually by repaying the principal in installments, plus a share of the realized profits to the bank.

  • Salam entitles instant cash to a bank customer against its commitment to deliver prescribed commodities at a future date. Parallel salam, on the other hand, is practiced by banks to hedge their salam operations.

  • In istisna the bank finances the manufacturing of a commodity for a customer who pays its price in installments. It is practiced mostly in Gulf countries.

  • Islamic financial institutions, in the form of the limited liability joint stock company, rely totally on “ordinary shares” for raising their capital.

  • Multiple-party mudaraba has enabled Islamic banks to work as partner/investor on a profit/loss basis for large numbers of capital owners whose deposits take the form of investment accounts.

  • Islamic financial institutions have recently extended their activities in capital markets, and sukuk (Islamic bonds) are playing an important role in mobilizing resources.

  • Because of riba prohibition, securitization (for sukuk purposes) should neither include murabaha, istisna, and salam assets, which are debt arrangements, nor allow for guaranteed regular payment to sukuk holders. Yet although sukuk experience, has been successful in terms of resources mobilized, it shows deviation from these rules.

  • If sukuk do not maintain strict shariah rules they are bound to be confused with conventional bonds.

Introduction

Broadly speaking, Islamic modes of finance can be divided into two types: either they provide direct finance as capital funds through partnership (musharaka and mudaraba), or they provide indirect finance through leasing (ijara) and sale contracts (murabaha, bai ajil, salam, and istisna). All modes are based on the principle of riba (interest) prohibition, and all seek to maintain Islamic business ethics (freedom and leniency of transactions, recognition of and regard for private property, and justice).

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Further reading

Books:

  • Hassan, M. Kabir, and Mervyn K. Lewis (eds). Islamic Finance: The International Library of Critical Writings in Economics. Cheltenham, UK: Edward Elgar Publishing, 2007.
  • Iqbal, Munawar, and Tariqullah Khan (eds). Financial Engineering and Islamic Contracts. New York: Palgrave Macmillan, 2005.
  • Karim, Rifaat Ahmed Abdel, and Simon Archer (eds). Islamic Finance: Innovation and Growth. London: Euromoney Books, 2002.
  • Warde, Ibrahim. Islamic Finance in the Global Economy. Edinburgh, UK: Edinburgh University Press, 2007.
  • Yousri Ahmad, Abdel-Rahman. “Islamic banking modes of finance: Proposals for further evolution.” In Munawar Iqbal and Rodney Wilson (eds). Islamic Perspectives on Wealth Creation. Edinburgh, UK: Edinburgh University Press, 2005.

Articles:

  • Yousri Ahmad, Abdel-Rahman. “Islamic securities in Muslim countries’ stock markets and an assessment of the need for an Islamic secondary market.” Islamic Economic Studies 3:1 (December 1995): 1–37. Online at: tinyurl.com/cx6qtgy [PDF].

Reports:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). “Shari’a standards.” Listed online at: tinyurl.com/c7hqjkl
  • Ali, Salman Syed. “Islamic capital market products: Developments and challenges.” Occasional paper no. 9. Jeddah: IRTI, Islamic Development Bank, 2005. Online at: www.irtipms.org/PubDetE.asp?pub=213
  • Islamic Fiqh Academy of the Organization of Islamic Countries. “Resolutions and recommendations of the council of the Islamic Fiqh Academy 1985–2000.” IRTI, Islamic Development Bank, 2000. Online at: www.irtipms.org/PubDetE.asp?pub=73

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