What is Islamic Finance?

by George Hatjoullis

David Cameron, the FT informs us, aims to boost Islamic Finance (http://on.ft.com/19a8z0t). The first question many will ask is what is Islamic Finance and in what way does it differ from what we habitually refer to as ‘Finance’? Searching the net for some authoritative information revealed a piece written by Abid Shakeel, of the Muslim Council Of Britain in 2009 (http://bit.ly/HpD7RN). It is a concise statement and easy to read. The impression one is left with from this document is that economic differences between ‘Finance’ and ‘Islamic Finance’ are not as dramatic as one might have thought.

The main principles are listed thus:

1. The prohibition or taking or receiving interest at exorbitant rates (Riba), but this does not preclude a rate of return on investment which is agreed up front by both parties contracting. In most cases, the references to interest rates by Islamic financial institutions are to help benchmark the return on investment to offer transparency. This does not imply interest is being used in the transaction.

2. Risk in any transaction must be shared between at least two parties so that the provider of capital and the entrepreneur share the business risk in return for a share in profit.

3. The prohibition of speculative behaviour (Gharar), meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited and thus contractual obligations and disclosure of information are a sacred duty.

4. Investments that violate the rules of Shariah, advised against by Shariah boards, and are generally non-ethical meaning that investment in businesses related to alcohol, pork related products, conventional financial services, entertainment (gambling and casinos, pornography, weapons and defense. An example of index restriction can be seen on Page 5 of the Dow Jones Islamic Market Index Rulebook.

Taking each point in turn the following points are worth noting:

1. No one likes exorbitant interest rates as the public outcry against payday lenders demonstrates. However how is exorbitant defined? There is no economic difference between a rate of interest and a rate of return between two contracting parties if it is agreed up front.

2. Sharing risk and reward is equity.

3. Speculative behaviour, gambling and extreme uncertainty are prohibited but not precisely defined. Are institutions that make markets in specific assets speculators? It would seem that Islamic Finance favours broking over market making and so may not be consistent with fully functioning liquid markets. Western regulators are also moving in this direction. It does raise the question of whether hedge funds are shariah compliant (no would be my guess). Contractual obligations and transparency are a sacred duty as opposed to merely a legal one. Now that is different.

4. Non-ethical investment is prohibited. There are western ethical funds as well though the ethics differ.

Shariah compliant bank savings accounts allocate the banks profits to account holders on some pre-advised basis. Sounds very much like a ‘with-profits’ structure once common in the insurance sector. The banks make money from such activities as Murabaha. The bank purchases a tangible asset and resells to a customer on a cost + basis. The customer repays according to a pre-agreed schedule at the end of which the ownership is transferred to the customer. The + seems economically equivalent to a fixed rate of interest and the whole arrangement bears a strong resemblance to a repurchase agreement.

Another source of bank income might be Ijara. This is quite simply a leasing contract where the customer leases the asset from the bank at an agreed rate and takes ownership on a final payment. Musharaka amounts to equity sharing and Mudaraba corresponds to a partnership. Neither are concepts Finance would have any problem with. Istinaa offers a solution to the prohibition on short selling for producers trying to hedge output (e.g. crude oil). The bank commissions the output at a pre-agreed price and takes the risk of selling it on to the customer (It is unclear whether the bank can pre-agree the price with the customer from the document).

Insurance is based on the principle of Takaful or mutuality. Many contribute to a pot which is available to those that meet pre-agreed terms of need. Not a difficult or alien concept at all and was the basis of mutual societies in the west. The Sukuk or Islamic note is a little more complicated and the following reference may clarify ( http://bit.ly/S7DFx). In essence the note or bond must be structured to correspond to the above principles.

What then is the material difference between Islamic Finance and Finance? Abid Shakeel offers this clarification:

 The difference is in the approach and not necessarily on the financial impact. Some consider this as just a play on words but to Muslims there is an inherent difference in the way the transaction is carried out, and all based upon the previously mentioned prohibition of Riba. The intention is to avoid injustice and unfair enrichment at the expense of another party.

Sharia compliance of investments is judged by a committee of muslim scholars.

Several things emerge from Abid Shakeel’s concise explanation. The economic differences are small and involve concepts well understood and widely used in Finance. The contractual relations have the authority not just of law but also of a higher authority. In Islam the law and higher authority are one and the same. In the west this is not so and the material difference may lie in the ethics and sanctity of the religion of Islam.  It is also evident from wider reading that not all muslim scholars agree on what is and what is not shariah compliant. However, this corresponds to different legal jurisdictions in western societies. The important issue is the religious and ethical significance accorded to financial transactions in Islam.