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Thursday, 6 September 2007

What is Islamic finance?

With increasing interest in Islamic finance, many people are asking how this system differs from conventional finance. Islamic finance is a system of banking and financial transactions that is consistent with the Shariah, or Islamic Law, the most important characteristic of which is the prohibition against charging interest, known as ''riba'', strictly forbidden in the Koran, the book that forms the basis of Islam. Islamic banking dates back to the time of the Prophet Muhammad, when a form of Islamic treasury was set up for the benefit of needy Muslims, funded by a number of customary taxes. But the birth of modern Islamic financial institutions came about in the 19th and early 20th centuries, and was further developed in Pakistan and Egypt in the 1950s and 1960s, reaching maturity in the 1970s with banks in Saudi Arabia, Dubai and Kuwait. Islam is not only a religion, but also a system of beliefs, including concepts of justice, equity, fairness and morality. These beliefs are governed by Shariah Law, derived from various sources and therefore capable of a variety of interpretations. To ensure the conformity of banking activities and products within the stipulations of the Shariah, an Islamic bank has a Shariah Board to advise and ensure compliance. These principles include prohibition on interest charging, speculation, profit-taking, uncertainty and hoarding of money. The charging of interest is strictly prohibited under Shariah rules. Any return on money should be linked with the profits of an enterprise. Since the Shariah does not permit speculation, many Islamic financial institutions feel unable to enter into transactions such as swaps, futures, or options. Investments involving certain products, such as pork, alcohol or armaments, and activities such as gambling, are prohibited. Some Islamic banks may encounter difficulties with investments in businesses such as hotels and the entertainment industry because of these prohibitions. Profit cannot be assured, and an Islamic financial institution must assume at least part of the risk of a transaction. There can be no guarantee of a fixed return on a deposit. The Shariah also prohibits any element of uncertainty in a contract. There must be full disclosure by both parties, and any type of transaction where the subject matter, the price or any other factor are not determined and fixed in advance would run counter to Shariah Law. Trade and enterprise, which can generate real wealth for the benefit of the community as a whole, are encouraged between partners, sharing profits and losses. On the other hand, hoarding money is considered improper, as money is conceived as a means of exchange, and not a commodity in itself. Islamic financing institutions have developed a wide range of techniques that allow them to uphold religious and Shariah legal principles, while enabling them to offer viable financial products, such as current accounts, investment accounts, savings accounts and overdrafts. Among the many products that have been developed, may be mentioned in particular six best-known techniques. Leasing can be undertaken by Ijara. This encompasses the leasing of machinery, equipment, buildings and other capital assets. The Islamic financial institution purchases the asset and leases to a customer at an agreed rental, either fixed in advance, or subject to periodic review by a mutually acceptable third party. The Mudarabah is a trust financing, whereby the Islamic financial institution provides funds, usually sourced from investors, with the institution acting as trustee. The borrower retains a fixed percentage of profits, while the institution gains a fixed proportion of revenue, and the remainder goes to the investors. But there is no guarantee that a profit would be generated. The most popular transaction has become the Sukuk bond, which provides the subscriber with part-ownership of the underlying asset. Typically a special purpose company purchases an asset, leases it out, and issues Sukuk certificates entitling holders to pro rata ownership and the right to receive a proportion of rental payments. Sukuk are often issued in tradeable form, with a secondary market. The Murabahah facilitates trade finance. The bank purchases equipment or goods, using its own funds or those of investors. The goods are then sold to the customer at cost plus reasonable profit, often on deferred payment terms. As the price is fixed, the customer is not affected by base lending rate fluctuations. A form of Murabahah is the Istisna'a, or financing of major industrial projects or large items of equipment such as power plants, ships or aircraft. The institution finances construction, acquires title and then either passes title to the developer on agreed deferred payment terms or may offer leasing facilities. The Musharakah is a form of equity financing whereby the bank joins with the customer to finance a specific project. Profits and losses are shared in direct proportions to original contributions, with the bank taking an agreed management fee. All of these techniques imply a partnership between the bank and the customer, rather than the creditor-debtor relationship of conventional banking, evidencing the spirit of fairness that characterises Islamic banking. The attractiveness of the opportunities that it offers, help to explain the rapid growth of Islamic finance throughout the world. - (BP, 6 Sep 07)
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