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Wednesday, 16 July 2008

Understanding Islamic finance

By Paul Ng
Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free.
Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values. Islamic jurists arrive at these ethical restrictions by applying rules prescribed in the Quran and stories in the Sunnah and the Hadis, the records of the life and sayings of the Prophet.
Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork.
Hence, Islamic unit trusts would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products.
Occasional disagreements between Islamic jurists arise as there are separate sects or schools of thought in Islam.
Islamic financial jurisprudence reflects this variety of opinion, but most Islamic jurists would agree that Islamic finance prohibits, or makes haram, instruments which violate the following precepts:
  • Against riba, which is best translated today as the charging of any interest, meaning money earned on the lending out of money.

    Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange.

    In order for a syariah-compliant financier to earn a return on his money, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset.

    Hence, there is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn purely fee-based remuneration.

    Conventional loans therefore tend to be re-cast as sale-and-purchase or lease-then-buy transactions.

  • Against gharar, or excessive, speculative uncertainty, as in casino-gambling games or in a sale of goods situation where the seller offers his goods for sale without a proper description to the buyer, hence making it impossible to ascertain precisely what the buyer is paying for.

    In such a situation the sale and purchase contract would be void in Islam.

  • Against zalim or zulm, meaning oppression or excessive unfairness between the parties to the contract.

    This concept may be viewed as an Islamic equivalent to the English common law concept of equity.
Takaful as a case study
One example of how the Islamic precepts mentioned above apply to the redesign of a conventional instrument is takaful, or Islamic insurance.
In modern-day conventional insurance, the insurance vendor sells policies and invests the proceeds for the profit of its shareholders, who are not necessarily policyholders.
There is therefore a clear disjunction between policyholders and shareholders.
Payouts to policyholders may vary depending on financial performance, but a minimum positive return is always contractually guaranteed.
In takaful, meaning 'joint guarantee', policyholders are joint investors with the insurance vendor, who acts as a mudarib - an entrepreneurial agent for the policyholders.
The policyholders share in the investment pool's profits as well as its losses.
A positive return on policies is not legally guaranteed, as any fixed profit guarantee would be akin to receiving interest and offend the prohibition against riba.
Further, basic term life policies, which provide a payout only upon death, and would otherwise expire without any return to the policyholder, would be unlikely in a takaful scheme.
This is because the Islamic prohibition on zalim would make it unconscionable to allow the mudarib to keep all the returns from the investment, and the prohibition on gharar would require all investment gains and losses to eventually be apportioned in order to avoid excessive uncertainty with respect to a return on the policyholder's investment.
Similarly, endowment policies which promise a contractually-guaranteed payout, and hence offends the riba prohibition, are also very unlikely in a takaful scheme.
To avoid gharar, a takaful mudarib would be unlikely to invest his policyholders' funds in futures, which are assets that may have a future but certainly not a current existence.
Risk and development
In Singapore, Islamic finance products tend to be marketed, risk-managed and priced as analogous competitors to conventional instruments.
For instance, takaful is marketed as 'Islamic insurance', sukuk is 'Islamic bonds', and AITAB or Al-Ijarah Thumma al Bai is 'Islamic hire purchase'.
Islamic financiers are viewed through the lenses of the conventional banking system and Islamic financial institutions are effectively expected to adhere to the same standards of financial prudence as their conventional counterparts.
Islamic financiers do not enjoy lower risk from the avoidance of speculative instruments and the absence of positive return guarantees.
This is because such moves are offset by prohibitions on hedging, greater market concentration, the need to commercially (even if not legally) guarantee a return, and the risk, unique to Islamic finance, of a collapse of customer confidence in the Syariah-compliant nature of the institution's products.
Risk equivalence means that Islamic financiers can usually price their products to compete with their conventional counterparts, if they can control costs.
To assist in cost control and encourage development, regulators usually prescribe changes to conventional tax systems to 'level the field' for Islamic financiers.
The Islamic Financial Services Board is working towards harmonising international standards for the design of Islamic finance products.
Learning more
A basic familiarity with the banking and financial services industry is a must for an investment or career in Islamic finance.
This can be followed up by a specialist education in the field. Occasional training events are organised by the private sector.
Across the Causeway, Malaysia boasts two prestigious university-level institutions, the International Centre for Education in Islamic Finance and the International Islamic University Malaysia, as well as an industry-supported training body, the Islamic Banking and Finance Institute Malaysia.
Farther afield, universities from Pakistan to the UK have begun to offer courses in this area.
The prospects are bright, the workers are few, and it is an ethically responsible industry.
So what are you waiting for?
Paul Ng is a former legal practitioner with experience in Islamic finance. He teaches law and economics at Ngee Ann Polytechnic.
This article was first published in The Business Times on 14 July 2008.

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