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Friday, 3 July 2009

Basics of Islamic finance: addressing misunderstandings or misconceptions

The Islamic finance industry is becoming popular worldwide. This popularity has not come without certain misunderstandings or misconceptions.

One major issue is the question of how Islamic finance is different from conventional finance when the “rates” (or profit margins) charged by Islamic financial institutions from borrowers are the same as those charged by conventional financial institutions. The layman does not differentiate between the Islamic finance contract and the conventional finance contract when the repayment schedule of a financing transaction looks similar.

The conceptual difference between an Islamic finance and a conventional finance transaction lies in the fact that in conventional finance, the financial institution generally lends cash for a length of time, often direct to the client or borrower, of course based on a credit rating or evaluation, on the basis that the borrower would return the borrowed amount plus an interest amount. The interest amount and the original borrowed amount is required to be repaid to the lender over the loan period or by the end of the loan period. Thus the transaction in essence is the lending of cash against the return of a higher amount of cash, and not necessarily for a specific purpose. One of the basic ideas behind the interest rate is the time value of the money lent. The excess cash returned to the lender over and above the borrowed amount is considered “riba” in Islamic finance.

In Islamic finance, there is no direct lending of cash against return of a higher amount of cash, unless the transaction is “asset backed” implying that the transaction has to involve the sale and purchase of an asset. In a typical financing transaction, the Islamic financial institution will purchase assets required to be financed by a borrower at a price and sell them to the borrower at an agreed (higher) price allowing the financial institution to make a profit. This purchase and sale of an asset basically renders the financing as “Shariah-compliant.” Islamic Shariah laws allow cash to be lent, but generally only as “Qard Hassan” where only the same amount of cash is required to be returned, if returned at all.

The point to note is that in an Islamic finance transaction, the financier takes an element of risk, that of ownership of an asset and consequent non-payment by the client of the asset’s sale price. Any default penalties imposed to encourage payment on time do not accrue for the benefit of the lender but get paid to charity. There are other inherent risks in the transaction but the idea is that this risk-taking is what allows the Islamic financial institution to make a profit on the financing transaction. Therefore, even though the payment terms in a conventional and Islamic financing contract may look alike, there are differences in the conceptual structure of the transaction. Usually the profit margins charged by Islamic financial institutions are about the same as interest rates of conventional financial institutions, but this is largely due to competition, the required profits of shareholders of such institutions, and also quite possibly driven by higher legal and administrative costs pertaining to the financing transactions.

It can be logically derived that Islamic financiers would need a deeper understanding of a borrower and his business to allow minimizing risks of borrowers defaulting on purchase of the asset underlying a finance transaction. This effectively results in lending to real businesses and not speculative and high risk businesses, quite a relevant topic these days. Even Qard Hassan generally implies money moving into productive activities since lenders would not in general fund leisure or speculative activities of any borrower.

In conclusion, using Islamic finance or even regulating it, requires an understanding of concepts that underlie the industry — in this case the Islamic code of law — the Shariah. An understanding of Shariah and its goals or maqasid will greatly enhance one's perception of Islamic finance and economics.

(Saeed Jawed Ahmad is an Islamic banker and investment analyst based in Jeddah. The views or opinions expressed in the article are solely his own and do not necessarily reflect the views of any institution.)

Source: Arab News

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