The Islamic Finance System: a primer

THE ISLAMIC FINANCE SYSTEM: WHAT’S IT GOT TO DO WITH AUSTRALIA; WHAT’S IT GOT TO DO WITH ME?

This is a primer for those who wish to know more about the fundamentals of the Islamic finance system

Warning: There is a considerable amount of relevant but very basic information here concerning the Islamic financial system. It has been prepared for both investors and business owners who normally work under western conventional accounting rules and guidelines. Because companies using the Islamic financial system are becoming more prevalent,  conventional investors and business owners may like to consider an involvement with Islamic finance as a practical, convenient and uncomplicated system. As the primer covers a lot of ground, expect a long read.

Introduction

Islamic finance & the 2008 GFC. The Global Finance Crisis of 2008 hardly even made a small dent in those countries and financial institutions that operate under the Islamic finance system. What is it that Muslims know about economics and finance that we in the west don’t know? How did they insulate themselves from the worst excesses of the western financial system? What is their secret? Can we in Australia get involved in the Islamic finance system? If we in Australia do get involved, what will that mean for us? That raises the ultimate question: should we in Australia get involved in the Islamic finance system?

Should we or shouldn’t we? The Australian Government has the answer to that question; it wants Australia to become an Islamic financial centre.

First steps in Islamic finance

What’s this primer all about? Chiron! the business doctor.™ presents this very basic primer on the Islamic finance system for the information of his clients and site visitors. It does not pretend to be a learned thesis, because the subject is one that is very complex. There are libraries upon libraries of books on the subject. However, because the focus of Chiron! the business doctor.™ is to help clients to raise equity capital for business expansion purposes, this paper will focus on the venture capital aspects of the Islamic financial system.

The present situation: the Australian Government & the Islamic finance

In June 2009, The Hon. Chris Bowen MP, then the Australian Minister for Financial Services and Corporate Law, set out an ambitious plan for Sydney to lure Islamic finance in a quest to beat the global recession and attract wealth and jobs. Mr Bowen said Sydney was under-selling itself as a financial services hub for Asia.

‘I think there are great opportunities such as Islamic finance,’ he said. ‘The majority of the world’s Islamic population lives in Asia, and Singapore and Kuala Lumpur are trying to corner this market for themselves and I think Australia can play a role. Even if we only take a small percentage of the market it could generate a lot of wealth and a lot of jobs in Australia … This is just one example of the untapped opportunities out there for Australia.’

Subsequently, the Australian Government, through The Hon. Simon Crean MP, Minister for Trade (a very senior Cabinet Minister), endorsed the participation of Australian financial and commercial institutions in the international Islamic finance industry. In January 2010, Minister Crean authorised the issue of a publication entitled ‘Islamic Finance’ through AusTrade, the Australian Government agency to promote Australian industry (reference: Austrade publication: ISBN 978 0 9807059 0 4).

The publication in part said:

‘The purpose of this publication is to raise public awareness of Islamic finance in Australia and to promote opportunities for Islamic finance in Australia … Islamic finance is one of the fastest growing segments of the global financial services industry. Shari’ah compliant financial assets have been growing at over 10 per cent per annum over the past 10 years. Measured by shari’ah compliant assets of financial institutions, the global Islamic finance industry is estimated at US$822 billion in 2009.

‘Islamic finance has considerable potential to become an important element in Australia’s aspirations to be a global financial services centre in the region. ‘Australia’s Muslim population of 365,000 … present an important base to service this fast growing sector in the global financial services market.

‘The Australian Government is committed to an open and competitive financial system and a socially inclusive environment for all Australians. The Government sees the development of an Islamic finance industry in this country not only as having the potential to make a very positive contribution to achieving both of these principles, but also as being part of its effort to establish Australia as a financial centre in the region.”

Following on from that, Senator The Hon. Nick Sherry MP, then Assistant Treasurer, told Australian funds managers on March 26th 2010 that the Australian Government was pressing ahead with plans to develop Islamic finance in Australia to help position the nation as a leading global financial services hub. To that end, Senator Sherry travelled to the United Arab Emirates, Qatar and Bahrain at the end of April 2010 for talks on the regulation, promotion and export of Islamic finance, banking and insurance.

Since that time, the Australian Government has continued its support for the establishment of Australian Islamic Financial institutions and services. For example, as recently as 16 April 2013, in an Address to the Amanie Australia Islamic Finance Forum held in Melbourne, The Hon. Bernie Ripoll MP, Parliamentary Secretary to the Treasurer & Parliamentary Secretary for Small Business said, inter alia:

‘the Australian Government regards the introduction of Islamic finance products into the domestic market as a way to open our financial services sector – and our economy – to new opportunities for growth. Because Australia’s current regulatory arrangements already allow shari’ah-compliant funds to be established here, the potential for new opportunities already exists at the institutional level.  And, we have already seen some successful ventures in this area. There are over 470,000 Muslims in Australia who may use Islamic financial services if they are more accessible.

As well as appealing to Muslim Australians, Islamic financial transactions can be undertaken between Muslim and non-Muslim parties. The underlying ethical and environmental character of Islamic financial products makes them attractive to non-Muslim investors.

The introduction of Islamic finance products into the Australian market is not a replacement for other forms of finance, but rather a door to new opportunities for our financial services sector and for our economy more broadly … While Islamic finance is still in its early stages here in Australia, it offers much potential – to this nation, and to other economies in the region.

This is why the Australian Government is committed to further developing Islamic finance in Australia.’

The Islamic Financial System

General characterisation. The Islamic financial system is ideologically characterised by the absence of interest-based financial institutions, interest-based commercial transactions, questionable or problematic commercial transactions, investments in companies dealing in unlawful or antisocial activities that include weapons and armaments production, alcoholic beverages production, gambling, vice and pornography, as well as unethical or immoral business transactions such as market manipulations, insider trading, short-selling and the like. Islamic Law, shari’ah, sets the overall objectives and methodology of the Islamic finance system.

Interest outlawed. The charging and the payment of interest (riba in Arabic), as a business concept under shari’ah, is therefore unlawful; that is, the charging and the payment of interest is haram (forbidden in Arabic). The concept of riba is clearly set out in the Quranic verse Al Baqarah 2:278-9:

“O those who believe, fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your capital; neither will you do wrong nor will you be wronged.”

What this strongly worded verse confirms is the seriousness with which Islam regards the actions of engaging in transactions with a riba component. However, note should be taken that not all forms of financial excess or profit are forbidden, since the Qur’an explicitly permits profits from trading and commerce, even though some scholars have attempted, quite unsuccessfully and rightly so, to paint trading profits as a form of interest.

Other religions also embargo interest. Intriguingly, both the Christian and Jewish faiths also unequivocally forbid interest, although their faithful seem to be faithfully ignoring the injunction. In Deuteronomy 23:19 the faithful are entreated: ‘Do not charge your brother interest, whether on money or food or anything else that may earn interest’.

Ezekiel 18:8-9 states: ‘He does not lend at usury or take excessive interest. He follows my decrees and faithfully keeps my laws. That man is righteous; he will surely live, declares the Sovereign Lord’.

In the light of the 2008 Global Financial Crisis, which as I said, hardly made a dent in the Islamic finance world, is there a message here?

The source of shari’ah. The source of shari’ah is the Holy Quran, the Sunnah (the sayings and acts of the Prophet Mohammed) and the Hadith (the written records of the Prophet Mohammed’s words and deeds). The shari’ah therefore provides the legal framework of Islam and it governs all aspects of a Muslim’s life, from moral and spiritual obligations to all economic activities, including property dealing and wealth creation. It includes the ethical concepts surrounding the use of money and capital, the relationship between risk and reward, and the social responsibilities of financial institutions.

In Islam, wealth is a trust from God. It is very important to understand that Islamic finance is asset based. Within that context, shari’ah recognises man as the vice-regent of God on earth. Any wealth earned by an individual is seen to be merely entrusted to him or her. Individuals therefore hold the wealth as a trust from God and do not have absolute ownership of the wealth. This means that individuals or corporations, in the Islamic finance system, have freedom of enterprise as well as freedom to make financial decisions, provided that they act in accord with shari’ah guidelines. Shari’ah does not prohibit profit making as the objective for participating in business activities, as long as the interests of society and the nation as a whole are protected and preserved.

Money cannot be a subject of trade.  When you consider that the whole western economic system rests on the concept of interest, it is sometimes difficult for westerners to comprehend that under shari’ah, money cannot by itself or of itself be a subject matter of trade or commerce. Profit under shari’ah can only be generated through the production or sale of something having intrinsic value or utility (and not through the exchange of money alone). That is why Islamic banks cannot provide what the western economic system regards as conventional finance products that involve a component of interest.

Riba (Interest)

The prohibition of interest. Western democracies, with their reliance on interest-based financial systems and institutions, are fascinated with the concept of a financial system without interest. It seems therefore appropriate that at this stage I spend a little time explaining the prohibition of interest under the Islamic financial system.

Money is a medium of exchange only. In western economic terms, interest is defined as the time value of money, described by the common expression: ‘time is money’. However, Islamic scholars take a different view: time is not money, ‘time is life’. Consequently, in Islam, money is simply used as a medium of exchange that has no intrinsic value in itself. That means that in Islamic terms, money cannot be lent simply to earn a guaranteed rate of return (viz., interest) on the money. The Arabic word riba literally means “an addition to” or “excess” over the original price of the good or service.

Profit derives from commercial risk. With the prohibition on riba, any return on funds provided by an Islamic financier must be earned by way of profit derived from a commercial risk taken by the financier. By contrast, in the western economic system, conventional interest is charged and collected irrespective of the outcome of a venture and is considered a return on money simply for the use of the money. In the western economic system, should the borrower’s business venture fail, the borrower would still be liable to the lender for interest payments. This disconnect between supplying finance for a venture and the underlying venture business itself is not acceptable under shari’ah.

Shari’ah requires joint profit sharing and loss sharing. Under shari’ah, the principle of joint profit sharing and loss sharing is held to create a proper balance between lenders and borrowers. It is such an important tenet of Islamic finance that joint profit sharing and loss sharing must necessarily be present in all shari’ah-compliant transactions. As mentioned earlier, shari’ah requires that parties to a transaction act in a just, fair and ethical manner with one another. Financial exploitation by one party of another is prohibited and the parties to a transaction must actually share the risk in a reasonable manner.

Risks & rewards must be shared. Under shari’ah therefore, to receive a return that is halal (viz., permitted or lawful), parties must share in the real risk involved in the production of such return. Profit sharing and loss sharing therefore creates a real linkage between the purpose of the financing and the outcome. This can be contrasted with conventional western practices of separating the financier’s risk from the venture’s ownership and outcome.

Riba and Inflation

Inflation, defined simply as a continuous rise in prices without a commensurate rise in productivity, can reduce the value of money. Assume that person X provides a $1,000 interest-free loan to person Y to be paid back in 12 months time. However, if prices increase by 10 per cent during that time, the value of that $1,000 will be worth less to the lender, person X. In such a case, can person X charge an excess or premium or interest to take into account the loss of value of the money?

The Islamic opinion is against the charging of any premium. Scholars contend that although it is unfortunate that person X, the lender, has lost some value, this is not the fault of person Y, the borrower; and for this reason the borrower should not be burdened with this excess.

The Islamic Financial System and Society

Importance of shari’ah. As explained earlier, the importance of shari’ah is that it rules Muslims’ ethical, moral and spiritual obligations in respect of all economic activities, including property dealing, wealth creation, the use of money, and the relationship between risk and reward. It further includes Muslims’ duties, obligations and social responsibilities if they are executives within financial institutions that interact with the community.

Islamic finance is economy focused. Within shari’ah, the Islamic financial system is an important vehicle for wealth distribution throughout an economy by providing the framework for the transfer of wealth from those with a surplus to those with deficits. In practical terms, the objective of the Islamic financial system is to ensure the equitable allocation of capital to those sectors that yield the best returns to the owners of capital, thereby contributing towards the overall growth and expansion of an economy. The Islamic financial system therefore eschews interest but embraces profit.

Money, profit & society. One of the foundations of Islamic finance is the belief that commercial activity should be beneficial to society and reflect sound moral and ethical standards. Within that belief, and of itself, as I said earlier money has no intrinsic value. Rather, money is merely a medium of exchange and cannot itself be a subject matter of trade. Profit can only be generated by the production or sale of something having intrinsic value or utility. Profit cannot be generated through the exchange of money alone. That is why Islamic financial institutions cannot provide what we in Australia call ‘conventional finance products’.

Islamic finance is asset based. That leads to the point that Islamic finance is asset based. There must be an actual asset that is the subject of the finance contract. Unlike in the western economic system, where financial transactions are predominantly debt-based, interest bearing and generally at arm’s length from the venture being financed, Islamic finance relies on structural arrangements based on asset creation, transfer and ownership between borrowers and lenders.

Islamic Finance and Venture Capital: musharakah & mudarabah

Lets’ look at that last statement from the venture capital perspective. From the venture capital perspective, another important objective of the Islamic finance system is to help owners of wealth to find suitable opportunities to invest for the short to medium term, since it is contrary to shari’ah principles to hoard wealth. While there is some dispute in defining what constitutes short to medium term as a shari’ah concept, it is necessary for the owners of wealth to invest their funds in appropriate projects. In that respect, as I have explained, shari’ah principles require that there is an underlying asset involved in any investment transaction, a significant point of difference with the traditional Australian debt-based and interest-bearing financial model.

The Islamic finance system has unique norms and regulations as regards both equity and debt financing. In the case of equity financing, the Islamic system is based on profit sharing contracts. In this category, there are two important contracts commonly used: musharakah and mudarabah.

Musharakah refers to the issue of shares with management or voting rights. Musharakah is a partnership between the company providing capital (such as a venture capital firm) and its client investee companies under which the venture capital firm provides capital finance in accordance with negotiated and agreed terms, with profits and losses shared in agreed ratios. Under musharakah, the venture capital firm and the investee companies can pool their resources, talents and expertise for the management of the business. There is almost unanimous consensus amongst shari’ah scholars and other players in the Islamic finance industry that musharakah is the purest form of Islamic financing. Islamic finance products structured according to musharakah principles should therefore, in theory at least, be categorised as shari’ah based.

Mudarabah, in respect to its use in profit sharing arrangements, refers to the issue of shares without having the right of management or voting rights in the project concerned. In a typical mudarabah arrangement, one person or company participates by providing capital and another person or company participates by providing efforts. Their proportionate shares in the profit are determined by mutual agreement. The loss, if any, is borne by the owner of the capital only.

Islamic Finance and Venture Capital: debt financing without riba

In the case of debt financing, Islam does permit contracts of exchange that involve deferred payments. There are four important contracts in this category:

  • Sale on deferred payment contract. The sale on deferred payment contract permits an entrepreneur of a project to buy the required goods and pay in installments later on. This contract is called Bai al’Muajjal.
  • Leasing contract. Leasing contracts permit an entrepreneur to lease goods required for his or her project . This contract is called Ijarah.
  • Hire purchase contract. The hire purchase of goods contract is called Ijarah wa-Iqtina or Ajar.
  • Sale with price markup contract.  The sale with price markup is commonly used in trade financing where an entrepreneur can purchase raw materials but settle the payments in cash at a later date. This contract is called Bai Murabahah.

These four types of contract all provide a halal profit margin to the financier through the cost plus pricing of sale and rental on leasing as agreed between the parties. There is no interest component in any of these contracts.

Arcane Technicalities: Is this important? Does it matter?

Characteristics of Islamic finance instruments. I would like to digress here for a moment to discuss what many would consider as an arcane technicality, although a technicality that runs hot and strong throughout the Islamic finance industry. Increasing debate is taking place within the international Islamic finance industry regarding the nature and characteristics of financial instruments which seek to comply with shari’ah principles.

The debate: shari’ah-compliance vs shari’ah-base? This debate has resulted in some mainstream Islamic finance scholars classifying products as either shar’iah-compliant or shari’ah-based. Shari’ah-compliant products are financial products that mimic their conventional western counterparts by making necessary cosmetic changes simply to satisfy shari’ah sensitivities. On the other hand, products that observe the real spirit of shari’ah and faithfully reflect shari’ah principles in substance, are deemed shari’ah-based.

Islamic Finance and Venture Capital: musharakah & mudarabah [continued]

Musharakah. The reason I digressed in the section above is that a number of recent developments in musharakah financing techniques have been categorised by some as being only shari’ah-compliant, as distinct from being shari’ah-based. This has importance when attracting funds into venture capital investment firms that are used as an investment pool. To determine the correctness of these categorisations, one must have a general understanding of the concepts of musharakah.

Investment transaction principles. The word musharakah derives from the Arabic word shirka, which means ‘sharing’. In the context of shari’ah investment financing where investment transactions are based on the creation of joint venture partnerships in which all the partners share the profit or loss generated by the joint ventures, then depending upon the specific characteristics of the particular investment transaction, one of three shari’ah principles may be applied to the transaction. These three shari’ah principles fall within an umbrella term called shirkat al aqd.

Brief analysis. Space does not permit detailed analysis of these principles here, but a clear majority of classical Islamic finance texts state that the principles of shirkat al aqd focus almost exclusively on the following values and ethics:

  • The proportion of profit to be distributed between the partners must be agreed upon prior to the commencement of the musharakah.
  • The shari’ah does not permit any of the partners to be guaranteed a pre-determined fixed return.
  • There is a difference of opinion among classical shari’ah scholars as to whether the ratio of profit for each partner should be proportionate to each partner’s investment. The majority of contemporary scholars, however, permit the ratio of profit to differ from the proportion of investment made by each of the partners.
  • There is unanimous consensus among both classical and contemporary shari’ah scholars that loss must be shared proportionately to each partner’s investment.

Core principles. The application of shirkat al aqd encapsulates the core principles of musharakah investing, namely the sharing of risk and the sharing of profit and loss. By implementing a joint venture with an investee company, investors (such as a venture capital firm) will directly participate in the risk of the business that they are seeking to fund. In simple terms, if the joint venture is successful both the investors and the investee company will benefit, as the profits will be distributed between them according to the pre-agreed ratios.

If the joint venture is not successful, the investors and the investee company will share the losses of the business in proportion to each of their respective investments. In any event, the investee company will never be obligated to repay the capital investment made by the investors.

Mudarabah. As explained earlier, mudarabah is also an important component of Islamic finance venture capital. In its’ purest form, mudarabah is an investment agreement between an investor (who provides capital) and an entrepreneurial company (who provides management expertise) with profits shared on a pre-determined ratio and losses borne by the investor only.

Investor role in a muderabah. In the theoretical model, the investor plays no part in the conduct and management of the business. But this is clearly not practical where investors contribute large sums to the entrepreneurial company. Venture capital firms have both a de jure and a de facto responsibility to ensure that they protect their investments, which after all, are contributing shareholder funds that create the investment pool.

Business realities prevail. Venture capital firms have to report to their own shareholders in relation to their investments and therefore, to protect their investments, they must become involved in investee companies’ commercial operations to a greater or lesser degree. So while there may some controversy between Islamic scholars as to the extent to which an investor can participate in the management of the business under mudarabah, the business realities of the mudarabah system will prevail.

Sukuk: Islamic bonds

Capital market securities. The last aspect of the Islamic financial system that I want to briefly refer to in this paper is sukuk. Sukuk or Islamic bonds are capital market securities. They take the form of trust certificates or notes representing a proportional or undivided ownership interest in an asset or pool of assets (remember I explained that all Islamic finance transactions must be asset based or have an underlying physical asset). Sukuk therefore, are used in combination with the shari’ah-compliant financing techniques I have briefly described above to produce a shari’ah compliant capital markets instrument to allow investment in underlying assets.

Sukuk do not pay interest. Unlike conventional bonds in the western economic system, sukuk do not pay interest but generate returns through actual transactions based on the shari’ah-compliant financing structures described above. While a conventional bond is actually a loan of money creating a creditor-debtor relationship, an Islamic bond represents an ownership stake in an existing asset. What this means in practice is that while trading in western-style conventional bonds is a sale of debt, trading in sukuk generally equates to a transfer of ownership interests.

Islamic Finance and Venture Capital: the future for Australia?

There is no doubt that the influence of the Islamic finance system on Australia is set to increase. Space limitations have restricted me to a brief outline of venture capital and investing under the Islamic finance system, the primary focus of my business activities. However, there are many other aspects of the Islamic finance system that are important to the management and conduct of small and mid-size enterprises. For example, a major topic under the Islamic finance system is how insurance is dealt with. I will elaborate upon this and other Islamic finance issues in future additions to my website.

Yours sincerely,

Graham  Segal

Chiron! the business doctor.™ ... relieves business pain!™ 

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© Graham Segal, Author. March 2013. All Rights Reserved

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This website and the associated webpages content are produced by Graham Segal trading as Chiron! the business doctor.™. They are licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License based on Graham's work at http://chironthebusinessdoctor.com.

 

Date this webpage was last reviewed/updated: 4 May 2013

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