The Basics of Sharia Finance explained

Let’s say you need some money to start a business. You approach a bank offering conventional non-Sharia finance and they give you a loan. Whether or not you turn a profit or your business fails, you must still make payments to the bank with interest. With compound interest, the longer you take to pay off the loan, the more interest you pay. So if your business loses money, the financial difficulty you’ll face will be even more severe. You’ll have no income from your business and the bank can take legal action against you. This is the reality of debt. The bank earns a surplus without having to assume risks and obtains the added income through interest, making money on top of money; getting extra from the interest just because they were in the position to lend.

The distinction in Sharia finance is clear. It aims to protect all parties, ensuring that transactions are done according to Sharia principles, on fair grounds and for the benefit of the community. Profits must be generated through trades and economic activities in the real economy (see box). In addition, business risks must be shared rather than transferred to borrowers when they take out a loan.

Real Economy

This refers to sectors of the economy concerned with actually producing goods and services, as opposed to the part of the economy that is concerned with buying and selling on the financial market

Source: Financial Times

As the Sharia prohibits dealing with interest, the products that you see in Islamic banks are generally based on one of the following concepts:

Profit Sharing  – These are profit sharing arrangements in which the financier and the receiver of funds will share the profits and loss borne from the partnership. An example is a savings or current account called Mudarabah. When you deposit money into the account, profit is given to you based on the performance of the bank. The bank needs customers to place funds with them so that they can make a profit from having received customer deposits.

Buy and Sell – Charging a profit is justified when selling a product because of the risks associated with developing, sourcing and owning the product. Buying and selling of products can be done when you require funds. Because there is no borrowing or lending arrangement, the term ‘loan’ is not used in Islamic banks. Instead, the term ‘financing’ is preferred. For a personal finance arrangement, a bank generally follows a Murabahah contract where you agree to buy from the bank commodities – metal, for example.

This is how it’s done:

I. Let’s say you require $10,000 cash. You apply for personal financing from the bank, which sells you commodities worth this amount. They charge you, for example, $10,700, with $700 being the bank’s profit.

II. At this stage, you own $10,000 worth of commodities. Next, the bank arranges to sell these commodities to a third party on your behalf. The bank then gives you the $10,000 cash, providing you with the funds you needed.

III. You now owe the bank $10,700, which you will pay in instalments until the entire sum is paid off.

Unity and social cohesion are so central among the objectives of the Quran for humankind that all conducts prohibited may be regarded as those that cause disunity, and those prescribed are to promote social cohesion. It is a natural consequence of such a system to require risk sharing as an instrument for social integration. Therefore promoting maximum risk sharing is, arguably, the ultimate objective of Islamic finance.– From the book Risk Sharing in Finance:The Islamic Finance Alternative by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor

The system envisioned by the Qur’an does not reward the rich at the expense of those in need of funds

Instead of the financier just providing funds and expecting a payment, the parties of the contract are expected to cooperate and work together, ensuring solidarity is created in the community. Those in need of help in business or trade activities should be duly supported.

The system envisioned by the Qur’an does not reward the rich at the expense of those in need of funds. This is why compound interest is prohibited, as it ensures that a brother or sister who needs help is not exploited in times of hardship. In trade, there is real movement in economic activity. The buy and sell arrangement, for example, gives the supplier of the product a chance to earn an income from selling their goods.

Sharia finance also prohibits unfair practices in transactions. The notions of fairness and justice are the cornerstone of all its activities. Products that are full of uncertainty or based purely on chance, speculation or gambling one’s positions all boil down to making money on top of money without justification. This is unfair, and is evident in the global financial crisis. A group of people benefited from manipulating transactions, causing others to face financial difficulty as a result.

Another feature unique to Islamic banking is the presence of Sharia scholars who advise and govern matters relating to the Sharia. The extent of their involvement varies between regions. In the UAE, for example, scholars govern the products of the bank and how they are implemented. In Saudi Arabia and Malaysia, however, scholars oversee products and the bank’s entire operations to ensure that they do not contravene the Sharia. Regardless of the model adopted, whenever Sharia non-compliance is found, the bank cannot profit from a transaction that was done against Sharia principles. The profit would have to be purified by giving to charity.

The Islamic financial industry is still in a development phase and is a system that is not without its own set of issues. These include limited customised infrastructure to support its model, as well as differing regulatory standards that have resulted in different practices across countries. But in a world so heavily entrenched in debt and unfair practices, it may be worth our while to appreciate the potential that Sharia finance has for true risk sharing and mutual cooperation.

Source: http://www.aquila-style.com/lifestyle/sharia_finance/basics-sharia-finance/82533/?ref=sidebar

Kazakhstan Islamic bank eyes regional expansion

Kazakhstan's Al Hilal Islamic Bank, the only Sharia-compliant lender in the country, may expand into neighbouring countries as legislative efforts to develop Islamic finance gather pace across the region, its chief executive said.

Fresh Islamic finance legislation is being developed in Azerbaijan, Kyrgyzstan and Tajikistan, creating a more welcoming framework for the industry in countries which have secular regulatory regimes.

Legislation is also being redrawn in Kazakhstan, the first former Soviet country to introduce Islamic finance rules in 2009; the initial set of rules failed to spur much activity.

Almaty-based Al Hilal, whose parent is wholly owned by the Abu Dhabi government, is considering increasing its geographical presence as part of its 2015 business plan, chief executive Prasad Abraham said on the sidelines of an industry conference.

"Our medium-term strategy is to test the effectiveness of the Kazakhstan model, and then use that as a base for further expansion to other regions of the CIS (Commonwealth of Independent States) as appropriate.

"An important precondition for any expansion is the existence of a proper legislative framework for Islamic finance in the respective countries."

A draft amendment, currently awaiting discussion in Kazakhstan's parliament, would provide the bank with a clearer framework that could translate into better commercial opportunities, Abraham said.

This could spur new entrants into the sector, such as Zaman Bank, a local bank which is working to convert itself into the country's second Islamic bank. It has not given a time frame for that plan.

In addition to Zaman, the regulator has now received an application to operate another fully-fledged Islamic bank, Abraham said without elaborating.

Launched in 2010, Al Hilal is on target to see asset growth of 70 per cent this year, with similar growth expected for 2015, he said, adding this was partly because growth was from a low base; it is expected to slow as the bank gains size. The bank posted a 46pc increase in assets in 2013, reaching 16.7 billion tenge ($92 million), financial statements showed. Its business is focused on government and large corporate clients, and after conducting a feasibility study earlier this year it has decided to wait for legal issues to be resolved before offering retail banking services. Islamic banks in Kazakhstan are categorised on a par with other commercial banks, known as Tier 2 banks, but current law does not extend to them all the tax privileges that conventional banks have.

Islamic Banking VS Conventional Banking

Islamic banking has developed  recently.  Put forward  to be having high ethical criterions, the banking system upraises questions from many.  First of all, we should answer some questions like that in this field.   Are these standards just a sham —a smart  way to hide  that Islamic banks are basically like any other?  Are they a real attempt to reunite religious principles with finance in a capitalist world?

To answer if Islamic banking is totally different from the conventional banking system, we  should know the history of  this  interest-free  banking system.

Origin of Islamic banking

The most important property  of Islamic banking is its banning  of  interest. Doing business  without the use of interest-bearing loans, in the form of Mudaraba rules, advances the coming  of Islam.

Before Islamic period, Arabs  in Mecca, close to the crossroad  of old commerce  routes, coordinated  caravans to carry  goods between Syria and Yemen.  The Meccan merchants  sometimes  used agents to deliver the goods, buy, sell and report back with the numbers for profit or loss.  Later on, it  was  shared according to the traditional  principles  of Mudaraba.

When a merchant  united with others in a shared trading initiative, the profits or losses were shared, under an another principle called Musharaka, suitable  for an agreement between participating sharers in a trade.  Therefore,  the trading caravans were capitalized with  the principle of  sharing profits or losses, not by interest-bearing loans.

Smaller communities

Before modern banking system becomes popular, Mecca was a quite small town, and the forming  a trade caravan was a principal  occasion.  The travelers and their patrons were acquainted  with one another’s general fame  and status, and possibly knew each other as a  person.  That continued true of societies in the early Muslim period.

But, society is more disunited in today’s world.  Rich people  to invest do not need to know anybody  with an  initiative  that requires capitalizing, and people who have trade thoughts may have no contact  with possible investors.

The conventional banking system has grown up to intercede  between the groups of people, enterprisers and investors.  To exist, the banks obviously  have  to make a profit.

Prohibition on interest

The prohibition of  interest (riba) on loans in Islamic banking system is well known.  Riba is considered as haram, or forbidden in Islam.  But to operate  a bank needs  to charge some fees for its services.  For conventional banks, a principal  of profit is from revenue that is obtained from charging interest.

In contrast, Islamic banks make their profits in other ways such as ‘profit-sharing’.  Is it possible for Islamic principles of profit-sharing rather than interest taking to transfer from the  trading caravans to the anonymous banking system that we experience now?

The old systems of Musharaka and Mudaraba survive in the modern Islamic banking system.  They both refer to ways of sharing risk and reward in place of remuneration at a fixed interest rate.

Mudaraba is used for a more passive kind of investment or participating, in which  one side supplies capital or goods, and  the other side  carries out the work necessary  to gain  a profit.

Musharaka presents  a more active investment style by a person  who is either a partner in the business or  a supplier of money.

A very distinct  difference of the Islamic banking system over conventional banks is on the sharing of risk, that is equally spread to either the lender or borrower.