The principles of Islamic finance
What is it all about?
The Islamic financial system is a subtle mix of economy, ethics and Islamic law (Sharia'a) resulting in financial transactions based on fairness, profit, loss sharing and real transactions.
The difference between Islamic finance system and conventional finance in investment consists of the fact that investors should observe certain principles in order to reconcile their belief with their investment practices. This requires specific contracts and agreements while doing business.
Such contracts are generally based on a risk-reward distribution key and their drafting necessitates a lot of attention so as to exclude any ambiguity between the different contracting parties.
Main principles – restrictions
Riba which has come to be interpreted as interest, is forbidden in Islamic transactions. This is a fundamental principle found within the Islamic financial system and banking. Therefore a conventional loan, for instance, is impermissible as it includes interest.
Avoid gharar and maysir
Any agreement that has a significant part of gharar (excessive uncertainty) or maysir (speculation) will be considered as invalid from a Sharia'a perspective. Preventable ambiguities and faults in the terms of the contract are also banned.
According to Sharia'a, trade is only permitted in the goods and commodities that are declared halal (lawful). Consequently, any stock of a company that derives substantial income from haram (unlawful) activities (e.g. alcohol, gambling, non-halal meat, conventional banking) should not form a part of an Islamic investor’s portfolio.
Two types of screening are performed as regards Sharia'a compliant portfolios: an ethical screening (sector-based) and a financial screening (accounting based). Indeed, in addition to removing companies with non-compliant (haram) business activities, the companies are also examined for compliance with certain financial ratios.
The screening process focuses on three main areas which are leverage, cash and the part of income coming from noncompliant activities. This evaluation is monitored on an ongoing basis by the Sharia'a board. It must be noted that some Sharia'a compliant indexes already exist (e.g. Dow Jones). Nevertheless, although there is growing consensus amongst Islamic scholars relating to the financial screening ratios to be applied, some differences in approach may still exist.
Some contracts and structuring
The main contracts that serve for developing more complex financial instruments, given the great potential for financial innovation and expansion in the Islamic financial system, are the following:
- Mudarabah (financing partnership): profit sharing partnership with only one of the partners providing the finance and the other having a return for entrepreneurial activity. This usually applies to bank deposits and is a common basis for structuring Sharia'a compliant investment funds
- Murabaha (cost-plus sale): purchase and sale for a mark-up which is disclosed Islamic finance is a subtle mix of economy, ethics and Islamic law (Sharia'a) resulting in financial transactions based on fairness, profit and loss sharing and real transactions.
- Musharakah (equity partnership): a highly flexible tool for organising international business between several business partners. Losses must be shared in the same proportion as contributed capital and profits will be distributed according to a pre-defined ratio. An interesting application of such agreement is a partnership in goodwill in which there may not be any form of cash investment, but a partner contributes his name, credit or track record with a particular value, thereby allowing his partner to engage in business
- Salam (Islamic forward): similar to a forward sale contract consisting of a purchase of a commodity for future delivery with the price fully paid in advance. The salam purchaser (usually an Islamic bank) advances money to the salam seller, the latter delivers the commodities at maturity
- Sukuk (Islamic bonds): investment certificates evidencing a prorata ownership or a beneficial interest in an asset or enterprise
- Takaful (Islamic insurance): insurance provided on a mutual basis
- Ijarah (Islamic leasing): legally binding contract whereby the owner of something which has intrisic value will transfer its usufruct to a third party for a predefined period in exchange for an agreed consideration
The role of scholars and the Sharia'a board
In order to oversee the product development, and to get approval of a product as Sharia'a compliant, promoters will need a Sharia'a board. The board is typically made up of a team of prominent Islamic legal scholars, well disciplined in jurisprudence (fiqh), particularly in areas of transactions and business dealing.
The Sharia'a board is independent and has the duty to monitor the Sharia'a compliance of the transactions, the portfolio and the agreements as well as initially advising on the set-up of investment funds and contracts.
In addition to the purification obligation monitoring, advising on the zakat (alms tax) calculation is also one of the other Sharia'a board responsibilities. The purpose of zakat is to donate a part of one’s wealth to the poor and needy.
As the board has an advisory and supervisory role, a close communication needs to be maintained between the product development team and the board.