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Islamic Finance Principles
Professor Habib AhmedDurham UniversityJanuary 22, 2009
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Where do we go from here?
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Agenda
Introduction to Islamic Law and Principles
Riba and Gharar
Islamic Contracts
Islamic Banking Models
Shariah Governance
Islamic Financial Sector
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Sources of Islamic Law
Two sources of law in Islam
ShariahRevealedknowledge
Quran
Hadith/Sunnah (Sayings/doings of the Prophet)
FiqhDerived knowledge through ijtihad
(exertion)
Four major schools of thought in the Sunni
tradition
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Basic Approach to Islamic Law
Islamic laws can be broadly classified into
two types Ibadat(devotional acts) Any act which is not legalized
by Shariah is void Muamalat(dealings or transactions)All transactions
are permitted unless explicitly prohibited by Islamic law
(principle ofpermissibility)
In muamalat, new transactions can beaccommodated through ijtihadas long as
they do not contain the prohibited
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Contracts-Islamic Nature
Freedom of contractsprovided the prohibited
elements are avoided
Some aspects of the contractual relationship
determined by Shariah/Fiqh to avoid Injustice
Conflicts/Misunderstandings
Exploitation
The prohibitions in transactions include: Riba
Gharar
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Riba
Riba (literal meaning increase) is prohibited...they say: trading is only like riba, whereas God has permitted
trading and forbidden riba (Quran 2:275)
Various interpretations ofriba
Implications ofriba:
Interest is forbidden
Selling debt (at a discount) is not allowed
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Gharar
GhararExcessive risk, hazard, or ambiguity Ghararcan exist in the object or terms of the
contract
Implications ofgharar:
Existence of the object (& ability to deliver)
Two sales in one
The future sale
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Agenda
Introduction to Islamic Law and Principles
Riba and Gharar
Islamic Contracts
Islamic Banking Models
Shariah Governance
Islamic Financial Sector
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Major Islamic Contracts used in
Financing
1. Sale (Exchange) Contracts
1. Deferred trading contracts
Price deferred sale (murabahah)
Object deferred sale (salam, istisna)
Leasing-sale of usufructs (ijarah)
Partnerships musharakah or mudarabah
Interest free loans (qard hassan) or loans atservice charges
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Murabahah
Financing Mode in Islamic BanksDebt The financial institution buys and then sells a good to the
client at a mark-up Price paid at a later date The bank must own and posses the good The profit rate and other terms should be clearly specified in
the contract The bank can ask for guarantees or collateral
Productspot
Pricefuture
Traditional Murabahah/Bai al-Muajjal
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Salam
Financing Mode in Islamic BanksDebt
Used to finance the agricultural sector
The price has to be fixed and paid when the contract isconcluded
Commodities delivered at a later date
The delivery time should be fixed
Pricespot
Commoditiesfuture
Traditional Salam
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Istisna
Financing Mode in Islamic BanksDebt A pre-production sale used when an item/asset needs to be
manufactured/constructed
The price of the asset should be known and time of payment
can be negotiated among the parties
The seller of the asset (bank) can either manufacture it or
sub-contract it
Paymentinstallments
Assetfuture
Traditional Istisna
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Ijarah
Financing Mode in Islamic BanksLeasing A hire-purchase leasing contract Ownership is transferred to lessee at the end of the contract
period Fiqhiobjectionstwo contracts in one; purchase contract
cannot be binding Banks give away the asset at nominal value or as a gift at the
end of the lease period
Asset (for rent)fixed period
Rental Payments
Traditional Ijarah
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Mudarabah
Financing Mode in Islamic BanksEquity Partnership between bank and clients Used on the liability and asset sides Profit shared among parties at an agreed upon ratio Loss borne by financier only Financier cannot ask for a guarantee of capital or return Mudarabah can be restricted or unrestricted
FundsspotService/labour
Profit sharefutureProfit sharefuture
Traditional Mudarabah
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Musharakah
Financing Mode in Islamic BanksEquity A partnership contract in which bank contributes capital and
managerial services Like a mudarahah, but all partners manage the project The profit share among the partners at an agreed upon ratio Loss shared according to share of capital
Funds & labour Funds & labour
Profit sharefutureProfit sharefuture
Traditional Musharakah
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Agenda
Introduction to Islamic Law and Principles
Riba and Gharar
Islamic Contracts
Islamic Banking Models
Shariah Governance
Islamic Financial Sector
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Ideal Islamic Banking Model
Two-tier mudarabah model
Profit-loss sharing modes of financing on both the asset and
liability side
Liabilities and EquityAssets
Profit-sharing investment
accounts (PSIA-Mudarabah
based)
Demand Deposits (qardhasan)
Capital
Equity financing
(Mudarabah/musharakah)
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Islamic Banking Practice:
2nd Best ModelOne-tier Mudarabah with Multiple Investment Tools
Liability SidePSIA (Mudarabah based)
Asset Sidemultiple investment tools, dominated by fixed-income contracts (murabahah, ijarah, istisna, etc.)
Liabilities and EquityAssets
PSIA-Mudarabah based
Demand Deposits (Qard
hasan)Capital
Reserves
Debt-based financing
(Murabahah, Istisna, salam)
Leasing-based financing(Ijarah)
Equity-financing
(Mudarabah/musharakah)
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Tawarruq
The client wants a personal loan and approaches the bank
1. Bank buys commodity from a broker paying spot (for 100)
2. Bank sells the commodity to client payable at a future date (for 110)
3. The client sells commodity to broker spot (for 100)
[Organized tawarruq: The client appoints the bank as agent to sell thecommodity. The bank sells the commodity spot to the broker for 100 onbehalf of the client and deposits the money in clients account.]
At the end of the transaction, the client gets 100 and owes the bank 110payable in the future
1
2
3 BankClient
Broker
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Implications ofTawarruq
Tawarruq and Greshams Law (bad money
drives away good money)
Tawarruq is driving all other modes away
Tawarruq replicates a loan transaction
The resultthird best model of Islamic banking
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Islamic Banking Practice:
3rd Best Model
Fixed Liability with Multiple Investment Tools Liability SideFixed-income investment accounts (using
tawarruq)
Asset Sidemultiple investment tools, dominated by fixed-income contracts (tawarruq,murabahah, ijarah, istisna, etc.)
Liabilities and EquityAssets
Fixed income investment
accounts (Tawarruq)
Demand Deposits (Qard
hasan)
Capital
Reserves
Debt-based financing
(Tawarruq,Murabahah,
Istisna, salam)Leasing-based financing
(Ijarah)
Equity-financing
(Mudarabah/musharakah)
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Islamic Modes of Financing
UAEBahrainPakistanSudanModes
49.2951.7350.9642.45Murabahah
2.590.892.5217.77Musharakah
4.361.96-3.10Mudarabah
18.905.5620.410.87Ijarah
3.220.63-0.95Istisna
--0.230.55Salam
21.6539.2325.8834.31Others
Source: 2007 Islamic Finance Directory,Gen. Council for Islamic Banks & Fin. Institutions
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Islamic Modes of Financing
Saudi ArabiaJordanMalaysiaIranModes
15.8115.4141.0421.02Murabahah
0.652.990.240.97Musharakah
0.0511.360.271.51Mudarabah0.0413.809.402.18Ijarah
3.741.201.720.07Istisna
---0.03Salam
79.7155.2547.3374.22Others
Source: 2007 Islamic Finance Directory,Gen. Council for Islamic Banks & Fin. Institutions
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Agenda
Introduction to Islamic Law and Principles
Riba and Gharar
Islamic Contracts
Islamic Banking Models
Shariah Governance
Islamic Financial Sector
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Role ofShariah Scholars
Most Islamic banks initially created by private
initiatives by pious Muslims
Shariah compliance important feature of IF
organizations Authenticity, credibility, and public confidence of
products/services required
Establishment ofShariah bodies at different levels
Re-emergence of legal authority Shariah scholars
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Different Types ofShariah Bodies
Shariah bodies exist in different forms
Shariah Department (in the bank)
Advisor (external to the bank)
Supervisory Board (in the bank) Supervisory Board (national)
Professional Shariah Advisory Firms
International Fiqh Bodies
Depending on the regulations and size of theorganization, different models ofShariah
governance exist.
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Shariah and Legal Risks
No unified Shariah rulings
Application of Islamic contracts in non-Islamic
jurisdictions
Choice of law and dispute settlement clauses
included in contracts
Usually English law is preferred
IfShariah is the governing lawdisputes settledby commercial arbitration
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Agenda
Introduction to Islamic Law and Principles
Riba and Gharar
Islamic Contracts
Islamic Banking Models
Shariah Governance
Islamic Financial Sector
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1970s 1980s 1990s 2000s
Islamic Banks
Takaful/Retakaful
Mutual Funds
Mudarabah Co.
Leasing Co.
Investment Banks
Islamic indices
Sukuk
Private Equity &
Venture Capital
Hedge Funds
Infrastructure/
project finance
Islamic REITs
Trust/Waqf
Management
Islamic Banks
Takaful/Retakaful
Mutual Funds
Mudarabah Co.
Leasing Co.
Investment Banks
Islamic indices
Islamic Banks
Takaful/Retakaful
Mutual Funds
Mudarabah Co.
Islamic Banks
Takaful
Evolution of Islamic Financial Sector
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Size of Islamic Financial Industry
Islamic financial sector is significant andexpanding at a fast rate More than 500 Islamic financial institutions in
over 75 countries
Over 706 Shariah compliant mutual funds Total outstanding sukukissuesUSD 83.7billion
Estimated total Islamic financial assetsunder management-$1 trillion
Islamic financial Industry estimated toreach up to $2.8 trillion by 2015
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Questions?
habib.ahmed@durham.ac.uk