The essence of Islamic finance
Islamabad—Islamic finance is fast growing across the globe. Ernst & Young, a consultancy and accounting firm, estimates that Islamic banking assets grew at an annual rate of 17.6 per cent between 2009 and 2013, and will grow by an average of 19.7 per cent a year to 2018.
Khalid Howladar of Moody’s, a rating agency, calls this ‘a landmark year’ for Islamic finance. Islamic finance is basically based on economic needs. It’s also called need-based financing. In conventional sense, banks and financial institutions or intermediaries sell their loan products and fix interest on their loan amount.
But in Islamic mode of financing, finance is called investment. The first and most distinctive feature of Islamic finance is that there is no concept of time value of money. This means, money is not considered goods for sale but a medium of exchange.
There are five major types of debt and equity- based Islamic financing products from which to draw in order to finance debt as well as invest in development of business throughout the Islamic world. The most widely used financial debt instrument in Islamic finance is a sales contract known as Murabaha, which is a ‘cost plus margin’ contract.
In this contract, the financial institution, most commonly a bank, purchases a product for a client and then charges an agreed-upon fee on top of that price. The bank receives repayment for the total amount (fee plus price of product) from the client over a period of time. The transaction must be based on assets.
Ijara (Leasing): The second major type of debt financing, known as an Ijara, is primarily used for leasing of large equipment or real estate to businesses. In the Ijara mode of financing, the bank may choose to either rent land or equipment or sell the collateral to the borrower and receive a share of the profits generated from its use.
Obviously, this financing is based on assets. Sukuk (Islamic bond): The final debt product is referred to as Sukuk, which is an asset-backed, on a particular asset which generates profit. For example, a client borrowing money for his or her business does not pay the loan back with interest, but uses profits generated from operations to repay the loan to the bank. An underlying particular asset must be needed for Sukuk issuance.
Musharaka (Profit and loss sharing): Equity- based products include the Mudaraba and the Musharaka. These are partnerships in which the parties involved bring either monetary or knowledge-based capital to the table for investment. The Musharaka is a partnership in which both parties contribute money and develop a joint venture for investment.
Profits are shared on an agreed-upon basis and not always in direct proportion to the amount of financial capital invested. Loss is shared equally among all parties involved to remain in line with one of the main tenets of Shari’a finance: the sharing of risks and rewards in financial contracts.
Mudaraba (profit-sharing, loss-bearing): The other equity product alternative is a partnership known as the Mudaraba, with one party bringing financial capital, while the other party contributes business knowledge capital to the venture. Again like the Musharaka, rewards are shared among all parties involved on an agreed-upon basis.
However, only those parties that contribute financial capital suffer financial loss. This is an important distinction for the Mudaraba contract – it places equal importance on both financial and knowledge-based investment. The parties providing ideas and ongoing training for business ventures are viewed as equally important to the venture. There is also an understanding that these parties cannot provide initial funding and will therefore, not be able to sustain financial hardship.
There are many differences between the western and Islamic modes of finance though both the systems provide various forms of financing; the financing opportunities offered belong to two fundamentally different platforms. Conventional financing is based on fixed interest rate concept, and Islamic finance is based on a profit-loss sharing system.—Agencies
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