Islamic Finance – A Socioeconomic approach

“Islamic finance is about ethics, integrity, accountability and social responsibility.” – Mr. Imitaz Merchant – MD Pragmatic Wealth Management Pvt Ltd, a Shariah Investment company with specific focus on equity investment in line with Islamic laws.

Shariah finance has been present in the Islamic world since the beginning of Islam, which many historians believe dates back as far as the 7th century. Yet, it is only in the last 60 years or so that we have seen it being formally introduced to the global stage of finance.

In preparation for TFG attending IFN Asia next week in Kuala Lumpur, we put together a brief overview of shariah law and shariah finance, outlining the key differences between riba, gharar, musharakah and sukuk.

Shariah Finance – An Introduction

Shariah Law is a religious law which contributes towards the overall Islamic tradition. Shariah finance however,  is an industry of financing that does not permit the practice charging interest. Instead, they focus on the importance of risk sharing. The avoidance of interest is due to the religious association of ‘riba’ and ‘gharar’, which translates to usury and risk/uncertainty.

Riba’, or usury is a word used to describe the practise of lending money at unreasonably high interest rates. An example of usury would be if the set nominal rate of interest was 2%, yet a lending institution charged 25%. However, the Islamic financial community believe that any amount of interest is usury due to the very nature of interest. It is believed that interest is beneficial for the lender, at the direct expense of the borrower, thus exploitative.

Riba does therefore not correctly align with the shariah-financial ambition of furthering the socio-economic goals of Islam, and is therefore ‘haram’ (prohibited).

The uncertainty that stems from the Islamic word ‘gharar’, is that in financial terms it relates to products with a no physical existence. An example of this would be an insurance premium. You are believed to have to pay an increased amount in the event that accident X happens…but it might not.

Albeit rare, there is an interest concept of insurance in the Shariah finance world – mutual insurance. This is the practise of an individual paying their insurance into a pool of funds, along with other customers. This pool, is then invested in shariah-compliant (halal) companies, using shariah-compliant investment tools. Funds are withdrawn from the pool to satisfy any claims from the policy holders, but any money that is not claimed is then redistributed toward the policy holders. Which is a fine example of the other key pillar of shariah finance besides the disbelief in interest – Risk sharing.

Risk Sharing

This is a concept that makes shariah law particularly interesting, and has been the topic of much debate. Instead of charging interest, lending institutions make their money through halal (approved) investments and practises.

An example of one of these haram practises would be the ‘Ijara’ or ‘Muraba’ schemes. Both commonly used to purchase property without the charging of interest. Literally, the Arabic word ‘Ijara’ translates to the provision of goods/service temporarily for a wage, which is a good way of looking at it.

If one is to purchase a house with Ijara financing, then the lender of their choice actually purchases the property in exchange for an agreed upon rent. Contractually, the renter is liable for any day-to-day maintenance and the landlord institution is liable for any maintenance deemed as major. Even more interesting, the institution is prohibited from charging any compound fees if the renter defaults on payments.

Murabaha schemes are  similar. In the same situation of an individual hoping to finance the purchase of a home, a murabaha scheme would entail the lending institution purchasing the home, placing a margin on top of the purchase price and sell back to the borrower in instalments. This may sound like interest, but it does not accrue, is agreed from the beginning and it is also seen as a gesture of good will from the element of risk that is embraced by the institution.

Introduction to the Western financial world

If you are wondering if this form of finance is successful or not, then the introduction of this specific type of business into western markets should convince you. The proved growth of shariah-compliant practises have attracted great interest which has resulted in the provision of halal investment vehicles on a global scale.

For example, the Shariah Index. Launched on the Tokyo Stock Exchange in 2007, or the NIFTY index’s. The NIFTY shariah indices are purpose built to provide the market with shariah-approved investment opportunities. There is a NIFTY 25, 50 and 500. Furthermore, there is the S&P 500 shariah, which is composed of all the halal businesses included in the S&P 500. For more information on the S&P 500 Shariah vs. the S&P 500 Dow jones, see Trade Finance Global’s article here.

Other vehicles

Within the last 60 years, the reintroduction of shariah finance has led to substantial advancements in the capabilities of the technique. There have been many different shariah-compliant tools introduced, some of which are listed below;

Musharakah

This investment tool refers to a financing technique whereby the lending institution provides funds which are combined with the funds of the business and any other investors. All providers of investment are fully entitled to participate in the running of the company, but have no contractual obligation to do so. Moreover, the profit made from the investment is redistributed in pre-agreed ratios and any loss is liable to each partner proportionate to their initial investment.

Sukuk

If a situation requires a standard Ijara sukuk, the issuer will sell the financial certificates (and therefore ownership) to an investing group who will rent them back to the issuer with a predetermined rate of rental.

Standard Equity

Probably the most common form of shariah investing, is the participation with the regular stock exchange, bar companies who engage in haram activities. For example, a shariah-investor could very well purchase stock in a legal firm, but would be fully prohibited from investing in a tobacco company.

Overview

The success of Islamic finance is undeniable, to the extent that there is enough market demand for shariah-compliant tools in one of the most valuable industries to ever exist. It is gathering growing traction on the global finance stage, and rightly so.

As the wealth in Islamic nations grows, so will the amount of disposable income in those nations which will lead to a further growth in the demand for halal investment tools. This, will then lead to further investments within the shariah finance bracket, which will have interesting implications on the rest of the financial world.