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An Introduction to Islamic Finance

11 October 2015 |

Islamic Banking has become a somewhat popular form of financing over the last 15 years. This refers to a system of banking that is compliant with the principles of Sharia (Islamic rulings).

Sharia Law

Sharia law presents a legal system on the religion of Islam. Sharia in Arabic means 'the clear path to water'.

The central principle of Islamic banking, the prohibition of interest (riba), stems from the origins of Islam found in the Qur'an. The following quotation can be applied:

Trade is just like interest (riba). But Allah has permitted trade and has forbidden interest (riba). So whoever has received a caution from his Lord and abstains may have what is past, and his affair rests with Allah. But whoever returns to dealing in interest (riba) - those are the companions of the Fire; they will abide eternally therein. " - Qur'an Verse, Surah Al-Baqarah, 2:275

The Qur'an is the undisputed source of guidance in Islam so there is unanimous agreement on the prohibition of riba. The reason for this prohibition is because Islam is strictly opposed to exploitation in every manner and form as it stands for just and equitable dealing amongst all people. Hence why it is prohibited to charge interest to someone who is constrained to borrow to meet his essential needs. This also applies for those who wish to take out loans for productive needs.

So What Is Islamic Banking About?

Islamic banks provide commercial services such as financing for medium-sized businesses and multinational enterprises (MNEs), covering fields such as trade services* and asset-based lending**, whilst complying with the religious sanctions of Islam. Customers receive interest-free services, thus why the Islamic banking system differs from a conventional banking system. Practices are authenticated by the Sharia Supervisory Board. This board consists of high calibre Islamic scholars who have in-depth knowledge of Islamic law and its functions for transacting, in addition to specialist knowledge relating to modern business, finance and economics.

In comparison to conventional banks, the common westerner does not have a strong knowledge and understanding of Islamic banking. However, the generation of wealth in the Middle-East has made Islamic finance a popular form of banking. The Middle East has traditionally been the largest market for Islamic finance, with Islamic banking assets (in the form of real estate, automobiles and leases), in addition to revenues from transactions involving Islamic finance practices within commercial banks, exceeding US$778 in 2014 (according to Ernest & Young's World Islamic Banking Competitiveness Report 2014-15). Islamic banking has grown into a global industry however, with total assets of around $2 trillion being purchased using Islamic finance practices.

Moreover, the global profit pool is estimated to triple by 2019 which will in turn increase demand for Islamic banking services. Also, the demand for Islamic banking services over recent years has risen two to three times faster than the rate at which conventional banks grew over a similar period of time (the financial crisis had a part to play in this).

Clifford Chance are one of the leading advisors on Islamic finance transactions. One of their most recent transactions includes advising a group of 30 global and regional lenders on a US$10 billion revolving credit facility to Saudi Aramco (a state-owned Saudi Arabian Oil Company), the world's biggest oil exporter.

The Issuing of Bonds (Sukuk)

A bond is a certificate of debt issued by a government or a company. When an investor buys bonds, he or she is essentially lending money to the debtor, who in return agrees to repay the principal amount***.

Although Islamic finance has been developing since the establishment of the religion with key principles deriving from the Qur'an, modern banks did not start offering sharia-compliant products until the late 20th Century.

Investors still reap returns however, by investing in sukuk. These are Islamic bonds which are structured in a way that do not infringe the prohibition of riba (interest) under Islamic law.

Although profit making is allowed in Islam, earning interest on money lent is not, as it is believed that this may create social injustice. Conventional bonds impose a contractual obligation upon the issuer to pay the bond holder interest and repay the principal amount. However, under a sukuk structure the 'sukuk holders' each hold an undivided proportionate share in the company/government's profit and losses and have an equal right to all assets.

Ongoing Challenges

As Islamic banks are now working alongside more conventional banks, the compliance issues that arise mean that they are now being more closely regulated. A key challenge for Western financial institutions has been to comply with Islamic law.

It must be noted that Islamic banking can give rise to greater borrowing costs despite the no interest rule. As the transaction structures of Islamic finance can be much more complex, it can be more expensive to set them up than conventional banking structures. The reason for this is because each Islamic financial institution employs a Sharia Supervisory Board to oversee the transaction and affirm that it complies with Islamic law, thus increasing the total costs.

However, there is tremendous scope for Islamic finance practices to grow and compete with conventional banks and there are many benefits of having available this alternative method of financing. People and institutions that associate themselves with Islamic banking interact as partners rather than lenders and borrowers. The closer interaction between Islamic banks and customers encourages long-term investment, which in turn can facilitate economic development.

Defined Terms

* Trade Services

Refers to a transaction between a producer and consumer that involves providing a service. This mainly applies to international transactions, in particular the services required to import and export products.

** Asset-based Lending

A type of financing in which the asset (inventory, land, machinery etc.) being bought using borrowed funds is used as security (which is given to the lender). This particular form of lending usually involves the lender basing the amount they are willing to lend on the value of the asset being financed. This means that if the borrower defaults on payment, that asset can be sold by the lender so that they can recover (at least some of) the money they lent.

*** Principal Amount

The stated price of the bond at the outset (though it is worthy to note bonds may be purchased at a discount or premium to the stated principle amount).