Fundamentals of Islamic Finance
Islamic Finance provides for the making of profits in an inclusionary and socially equitable manner
The prohibition of debt and fractional reserve banking serves as a buffer against rampant inflation
The goals of Islamic Finance are in many respects similar to the goals of conventional finance
The manner in which these goals are achieved is vastly different
The purpose of this article is to explain the fundamental principles and underlying philosophy of Islamic Finance, and to explore the possibilities of the implementation thereof in South Africa. Firstly, the philosophy and socio-economic rationale underpinning Islamic Finance will be introduced, as it will be difficult to appreciate the resultant financial techniques without an understanding and appreciation of these principles. The next step will be to compare the aims and objectives of Islamic Finance with that of conventional finance. This will, in turn, introduce the reader to the major points of difference between Islamic Finance and conventional finance. Having firmly established the philosophy, rationale and difference in approach of Islamic Finance, the different modes of financing in Islam will be explained, and examples given of their application. The status of certain conventional financial instruments in Islam will then be discussed, followed by a discussion of the application of Islamic Finance techniques to achieve specific financing objectives. Having explained the mechanism and application of Islamic Finance techniques, the focus will shift toward creating specific investment products, and risk/return profiles using these techniques as the building blocks. Finally the scope and possibility for application in South Africa and Africa will be examined, and the role of religious scholars and institutions will be examined and explained. A brief examination of the way forward for Islamic Finance in South Africa will conclude the article.
Contrary to popular belief, Islam does permit the making of a profit. In fact, profit forms the basis of the Islamic financial system, in that every technique of Islamic Finance allows for the making of a profit by the party that provides the risk capital, as well as the party that uses the capital. There are, however, conditions on the manner in which the profit is made, and Islam certainly does not espouse the making of a profit in any way that violates religious law or is harmful to the stakeholders inherent in the business or economic activity. Profits in Islam must be inclusionary and ethical. By inclusionary, it is meant that both the provider and user of capital needs to assume risk, and share in rewards. The major tenant of Islamic Finance is that interest, in any way, shape or form is strictly and utterly prohibited. Islam regards interest financing as immoral and socially and economically harmful, for a number of reasons: the extension of credit increases money supply, which stimulates demand, but does not always result in real, tangible economic activity â€“ resulting in a variety of economic ills such as inflation, continued unemployment, widening income gaps, etc. In Islamic financing, money is never the object of trade, and every transaction must involve a tangible, useable asset â€“ therefore, the only way for an individual to increase his/her income is through undertaking greater trade, manufacturing or service provision. This emphasis on economic activity ensures that as money changes hands( from the provider to the user) , this change is accompanied by an increase in trade, manufacture, service provision and, as a result, employment. Greater economic activity will stimulate the need and development of infrastructure, basic services, etc. There are also strict requirements regarding the nature of profit sharing, the interaction between business partners, the types of businesses that may be invested in, prohibited activities, responsibility to the community and environment etc. Thus, while CSI and business ethics are very much flavour of the day in conventional finance, Islamic finance has been entrenching, in fact demanding, these qualities of business for over 1400 years. Islamic Finance is therefore built on divine principles governing and enforcing accountability to stakeholders, moral behaviour, fairness, equality, promotion of free trade, the harnessing of resources through partnership as opposed to debt, etc.
The underlying aims of Islamic Finance are the same as those of conventional finance, namely:
â€¢ To utilize the funds of surplus economic units to facilitate investment and asset allocation
â€¢ To facilitate trade
â€¢ To provide financial services
â€¢ To create investment opportunities
The difference, however, between Islamic Finance and conventional finance is in the manner in which they proceed to meet their objectives. The basis of Islamic Finance is equity (through profit and loss sharing schemes) and rental income whereas the pillar of conventional fiancÃ© is debt (through interest). The Islamic financier/investor deals in physical assets, whereas the conventional financier deals mainly in paper assets. Therefore an Islamic financier will assume the risk of the purpose of the funds he is investing and share in pre-agreed ratios in the profit or loss resultant there from, while the conventional financier will only assume the risk of default of the entity or person to whom he is advancing funds, and the only upside that he will receive is the interest payable on the loan. Therefore, if the interest payable on a loan is 10% p.a, the conventional financier will receive a return of R10 000 000 on a R100 million loan, regardless of the trading profit generated from that amount. If the Islamic financier had agreed to a 40% share of the profit or loss in return for investing R100 million in the entity, and the entity generated a net profit of R30 million, the financier would receive R12 million in dividends( much more tax efficient than interest!). Thus, the Islamic financier assumes business and operational risk in exchange of higher profits.
Seven major transactions form the building blocks of Islamic Finance techniques:
â€¢ Musharakah â€“ this entails forming a partnership to undertake some economic activity
â€¢ Diminishing Musharakah â€“ this entails one partner (or partners) buying out the interest of the other partner(s) over time, so that the interest of the other partner(s) in the venture diminishes.
â€¢ Ijara â€“ this entails the rental of a physical asset to another party.
â€¢ Salam â€“ this entails paying â€œnowâ€ for a commodity for delivery at some later, pre-agreed time.
â€¢ Istisna â€“ this entails paying â€œnowâ€ for delivery at some later, pre-agreed time for a commodity that has yet to come into existence.
â€¢ Murabaha â€“ this entails buying an asset, adding a fixed mark-up as profit, and then selling it, either as an installment sale or at spot.
â€¢ Mudaraba â€“ this entails a form of partnership where one partner provides the capital and the other partner provides the skills.
It is crucial to note that there are numerous factors regarding the execution, nature of commodity, etc. of the above transactions that will affect itâ€™s validity in terms of Shariah (Islamic religious law) â€“ the above descriptions are meant to provide a broad, conceptual overview of the different permissible transactions. A complete discussion on the technical details and finer points of the above transactions are beyond the scope of this article.
It should now be obvious to the reader that any financial instrument or product involving the use of interest in any way is forbidden in Islam. But what about listed equity and derivatives? There are numerous equity funds that invest in listed equity and claim to be Shariah compliant. Worldwide, a screening mechanism and certain debt/equity ratios, dividend cleansing etc. are used to evaluate the suitability of a listed equity as a Shariah compliant investment. There are, however, scholars who render investing in listed equity to be forbidden, and some conservative scholars in South Africa agree â€“ the important point, however, is to note that investing in listed equity has not gotten blanket approval as being permissible. Due to the fact that there is no physical underlying being traded (with a guarantee of exchange), any form of derivative is outlawed in Shariah. The precise reasons for the outlawing of derivatives are, again, beyond the scope of this article.
The true power of Islamic Finance comes to the fore when one considers the wide range of applications for the techniques described earlier. The possibilities are endless, but the following list gives a relatively comprehensive overview of the scope of application of the various Islamic Finance techniques:
â€¢ Murabaha â€“ House Finance, Fixed Asset Finance
â€¢ Musharakah â€“ Venture Capital, Private Equity, Project Finance
â€¢ Diminishing Musharakah â€“ Venture Capital, Private Equity, House Finance
â€¢ Ijara â€“ Asset Finance
â€¢ Salam â€“ Agricultural Finance, Hedging
â€¢ Istisna â€“ Asset Finance, Trade Finance
â€¢ Mudaraba â€“ Venture Capital, Investment Funds
Diverse risk and payoff profiles can be created by constructing an investment portfolio consisting of investments using different modes of Islamic Financing. For example, an investor wanting regular income from his capital could buy assets and utilize an ijara agreement, whereby he would rent them out for a specified period of time at a specified monthly rental. An investor wanting high returns could enter into a musharakah agreement and buy a stake in a business. An investor wanting a balanced risk profile could invest half his money in an Ijara investment, and the other half in a Musharakah investment. Therefore, the principles of investment management, such as diversification, income versus capital growth, low risk versus high risk, sector diversification etc. will still apply to an Islamic investor, but the manner in which these objectives are achieved, as well as the investments utilized, will differ from conventional finance.
The scope of application of Islamic Finance in Africa and South Africa is enormous. Islamic Financing structures can be used to encourage SME development, provide affordable housing, finance infrastructure projects, facilitate BEE deals, etc. while always ensuring fair, ethical business practices aligned with an increase in real assets and employment. The role of Muslim scholars in sanctioning the validity of Islamic Finance products and transactions is vital, as seemingly unimportant details can change the Shariah status of a product or transaction. The problem at the moment is that there is no unified approval structure for the entire country. The way forward for Islamic Finance will emerge as entrepreneurs realize the scope of the potential market for Islamic products, and innovation and vision take hold of the country. Judging by the success of ethical funds worldwide, the need to bolster GDP in South Africa, and the intense focus on business ethics, Islamic Finance is going to become a permanent feature of South Africa and Africaâ€™s economic landscape.
Any queries on Islamic finance issues can be directed to Mufti M.A. Minty at email@example.com