Islamic Banking

Islamic Banking refers to a method of banking that is based on Islamic Law (Shari’ah) which prohibits interest-based banking and encourages risk and reward sharing based banking. Islamic Banking is based on four main principles namely, the prohibition of interest, ethics by prohibiting investment in unlawful businesses, transparency, and equitable sharing of risk and reward primarily through the use of profit and loss sharing contracts.

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Basic Principles of Islamic Banking

The word Riba is loosely translated into English as usury or interest. Riba in its simplest form is any excess or premium charged on money loaned. Islamic Law considers the excess or premium charged an unjustifiable increase in capital without consideration.
In terms of Islamic law, money is not a commodity but a medium of exchange and a unit of measurement. Money represents purchasing power and cannot be used to increase such power without any productive activity. Islamic finance advocates creation of wealth through industry and labour via trade and commerce.

Simply put, in Islamic banking, if there is no exposure to risk, there shall be no entitlement to a gain. This principle provides a clear stance in Islam regarding its recognition of risk for justification of earnings in any economic venture. Indirectly, it also entails that in the absence of exposure to the risk element in business undertakings, one may find oneself in a circumstance that might give rise to interest-based transactions which is condemned and prohibited.

Gharar embodies the notion of ambiguity, contingency in a contract, lack of knowledge or uncertainty. Gharar, in practice, relates to issues such as pricing, delivery, quantity and quality of assets that are transaction-based and could affect the degree or quality of consent of the parties to a contract. Gharar may arise from misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of the parties to the contract, and give rise to settlement risk.

Islamic banking upholds contractual obligations and the disclosure of information as a sacred duty. This is intended to reduce the risk of asymmetric information and moral hazard.

Games of chance, excessive speculation and any zero-sum game which create no additional value to the society are forbidden. Islamic banking is geared towards directing surplus funds to the most productive assets.

Islamic banking upholds contractual obligations and the disclosure of information as a sacred duty. This is intended to reduce the risk of asymmetric information and moral hazard.

Only those goods and services that do not violate the rules of Islamic Law qualify for investment. Thus, any investment in a business dealing with alcohol, pornography, or gambling is prohibited. The prohibition is extended to the entire value chain including packaging, transportation, warehousing, marketing, and provision of after sale services.

Islamic Law requires that both the bank and the client share in the inherent business risk in an equitable manner. Any transaction leading to injustice or exploitation is prohibited.

Islamic contracts require rigorous following and transparency to ensure a fair distribution of risk and reward.

Islamic Banking Products

It is important to note that Islamic banking is not only for specific individuals or denominations, anyone can open an investment account and apply for the range of services on offer. Like conventional banks, Islamic banks accepts deposits for savings and transactional purposes.

1- Deposits

Mudaraba deposits are profit and loss sharing investment instruments. Islamic finance offers savings and time deposits in the form of investment accounts under the system of Mudaraba. The depositors of such accounts share profits with the bank under an agreed-upon formula. The capital loss is borne by the depositor. The bank incurs a loss in terms of operational expenses since it receives no income when it makes a loss on investment.

This is a contract where the depositor grants the bank authority to act on its behalf in a permissible dealing. Wakala deposit accounts give the bank mandate to invest funds on the behalf of the depositors in return for service fees. All profit and loss (minus services fees plus incentives) accrue to depositors.

Conventional ‘cheque’ accounts in modern commercial banks are non-interest bearing deposits, and since Islamic banking institutions shun interest rate based dealings, most of them offer such demand deposit accounts. Consistent with the “no risk no gain” principle, the principal amount on these deposits is guaranteed but no return is payable since the depositor is not taking any risk. The bank invests the money at its own account and risk and is therefore entitled to all the profit.

2- Advances

Islamic banks also offer Shari’ah asset-based finance through sale, leasing equity and equity-sale hybrid financing instruments.

In Mudaraba financing, the bank provides venture capital while the client manages the business and thereby contributes skill and expertise. The bank has no right to interfere in the day-to-day running of the business, but the Mudaraba contract normally contains mutually agreed conditions the client is required to abide by to manage the principle-agent problems arising from asymmetric information. The Bank shares in the net profit in terms of a pre-agreed profit-sharing ratio and any capital/monetary losses accrue only to the bank. The bank is liable only for capital provided, which means that the client cannot commit the business to any sum that is over and above the capital provided by the Bank.

Murabaha is a sale contract where the cost and the profit margin must be disclosed to the buyer/client. Murabaha is usually called cost plus finance because the bank discloses to the client the acquisition cost of a product/asset and how much profit is adding to the cost. The profit margin is negotiable between the bank and the client. The sale price (cost plus profit) is payable in instalments over an agreed finance term.

For example, a motor vehicle selling at a price of R200,000 may be bought by an Islamic bank and resold to a client at R220,000, to be paid back in monthly instalments over a 2-year period. Instead of interest in a traditional loan, the bank makes a profit with the difference of the purchase value.

The Islamic lease finance product entails the purchase from a supplier and leasing to the client of durable asset required by clients at cost plus over an agreed lease term. In a lease transaction, ownership does not transfer to the client and money is exchanged in lieu of transfer of the right to use an asset or usufruct. At end of the lease term, the asset is either donated or sold to the client depending on provisions of the finance lease contract. The sale price at the end of the lease term is usually a nominal amount. The client has the option to early terminate Ijarah finance through purchase of the asset from the Bank. In such cases, the bank normally sells the asset to the client at present value of the lease contract allowing thereby for the asset ownership to be transferred to the client.

3- Other Islamic banking financial instruments

Under Musharaka finance, both bank and client contribute share capital towards a business undertaking and agree to a profit-sharing ratio. The bank as one of the partners has the right to make strategic decisions and manage the business but not required to do so. Hence, the bank can opt to be a sleeping partner which is normally the case in practice.

The partners share in the net profit in terms of a pre-agreed profit-sharing ratio. Losses are shared in proportion to share capital contribution.

In Diminishing Musharaka, the client acquires the Bank’s equity in the enterprise gradually. The value of the bank’s equity in the enterprise is divided into units of equal value which are then sold to the clients at cost plus payable in monthly instalments. Profit mark-up is revised with each purchase as agreed between the bank and the client.

The client gradually owns a larger share of the enterprise and, as a result, its share of the capital increases. With this increase in capital, the client will be liable for a larger proportion of any loss.

The client has the option to early terminate the Diminishing Musharaka through acquisition of the Bank’s entire equity in the enterprise.

For example, a motor vehicle selling at a price of R200,000 may be bought by an Islamic bank and resold to a client at R220,000, to be paid back in monthly instalments over a 2-year period. Instead of interest in a traditional loan, the bank makes a profit with the difference of the purchase value.

Islamic law has strict principles around currency exchange, and it does not allow for commissions fees on foreign exchange transactions, hence the only source of income for Islamic banks with this type of product is the exchange rate. An Islamic forward exchange contract (FEC) provides businesses with a Shari’ah compliant instrument to hedge their currency risk. Due to volatility and risk of fluctuation in exchange rates of currencies, the businesses involved in international trade preferred to take forward cover on their import and/or export business to avoid losses. Shari’ah does not allow forward sale transactions however, Shari’ah scholars have been permitted to offer forward cover based on promises, in a situation where it is used for the more significant benefit of society and trade.

 

Islamic Banks intend to offer the facility of forward cover based on a unilateral promise. As per the rules of such transactions, actual sale/purchase would be executed on the specified date or within a specified period in the future at the agreed rate.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity”. An important difference between Sukuk and a conventional bond is that the former entitles the holder to a pro rata share of the income generated by the Sukuk asset. A conventional bond, by

contrast, entitles the holder to principal plus interest and makes the holder a creditor with a claim against the issuer’s asset.

Sukuk are the main instruments in the Islamic capital markets used by corporations and government institutions to raise capital directly from the public. Islamic banks use Sukuk capital instruments to raise economic and regulatory capital.

Islamic Banks intend to offer the facility of forward cover based on a unilateral promise. As per the rules of such transactions, actual sale/purchase would be executed on the specified date or within a specified period in the future at the agreed rate.