Origins of Islamic Finance

The Mountain of Light is a mountain near Mecca in Saudi Arabia’s Hejaz region. It is one of the most popular tourist attractions in Mecca. The mountain houses the famed Ghar Hira or Hira cave. The cave is quite small, four arm’s length long by 1.75 arm’s length wide. The mountain is barely 640 m tall. It does however, take two hours to make it to the cave and is extremely strenuous on the individual. However, the mount and the cave hold tremendous significance for Muslims throughout the world. The Islamic prophet Muhammad is said to have spent a great deal of time in the cave meditating and it is believed that he had received his first revelation from the Archangel Gabriel inside this cave.

Since this is where Muhammad is said to have received the first verses of the Holy Quran where Islamic Finance was also branched out, the mountain was given the title “Jabal-al-Nour”. “Jabal” in Arabic means mountain and “Nour” or “Noor” means light or enlightenment. This experience is sometimes identified with the beginning of revelation; hence the present name. The word Islam means “Peace” in English and technically means “Peaceful finance or Peaceful banking”.

Islamic finance is equity-based, asset-backed, ethical, sustainable, environmentally- and socially-responsible finance. It promotes risk sharing, connects the financial sector with the real economy, and emphasizes financial inclusion and social welfare.

The following key principles guide Islamic Finance: Prohibition of interest on transactions (riba), financing must be linked to real assets (materiality), iii) engagement in immoral or ethically problematic businesses not allowed like arms manufacturing or alcohol or drugs production and returns must be linked to risks.

Islamic finance Principles and Instruments

The term Islamic finance is used to refer to financial activities conforming to Islamic Law (Shariah). One of the main principles of the Islamic finance system is the prohibition of the payment and the receipt of riba (interest) in a financial transaction. The term riba covers all forms of interest and is not limited to usury or excessive interest only. The most critical and significant implication of banning interest is the indirect prohibition of a “pure” debt security. The key point to bear in mind is that Islamic law doesn’t recognize money and money instruments as a commodity but merely as a medium of exchange. Hence any return must be tied to an asset, or participation and risk-taking in a joint enterprise (such as partnerships). A pure debt security is replaced with an “asset-linked” security, direct financing of a real asset, and different forms of partnerships of which equity financing is the most desirable.

In addition to prohibition of riba, there are several other important provisions which may affect financial transactions. These include the prohibition of ‘gharar’ (uncertainty or asymmetrical information), ‘maysir’ (gambling, speculation), hoarding, as well as trading in prohibited commodities (for example, pork and alcohol).

Three Principles

Principle of equity: Scholars generally invoke this principle as the rationale for the prohibition of predetermined payments (riba), with a view to protecting the weaker contracting party in a financial transaction. The term riba, which means “hump” or

“elevation” in Arabic, is an increase in wealth that is not related to engaging in a productive activity. The principle of equity is also the basis for prohibiting excessive uncertainty (gharar) as manifested by contract ambiguity or elusiveness of payoff. Transacting parties have a moral duty to disclose information before engaging in a contract, thereby reducing information asymmetry; otherwise the presence of gharar would nullify the contract. The principle of equity and wealth distribution is also the basis of a 2.5 percent levy on cash or in-kind wealth (zakat), imposed by Shari’ah on all Muslims who meet specific minimum levels of income and wealth to assist the less fortunate and foster social solidarity.

Principle of participation: Although commonly known as interest-free financing, the prohibition of riba does not imply that capital is not to be rewarded. According to a key Shari’ah ruling that “reward (that is, profit) comes with risk taking,” investment return has to be earned in tandem with risk-taking and not with the mere passage of time, which is also the basis of prohibiting riba. Thus, return on capital is legitimized by risk-taking and determined ex post based on asset performance or project productivity, thereby ensuring a link between financing activities and real activities. The principle of participation lies at the heart of Islamic finance, ensuring that increases in wealth accrue from productive activities.

Principle of ownership: The rulings of “do not sell what you do not own” (for example, short-selling) and “you cannot be dispossessed of a property except on the basis of right” mandate asset ownership before transacting. Islamic finance has, thus, come to be known as asset-based financing, forging a robust link between finance and the real economy. It also requires preservation and respect for property rights, as well as upholding contractual obligations by underscoring the sanctity of contracts.

Instruments

Basic instruments include: cost-plus financing (murabaha), profit-sharing (mudaraba), leasing (ijara), partnership (musharaka) and forward sale (bay’salam).  These constitute the basic building blocks for developing a wide array of more complex financial instruments.

Murabaha – Trade with markup or cost-plus sale. The purchase of an asset is financed for a profit margin, with the asset purchased on behalf of client and resold at a pre-determined price. Payment could be in lump sum or in installments and ownership of the asset remains with bank till full payments are made

Ijara – Operational or financial leasing contracts.  Bank purchases asset on behalf of client and allows usage of asset for a fixed rental payment. Ownership of the asset remains with the financier but may gradually transfer to the client who eventually becomes the owner (ijara wa iqtina).

Mudaraba – Trustee financing contract.  One party contributes capital while the other contributes effort or expertise. Profits are shared according to a predetermined ratio and the investor is not guaranteed a return and bears any financial loss.

Musharaka – Equity participation contract.  Different parties contribute capital and profits are shared according to a pre-determined ratio, not necessarily in relation to contributions, but losses are shared in proportion to capital contributions. The equity partners share and control how the investment is managed and each partner is liable for the actions of the others.

Sales contracts.  Deferred-payment sale (bay’ mu’ajjal) and deferred-delivery sale (bay’salam) contracts, in addition to spot sales, are used for conducting credit sales.  In a deferred-payment sale, delivery of the product is taken on the spot, but delivery of the payment is delayed for an agreed period.  Payment can be made in a lump sum or in installments, provided there is no extra charge for the delay.  A deferred-delivery sale is similar to a forward contract where delivery of the product is in the future in exchange for payment on the spot market.

Sukuk – Certificates of Ownership. Sukuk are 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. The returns on the certificates are directly linked to the returns generated by the underlying assets.