“In what ways does Islamic banking differ from conventional finance?” by Mervyn K. Lewis. This article was published in Journal of Islamic Economics, Banking and Finance in 2009.
The article elucidates some arguments and examines these views about Islamic finance and its components such as profit-and-loss sharing (PLS) concept as well as the risk of merchandising and banks' profit rates charging of a difference between the deferred price and the spot price that can be ‘benchmarked' to conventional interest rates. The system of Islamic finance has been taken by Prominent Islamic scholars to task on the grounds that the contractual modes offered by Islamic bankers are little different from conventional ones. The profit-and-loss sharing (PLS) concept is not readily adaptable to consumer, trade and government finance.
The concept of Shariah. Shariah is the set of rules and principles that Muslims believe to be revealed by God to the Prophet Mohammed (570-632 AD) as the way to lead a pious life and pursue what is good in the life hereafter. It is derived from two primary sources: the Quran - the sacred book of Islam that Muslims believe records the Words of God as revealed to the Prophet Mohamed; and the Sunnah - the sayings and practices of the Prophet Mohamed. Specific rulings are derived from these sources to create a body of law (Fiqh, or Islamic jurisprudence). Schools of thought have emerged in Islam that differ in their methodology for developing Fiqh.
Objectives of Shariah. Shariah rulings relating to transactions in particular are extensive and pursue an objective: the establishment of justice for mankind. Therefore, practices that are considered unjust - such as the payment and receipt of interest (Riba) - are prohibited. Indeed, the prohibition of interest was common to all three of the Abrahamic religions: Christianity, Judaism and Islam.
Other practices that Shariah considers to be contrary to its pursuit of justice are those that rely on speculation (Maysir) and have inherent uncertainty (Gharar).
Although interest is prohibited under Shariah, profit from trade and enterprise is permitted and encouraged. Accordingly, the main Islamic finance practices used by modern industry include trading, leasing, and partnerships and these bear many similarities with their conventional equivalents.
Although there may be economic similarities between Islamic finance practices and their conventional counterparts, there will inevitably be some differences - particularly from a risk perspective.
The principles of Islamic financial system are about 1400 years old, but the modern, institutionalized form of such principles first appeared only about 4 decades ago, when the first Islamic bank was established in Egypt in 1963.
Islamic finance is based on shariah, an Arabic term that is often translated into “Islamic law.” Shariah provides guidelines for aspects of Muslim life, including religion, politics, economics, banking, business, and law. Shariah-compliant financing (SCF) constitutes financial practices that conform to Islamic law. Major principles of shariah that are applicable to finance and that differ from conventional finance are:
- Ban on interest (riba): In conventional forms of finance, a distinction is made between acceptable interest and usurious interest. In contrast, under Islamic law, any level of interest is considered to be usurious and is prohibited.
- Ban on uncertainty: Uncertainty in contractual terms and conditions is not allowed, unless all of the terms and conditions of the risk are clearly understood by all parties to a financial transaction.
- Risk-sharing and profit-sharing: Parties involved in a financial transaction must share both the associated risks and profits.
- Ethical investments that enhance society: Investment in industries that are prohibited by the Qur'an, such as alcohol, pornography, gambling, and pork-based products, are discouraged.
- Asset-backing: Each financial transaction must be tied to a “tangible, identifiable underlying asset.” Under shariah, money is not considered an asset class because it is not tangible and thus, may not earn a return.
Some question how lenders profit from financial transactions under Islamic law. For instance, in a real estate setting, SCF takes the form of leasing, as opposed to loans. Instead of borrowing money, the bank obtains the property and leases it to the shariah compliant investor, who pays rent instead of interest. Earnings of profits or returns from assets are permitted so long as the business risks are shared by the lender and borrower.
Article review and findings
The Problem with Interest. The most well-known aspect of an Islamic financial system is the prohibition of paying or receiving interest on capital. Essentially, any positive, fixed, predetermined rate tied to the maturity and the amount of principal, which is guaranteed irrespective of the performance of the investment, is considered riba and is so prohibited.
This prohibition is not to be confused with a rate of return or profit on capital, as the earnings and sharing of profit is very much encouraged within Islam. Moreover, profit, determined ex post, symbolises the creation of additional wealth through successful entrepreneurship, whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations, and may create wealth, even if there are business losses. In both the Holy Qur'an and the Sunna, interest is treated as an act of exploitation and injustice and as such it is inconsistent with Islamic notions of fairness and property rights.
Siddiqi (1980, 1982), Chapra (1985), Khan (1985), moved away from equity considerations, and criticized conventional theories of interest for equating interest with either ‘impatience' or ‘waiting', on the savings side, or with the ‘productivity of capital', on the investment side of, respectively, the supply and demand for loanable funds.
The creation of unjustified property rights is lead by another approach to the question of riba revolved around the Islamic law of property rights, the argument being that interest on money.
Based on a general principle of Islamic law, based on a number of passages in the Holy Qur'an, Schacht (1964) argues that riba is simply a special case of unjustified enrichment or, in the terms of the Holy Qur'an, consuming (that is, appropriating for one's own use) the property of others for no good reason, which is prohibited.
Only two individual claims to property are recognized by shari'ah: property that is a result of the combination of creative labour and natural resources; and property the title of which has been transferred as a result of exchange, remittance, outright grants or inheritance.
Razi ( 1938) advanced five reasons for the prohibition on riba:
1. That riba is but the exacting of another's property without any countervalue while according to the saying of the Prophet a man's property is unlawful to the other as his blood.
2. That riba is forbidden because it prevents men from taking part in active professions, and earning their livelihood by way of trade or industry.
3. That the contract of riba leads to a strained relationship between man and man, which results in friction and strife and strips society of its goodliness.
4. That the contract of riba is a contrivance to enable the rich to take in excess of the principal which is unlawful and against justice and equity.
5. That the illegality of riba is proved by the text of the Holy Qur'an and it is not necessary that men should know the reasons for it. We have to discard it as illegal though we are unaware of the reasons (Vol. 2, p. 531).
The predetermined return is eschewed in Islam. The sharing of profit is legitimate and the acceptability of that practice has provided the foundation for the development and implementation of Islamic banking. In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit-sharing permissible, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.
In the interest-free system sought by adherents to Muslim principles, people are able to earn a return on their money only by subjecting themselves to the risk involved in profit-sharing. The basic building block of the Islamic banking alternative is to link the return on an Islamic financial contract to productivity in the real sector and the quality and success of the project, in this way seeking to achieve a more equitable distribution of wealth and financial returns.
Instruments of Islamic Finance. Given the restrictions outlined above, modern-day scholars have developed principle modes of financing which can be applied to contemporary financial scenarios while adhering to Islamic principles. Some common financial instruments currently being utilised in Islamic finance in various forms are as follows.
For financing working capital and liquidity management. Murabaha: this is effectively cost-plus financing, as used for trade and asset finance, allowing deferred payment by customers. Rather than lending money as in conventional loan, the bank purchases the requested commodity (thereby taking in on risk) and sells it to the customer at the agreed mark-up price. In recent times murabaha contracts have been the instrument of choice for many financial products, be it trade and asset finance or the provision of working capital facilities.
Istisna'a: aimed at long-term construction projects, this along with murabaha products, is one of two types of finance which allows the sale of a commodity prior to it coming into existence. Istisna'a contracts are clearly aimed at long-term projects, and are frequently used to finance the construction of real estate developments and large assets such as ships.
Profit-and-loss sharing. The two profit-sharing arrangements preferred under the value system of Islam are Mudaraba and musharaka. and of these mudaraba is the PLS method employed by banks in the raising of funds. A mudaraba can be defined as a contract between at least two parties whereby one party, the financier (rabb al-mal), entrusts funds to another party, the entrepreneur (mudarib), to undertake an activity or venture. According to Usmani (2000), this type of contract is in contrast with musharaka, where there is also profit-sharing, but all parties have the right to participate in managerial decisions. In mudaraba, the financier is not allowed a role in management of the enterprise. The mudarib becomes a trustee (amin) for the capital entrusted to him by way of mudaraba. The mudarib is to utilise the funds in an agreed manner and then return to the rabb al-mal the principal and the pre-agreed share of the profit. The mudarib keeps for himself what remains of such profits as a reward for his labour and entrepreneurial contribution. Monetary losses are borne entirely by the investor. Liability for losses, however, is limited to his investment unless he has given the mudarib an express permission for incurring debts (Usmani, 2000).
Musharakah: this is akin to a joint venture arrangement, through an equity participation contract. Ownership is distributed according to each partner's share in the financing, and profit and loss is shared by the partners. Such contracts are often used in connection with large project finance and private equity funds. Despite it being a preferred option by many Islamic scholars, musharakah still captures only a tiny portion of all Islamic finance, as there can be questions over the control of the assets.
Mudarabah: this is essentially an investment fund where one party provides the entire capital, and the other party provides the management (usually the bank, but can be the reverse). Profit sharing is agreed up-front, although the loss is borne by the provider of the funds alone.
Ariff (1982, 2007) argues, that Mudaraba and musharaka constitute, at least in principle if not always in practice, the twin pillars of Islamic banking.
According to Algaoud and Lewis (2001), the latest available global statistics on Islamic banking shows that mudaraba and musharaka combined account for only 2 per cent of financing in Pakistan, 11 per cent in the Gulf countries, 13 per cent in South Asia, and less than 1 per cent in South East Asia. These financing modes have assumed greater importance in the fully-Islamicized system of Iran, in Sudan and other parts of Africa (where musharaka has been used for agricultural financing), and in the West (diminishing musharaka for residential property financing).
The prevailing instruments of interest free finance along the lines relevant for financing can be divided into three categories, (1) the different buying-and-selling arrangements adapted for credit financing through the process of ijtihad in the last three decades, (2) leasing (rental) operations and, most recently (3) Islamic bonds (sukuk).
Credit instruments. As mentioned by the author, there is no scope for interest- or discount- based financing instruments in Islam on a strict interpretation. However, jurists adapted some contracts for finance that in the classical interpretation were meant for engagement in the real business of buying and selling. For instance, bai' bi-thaman ajil (BBA)/bai' muajjal is a deferred payment sale of goods permitted in shari'a. According to some shari'a scholars, the mutually agreed price could be different than the spot price. Likewise, shari'a does not object to a murabaha arrangement wherein a seller discloses his cost of goods to a buyer and a mark-up is mutually agreed in lieu of profit for the seller. These concepts are combined and adapted for Islamic banking. They allow a prospective trader or a potential real asset purchaser to approach a bank specifying his need for a real good. The bank purchases the asset and on-sells it to him adding its mark-up covering deferred payment and the risk that it takes in owning the goods between the original purchase and its on-selling to the customer.
Saadallah (2007) argues, in classical Islam a murabaha transaction involving a sale for cash was the norm. The first step in converting the original murabaha into a vehicle for financing was to make the extension of credit an essential feature of the transaction. Saadallah (2007) mentioned this was done by having the murabaha concluded on the basis of deferred payment instead of cash settlement. According to his opinion, the second step in transforming the murabaha into a financing technique (or in Saadallah's words, making the original murabaha into a ‘financial murabaha') was to address the issue of the inherent trading risks.
Leasing operations (ijara). Ijara: this is a quasi-debt instrument, essentially equivalent to leasing. Often used in the context of home purchasing, most aspects of an ijara are the same as those of conventional leasing, whereby the investor (lessor) purchases and leases the underlying asset to the prospective borrower (lessee) for a specified rent and term. Ijara are frequently used to finance the acquisition of real estate and equipment, although they have also been utilised to effect leveraged buy-outs in private equity transactions. Tag El-Din and Abdullah (2007) argued that ijara contracts were being standardized and the documentation merged with that for conventional leases.
According to Warde (2000), despite its obvious similarity to an interest charge, this profit element in the lease is permissible. According to Islamic jurists, shari'a allows a fixed charge relating to tangible assets (as opposed to financial assets) because by converting financial capital into tangible assets the financier has assumed risks for which compensation is permissible. These risks legitimise any profits obtained. Warde (2000) argues that the conditions attached to ijara clarify the risk involved to the lessor: first, the duty of repair is incumbent upon the lessor, second, the lessee is free to cancel the lease if the usufruct proves less beneficial than expected, and third, the price of the asset at the termination of the lease period cannot be fixed in advance.
Diminishing musharakah: recent times have witnessed a shift in emphasis away from ijara towards diminishing musharakah (DM) as a mode of financing Islamic mortgages. Many of the major Islamic mortgage providers have either already switched to DM or are planning to do so imminently. DM is a hybrid financing technique involving both ijara and musharakah. It appeals to Islamic investors because it is based on the fundamental principle of sharing risk. The attraction for financiers is twofold, in that it can incorporate a variable rate of return and has a credit profile that would be acceptable to most conventional institutions.
Islamic bonds (sukuk) and financial engineering. Sukuk: this is an investment certificate (bond) that represents a proportionate interest in a well-defined pool of assets that yield income and capital returns. Usually set up through the conventional securitisation process, with a special purpose vehicle acquiring the assets, the returns from the assets are passed to sukuk holders (investors). To date popular asset classes have included real estate. This method has been a popular way for many governments to raise funds for infrastructure, and accounts for the largest portion of Islamic finance.
Rosly and Sanusi (1999) argues, pressures for innovation have resulted in finding a way out of these limitations, admitting ‘financial engineering'. In particular, leasing-based bonds (sukuk al-ijara) have been developed. The ijara sukuk remains the most popular, although other sukuk have been issued, for example, sukuk al-mudaraba, sukuk al-musharaka, sukuk al-murabaha.
If they can be traded on the secondary market to gain liquidity, Islamic bonds are more useful. But certain requirements must be met with respect to the trading capacity of the bonds on the Islamic financial market. Specifically, they cannot represent a debt (in Islam, debt-selling is forbidden), as conventional bonds can. Instead they must constitute property of an approved asset. Through the securitization of the asset such a bond is obtained. The author argues, the property of this security is divided into equally valued units and incorporated in the sukuk certificates. The value of the sukuk thus remains connected to the value of the underlying asset. They may come in zero coupon and coupon versions. According to the author's opinion, their productivity and return is linked to the profit of the underlying asset and not to an interest rate (although an interest rate such as LIBOR can be used as a ‘benchmark').
It is the potential for tradeability that primarily makes for the popularity of sukuk al-ijara. Though ijara is less commonly employed than murabaha as an asset in Islamic banks' balance sheets, it offers much greater flexibility for the Islamic bond market. Each security called sukuk-al-ijara represents a pro rata ownership of physical assets as against a pro rata share in financial claims or debt in the case of sukuk-al-murabaha. Obaidullah (2007) argues that ownership in physical assets can always be transferred at a mutually negotiated price, while debt can only be transferred at par. Hence sukuk-al-ijara allow for creation of a secondary market since they represent a share in the ownership of a physical asset.
Islamic Finance has become a very significant part of the global financial industry. It has come a long way and is there to stay. Although it is still much smaller than the conventional financial industry, it is significant enough not be ignored anymore. Keeping in view the growing Islamic finance industry and its attractive market potential, the conventional banking institutions have also established ties with Islamic banks to finance large development projects.
According to findings of Samad, Gardner, and Cook (2006), among financial contracts, mudarabah, musharakah, qard al-hassan, and istisna` are the most distinguishing products in the theory of Islamic finance. However, the data indicate that for the two Islamic banks studied in their research, mudarabah, musharakah, and qard al-hassan financing are the least significant financial instruments. The average level of mudarabah financing engaged in by these two Islamic banks is only 5%, and for musharakah it is less than 3%, making the combined average less than 4% of total finance and advances. The average financing under the qard al-hassan (benevolence) mode is about 4%. Istisna` (progressive) is not yet used by these two Islamic banks.
It is understandable that, during the initial development of the Islamic banking system, musharakah and mudarabah financing should be deemphasized due to the increased risk associated with them. Nevertheless, it be can expected that these Islamic financial instruments will increase in importance as the Islamic banking system continues to mature.
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