Finance Weblog: The beauty of Islamic Finance - Instituto de Empresa Business School

Islamic Finance constitutes a key area within Global Finance. It deals with finance but... being consistent with Islamic religious principles.

For example an islamic bond is called "sukuk". It complies with Islam but it is similar to our "Western" version of debt.

The obvious reason why Islamic Finance is huge is self explanatory: Oil Prices...

There are many concepts within Shari’ah which limit the degree to which conventional capital market techniques can be applied, but the most fundamental is the prohibition of Riba.

Riba – often interpreted simply as interest – is considered to be any pre-determined return on money, in other words, the generation of income from money alone. While interest is prohibited, Shari’ah does allow for financing to be provided (or accepted) in the event that it is linked to certain identifiable assets (e.g. for the trading of those assets, or for their construction).

Aside from the prohibition of riba, Islamic finance also prohibits:

* Investment in companies that manufacture certain forbidden – haram – products, such as tobacco, alcohol, firearms, pork products and also investment in companies in the entertainment industry, casinos, hotels, restaurants, adult entertainment etc. (which restricts the commercial assets in which the proceeds of a Sukuk issue can be invested).

* Speculation, betting and gambling (maisir) including the speculative trade or exchange of money for debt without an underlying asset transfer.

* Preventable uncertainty (gharar) such as that related to derivative instruments, forwards and futures.

Islamic Finance itself is not a recent phenomenon but has developed over many hundreds of years. Over that time a variety of different contractual instruments have become well established as common ways of financing, and been given the green light by Islamic scholars tasked with developing Islamic jurisprudence and interpreting the principles laid down in (most importantly) the Qu’ran.

Traditionally these instruments have formed the basis for commercial banking, although as we will see later they are now being used as the basis for many Sukuk and hence are being translated into the investment banking arena.

Now let´s look at several contracts in Islamic Finance, which form the building blocks of Sukuk. Given the Shari’ah restrictions on the trading of indebtedness, we have divided the contracts into two groups:
those which can tradable at a market price and those that can only be transferred at face value. Naturally the ones in the former group are the most important for Sukuk, although the ones in the latter do occur within some Sukuk – hence their inclusion here.

Ijara – an ijara is essentially a lease contract whereby assets (or the usufruct of an asset) is leased out with the lessor retaining all the rights and responsibilities that go with ownership.

Ijara represents the typical Islamic mortgage structure. As Ijara bonds represent ownership in well defined securities they can be freely traded in the secondary market at a market price.

Mudaraba – a mudaraba can be thought of as an asset management agreement whereby one party provides finance to another party and the second party (known as the mudarib) invests the capital according to some pre-agreed business plan. The profit of the business is distributed according to a pre-determined ratio, but any financial loss is incurred only by the finance providers.

Musharaka – a musharaka agreement is somewhat similar to that of a mudaraba, but in this case both parties provide capital (or assets) and both may be involved in the management of the assets. Essentially a musharaka is a joint-venture. As with the mudaraba, the profit of the business is distributed according to a pre-determined ratio, however, in a musharaka the loss is distributed in proportion to each partners share of the capital.

Murabaha – the most common instrument in Islamic Finance, the murabaha is essentially a tool for financing the purchase of specific assets. Under the contract the counterparty providing the financing purchases the required assets and sells them to the buyer at a pre- agreed marked-up price. The payment can be settled in instalments or as a lump sum within an agreed period.

Istisna’a – a contract which exchanges an upfront payment for the future delivery of an asset. An istisna’a contract requires that the asset is made to order. Full payment need not necessarily be made in advance and can be phased. This is the most common form of financing for construction projects.

As an indication of the relative importance of these various forms of Islamic Finance instruments, Figure 1 below illustrates the composition of the assets of the Dubai Islamic Bank (the world’s third largest Islamic bank) as of the end of 2006.

I have used a very good Deutsche Bank research report as source for this article.
See "Bond Market Guide. Introduction to Sukuk" written by Marc Balston and Arend Kapteyn.
Both very good analysts.

Let the force be with you...

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