Let's understand Islamic Finance and how it is different from Conventional Finance
Introduction, Principle, Riba (Interest), Instruments in Islamic Finance
Introduction
The Guiding Principle of Islamic Finance is based on the Sharia as revealed in Quran and Sunnah (words or acts) of Prophet Muhammad. All Islamic finance products and services offered follow Sharia Rules. Also Sharia Board oversees and reviews all new product offered by the financial institutions.
Principles of Islamic Finance
Principal of Equity : Lending of money on interest (Riba) is forbidden and so is excessive uncertainty (Gharar).
Principle of Participation : Investment return should be directly proportional to risk taking and not connected with mere passage of time
Principle of Ownership : Islamic Finance mandates asset ownership before dealing in any transaction.
Prohibition of trades that are Haram (prohibited) : Trading activities which are inappropriate under the Islamic principles like trading in alcohol, pork etc., are strictly prohibited
RIBA - INTEREST
Riba is considered as Haram as it is considered to be an act of exploitation and injustice of the economically weak by the strong and resourceful.
The objection of interest is that it is fixed and certain, i.e., the insistence on a sum certain in return for what is uncertain is unfair.
Islamic Finance models are based on risks and profit/loss sharing contract as opposed to conventional banking process.
As interest is not allowed depositors are rewarded by a share of profit from the underlying business.
It can be said that money has no intrinsic value, i.e., time value of money. The intrinsic value of any assets is its Net Realizable Value.
Under Islamic Finance, the relationship between depositor and banker can be viewed as:
Agent and Principal
Depositor and Custodian
Investor and Entrepreneur
Fellow joint partners
ISLAMIC FINANCE V/S CONVENTIONAL FINANCE
Under Islamic Finance, Interest is prohibited where as under Conventional Finance Interest is an integral part of the business and must be paid.
The Guiding Principle of Islamic Finance is based on the Sharia as revealed in Quran and Sunnah (words or acts) of Prophet Muhammad. All Islamic finance products and services offered follow Sharia Rules but in case of Conventional Finance their is no such framework.
Under Islamic Finance, Financial transactions should be free from uncertainty (Gharar) and gambling (Maisir) but in case of Conventional Finance their is no such framework.
Under Islamic Finance, Transactions are debarred from activities involving alcohol, pork and other socially detrimental products but in case of Conventional Finance their is no such restriction.
Lets understand various instruments in Islamic Finance
MUDARABAH - VENTURE CAPITAL
One party contributes 100% of the capital (Rab-al-Maal)
The other party contributes through management skill and labor (Mudarib)
Profit is shared amongst them in a pre-decided ratio
Loss is shared only by the financier.
MUSHARAKA - PARTNERSHIP
A partnership contract between two or more parties.
All the parties provide the capital in the business in the agreed ratio.
The parties have the right to participate in the business.
Loss is shared amongst them in the ratio of capital contribution.
Profit is shared as per pre-agreed ratio.
SUKUK - BONDS
Sukuk is a Sharia compliant bond which is different from the western bonds.
Instead of paying bondholders a rate of interest over a set period of time it offers a fixed rate of share of profit.
Bondholders also have share in the underlying assets of the company on realization of the assets.
IJARAH - LEASE
In this the lessor purchases the property from the seller
Lessor and Lessee execute the Ijarah contract against the predefined periodic lease rent for a specific lease period.
The lessor delivers the asset to the lessee
Lessee pays lease rent also the lessor as per the terms and conditions of the Ijarah contract.
The responsibility for maintenance of the asset remains with the lessor.
Ijarah Muntahia Bittamleek is also known as Finance Lease.
Ijarah contract is concluded between the lessor and the lessee for a specified but unidentified asset.
MURABAHA - COST PLUS CONTRACT
The mark-up is either in the terms of a percentage of the selling price or a lump sum amount
This transaction involves the financier explicitly disclosing the purchase price and the profit margin to the buyer.
The buyer pays to the financier in installments consisting of two elements
Cost of asset financed
Financier’s profit on acquisition of asset.
ISTISNA - MANUFACTURING FINANCE
The word Istisna means to manufacture or to construct something.
It is a fund arrangement for long term construction contracts.
The whole project is funded by the financier.
The client pays certain initial amount and the balance is repayable in installments.
It is an obligation on the part of the financier to deliver the project to the client upon completion.
SALAM - FORWARD CONTRACT
It is an arrangement where the price is paid in advance for a transaction to be executed in future
While the delivery to be made is deferred but the goods are as per pre-decided quality and quantity.
The sale is generally made at a discounted price.
Salam is prohibited in commodities such as gold, silver and other type of monetary assets.
Bottom line
Islamic Finance is different from Conventional Finance but Islamic Finance has lots of practical applications as it does not consider Interest for time value as well as prohibited trading in commodities such as gold, silver and other type of monetary assets of speculative instruments.