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What is so Islamic about Islamic Banking?

The fundamentals of Islamic Banking

by Nada Abdelsater-Abusamra

The Islamic banking industry has grown impressively during a short period of time. In the early 1960s, the Islamic finance sector witnessed a steady growth in different aspects such as size, complexity of the transactions, and internal processes. It has been estimated that the sector is witnessing a 15% to 20 % annual growth rate (10% of which is in the Gulf region). One of the reasons pertaining to this growth — but certainly not the only reason — is the huge amount of petro-dollars following the rapid increase in oil prices.

Islamic finance now exists in more than 75 countries with more than 300 Islamic financial institutions and Islamic windows operating globally. According to McKinsey & Co, it is estimated that this sector will attain $1 trillion in assets by 2010. Currently, this sector is estimated at more than $500 billion in assets. The success of Islamic banking prompted many multinational conventional banks to offer Islamic financial services. For instance, HSBC, Citibank, and Deutsche Bank are already providing such services worldwide. So what is so different about Islamic banking and what is so “Islamic” about it? Is conventional banking non-Islamic? And is Islamic banking non-conventional?

Answering these questions warrants an in-depth analysis of Islamic Finance which is clearly beyond the scope of this article. This article aims at introducing, from a legal perspective, basic concepts of Islamic finance.

Some have questioned the rationale of distinguishing between Islamic and conventional finance with a skeptical approach advocating that there were no real differences between the two systems. However, the Islamic banking industry is different from conventional banking in several aspects of its core legal features even though some Islamic banking operations may ultimately lead to the same results as conventional banking operations.

The fact that the same result may be reached in both systems does not mean that both systems are identical. An expressive example was used by Professor Mahmoud Amin El- Gamal from Rice University when comparing an “Islamic finance contract” to a “marriage contract”. Whether the “marriage contract” is held under Islamic or civil law, this will lead in both cases to two persons being married and forming a family. In certain respects, “a marriage is a marriage” and “a “financial contract is a financial contract.”

Does this mean that Islamic marriage is identical to civil marriage only because both lead to the same result? The answer is “of course not.” In Islamic marriage (and similarly in Islamic leases), the contract must comply with additional requirements warranted by the sharia. As with marriage, the outer form of an Islamic lease (for example) may seem to a casual observer to be identical to a regular lease. However, recognizing the differences requires alertness to the legal requirements of sharia.

Fundamental principles
We shall now turn to some fundamental principles of Islamic banking including the prohibition of riba, the requirement to structure transactions according to Islamic compliant vehicles and invest in halal activities, the concept of Profit and Loss Sharing schemes, and the prohibition of gharar (uncertainty).

In Islamic banking, no interest (riba) is paid or charged for any transaction or service. In other terms, one cannot make “money from money.” According to Islam, prohibition of riba ensures justice, welfare and non-exploitation of the other party’s weaknesses.

However, an increase in business activity derived from invested money is not riba. Taken as a “trade” activity, investment is not only permitted by sharia, but it is also encouraged. This is taken from the hadith whereby “a man’s labor and every legitimate sale” are the best forms of income generation. This shows the necessity to clearly define what constitutes a “prohibited” interest (i.e. riba). In addition, the prohibition of interest is not the only “Islamic finance rule”. In fact the Islamic financial system is supported by other key principles consecrated by sharia such as risk sharing, trade, property of rights and the “sanctity of contracts”.

Second, investments of an Islamic bank must be channeled to approved (halal) sectors, and such by using Islamic structures of finance such as mudaraba, musharaka, bai- muajjal, bai-salam, and ajar among others.

Third, Islamic banking deals with the Profit and Loss Sharing (PLS) scheme. In fact, the financer or investor usually shares in the profits or losses arising out of the enterprise’s business where the money is invested with other contributing parties. This concept is derived from sharia, where Islamic finance is based on the belief that the provider and the user of capital should share the risk of business.

Fourth, gharar (uncertainty, risk or speculation) is prohibited under sharia. Consequently, the contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. For instance, maysar (gambling) is prohibited by sharia law since it involves speculation and uncertainty. At this level, a distinction should be made between gharar and “risk” as such. In fact, according to Islamic principles not only is risk permitted but risk must be inherent to any profit. In other terms, reward must be accompanied by risk. For example, this is why investment in stock is permissible (market risk) while investment in bonds is not (credit risk).

In addition to the above, several points are worth noting when addressing the particularities of Islamic banks such as the principle of non-guaranteed investments as well as the most common Islamic vehicles.

Value of investment not guaranteed
Islamic banks neither guarantee the capital value of investment nor the return on investment except in the case of mismanagement or negligence. These banks mainly pool funds provided by the “depositors” (account holders) and therefore provide them with professional investment management (whilst conventional banks guarantee the depositors’ fund and provide them with a fixed interest rate). From this perspective and due to the application of the PLS scheme, Islamic banks may viewed as being in a better position than conventional banks in absorbing external shocks. This is because they have the ability to reduce the capital value of investment deposits in the case of loss, thus transferring part of the loss to the investment accounts of the investors.

As for Islamic legal vehicles, these include murabaha or mark-up financing, accounting for 75% of Islamic financial activities, where the seller adds a cost plus to the initial price of the acquired product. Another well-known instrument is mudaraba or profit sharing where the rabb al- mal (capital owner) provides the total amount needed to finance a project while the entrepreneur offers his labor and expertise. Another instrument is musharaka or equity participation where the bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project. Profits and losses are shared strictly in relation to the respective capital contributions. Other tools include ijara (lease), salam (deferred payment), and sukuk (Islamic bonds).

The use of the above described Islamic legal vehicles is not limited to Islamic banking, nor should Islamic banking be viewed as the only component of Islamic finance. Islamic finance is much broader and forms part of a comprehensive financial and legal system. As such this system also encompasses financial intermediation, financial markets, funds, insurance, and other financial and non-financial transactions.

However, the legal and technical framework of these systems needs further elaboration and development. The implications of corporate governance, risks, systemic risks as well as other considerations need to be addressed by regulators and appropriate best practice Islamic standards have started to be developed.

In addition, capital market players (as well as regulators) need to take cognizance of the importance of Islamic finance compliance notably in the context of an IPO. In this respect Islamic Investment criteria (also referred to as sharia “filters” or “screens”) have been developed by Islamic law scholars as well as international financial institutions. The most widespread sharia “filters” or “screens” are the ones adopted by the Dow Jones Islamic Market Indices, Standard & Poor’s Islamic Indices, the Bahrain-based Accounting and Auditing Organization for Islamic Banks and Organizations (AAOIFI), FTSE’s indices, the Malaysian Securities and Exchange Commission, Meezan Bank of Pakistan and many other private and public institutions in Saudi Arabia, Kuwait, the United Arab Emirates and other Arab and Muslim countries including also Iran.

 

Nada Abdelsater-Abusamra is a corporate and finance attorney admitted to the courts of Beirut and courts of New York. She is a lecturer of law at the American University of Beirut and speaker on Islamic Finance in international conferences. She advises regulators as well as private and public financial institutions on Islamic Finance. Bassem Dagher is a legal counsel and holds an MBA from the American University of Beirut.

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Nada Abdelsater-Abusamra


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