Sources of finance – islamic finance

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1 Introduction

Under the principles of Islamic law, wealth must be generated from legitimate trade and asset-based investment. Also, investments must have a social and ethical benefit. Speculative investments are not allowed, and investments in such areas as alcohol and gambling are forbidden.

2 Riba

As a consequence of the laws regarding the generation of wealth, it is strictly forbidden to use money for the purpose of making money – i.e. it is forbidden to charge interest (riba).

Financial institutions cannot therefore make money by charging interest, but instead provide services for a fee or enter into a form of agreement with the client in which the risk and the profits or losses are shared between the institution and the client.

3 Islamic financial instruments

You should be aware of the following Islamic financial instruments and be able to briefly discuss them:

1. Murabaha

This is effectively a form of credit sale, where the customer receives the goods but pays for them later on a fixed date.

However, instead of charging interest, a fixed price is agreed before delivery – the mark-up effectively including the time value of money.

1. Ijara

This is effectively a lease, where the lessee pays rent to the lessor to use the asset.

Depending on the agreement, at the end of the rental period the lessor might take back the asset (effectively an operating lease) or might sell it to the lessee (effectively a finance lease – Ijara-wa-Iqtina).

Whatever the agreement, the lessor remains the owner of the asset and is responsible for maintenance and insurance, thus incurring the risk of ownership.

1. Muduraba

This is similar to equity finance, or a special kind of partnership. The investor provides capital and the business partner runs the business. Profits are shared between both parties, but all losses are attributable to the investor (limited to the capital provided).

1. Musharaka

This again is similar to a partnership, but here both parties provide both capital and expertise. Profits are shared between the parties according to whatever ratio is agreed in the contract, but losses are shared in proportion to the capital contributions.

It is regarded as being similar to venture capital.

1. Sukuk

This is the equivalent of debt finance (Islamic bonds).

Sukuk must have an underlying tangible asset, and the holders of the Sukuk certificates have ownership of a proportional share of the asset, sharing revenues from the asset but also sharing the ownership risk.

An example may be where the financial institution purchases a property financed by Sukuk certificates and rents it out at fixed rent. The certificate holders receive a share of the rent (instead of interest) and a share of the eventual sale proceeds.

The Sukuk manager is responsible for managing the assets on behalf of the Sukuk holders (and can charge a fee). The Sukuk holders have the right to dismiss the manager.

(Although there can be a secondary market as with conventional debt (the purchase and sale of certificates on the stock exchange) it is currently very small. Most Sukuk are bought and held – virtually all of any trading is done by institutions.)