Paper F9 Dinesh Kumar

Islamic Finance
Syllabus Area:
Raising short and long term finance through Islamic financing
a) Explain the major difference between Islamic finance and the other forms of business finance.
b) Explain the concept of interest (riba) and how returns are made by Islamic financial securities.
(calculations are not required)
c) Identify and briefly discuss a range of short and long term Islamic financial instruments available
to businesses including
i) trade credit (murabaha)
ii) lease finance (ijara)
iii) equity finance (mudaraba)
iv) debt finance (sukuk)
v) venture capital (musharaka)

Introduction to Islamic finance

Islamic finance rests on the application of Shariah. Sharia law is derived from the Quran (believed to
be Allah’s divine revelation to the prophet Muhammed) and the teachings of Muhammed.
Muslims believe that Sharia law shows the path to be followed as ordained by ALLAH. It covers all
aspects of life and Muslims believe that following this path will lead to physical and spiritual
wellbeing.
Sharia law sets out five categories of actions that guide a Muslim’s actions:
These are acts that are:
 Obligatory (Wajib)
 Meritorious (deserving honour)
 Commendable (worth praising)
 Reprehensible (deserving strong criticism) and
 Forbidden (Muharram).

The main principles of Islamic finance are that:

 Wealth must be generated from legitimate trade and asset-based investment (the use of money
for the purposes of making money is expressly forbidden).
 Investment should have a social and an ethical benefit to wider society beyond pure return.
 Risk should be shared.
 Harmful activities (haram) should be avoided.

The intention is to avoid injustice, asymmetric risk and moral hazard (where the party who causes a
problem does not suffer its consequences) and unfair enrichment at the expense of another party.

It is estimated US $1 trillion of assets are managed according to these principles under the rules of
Islamic finance.

Specific guidance
The following activities are prohibited:
Charging and receiving interest (riba).
 This contradicts the principle that risk must be shared and is also contrary to the ideas of
partnership and justice.
 Using money to make money is forbidden.
 Investment in companies that have too much borrowing is also prohibited. What constitutes “too
much borrowing” is a matter for interpretation but is typically defined as debt totalling more than
33% of the stock market value over the last 12 months.
Investments in businesses involved in alcohol, gambling, or anything else that the Shariah considers
unlawful or undesirable (haram).
Investments in transactions that involve speculation or extreme risk. (This is seen as gambling).
Entering into contracts where there is uncertainty about the subject matter and terms of contracts
(This includes a prohibition on short selling, ie selling something is not yet owned).

Permitted activities
Islamic banks are allowed to obtain their earnings through profit-sharing investments or fee-based
returns. If a loan is given for business purposes the lender should take part in the risk. This usually
involves the lender buying the asset and then allowing a customer to use the asset for a fee.
The following Islamic financial instruments provide Shariah-compliant finance:

Murabaha
In traditional western finance a customer would borrow money from a bank in order to finance
activity, say the purchase of an asset. However, under Sharia the bank cannot charge interest.
Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. The
bank buys the asset and then sells it on to the customer on a deferred basis at a price that includes
an agreed mark-up for profit. Payment can be made by instalments but the mark-up is fixed in
advance and cannot be increased, even if there is a delay in payment.

Ijara
A form of lease finance agreement where a bank buys an asset for a customer and then leases it to
the customer over a specific period at agreed rentals which allows the bank to recover the capital
cost of the asset and a profit margin.

Mudaraba
The bank provides capital and the customer provides expertise to invest in a project.
Profits generated are distributed according in a predetermined ratio but cannot be guaranteed. This
is like the bank providing equity finance.

Musharaka
This is a joint venture or investment partnership between two parties who both provide capital
towards the financing of new or established projects. Both parties share the profits on a pre-agreed
ratio, allowing managerial skills to be remunerated, with losses being shared on the basis of equity
participation.

Sukuk
This is debt finance but Islamic bonds cannot bear interest.
Sukuk holders must have an ownership interest in the assets which are being financed. The sukuk
holders’ return for providing finance is a share of the income generated by the assets.
Often the cash flows from these techniques might be the same as they would have been under
standard western practice. However, the key difference is that the rate of return is based on the
asset transaction and not based on interest on money loaned.

The Shariah board

There is no ultimate authority for Shariah compliance.

Each Islamic bank’s adherence to the principles of Shariah law is governed by its own Shariah board.
This is a body within an Islamic financial institution that has the responsibility for ensuring that all
products and services offered by that institution are compliant with the principles of Shariah law.