Pursuit of Islamic Finance: The Big Picture of Islamic Banking and Insurance

all over the World

Islamic finance refers to the means by which corporations in the Muslim world, including banks
and other lending institutions, raise capital in accordance with Shariah. It also refers to the types
of investments that are permissible under this form of law. A unique form of socially responsible
investment, Islam makes no division between the spiritual and the secular, hence its reach into
the domain of financial matters.

Although they have been mandated since the beginning of Islam in the seventh century, Islamic
banking and finance have been formalized gradually since the late 1960s, coincident with and in
response to tremendous oil wealth that fueled renewed interest in and demand for Sharia-
compliant products and practice. Central to Islamic banking and finance is an understanding of
the importance of risk sharing as part of raising capital and the avoidance of riba (usury) and
gharar (risk or uncertainty). Islamic law views lending with interest payments as a relationship
that favors the lender, who charges interest at the expense of the borrower. Because Islamic law
views money as a measuring tool for value and not an asset in itself, it requires that one should
not be able to receive income from money alone. Deemed riba, such practice is proscribed under
Islamic law as it is considered usurious and exploitative. By contrast, Islamic banking exists to
further the socio-economic goals of Islam.

Accordingly, Shariah-compliant finance consists of profit banking in which the financial

institution shares in the profit and loss of the enterprise it underwrites. Of equal importance is the
concept of gharar. Examples of gharar would be forms of insurance, such as the purchase of
premiums to insure against something that may or may not occur or derivatives used to hedge
against possible outcomes. The equity financing of companies is permissible, as long as those
companies are not engaged in restricted types of business, such as the production of alcohol,
pornography or weaponry, and only certain financial ratios meet specified guidelines.

Below is a brief overview of permissible financing arrangements often encountered in Islamic

finance:
1. Profit-and-loss sharing contracts (Mudarabah). The Islamic bank pools investors' money
and assumes a share of the profits and losses. This is agreed upon with the depositors.
What does the bank invest in? A group of mutual funds screened for Sharia compliance
has arisen. The filter parses company balance sheets to determine whether any sources of
income to the corporation are prohibited or if the company is engaged in prohibited lines
of business.
2. Partnership and joint stock ownership (Musharakah). Three such structures are most
common:

a. Declining-balance shared equity: Commonly used to finance a home purchase,

the declining balance method calls for the bank and the investor to purchase the
home jointly, with the institutional investor gradually transferring its portion of
the equity in the home to the individual homeowner, whose payments constitute
the homeowner's equity.

b. Lease-to-own: This arrangement is similar to the declining balance one

described above, except the financial institution puts up most, if not all, of the
money for the house and agrees on arrangements with the homeowner to sell the
house to him at the end of a fixed term. A portion of every payment goes toward
the lease and the balance toward the purchase price of the home.

c. Installment (cost-plus) sale (Murabaha): This is an action where an

intermediary buys the home with free and clear title to it. The intermediary
investor then agrees on a sale price with the prospective buyer; this price includes
some profit. The purchase may be made outright (lump sum) or through a series
of deferred (installment) payments.

3. Leasing ('ijarah/'ijar): The sale of the right to use an object (usufruct) for a specific
time period. One condition is the lessor must own the leased object for the duration of the
lease.

4. Islamic forwards (salam and 'istisna): These are rare forms of financing, used for
certain types of business. These are an exception to gharar. The price for the item is
prepaid and the item is delivered at a definite point in the future.
In a typical ijara sukuk (leasing bond-equivalent), the issuer will sell the financial certificates to
an investor group who will own them before renting them back to the issuer in exchange for a
predetermined rental return. Like the interest rate on a conventional bond, the rental return may
be a fixed or floating rate pegged to a benchmark, such as LIBOR. The issuer makes a binding
promise to buy back the bonds at a future date at par value. Special purpose vehicles (SPV) are
often set up to act as intermediaries in the transaction. A sukuk may be a new borrowing, or it
may be the Sharia-compliant replacement of a conventional bond issue.

Basic Insurance Vehicles: Traditional insurance is not permitted as a means of risk

management in Islamic law. This is because it constitutes the purchase of something with an
uncertain outcome (form of ghirar), and because insurers use fixed income - a form of riba - as
part of their portfolio management process to satisfy liabilities. A possible Shariah-compliant
alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which
are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims,
and unclaimed profits are distributed among policy holders. Such a structure exists infrequently,
so Muslims may avail themselves of existing insurance vehicles if needed or required.

Islamic finance is a centuries-old practice that is gaining recognition throughout the world and
whose ethical nature is even drawing the interest of non-Muslims. Given the increased wealth in
Muslim nations, expect this field to undergo an even more rapid evolution as it continues to
address the challenges of reconciling the disparate worlds of theology and modern portfolio
theory.