Islamic Finance: An Ethical Alternative to Conventional Finance

Robert E Michael, the Head of Islamic Finance at the New York City Bar, when asked whether Islamic Finance is a viable alternative in the current crisis, responded saying: “The answer is clearly yes, but for two mutually exclusive reasons. On the one hand, it is clear that, properly employed, Quranic restrictions would have prevented the excesses of leverage and gambling on derivatives that lead to the current collapse; on the other hand, however, those same restrictions would have prevented our western economies from reaching anywhere near the levels of size and complexity we enjoy that make it possible for such enormous problems to occur.”

“The global Islamic finance industry, valued by the Asian Development Bank at US $ 1 trillion, has been regarded by some investors as a safer alternative as the Shari’ah forbids complex, opaque financing structures similar to sub-prime loans that triggered the US housing collapse “Bank Negara governor Tan Sri Dr. Zeti Aziz said in a speech at a Shari’ah Banking Conference in Boston.

“The current global market conditions has given Islamic finance a great opportunity to show what it can do-help to fill the liquidity gap”, said David Testa, chief executive of Gatehouse Bank Plc which began operations as Britain’s fifth Islamic bank. Testa said that Islamic finance practices were fiscally conservative, with genuine end-investor participation that did not involve parking of assets in off-balance sheet vehicles.

The former British Prime Minister, Gordon Brown, said at the G20 meet that:”It is time for a value based market which is premised on a shared global ethics. A market with morals is possible based on demanding responsibility from all and fairness to all”.

 “As trust in conventional markets continues to erode, Islamic finance as an industry is rapidly evolving into a viable alternative to conventional sources and forms of capital for Muslims and non-Muslims business. To describe Islamic finance as simply a system of finance that happens to be devoid of interest understates the true nature of the Islamic ideal, namely the fair and equitable exchange between two parties. Islamic finance is the execution of financial transaction through a trusted third party that acts to balance risk and return between parties. Corporations such as Tesco (UK) and Tyota (Japan) have used Islamic financial instruments to meet their capital requirements” writes Joseph Divanna & Antoine Sreih in their new book, A New Financial Dawn, the Rise of Islamic Finance.

 

The most important principles on which the modern Islamic finance framework rests on:

Prohibition of the payment or receipt of interest: Money itself is considered to have no intrinsic value-it is merely a store of wealth and medium of exchange.

Prohibition of uncertainty or speculation: Everybody participating in a financial transaction must be adequately informed and not cheated or misled. Derivatives and debt financing is prohibited.

Prohibition of financing certain economic sectors: Investment is forbidden in what are considered to be socially detrimental activities like gambling, pornography, alcohol, armaments, etc.

Importance of profit and loss sharing: The investor and investee must share the risk of all financial transactions; and

Asset-backing principle: Financial transactions should be unpinned by an identifiable and tangible underlying asset.

 

Some common financial instruments currently being utilised in Islamic finance in various forms are as follows:

For financing working capital and liquidity management

Murabaha: This is effectively cost-plus financing, as used for trade and asset finance, allowing deferred payment by customers rather than lending money as in conventional loan. The bank purchases the requested commodity (thereby taking it on risk) and sells it to the customer at the agreed mark-up price. In recent times, murabaha contracts have been the instrument of choice for many financial products, be it trade and asset finance or the provision of working capital facilities.

Istisna’a: Along with murabaha products, it is one of two types of finance which allows the sale of a commodity prior to production. Istisna’a contracts are clearly aimed at long-term projects, and are frequently used to finance the construction of real estate developments and large assets such as ships.

For asset finance

Ijara: This is a quasi-debt instrument, essentially equivalent to leasing. Often used in the context of home purchasing, most aspects of an ijara are the same as those of conventional leasing, whereby the investor (lessor) purchases and leases the underlying asset to the prospective borrower (lessee) for a specified rent and term. Ijara are frequently used to finance the acquisition of real estate and equipment, although they have also been utilised to affect leveraged buy-outs in private equity transactions.

Diminishing musharakah: Recent times have witnessed a shift in emphasis away from ijara towards diminishing musharakah (DM) as a mode of financing Islamic mortgages. Many of the major Islamic mortgage providers have either already switched to DM (HSBC Amanah uses DM) or are planning to do so imminently. DM is a hybrid financing technique involving both ijara and musharakah. It appeals to Islamic investors because it is based on the fundamental principle of sharing risk. The attraction for financiers is twofold, in that it can incorporate a variable rate of return and has a credit profile that would be acceptable to most conventional institutions.

Equity based instruments

Musharakah: This is akin to a joint venture arrangement, through an equity participation contract. Ownership is distributed according to each partner’s share in the financing, and profit and loss is shared by the partners. Such contracts are often used in connection with large project finance and private equity funds. Despite it being a preferred option by many Islamic scholars, musharakah captures only a tiny portion of all Islamic finance.

Mudarabah: This is essentially an investment fund where one party provides the entire capital, and the other party provides the management (usually the bank, but can be the reverse). Profit sharing is agreed up-front, although the loss is borne by the provider of the funds alone.

Fixed income investment

Sukuk: This is an investment certificate (bond) that represents a proportionate interest in a well-defined pool of assets that yield income and capital returns. Usually setup through the conventional securitisation process, with a special purpose vehicle acquiring the assets, the returns from the assets are passed to sukuk holders (investors). Nowadays popular asset classes have included real estate. This method has been a popular way for many governments to raise funds for infrastructure, and accounts for the largest portion of Islamic finance.

 

Distribution of Wealth: The wealth produced in a society must be distributed in a just and fair manner, so that it may not be concentrated in the hands of a few people. The Holy Quran says: ‘so that it may not circulate only among the rich among you’ (Holy Quran 59:7)

20 richest Indians earn as much as what 30 crore poorest people are earning, writes Bimal Jalan, former RBI Governor. While GDP growth is nearly 9%, Aam Aadmi, the 860 million marginalised Indians earn only Rs 20 per day. The system has created two sections in our societies: super rich and super poor.

The study by specialists at Oxford University based on an innovatory’ multidimensional poverty index” or MPI, more than 410 million people live in poverty in the Indian states. The study’s conclusions reinforce claims that distribution of wealth generated by India’s rapid economic growth (10 percent in one year, recently) is deeply unequal. Even though after Prime Minister Dr. Manmohan Singh’s repeated statement that he wants to see ‘inclusive’ development.

 Islamic finance set values and principles that may remove this disparity and provide justice and equity for all.

 

The real economy consists of land and agriculture, factories and manufacturing goods etc. These are the tangible goods which can be traded, leased and sold. They are physical goods which are produced, and people are employed to make them. But financial economy consists of tradable paper with financial values that rise and fall based upon the value. People give them without backing real assets, which is beautifully termed as ‘Financial Engineering’.

Sustainable economic growth needs to go through a proper development process: a) Develop agriculture, b) Develop Industry, c) Develop services

Real economy has to avoid temptation to copy western developed economies in their promotion of developing the services sector, while forgetting to develop the two underlying primary sectors. Also there is a challenge in finding and financing tomorrow’s technology which will have direct implication and application today.

 

Zakah: Collective system of zakah and its proper distribution has to be strengthened as it was prevalent in the days of the prophet and up to the seventh century hijra, till the invasion of the Tatars Conceptually. Zakah is supposed to be a major instrument for social security, eradicating poverty, curbing excessive economic disparities and stimulating economic activity by transferring substantial purchasing power to the have-nots.

In Malaysia and South Africa a system is evolved with a rehabilitative mechanism is successfully evolved categorising the poor into two categories i.e., Productive Poor and Unproductive Poor and treating them separately.

To begin with, in towns and villages, each mohalla with a mosque should form an NGO wherein a committee of 4-5 persons with skills and spirits is formed to collect zakath and sadaqat. Based on the survey of the area, the basic needs of the marginalised and needy sections can be addressed.

Waqf: The institution of waqf provides a foundation set up by keeping a property in perpetual existence and making its income available for specified beneficiaries which plays an important social and economic role. The waqf properties have traditionally financed expenditure on mosques, schools, research, hospitals, social services, etc. Today it can support microfinance institutions that can provide interest free loans to the needy and marginalised sections of the society.

Insurance

The conventional insurance system is based on gharar (speculation) and maysar (gambling) and the investments are made on unethical businesses, a new system has been evolved called Takaful based on Islamic principles.

Microfinance: Based on the successful experiments of Prof. Yunus of Bangladesh Grameen Banks, similar institutions are the need of the hour. Self Help Group (SHG) formed, finance collected and guidance provided to earn the decent livelihood to the needy has to be evolved. Finance provided has to be interest free and the development should focus on the family instead of only women folk.

Islamic Banks: Almost non-existent 30 years ago, modern Islamic finance has risen to become a trillion dollar industry. The sector, though small in global terms, appears to have held up well in the crisis, with the Asian Development Bank putting annual growth at more than 15% over the next 5-10 years.   Long focused on a potential global market of 1.5 billion Muslims, Islamic banking is now drawing attention from players the world over. Nowadays, major establishments such as Al Rajhi Bank of Saudi Arabia, the Kuwait Finance House, and Malaysia’s Islamic bank may compete with western financial institutions such as Barclays, HSBC and Deutsche Bank.

Several banks have set up separate Islamic financial services departments in their home markets as well. In the UK, the Financial Services Authority has introduced regulatory standards for Islamic financial products and has a separate department dealing with Islamic financial institutions. Moreover, non-Muslims make up as much as half of Islamic bank customers in some cases. Similar developments have taken place in Singapore, Japan, Hong Kong and France. If London, Singapore, Hong Kong, Tokyo and Paris can become hub and house of Islamic finance and banking why not Mumbai and Kochin?

Committee on Financial Sector Reforms (CFSR) of the Planning Commission of India headed by Dr Raghuram Rajan has recommended interest free finance in the main banking sector of the country for inclusive growth with innovation.

Recently Dr. MS Swaminathan, father of green revolution has suggested Islamic Banking with zero interest to be the solution to the crisis of the farmers’ suicide deaths in Vidharba and even Vatican has offered Islamic finance principles to Western banks as a solution for worldwide economic crisis.

The challenge of the 21st century lies in inventing and implementing a mechanism that would be able to unshackle humanity from the bonds of money-an era of human supremacy over money rather than money over human beings. Although interest on finance has been denounced by all religions, a serious effort has to be made to find out a practical mechanism to provide institutional finance on an interest free basis.

We need to offer an alternative in the form of Islamic finance free from interest, speculation, financial engineering and concentration of wealth in the hands of a few in this 21st century and develop a practical mechanism to make finance available free of cost. All other strategies to promote world prosperity and peace are likely to fail if adequate finance is not available. Therefore, firstly, we should try to overcome the most insurmountable of all obstacles. It would be an era of prosperity for all.

The suggestion may seem to be utopian to some. But history gives us hope and courage. There was a time when ideas like abolition of slavery, the introduction of adult suffrage, education for all, and equality between men and women were wild dreams of visionaries. Few decades back, the vision of an interest-free world was considered as impractical concept. Given the ingenuity and will of man, however, this dream can come true. It would make the 21st century worth living. It would virtually transform the whole earth into a heaven.