Introduction to Islamic Banking & Finance Abdulazeem Abozaid

Basis of IBF Islamic Finance is based on principles that are derived from the Quran and Sunna of the Prophet peace be upon him. The basic principle in Islamic Law is permissibility. Under this principle all commercial and financial transactions are permissible except those that contain prohibited elements.

How does Islamic Finance differ from conventional finance ? Islamic Modes of Finance & Investment are committed to all Sharia Prohibited Practices Prohibited Practices Riba ( Interest ) Sale of Debt Ghabn (Fraud) Gharar (Uncertainty) Dealing in unlawful properties

What is Riba? Literally: Increase. Technically: stipulated increase over the loan which a debtor agrees to pay to his creditor in relation to time. Rationale: Money does not have an intrinsic value. It is a measuring tool, a store of value unit and a medium of exchange, not a commodity that could be bought or sold Lending = renting money

Sale of Debt Sale of debt occurs in: Discounting commercial papers Dealing in bonds Sale of Sukuk, shares or fund units when they do not represent tangible assets, usufructs or services

Uncertainty (Gharar) Gharar: Uncertainty/Ambiguity in a contract Examples of Gharar: Selling unknown goods - The contents of a sealed box are sold; presumably, the box contains a collection of goods, without specifying the quantity of each. - Buying an a commodity for unknown price; what’s in one’s wallet/pocket. Gambling The gambler is ignorant of the result of the gamble; the outcome depends on chance and not efforts. Rationale: Uncertainty is likely to lead to dispute between contracting parties.

GHABN Deception that leads the seller to underestimate or the buyer to overestimate the price of the good. It can be divided into two kinds: Slight or minor Ghabn (الغبن اليسير). It is tolerated in contracts. Large, excessive, or major Ghabn (الغبن الفاحش). Not tolerated. Examples: Selling at higher than the market value by means of cheating Bidding a price without intending purchase, just to increase the price payable by the actual purchaser (Najash). Covering defects and selling as defect free.

Dealing in Unlawful Properties Liquor Intoxicants Lawful properties but used for unlawful purposes

SOME allegations of similarities with conventional finance

DIFFERENT PRICING FOR CASH AND CREDIT SALES Price in deferred sale is higher than spot sale. The bank purchases goods on cash and sells them on credit. The forward price depends on the repayment period. The longer is the maturity, the higher the price. Such price difference, being dependent upon repayment time, is it similar to the interest charged on conventional loans?

Why price should be higher with spot than deferred payment? In fact, price difference is similar to the difference between the price of the same commodity under present and future delivery. Price difference is due to the degree of urgency of benefiting from the direct use of real commodities. Similarly, prices charged with deferred payment should justifiably be higher than with spot payment. The difference is not Riba.

Cont’d The misconception stems from misunderstanding of the prohibition of Riba Modern capitalist theory does not differentiate money and physical commodity Both are seen as factors of production, money is a form of commodity

Cont’d Acquire goods and services. Store some wealth, In Islam, money is differentiated from commodities Money has no intrinsic utility. It cannot be utilized directly . As a means of exchange, money can only be used to: Acquire goods and services. Store some wealth, As a unit of account to measure the monetary value of things.

Cont’d Commodities, on the other hand, have intrinsic utility and can be utilized directly. Because money has no intrinsic utility, present money does not command a higher value than future money when money is exchanged for money. Present money cannot therefore be sold for a higher quantity of future money, as both have no value of their own. Conclusion: Sharia acknowledges time value of money in sale contract, not in loan contracts since money cannot be treated as commodity.

Classification of Islamic Banking Products: Deposit (Wadi’a) products: Current account; based on Loan Saving account; based on Mudaraba Time deposit; based on Mudaraba/wakala (agency in investment)

Financing Products Sale-based financing contracts: Murabaha Forward Sale Salam Istisna Ijara Financing Equity-based financing contracts: Mudaraba Musharaka Fee based Financing Wakala

PRODUCTS OF ILL REPUTE IN ISLAMIC BANKING

Buy-Back Sale (Einah) Einah refers to selling a commodity on a deferred basis then buying it bank on a spot basis at a lower price. Obviously, it is meant for extending interest-based debt. This legal trick cannot be condoned by Shariah. Some applications: Personal Financing Overdraft Facility IPDS: ‘Islamic’ Private Debt Securities

SELL FOR IMMEDIATE CASH IN COLLUSION WITH SUPPLIER EINA SALE EINA SALE INDIVIDUAL IMMEDIATELY AFTER PURCHASE GOODS, DEFERRED PAYMENT WANTS CASH SELL FOR IMMEDIATE CASH SAME SUPPLIER 19 19

IPDS: Creation of debt (dayn) via Einah Sell Asset X for $100m Investor (Financier) Issuer Cash payment $100m Sell Asset X for $120m Deferred payments $120m Securities issued against the debt and made negotiable

Tawarruq Tawarruq refers to purchasing a commodity from one party on credit then selling it immediately to another for cash. Tawarruq shares the same objective of Eina as both are meant for obtaining cash. Some applications: Personal & Corporate Financing Overdraft Facility

SELL METAL FOR IMMEDIATE CASH INSTITUTIONAL TAWARRUQ BANK SELL ON MURABAHA BUY METAL PROMISE TO BUY AGENCY AGREEMENT SELL METAL FOR IMMEDIATE CASH INSTITUTIONAL TAWARRUQ التورق المؤسسي CUSTOMER COLLUSION WITH BANK NEEDS CASH LME

Sale of Debt (Bay’ al-Dayn) Although sale of debt is prohibited in the Shariah, it has been unlawfully practiced in Islamic finance, like in: ‘Islamic’ factoring ‘Islamic’ accepted bills ‘Islamic’ Debt Securities With these arrangements, the underlying consideration is the permissibility of the sale of debt, by the creditor, at a discount Based it on the assumption that Debt arising from sale of commodities is different from debt arising from a money loan.

The Criterion of the Non-Shari’ah Compliant Transaction When a financing mode is structured in such a way that secures a guaranteed profit to the financier without taking any risks. Or, when the financier acts in reality as a creditor who provides money without being involved in the investment process; i.e. when the substance is interest-bearing debt. This will render the transaction impermissible regardless of its legal form, e.g. sale, lease… . Some banks’ Sharia boards attempt to validate transactions based on their legal forms.

Islamic Finance Products

DEPOSIT PRODUCTS

checks debit cards ATM Money transfer PAYMENT SERVICES PROFIT SHARE CUSTOMERS WAKALA FEES checks QARD HASSAN CASH AS MUDARABA OR WAKALA CASH AS debit cards INVESTMENT DEPOSITS UNRESTRICTED ATM Money transfer ISLAMIC BANKS DEMAND DEPOSITS RESTRICTED

SIMPLE FINANCING PRODUCTS

FINANCE A SHARE IN PROFITS ISLAMIC BANK A SHARE IN MANAGEMENT EXTINGUISH gradually EQUITY FINANCE, MUSHARAKA DIMINISHING FUND USER

- + DO NOT’S DO’S ISLAMIC BANK MONITORING UNRESTRICTED MUDARABA FUND USER TRANSPARENCY

DEFERRED PAYMENT LUMP-SUM OR INSTALLMENTS Buyer Promise to Buy SPOT DELIVERY Murabahah contract SPOT PAYMENT ISLAMIC BANK Sale Contract SPOT DELIVERY MURABAHA SUPPLIER

DEFERRED PAYMENT: LUMP-SUM OR INSTALLMENTS SALE DEFERRED PAYMENT: LUMP-SUM OR INSTALLMENTS DEFERRED-PAYMENT SALE CONTRACT Buyer SPOT DELIVERY OWNS COMMODITIES ISLAMIC BANK

ISTISNA’ CUSTOMER MANUFACTURER PAYMENTS IN STAGES DELIVERY OF ASSET REQUIRES AN ASSET WITH CERTAIN SPECIFICATIONS PARALLEL ISTISNA COMMISSION TO MANUFACTURE ASSET DELIVERY INSTALLMENTS ISTISNA’ COMMISSION TO MANUFACTURE ISTISNA’ REQUIRES AN ASSET WITH THE SAME SPECIFICATIONS BANK

CUSTOMER BANK IJARAH FINANCING TITLE TRANSFER: FORWARD LEASE Conditional promise to gift or sell at token price CUSTOMER RENTAL PAYMENTS = USUFRUCT AND PART OF ASSET VALUE ASSET PRICE REAL ESTATE OWNER DELIVERY, LEASE STARTS PROMISE TO LEASE USUFRUCT IJARAH FINANCING DELIVERY PURCHASE BANK

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