Tuesday, 14 October 2008

fundamentals of Islamic finance part 1

Fundamentals of Islamic Banking: BY SUNTOU TOURAY PART 1
Introduction
Islamic banking derives its rule and compliance mechanics from the rulings of the sharia, the divine law of God. Islamic banking came to be as a result of conventional banks dealing in usury (interest) which is sternly forbidden in Islam. Muslims are required to live a life of Godliness; there is no separation of religion and other activities. Islam is a way of life that encompasses every dynamic of human dealings.
Money is not considered as a commodity or having a time-line which move according to interest rate fluctuations. Money is measured according to the value of goods and services which it is exchange during buying and selling. This is sanctioned by the sharia.
Islamic banks operate on the basis of profit and loss sharing, the term “profit is for that who bears risk”. Islamic banks completely reject interest as a cost for the use of money and loans as an investment vehicle. (aaoifi 26-27)
This means interest as the central tool use by banks across the globe is illegal as an item for pricing money.
The quran states that “trade is allowed and riba (usury or interest) is haram forbidden”. Muslims live by the commandment of Allah. The forbidden things are avoided at all cost. Interests are the key determinant of modern banking in measuring and valuing transactions in the west and else were. The prohibition of riba is very clear in the Quran, just like Alcohol or engaging in act of fornication or adultery. Why is it that riba or usury is part and parcel of the banking systems in muslim countries?
DR Umer Chapra stated that “due to the historical foreign occupation of most muslim countries, and particularly because of the domination of the world financial markets by western interest-based system”. Umer Chapra’s statement touches on the fact that, the global super powers control the markets of the global economy. Money being a medium in trade, the measurement of money is also a vital factor in valuing individual nations currency. This means even if muslim countries wish to avoid interest rate system, they have to design other tool of valuing their currency.
Clarifying the issue of interest or riba is paramount in Islamic countries determine to eliminate usury in their economy. Interest is the same as riba according to the consensus of muslim jurist across the world.
What tools is that Islamic finance is offering as an alternative to modern conventional interest regulated banking? The advocate of Islamic banking and the muslims economist have device tools that are halal or compatible with the teachings of Islam. The Islamic financial system based its operation on equity type of dealing instead of debt. There are fundamental difference between debt and equity.
The Islamic finance operates on trade; profit and loss sharing. Muslims economist put forward the following primary and secondary mechanism as a tool for conducting legitimate transactions. The primary Islamic finance tools are:
“Mudaraba (passive partnership), musharakah (active partnership),
The secondary tools are:
Murabahah (cost plus service charge), Ijarah wa iqtina (hire-purchase), salam (forward delivery contract), and Istisna (contracted production). The former are equity-based and relatively more risky because they involve profit-and-loss sharing, the rate of return on them is not stipulated in advance and may be either positive or negative. The latter involves credit and is relatively less risky because profit-loss-sharing is not involved.”
The secondary mode of financial tools is similar with interest regulated tools but there are big differences between the two. The three key differences are that: secondary modes are sales or leases, rather than outright borrowing and lending. Also the sharia forbid the selling of properties or commodities that one does not own or possess, the financiers takes risk once the ownership and possession of property for sale or lease is complete. And finally it is the price not the interest rate that is stipulated in the course of the transaction and once the price is fixed, it cannot be changed if there is delay in repayment due to unexpected circumstances. (Dr Umer Chapra,the future of economics, 258-261).
The avoidance of interest and over-burdening poor borrowers makes Islamic banking worthwhile and rewarding. Loans advance to customers are interest free. The deposit funds of wealthy Muslims are invested in ventures that are islamically acceptable. For instance, the bank avoid investing in forbidden projects and stocks such has alcohol companies, pornography, weapon manufacturing, conventional banking stocks etc. The banks do business with companies and institutions whose transactions are sanctioned by Islam, example, food products, medicine, media, cloths, energy etc. The first sample Islamic banks are the Bank Al-idakhar Al-mahalliyah 1950, this was set up by Ahmad Al-Najjar. The banks mobilises local savings and invest in rural development projects. The activities of the bank conform to agreed Islamic injunctions. There transactions include, opening deposit accounts for customers that did not pay interest, profit-loss share service account provide people with the opportunity to contribute a portion of the gains in charitable activities. This bank was closed down by the Egyptian government due to fear that the bank was undermining the secular government economic policies. The bank was actually a success attracting over a million customers in a short period of time.
The second successful Islamic financial institution is the Malaysian Tabung Hajji. This was a hajj fund were members save up for their pilgrimage to Mecca. The bank attracts large number of small deposits. The savings of customers are also invested in Islamicaly sanctioned institutions. This bank provides the catalyst for the first Malaysian Islamic commercial bank.
The petrol dollar flow into the Middle East provided the people with much needed resources to transact their wealth on investment ventures more islamically acceptable. People wanted to be comfortable with the activities of their banks. They don’t want interest and neither haram activities, so the policy makers were pressure to device means of engaging investors in a religious compliance financial method.
The economic tools provided by dominant conventional economic order is not acceptable to Muslims. The expectations of Muslim leaders became intense and resounding. In 1970, the idea of strong Islamic financial institution was negotiated by the ruling members of the Gulf States and Saudi Arabia. The Islamic Development Bank was set in 1975. The funds for this bank were provided by Saudi Arabia, Libya, The United Arab Emirates and Kuwait. The bank’s main duties was to provide interest free loans that complies with the profit and loss sharing principles of Islamic banks, directing development funds to poor areas, train individuals on the mechanisms of Islamic finance and above all show the world that there is an alternative financing economic methods available more ethical and caring. (Tripp. Charles, 2006 Islam and the moral economy)
Islam encourages the seeking of wealth.
Islam considers wealth seeking an act of worship. It is desirable. Classical Christianity encourages abstinence from worldly activity. Islam is against monastic life style.
Wealth is a blessing from Allah the almighty. Pursuing economics activity in the legal and acceptable ways is pleasing to God.
If islam encouraging accumulating of wealth, what is wealth? All things having monetary value.
Another definition is all goods and services having economic value. Quranic definition of wealth is Maal. Maal is define as anything that has a material value.

1 comment:

Demba Jalang said...

Thank you Brother Suntu for an illuminating insight into Islamic Finance.

One important thing that help insulate many Islamic Finance Institutions from the current financial crisis is the way debt is treated in Conventional (some may call it Western) Finance. Debt instruments are packaged in various fancy ways and traded in the market in Conventional Finance. To secure the "supposed" underlying value of such fictitious assets, holders resort to buying insurance and thus sell those policies in the market again. In short, these instruments do not have any asset of real value or fundamental backup. At a point the market basically strive on a bubble and burst situation. More crudely, greed mainly drives the market. From the Islamic Finance point of view, trading in debt/debt instruments is forbidden. Any dealing in liquid assets have to be backed by real assets driving the fundamentals on economic activity. There is no shortcut and no one get short-charged.

Another basic difference between Islamic Finance and Conventional Finance in all spheres of operation (be it banking, insurance, etc.) is the role the institution play in carrying its Corporate Social Responsibility (CSR). Yes, in a Conventional Finance sense, the Institution call build hospitals, roads and provide other charitable services, but in Islamic Finance, CSR is not only about that. An Islamic Finance Institution take care of their owners' and customers' interest as a guidance consul. For instance, in an insurance operation, there are both shareholders' funds and policyholders' funds. At the end of a review period, say Financial year for the company, after meeting claims, administrative expenses, reserves etc, both parties (shareholders and policyholders are entitle to any surplus funds and may be shared or retained in the company according to reset rules and guidelines. The is missing in a Conventional Insurance setup.

A close study of the setup under the two models in finance (Islamic and Conventional) will show that there are clear differences between these institutional, not by only nomenclature.