Islamic Finance: A Solution to Global Financial Challenges

INTRODUCTIONS

Islamic Finance or Sharia-Compliant Finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic Economics. Source of Sharia is the Quran (word of Allah), Sunnah (Authentic hadith of Prophet Muhammad-saw), Ijma (consensus of the muslim scholars) and Qiyas (process of deductive analogy).

The Main focus of Islamic Finance is on transparency, cooperative venture, risk sharing and ethical investing which attracts both Muslims and Non-Muslims.

Islamic finance has started to grow in international finance across the globe, with some concentration in few countries. Today, Islamic banking has become one of the fastest growing segments of the international banking and capital markets. Considerable growth of Islamic finance in recent years seems to point to its resilience and broad appeal, partly owing to principles that govern Islamic financial activities, including equity, participation, and ownership.

In theory, Islamic finance is resilient to shocks because of its emphasis on risk sharing, limits on excessive risk taking, and strong link to real activities. Empirical evidence on the stability of Islamic banks, however, is so far mixed. While these banks face similar risks as conventional banks do, they are also exposed to idiosyncratic risks, necessitating a tailoring of current risk management practices. The macroeconomic policy implications of the rapid expansion of Islamic finance are far reaching and need careful considerations.

Basic Principles of Islamic Finance

1. Avoidance of Gharar (Uncertainty): Gharar refers to entering into a contract in absolute risk or uncertainty about the ultimate result of the contract and the nature and/or quality and specifications of the subject matter or the rights and obligations of the parties. Gharar contains characteristics such as risk, hazard, speculation, uncertain outcome, and unknown future benefits.

2. Avoidance of Maysir (Speculation): Maysir (speculation) or any game of chance. Maysir refers to easily available wealth or acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar (similar to Maysir) means the game of chance; one gains at the cost of other(s) right. Maysir is prohibited by Holy Qura’n [ 2: 219 and 5: 90] as well as in Hadiths.

3. Prohibition of Riba (Interest): Under Islamic financial system money is mere a medium of exchange and not a factor of production independently. Human labour is required in addition to money to earn a return, hence there is no fixed return for capital, however capitalist can participate in business under profit and loss sharing with or without participation in management of entity Implication of this principle of Islamic finance is discouraging time value of money in its conventional banking sense.

4. Finance Only for Halal (Permitted) Business: There are various prohibited businesses (based on Quran & Hadiths) in which investment for Muslims (Islamic banks) is prohibited. Activities such as liquor, pork, pornography, adultery, dance clubs, conventional banking, insurance etc. are unlawful, hence earning return through investment in any of these activities is not allowed under Islamic financial system. Nothing is Haram except what is prohibited by a sound and explicit Nas [Verse of Qura’n and an authentic Sunnah].

5. Profit & Loss Sharing: According to this principle capitalist demanding profit on capital should also participate in loss as well. An investor can earn return on his investment subject to risk of loss, hence concept of risk free return is disappeared under Islamic financial system.

Conventional & Islamic Financial System: Similarities & Differences:

• Framework: Islamic Finance is based on Ethical & Moral Framework of Sharia, whereas conventional finance system is based on legal laws and regulations.
• Financing & Investments: Both types of system (Islamic and Conventional) are providing financing to productive channels for reward. The difference lies in financing agreements. Conventional banks offer loan for a fixed reward while IFIs cannot do that because they cannot charge interest. Islamic Financial Institutions (IFIs) can charge profit on investments but not interest on loans. In conventional banking mainly three types of loans are issued to clients including short term loans, overdrafts and long-term loans. Islamic banks cannot issue loans except interest free loans for any requirement however they can do business by providing the required asset to client and/or participating in outcome of the underlying project
• Deposits: Deposits are collected from savers under both types of institutions for reward irrespective a bank is operating under conventional system or Islamic system. The difference lies in agreement of reward. Under conventional system reward is fixed and predetermined while under Islamic deposits are accepted through Musharaka and Mudaraba where reward is variable. The only difference in conventional and Islamic system lies in sharing of risk and reward. Under conventional system total risk is born by the bank and total reward belongs to it after servicing the depositors at fixed rate while under Islamic system risk and reward both are shared with depositors.

Various Types of Islamic Financial Instruments

• Mudaraba: It is a form of partnership / venture where one party provides the capital/finance while the other provides labour (specialized knowledge) and both share in the profits. The profit of the venture is shared according to a pre-agreed ratio, while the entire loss is born by the capital provider unless it was due to negligence of the entrepreneur. This scheme is also used in deposit collection. Mudaraba contract can be restricted or unrestricted. No one can claim a lump sum amount of profit it must be based on actual outcome.
• Musharaka: Literal meaning of Musharaka is sharing. Musharakah is a joint enterprise or partnership structure in Islamic finance in which partners share in the profits and losses of an enterprise. In Musharaka all partners share the profit according to a specified ratio, while the loss is shared according to the ratio of the contribution. For a valid Musharaka fulfillment of certain conditions required. First is there must be an agreement written (verbal) among the partners stating clearly the terms and conditions including management, capital contributions, profit and loss sharing among the partners. Second capital can be contributed in cash as well as in assets.
• Murabaha: Murabaha is a form of sale where the cost of the goods to be sold as well as the profit on the sale is known to both parties. In this arrangements, Financier (mostly the Banks or HNI), buys the assets and sells to the buyer. Buyer pays back financier (seller) in istallments. This installment consist two part- Cost of Assets and Financiers profit on the acquisition of assets. Murabaha has been adopted as a mode of interest-free financing by a large number of Islamic banks to finance the purchase of the consumer goods, intermediary or capital goods, real estate, raw materials, machinery and equipment. It may also be used for trade financing needs such as import of goods or pre-shipment export finance. Murabaha can successfully replaced the overdraft and short term loans facility under conventional banking.
• Istisna: Istisna financing is provided in the form of advance progress payment(s) to the customer who builds, manufactures, constructs or develops the object of sale. Upon completion of the project, the asset is delivered to parties who agreed to take delivery of the asset. It is mainly used in the Long-Term Construction Projects such as buildings, warehouses, showrooms, shopping malls, residential towers and villas, as well as manufacturing activities involved in the construction of like aircrafts, ships, machines and equipment, etc.
• Salam: A Salam transaction is the purchase of a commodity for deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while delivery of the item to be sold, known as subject matter of Salam, is deferred. This is result beneficial for both seller and purchaser, as seller or the farmer can get capital to grow the crop and get better produce of the crop, while the buyer can be sure of its stocks and price. The Salam contract is very similar to the forward contract in conventional finance, since both involve deferred delivery. Generally spot price agreed is lesser than future the actual date of delivery, hence buyers are making profit.
• Ijarah: Ijarah is an Arabic term with origins in Islamic Fiqh, meaning to give something to rent. Leasing is a contract whereby usufruct rights to an asset are transferred by the owner, known as the lessor, to another person, known as the lessee, at an agreed upon price called the rent, and for an agreed upon period of time called the term of lease. The ownership of the leased asset remains with the lessor, along with all risks pertaining to ownership. The physical possession of the asset is held on trust by the lessee, who is not liable for any loss, destruction or reduction in value of the asset, unless caused by misuse or intentional negligence by the lessee.
• Sukuk: Sukuk are investment securities that correspond to a financial obligation representing modern asset-backed and asset-based securities. Sukuk represent an undivided beneficial ownership interest in the underlying assets (both tangible and intangible). It is kind of “Debt Certificate”. Although it frequently referred as “Islamic Bond” in fact, they are somewhat a hybrid security having both debt and equity characteristics.
• Takaful: Takaful is commonly referred to as Islamic Insurance. It is based on the principle of cooperation and separation between operations of shareholders and the funds. The ownership of takaful fund and operations are passed to the policyholders. The policyholders are joint investors with takaful operator who acts as a manager for policyholders. All policyholders agree to guarantee each other and contribute to pool of funds (takaful fund) instead of paying premium. All claims made would be met out of the fund and surpluses will be distributed among policyholders. In conventional insurance, the risk is transferred from insured to the insurer. Takaful, on the other hand, is based on shared risk.

RIBA (INTERST): An Economic Slavery

As per Islamic Law, money is considered as only a mean of carrying out transactions. Any earning on the same in the form of Interest (Riba) is prohibited. Riba counts in fact amongst the most destructive sins in the religion of Islam, ranking amongst the seven deadly sins mentioned by Prophet Muhammad (pbuh), a severe list of sins that also includes murder.

Riba is considered economic slavery, which makes the poor poorer, and the rich richer; a practice that prevents the poor from overcoming their weakened financial conditions and prospering. The one lending the money is not providing a service, instead solely profiting from the lending of money. This practice denies the poor the opportunity to get out of their situation. The one with the capital will remain rich for life since they eliminate the possibility of suffering losses and expanding their wealth as they extract funds from lending money.

Consuming Riba is the only crime that God the Almighty declared and waged war against those who consume it.

Riba is often translated to the English word Usury means, the illegal action or practice of lending money at unreasonably high rates of interest. Whereas usury is understood as the lending of money at a high rate of interest, the word Riba — as stated in Islam and the terminology of the Holy Quran — is the lending of money on interest regardless of the rate of interest, whether low or high.Riba is considered an unnatural growth of wealth; an unjust transfer of wealth; an unethical and harmful act, and a means of devouring the wealth of others. The act of Riba prevents wealth from circulating in the economy.

In the wholly Quran four verses are about Riba (interest) revealed on different occasions. The first verse is in Surah Al-Rum 30:39 whereby displeasure of Allah is disclosed for interest based practices. The second verse is in Surah An-Nisaa 4:161 where interest charging was disclosed as sinful act of Jews. The third verse is part of Surah Al-Imran 3:130 whereby prohibition of Riba (interest) was declared “O those who believe do not eat up riba doubled and redoubled. “The last verse revealed is reported in Surah Al-Baqarah 2:275 whereby severe punishment is declared for those dealing in interest “Those who take interest will not stand but as stands whom the demon has driven crazy by his touch.

That is because they have said: ‘Trading is but like riba’. And Allah has permitted trading and prohibited riba. So, whoever receives an advice from his Lord and stops, he is allowed what has passed, and his matter is up to Allah. And the ones who revert back, those are the people of Fire. There they remain forever”.

Types of Riba

I. Riba al-Nasiyah: The interest of delay. This is the addition of a surplus or an extra amount to an originally transacted sum for the party awaiting delivery of what he or she has transacted for. Loans today almost always fall into the category of riba al-nasi‘ah. Any commodity that gains its increase simply because of time passing is riba al-nasi‘ah.

Example of Riba-al-Nasiyah: If Mr. A lends Rs.1000 to Mr. B (a borrower) with a condition that Mr. B shall return him Rs.1100 after one month. In this case, the extra amount of Rs. 100 is Riba or Interest.

II. Riba al-Fadl: The interest of excess. Riba Al-Fadl is the unequal exchange of like commodities. One trades gold, silver, wheat, etc. for a greater amount of the same commodity from another. The Prophet(pbuh), said: “Sell gold for equal [amounts of] gold, sell silver for equal silver, sell dates for equal dates, sell wheat for equal wheat, sell salt for equal salt, sell barley for equal barley. Should one transact in excess, it is riba (interest). Yet sell gold for silver as you like hand-to-hand, sell barley for dates as you like hand-to-hand.”

During the dark ages, only the first form (Riba An Nasiyah) was considered to be Riba. However, the Holy Prophet(pbuh) also classified the second form (Riba-al-Fadl) as Riba.

Islamic Finance In India

Islamic Finance / Islamic Banking has huge potential in India as India is the third largest Muslim Populated country and as per projection, by the end of 2050, India will be the world’s largest Muslim populated country.

The participation of Banks in Islamic finance, what we refer to as Islamic Banking, has always been stuck in the abeyance for the lack of clarity in the Indian legal structure. The Banking Regulation Act, 1949 favours the ‘banking with interest system’, the operation of ‘banking without interest’ faces challenges in the form of various regulations, such as restrictions of profit sharing business, restriction on owning immovable property other than banking assets, SLR requirements, etc. However, it shall be pertinent to note that there is no specific legal bar on Islamic finance, though banks may be deferred from participating due to the Banking Regulation Act, nothing stops other financial institutions such as NBFCs. Hence, though Islamic finance products may be offered by entities other than banks, the participation of banks shall remain in abeyance till RBI takes any further steps.

In 2008, the financial sector reforms committee of the RBI, led by Raghuram Rajan, had recommended setting up of interest-free banking facilities in India. However, it did not mention Islamic banking or Sharia banking. Extract from the said report, named – A Hundred Small Steps- Report of the Committee on Financial Sector Reforms, as follows:

“Another area that falls broadly in the ambit of financial infrastructure for inclusion is the provision of interest-free banking. Certain faiths prohibit the use of financial instruments that pay interest. The non-availability of interest-free banking products (where the return to the investor is tied to the bearing of risk, in accordance with the principles of that faith) results in some Indians, including those in the economically disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non-availability also denies India access to substantial sources of savings from other countries in the region. While interest-free banking is provided in a limited manner through NBFCs and cooperatives, the Committee recommends that measures be taken to permit the delivery of interest-free finance on a larger scale, including through the banking system. This is in consonance with the objectives of inclusion and growth through innovation. The Committee believes that it would be possible, through appropriate measures, to create a framework for such products without any adverse systemic risk impact.

In report 2015-2016 of The committee on medium-term path on financial inclusion, it again raked up the issue as in absence of non-interest banking, a section of the population was not being able to take part in the banking system. The report also said: “It is observed that some sections of the Indian society have remained financially excluded for religious reasons that preclude them from using banking products with an element of interest. Towards mainstreaming these excluded sections, it is proposed to explore the modalities of introducing interest-free banking products in India in consultation with the Government.” The committee recommended that, “commercial banks in India may be enabled to open specialised interest-free windows with simple products like demand deposits, agency and participation securities on their liability side and to offer products based on cost-plus financing and deferred payment, deferred delivery contracts on the asset side.”

Meanwhile, the CPM in Kerala toyed with the idea, and after getting a go-ahead from the RBI, launched Cheraman Financial Services Limited, a co-operative on the lines of the practice of the Islamic banking system, with a corpus of Rs 250 crore. It was established with equity participation of Kerala State Industrial Development Corporation (KSIDC) and private investors, mostly Gulf-based NRIs. So, the concept of interest-free banking, which could have bolstered the economy by inviting huge investment from the West Asian countries, is not new to India.

Indian Centre for Islamic Finance (ICIF) in 2016 said, “if the proposal of RBI become a reality, huge investments from countries like UAE, Qatar and Bahrain will flow into India.” Islamic window in conventional banks will lead to trillions of dollars from Gulf nations getting invested in India from Islamic Financial Banking.

In December 2016, in a written reply to the Lok Sabha, minister of state for finance, Santosh Kumar Gangwar, had said, “The objectives of the financial inclusion for which Islamic banking was explored by RBI has no relevance, as government has already introduced other means of financial inclusion like Jan Dhan Yojana and Suraksha Bima Yojna for all citizens.” Apart from this, no financial reason was given so far.

In 2017, Reserve Bank of India has dropped the proposal for introduction of Islamic banking in the country. The idea, once pushed by former RBI governor Raghuram Rajan, has died a natural death, as it were, given the amount of resistance it managed to create. However, it seems that the reason for nixing the proposal is more political than financial. It appears that just the presence of the word “Islamic” is enough reason to summarize that the current government and his ideological parent will not be comfortable with the idea of serving up interest-free products guided by Sharia law for Indian banking consumers.

India wants to become economic giants but it will not possible until the large group of population (second majority) remain excluded from mainstream economy. For the Muslims Islamic finance could open new doors, enabling the betterment of this community and achievement of the goal of financial inclusion for all. This will also help to open new avenues for flow of substantial funds in the market. It will help in mobilize large amounts of money from Muslims who participate very little in conventional banking. This will also help to channelize huge amounts of Investments from Gulf and other Muslim countries that India is currently loosing.

Misconception About Islamic Finance System

Islamic Finance is having the misconception that it is meant only for Muslims. But in fact, it is an alternative to conventional financial system which is meant for people of all religions. Islamic banking has barriers in India but it can be addressed with some flexibility and modifications in regulations which ultimately depend upon the political will. With huge marketing India, influence from Muslim community will help to growth of Islamic financial system.

• Exclusive for Muslims: Islamic Finance is not only limited to Muslims. Although the products and services are structured to meet the specific requirements and needs of Muslims and basic principles are derived from religion-Islam; but there are no restrictions at all for non-Muslims to participate in Islamic Finance activities.
• Spreading Islam: This is truly misunderstanding as Islamic finance exists to fill a gap in the market as the mainstream conventional finance is not compatible with the Islamic belief system. Islamic finance seeks to be the alternative option and compete side by side with conventional finance.
• It Is More Expensive Than Conventional finance: When the industry was just evolving and operating in a very niche market it was difficult to price products competitively against more traditional alternatives. However, as more people are buying Islamic financial products and services, the industry has become more mainstream. Consequently prices have fallen in line with more traditional financial products.
• It Is Only Focused On Charity: Charity is a core pillar of the Islamic faith, but that’s not to say that these investment products are prohibited from making a profit. You can, however, make profit from doing “work” – so asset-classes like equity, property, and commodities are permissible if the money has been earned. Islamic financial entities are profit-driven entities whose aim is to facilitate tangible and productive activities for mutual benefit. It is about wealth creation and just like any other business, is profit oriented.
• You Have To Forgo Returns: A concern which often gets thrown around when people talk about types of ethical investment is that you have to sacrifice return. Like all players in the financial market, those running Islamic finance institutions are doing so to make money and are fully accountable to their investors and shareholders.
• Launder Money For Terrorism Support: The Islamic financial market is regulated just as conventional financial market i.e. relevant laws, regulations, etc. Islam, without a doubt eschews violence and therefore does not condone the use of Islamic banks and financial institutions as a tool to fund terrorism or violence. It is against the values and principle of Islam to participate and support in any way acts of violence and terrorism.
• More Risky Than Conventional Finance: Islamic Finance products and transactions, by avoiding uncertainty (gharar) and speculation (maysir), restrict the availability of certain products or investments and therefore prevent consumers and investors from being exposed to risks that are inherent in certain complex conventional financing products.

To Summarize

We are living in the world, where more than 25% of population are followers of Islam. Islam is the second most followed religion globally, and hence, Islamic Finance can simulate the growth of business sector by providing much needed financing, while also release the untapped sources of capital as some investors may only be willing to invest in product that are permissible under their faith. As living in the globalizing economy, we cannot ignore the Islamic Financial System.

Islamic financial system ensures justice between savers and investors. By demolishing risk free return and promotion of profit and loss sharing, justice is ensured for both parties i.e. capital supplier as well as capital user. As a model of modern commercial banking, initially capital is supplied by depositors and later on by bank to business community. Under Islamic financial system bank can invest in businesses to earn variable return based on actual results of activities and share profit earned with depositors based on agreed sharing formula. Hence it is ensured to distribute the actual outcome and none is to bear risk alone and none is to earn with zero risk.

Three key principles govern Islamic finance: equity, participation, and ownership. These principles imply that in an Islamic financial system, financing can only be extended to productive activities, trade, and real assets—thus it is often considered an asset-based financial system. If fully complied with, these principles ensure appropriate leverage and help limit speculation and moral hazard.

Importantly, the application of interest free banking cannot be said to be limited to a particular faith. The nuances caused by unchecked interest rates, and exploitation of the poor by debt trap of the high interest loans has its impact across geographies.

Bonus Note: For Successful Business As Per Islamic Law

• Indulge Only in Halal Transactions: Restrict yourself from activities which are prohibited as per Sharia.
• Start Small, Expand Large: One secret of business success is diversification and reinvestment of profits.
• Avoid Debt: Avoid incurring debts and welcoming debtors as this does little good to a running business. Keep a steady cash flow in the business.
• Start With The Good Intention: In relation to business, start with a good intention, have a positive-hardworking attitude and aim for success in both worlds.
• Be Truthful and Honest: Honesty and truthfulness are essential in business. The Prophet has said the honest and truthful businessman will be in paradise amongst the Prophets the Truthful and the martyrs.
• Be Tolerant: It is encouraged to be tolerant and easy-going in transactions, to have the most sublime of attitudes, and to avoid miserliness, and it is encouraged to avoid putting pressure on people when asking for payment, and to take from them what they can afford.
• Be Crystal Clear, Avoid Ambiguity: It is important for a any entrepreneur to be very specific and clear about what he or she is doing, and what sort of job that business will perform. If you are lying about your business just to grab the customers out of the market then it is under deception and will not benefit you in the long run.
• Be Open For Criticism: When you will start your business you will find many people criticizing your business; But in between such people, there will be someone who will guide you by pointing your mistakes out and literally correcting them can make your business touch the sky.
• Make Profit as Secondary Goal: Do not run only for profits / money. Make your business activities as a mean of overall development of society.