Paper F9

Islamic Finance

Dinesh Kumar

Syllabus Area:
Raising short and long term finance through Islamic financing
a) Explain the major difference between Islamic finance and the other forms of
business finance.
b) Explain the concept of interest (riba) and how returns are made by Islamic
financial securities. (calculations are not required)
c) Identify and briefly discuss a range of short and long term Islamic financial
instruments available to businesses including
i) trade credit (murabaha)
ii) lease finance (ijara)
iii) equity finance (mudaraba)
iv) debt finance (sukuk)
v) venture capital (musharaka)
Introduction to Islamic finance
Islamic finance rests on the application of Shariah. Sharia law is derived from the
Quran (believed to be Allahs divine revelation to the prophet Muhammed) and
the teachings of Muhammed.
Muslims believe that Sharia law shows the path to be followed as ordained by
ALLAH. It covers all aspects of life and Muslims believe that following this path
will lead to physical and spiritual wellbeing.
Sharia law sets out five categories of actions that guide a Muslims actions:
These are acts that are:
Obligatory (Wajib)
Meritorious (deserving honour)
Commendable (worth praising)
Reprehensible (deserving strong criticism) and
Forbidden (Muharram).
The main principles of Islamic finance are that:
Wealth must be generated from legitimate trade and asset-based investment
(the use of money for the purposes of making money is expressly forbidden).
Investment should have a social and an ethical benefit to wider society
beyond pure return.
Risk should be shared.
Harmful activities (haram) should be avoided.
The intention is to avoid injustice, asymmetric risk and moral hazard (where the
party who causes a problem does not suffer its consequences) and unfair
enrichment at the expense of another party.
It is estimated US $1 trillion of assets are managed according to these principles
under the rules of Islamic finance.
Specific guidance
The following activities are prohibited:
Charging and receiving interest (riba).
This contradicts the principle that risk must be shared and is also contrary to
the ideas of partnership and justice.
Using money to make money is forbidden.
Investment in companies that have too much borrowing is also prohibited.
What constitutes too much borrowing is a matter for interpretation but is

typically defined as debt totalling more than 33% of the stock market value
over the last 12 months.
Investments in businesses involved in alcohol, gambling, or anything else that
the Shariah considers unlawful or undesirable (haram).
Investments in transactions that involve speculation or extreme risk. (This is
seen as gambling).
Entering into contracts where there is uncertainty about the subject matter and
terms of contracts (This includes a prohibition on short selling, ie selling
something is not yet owned).
Permitted activities
Islamic banks are allowed to obtain their earnings through profit-sharing
investments or fee-based returns. If a loan is given for business purposes the
lender should take part in the risk. This usually involves the lender buying the
asset and then allowing a customer to use the asset for a fee.
The following Islamic financial instruments provide Shariah-compliant finance:
Murabaha
In traditional western finance a customer would borrow money from a bank in
order to finance activity, say the purchase of an asset. However, under Sharia
the bank cannot charge interest.
Murabaha is a form of trade credit for asset acquisition that avoids the payment
of interest. The bank buys the asset and then sells it on to the customer on a
deferred basis at a price that includes an agreed mark-up for profit. Payment can
be made by instalments but the mark-up is fixed in advance and cannot be
increased, even if there is a delay in payment.
Ijara
A form of lease finance agreement where a bank buys an asset for a customer
and then leases it to the customer over a specific period at agreed rentals which
allows the bank to recover the capital cost of the asset and a profit margin.
Mudaraba
The bank provides capital and the customer provides expertise to invest in a
project.
Profits generated are distributed according in a predetermined ratio but cannot
be guaranteed. This is like the bank providing equity finance.
Musharaka
This is a joint venture or investment partnership between two parties who both
provide capital towards the financing of new or established projects. Both parties
share the profits on a pre-agreed ratio, allowing managerial skills to be
remunerated, with losses being shared on the basis of equity participation.
Sukuk
This is debt finance but Islamic bonds cannot bear interest.
Sukuk holders must have an ownership interest in the assets which are being
financed. The sukuk holders return for providing finance is a share of the income
generated by the assets.
Often the cash flows from these techniques might be the same as they would
have been under standard western practice. However, the key difference is that
the rate of return is based on the asset transaction and not based on interest on
money loaned.
The Shariah board

There is no ultimate authority for Shariah compliance.

Each Islamic banks adherence to the principles of Shariah law is governed by its
own Shariah board. This is a body within an Islamic financial institution that has
the responsibility for ensuring that all products and services offered by that
institution are compliant with the principles of Shariah law.