Introduction to Islamic Finance

Introduction to Islamic Finance

By Omolaoye Kunle, ACA

Let me share my little knowledge about this interesting topic on Islamic finance or halal funds.

Recently, there have been arguments on whether the Federal Government of Nigeria should borrow interest-free loans but before you start throwing criticizing President Buhari or “Arabinrin” Kemi Adeosun there is a need to enlighten ourselves on what Islamic finance really means.

Islamic Finance rests on the application of Shariah. Sharia law is derived from the Quran which is believed to be Allah’s divine revelation to the prophet Muhammed (SAW) and his teachings. 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 (5) categories of actions that guide a Muslim’s actions. These are acts that are:

  • Obligatory;
  • Meritorious;
  • Commendable;
  • Reprehensible; and
  • Forbidden.

The major principles of Islamic finance are that: Wealth must be generated from legitimate trade and asset-based investments. 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 returns. Risk should be shared. Harmful activities (haram) should be avoided. The intention is to avoid injustice, asymmetric risk and moral hazards where the party who causes a problem does not suffer its consequences and unfair enrichment at the expense of another party.

It is estimated that US $1.6 trillion of assets are managed according to these principles under the rules of Islamic finance.

“In the United States a quiet financial revolution is going on under the radar of the public eye. It’s the rise of Islamic financial institutions — ranging from small community banks in the Midwest to nationwide investment banks and brokerage firms.” -CNBC News, December 5th, 2016.

Islamic financial services have quickly expanded outside the GCC states and Malaysia and 2014 was a pivotal year, as it marked the issuance of sukuk by the United Kingdom, the first Sovereign sukuk issued by a non OIC country. The UK was quickly followed by Luxembourg and South Africa. Since then many other European nations had tapped into this beautiful finance without recourse to religious beliefs.

The most important reason I see while the western world has started to adopt the Islamic fiance is that conventional banking enslaves poor countries by crushing them under debt to rich countries.

In the Muslim world, Interest does not exist, with financial transactions being based on real world value and development rather than in easily manipulated factors.

It is essentially a banking system with a conscience, one of the most decried flaws of conventional banking by regular consumers.

Let me conclude by listing the various types of the Islamic finance and the benefits available in the finance.

Types of Islamic finance

The following Islamic financial instruments provide Shariah-compliant finance. 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 at which return is based on the asset transaction and not based on interest on money loaned.

  1. 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.

  1. 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 an agreed rentals which allows the bank to recover the capital cost of the asset and a profit margin.

  1. Mudaraba

The bank provides capital and the customer provides expertise to invest in a project. Profits generated are distributed according to a predetermined ratio but cannot be guaranteed. The bank does not participate in the management of the business. This is like the bank providing equity finance. The project might make a loss. In this case the bank loses out. The customer cannot be made to compensate the bank for this loss as that would be contrary to the mutual sharing of risk.

  1. 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.

      5. 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. Modern sukuk share many features with western securitisations. There are many different types of sukuk including: Ijara sukuk (sukuk al-ijara)

  • Mudaraba sukuk (sukuk al-mudaraba)
  • Murabaha sukuk (sukuk al-murabaha)
  • Musharaka sukuk (sukuk al-musharaka.

These and many others I shall be explaining in another article very soon. Should you have any questions, comments, observation or additions, use the comment box I shall be delighted to read from you.

 

Omolaoye Kunle, is a Chattered Accountant a partner at Frontline Property.

Twitter @adex0057

Contact 08065616809

Email adex0057@gmail.com

 

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