Islamic Financing Techniques- An Overview

Written by Muneer Ahmed Shahabuddin

This article was published in the renowned Malaysia-based magazine Islamic Finance News (IFN)

The practice of Islamic banking is based on two core tenets Quran and Sunnah together called Sharia. There are as many as ten other sources of legislation in Islamic economics. The Islamic banking concept first evolved over 1400 years ago at the time of the revelation of the holy Quran, however, the first known Islamic Banking practice started in 1953 in Mit Ghamer, Egypt as a cooperative society concept. Dubai Islamic Bank in UAE emerged in 1975 as the first-ever fully Sharia-compliant bank in the world.

There are a few misconceptions about Islamic Banking practice due to its apparent complexity of financing techniques and contract documents. Looking at the end-use of both Islamic and conventional banking products, which are almost similar, the consumers tend to have ambiguities in the financing techniques. Economic inputs as well as outputs in both financial systems are similar or very close to be similar, the difference remains with the financing process. Islam allows trade but prohibits interest. It is not permissible to use money as a ‘commodity’ or ‘item’ for trade. Conventional banking operates on the techniques of buying and selling money as deposits or loans. The incremental value of money in such financing techniques i.e. over and above the given loans to customers or borrowed deposits from customers, is called interest (as mentioned as Reba’ in the Quran). As per Sharia norms, Islamic banks can neither directly/indirectly trade in money nor it can accept/offer interests. ?

As guided by Sharia, there are five core fundamentals in Islamic economics. These are:

1.????? Ban on interest (riba’)

2.????? Ban on uncertainty or speculation (gharar or mysir)

3.?????? Ban on certain economic sectors (the industries which are deemed unlawful by Sharia such as weapons, wine, pork, gambling, etc.)

4.?????? Profit and loss sharing (parties to a financial transaction must share in the risks and rewards- ?depending on the financing structure*)

5.?????? Asset Backed Principle (each financial transaction must refer to a tangible, identifiable underlying assets)

* “Financing structure” is explained later.

?Like conventional financial systems, Islamic finance features banks, capital markets, fund managers, investment firms, and insurance companies, albeit through different techniques according to Sharia guidelines. For example, conventional commercial banks adopt two straightforward financing techniques. These are the execution of Principal-Agent contracts for deposit customers and Debtors-Creditors contracts for borrowing customers. In Islamic banking, the contracts are simple but not so straightforward. The Islamic financing techniques come through four main Sharia-compliant structures: (i) Trading (buying and selling), (ii) Lease/Lease to own (financial or capital lease), (iii) Partnership, and (iv) Services. There are varieties of contracts under each structure as practised by Islamic banks looking at the needs of their customers. Islamic banks will need to benchmark the features of economic outputs of conventional bank products as part of their business strategy. The attached diagram enunciates the varieties of contracts used by Islamic Banking.

In both financial systems, the core global deposit products are current accounts, savings accounts, and investment deposits. However, conventional banks across the world offer these deposits under their unique principal-agent contractual agreement. The Islamic banks will first have to look at the Sharia structure followed by the most pertinent contract to execute. As Islamic banks are in trade, they should benchmark conventional banking products to provide similar features to their customers. The techniques are however different for Islamic banks vis-à-vis conventional banks.

?The following table shows an example of the structure and contracts of Islamic banks deposit products:

??????????????????????????????????? Structure ?????????????????? Contracts ??????????????????

Current Account????????? Loan (safe custody)???? Wadia Ad Daman

Savings accounts???????? Partnership ??????????????? Mudaraba

Investment deposits??? Services?????????????????????? Wakala

?However, the contracts of treasury banking deposits could be numerous depending on the customer’s needs, placement of funds, fixing or floating the profit rates, etc. These deposit contracts could be well within the diversified range of Wakala, Mudaraba, Murabaha (Tawarruq), etc.

In regards to credit products, Islamic banks' financing contracts are plenty depending on the size and tenor of the facility. For consumer credit products or any short-term financing, Islamic banks also fix the profit rate with customers’ pari-passu with conventional banks. The suitable structure is the ‘Trading’ technique. For example, if the financing is for a ready asset and physically existing, the contract will be Murabaha, if the financing asset is under construction, the contract will be Istisna, if the contract is for a forward purchase of specified items, the contract will be Salam. Islamic banks will have to buy the assets first or must have the future ownership rights and as its owner or potential owner, it can make onward sale/ forward sale to the customers or lease to customers under lease financing. The question remains as to how Islamic banks handle cash financing. The most commonly used technique is the Tawarruq contract under the ‘Trading’ structure to supplement cash financing. This financing mode is used in case of extreme necessity by the customers or to buy out conventional bank loans. Islamic banks can use a ‘loan’ structure as a financing technique generally to accommodate short-term financing like temporary overdrafts, salary advances, etc. There are no interests or incremental value of money against such facilities except reasonable admin fees, charges or commissions. In most other financing structures, the applicable profit rates can be fixed, floating, or pre-agreed profit-sharing-ratio depending on the contract of the facility.

In view of religion-based banking, many people may have a misconception that Islamic banking is a charity and it sometimes expresses discontent due to the lack of their focus on their expected needs. A point to be noted is that Islamic banking is not a charity. It is a part of commercial business and trade. Islamic banks can apply their own strategies too to offer their products or not to offer, looking at the market profitability and overall feasibility of the product in a given economy.?

All the available Islamic banking products are not unanimously agreed upon among all Sharia scholars. There may be differences in views and opinions among them, maybe due to their respective mindsets, but there are no conflicts among the Sharia scholars at all.