Basic Concepts of Islamic Finance

Islamic financing has been a viable alternative to western banking since the
early 1970s and complies with the major concepts of Shari law, namely that:

interest (usury) should not be charged or collected;

no form of gambling be undertaken; and

no investment should be made in a business which is deemed to be

unlawful under Shari law.

Basic concepts
The essential basic concepts of Islamic financing are:
1. Islamic Debt financing
Ijarah Leasing

Ijarah structure entails the lender creating a special purpose vehicle (SPV) to
purchase asset(s) that is the subject of the financing. In turn, borrower agrees
to enter into a lease agreement to lease the asset(s). Lease payments act as
part rental payments (the profit component) for use of asset and part
repayment of principal debt.
Ordinarily transaction will take on the following elements:
(i) borrower and lender enter into a purchase contract to buy asset that is the
subject of the financing;
(ii) borrower and lender enter into a lease contract under the terms of which
borrower agrees to lease asset that is the subject of the financing;
(iii) on completion of the lease term, borrow can either make a balloon
payment to purchase asset or, alternative, if the rental has included part
principal payments, can pay a small sum to the lender in exchange for
ownership of asset.
This type of Islamic financing structure is very similar to hire purchase
contracts. As such, assets that are commonly the subject of this type of
Islamic financing include motor cars, home appliance, electronic goods, etc.

Murabaha - Cost-plus financing / buy-sell arrangement

Essentially works by borrower asking lender to purchase asset on the

understanding that after lender has purchased asset, borrower will purchase
asset from lender.
Agreement is made that lender on-sells asset to borrower at an increased
price.
Repayment can either be in one balloon payment or by way of installments
over a period of time. If repayment is a balloon payment, more commonly
known as a Bai Bithaman Ajil or deferred payment sale agreement.
Popular structure for purchasing real estate property. It should be noted,
however, that as lender on-sells property to borrower, all land title deeds, etc.
vest with the borrower. Thus, security provisions of such an arrangement
need to be considered carefully so that the lender can adequately protect
themselves.
Components of this type of Islamic financing include:
(i)

on-sell arrangement;

(ii)

agreed mark-up on on-sell price;

(iii)

asset must be Shari compliant;

(iv)
asset must exist at the time of the transaction; thus, this cannot
be utilized in futures trading transactions;
(v)
all terms and conditions of the arrangement must be known by
all parties at the time of entering into the arrangement;
(vi)

reoccurring expenses cannot be passed on to the borrower.

Bai al-Inah Sale and buy-back

Similar concept to Murabaha. However, due to security concerns on default,

structure is changed slightly. Lender purchases asset on behalf of borrower.
Borrower purchases asset from lender on deferred payment basis. Asset is
immediately resold to lender for cash at discount.

Preferred financing mechanism if there is any danger that lender will become
insolvent.
Musharakah - Partnership
It's can also be referred to as Islamic venture financing

An arrangement between a lender and a borrower where both parties agree to

make a capital contribution towards financing a commercial operation.

Parties agree to share profits from the arrangement at a pre-agreed ratio.

Losses from the arrangement need to be shared pro-rata to the capital

contributions of each of the parties.

Tawarroq finance - Monetary finance

Lender agrees to purchase a commodity on behalf of the borrower.

Lender sells commodity to the borrower.

Borrower sells commodity to a third party buyer.

Cash payment from third party buyer acts as monetary financing element of the
transaction.

Borrower repays lender in installments.

Qardul Hassan Benevolent loan

Consists of a loan given to a borrower on a goodwill basis, i.e. no interest or

fees are charged

Borrower may, at their discretion, repay more than they borrowed

Seen as being the only pure form of Islamic financing loan as, unlike all the
other financing structures, it makes no attempt to charge riba (interest), which is
prohibited under Islam.

Mudharabah - Profit sharing

Islamic investors agree that a Mudhareb (trustee) will provide skill and expertise.

Mudhareb agrees to hold and manage the assts for Islamic investors.


In return for providing services, Mudhareb earns an agreed share of profits from
the assets managed on behalf of Islamic investors.

Mudhareb cannot claim any right to the assets - merely acts as manager and
trustee of assets.

II.

Commodities financing

SSalam Advance payment

Under this Islamic financing structure, purchaser agrees to make advance

payment for asset/goods to be delivered at a future date.

It is essential that purchase price be paid at the time of making the agreement,
and not on delivery of the asset/goods - failure to comply with this requirement would
alter the nature of the agreement to that of a sale of debt against debt, which is
prohibited under Shari law.

As Shari law stipulates that items must exist at time of contract, i.e. no futures
contract, asset to be purchased must be clearly stated in the purchase agreement and
the quantity and quality of the purchased asset must be capable of being specified
exactly there can be no room for dispute.

Assets must be goods and cannot not include commodities; such as gold, silver
or money.

The exact date and place of delivery of the asset/goods must be specified in the
agreement.

Istisnaa is another Islamic financing structure that follows almost exactly the
same concept as found here

III.

Deposit taking functions/strong>

WWadiah - Safe-keeping

Agreement between two parties where on agrees to look after the property of
another.

Concept is used to take deposits of money, where bank acts as custodian of

money deposited by customer.

Bank agrees they will refund sums deposited on call, i.e. on demand.

Hibah - Gift


Hibah literally means a gift. This is used by banks to compensate depositors for
lost earnings (interest) on their deposits. It can also be used by borrowers who have
been granted Qardul Hassan loan mention above.

No agreement to provide Hibah can be made its an arbitrary payment made at

the discretion of the person making it.

IV.

Bonds/strong>

Fixed-term, fixed-income, interest-bearing securities cannot be issued under Shari law.

SSukuk Islamic bonds

Although fixed-income, interest-bearing bonds cannot be issued under Shari law,

it is estimated that over $500 billion in corporate and government bonds issues have
been made using Sukuk (Islamic bonds) mechanism.

Essentially, Sukuk bonds are long-term bond issues made by SPVs where the
bond sale proceeds are used to purchase assets that are then leased back to the issuer
in return for rent. Rental payments constitute part repayment of the principal and part
profit revenue to the bondholders.
Salam bonds/strong>
In certain circumstances, short-term bond issues can be made using the same
mechanism concepts found in Salam transactions. It should be noted, however, that
due to the precise nature of the assets/goods that are the subject of a Salam
transaction, these types of bond issues are rare and for very short-term periods.
Conclusion
The growth of Islamic financing in the past decade has been stellar. Given the large
amounts of cash available in the oil rich Middle-East, it is likely that the growth of Islamic
financing will continue. Moreover, as investors in the Middle-east look to break-out an
invest elsewhere, it is certain that governments around the world will need to familiarize
themselves with the principal concepts of Islamic financing, and to regulate for such, if
they wish to take advantage of this growth industry.