Islamic Finance and Socially Responsible Investment

Islamic financial institutions today manage around US$1.3 trillion, and their client base is spreading far beyond Muslim countries. But how do Islamic investments complement the western view of socially responsible investment, and to what extent do the products appeal to non-Muslim investors?

Almost three decades ago, the concept of Islamic finance was considered wishful thinking. Today, more than 400 Islamic financial institutions are operating worldwide, managing funds in the region of US$1.3 trillion and their client base is global.

The recent surge of religious awareness among Muslims has provided the drive towards implementing and adopting Islamic principles in financial transactions. Among the most important teachings of Islam for establishing justice and eliminating exploitation in business transactions, is the prohibition of all sources of unjustified enrichment and the prohibition of dealing in transactions that contain excessive risk or speculation. For that reason, Islamic scholars have defined two principles that form the benchmark of Islamic economics and which distinguish Islamic finance from its conventional counterpart: riba (or usury) and gharar.

Riba and Gharar

The prohibition of riba is clearly the most significant principle of Islamic finance. Riba translates literally from Arabic as 'an increase, growth or addition'. In Islam, lending money should not generate unjustified income. As a Shariah term, it refers to the premium that must be paid by the borrower to the lender along with the principal amount, as a condition for the loan or for an extension in its maturity, which today is commonly referred to as interest. Riba represents, in the Islamic economic system, a prominent source of unjustified advantage. All Muslim scholars are adamant that this prohibition extends to any and all forms of interest and that there is no difference between interest-bearing funds for the purposes of consumption or investment, since Shariah does not consider money as a commodity for exchange. Instead, money is a medium of exchange and a store of value. Profit and loss sharing is a form of partnership, and it is the substitute of riba, where partners share profits and losses on the basis of their capital share and effort. Unlike interest-based financing, there is no guaranteed rate of return.

Any transaction involving gharar, meaning uncertainty and speculation, is prohibited. Parties to a contract must have actual knowledge of the subject matter of the contract and its implications.

Islamic Contracts

Islamic scholars have approved certain basic types of contracts as being compliant with the principles of Islamic finance. Before going into the details of each type of contract, there are four conditions required for a valid Islamic contract:

1. The price for the goods should be agreed mutually between the parties and not under duress.
2. The subject matter of the contract (at the time of contract) should be in existence and able to be delivered without uncertainty or deception.
3. The contract should not be based upon a consideration that is itself prohibited under Shariah (e.g. alcohol, pork products, etc).
4. There must be a lawful purpose for the obligation arising out of the contract.

Listed below are some of the main Islamic finance contracts:

Mudaraba (trust financing)

Mudaraba is a form of partnership in which one partner provides the capital required for funding a project (rab-ul-amal), while the other party (known as a mudarib), manages the investment using his expertise. Profits arising from the investment are distributed according to a fixed, pre-determined ratio. The loss in a mudaraba contract is carried by the capital-provider unless it was due to the negligence, misconduct or violation of the conditions pre-agreed upon by the mudarib. In a mudaraba, the management of the investment is the sole responsibility of the mudarib, and all assets acquired by him are the sole possession of rab-ul-amal. However, the mudaraba contract eventually permits the mudarib to buy out the rab-ul-amal's investment and become the sole owner of the investment. Mudaraba may be concluded between the Islamic bank, as provider of funds, on behalf of itself or on behalf of its depositors as a trustee (please note this has a different meaning to the English law concept of trustee) of their funds, and its business-owner clients. In the latter case, the bank pays its depositors all profits received out of the investment, after deducting its intermediary fees. It may also be conducted between the bank's depositors as providers of funds and the Islamic bank as a mudarib. Mudaraba can either be restricted or unrestricted. Where unrestricted, depositors authorise the bank to invest their funds at its discretion. In the restricted mudaraba, the depositors specify to the bank the type of investment in which their funds should be invested.

Musharaka (partnership financing)

Musharaka is often perceived as an old-fashioned financing technique confined in its application to small-scale investments. Although musharaka is substantially similar to the mudaraba, all the parties involved provide capital and manage the financing of the investment, rather than just one party. Profits are shared between partners on a pre-agreed ratio, but losses will be shared in the exact proportion to the capital invested by each party. This gives an incentive to invest wisely and take an active interest in the investment. Moreover, in musharaka, all partners are entitled to participate in the management of the investment, but are not necessarily required to do so. This explains why the profit-sharing ratio is left to be mutually agreed upon and may be different from the actual investment in the total capital.

In a typical musharaka between a bank and a customer (i.e. partner), at the time of distribution of profits, the customer pays the bank its share in the profits and also a pre-determined portion of his own profits, which then reduces the bank's shareholding in the investment. Eventually, the customer becomes the complete and sole owner of the investment.

Morabaha (cost-plus financing)

Morabaha is the most popular form of Islamic financing techniques. Within a morabaha contract, the bank agrees to fund the purchase of a given asset or goods from a third party at the request of its client, and then resells the assets or goods to its client with a mark-up profit. The client purchases the goods either against immediate payment or for a deferred payment. This financing technique is sometimes considered to be similar to conventional, interest-based finance. However, in theory, the mark-up profit is quite different in many respects. The mark-up is for the services the bank provides, namely, seeking out, locating and purchasing the required goods at the best price. Furthermore, the mark-up is not related to time since, if the client fails to pay a deferred payment on time, the mark-up does not increase due to delay and remains as pre-agreed. Most importantly, the bank owns the goods between the two sales and hence assumes both the title and the risk of the purchased goods, pending their resale to the client. This risk involves all risks normally contained in trading activities, in addition to the risk of not necessarily making the mark-up profit, or if the client does not purchase the goods from the bank and whether he has a justifiable excuse for refusing to do so. However, the Organisation of the Islamic Conference (OIC) has declared that a customer's promise to purchase the goods in a morabaha is an ethically binding promise. Accordingly, the OIC Academy has held that the customer is bound to compensate the bank for any out of pocket expenses the latter incurs as a result of the refusal of the customer to purchase the goods. The purchase of goods under the murabaha contract may be funded by the Islamic bank either from its own funds, or from the funds of its depositors. In the latter case, the bank acts as its depositors' agent, retaining its fees from the mark-up profits. In such circumstances, the depositors will own the purchased goods during the period pending its resale, and therefore assume its risk.

Ijara (leasing)

Ijara is defined as sale of manfa'a (i.e. sale of right to use the goods for a specific period). The ijara contract is very similar to the conventional lease. Under Islam, leasing began as a trading activity and then much later became a mode of finance. Ijara is a contract under which a bank buys and leases out an asset or equipment required by its client for a rental fee.

During a pre-determined period, the ownership of the asset remains in the hands of the lessor who is responsible for its maintenance so that it continues to give the service for which it was rented. Likewise, the lessor assumes the risk of ownership, and in practice seeks to mitigate such risk by insuring the asset in its own name. Under an ijara contract, the lessor has the right to re-negotiate the quantum of the lease payment at every agreed interval. This is to ensure that the rental remains in line with prevailing market leasing rates and the residual value of the leased asset.

Salam (advance purchase)

Salam is defined as forward purchase of specified goods for full forward payment. This contract is regularly used for financing agricultural production. The goods must be such as can be specified by description and quantity, and must be available at the time of delivery. The contract must contain particulars of the nature, type, description, amount and delivery time of the goods.

Istisna'a (commissioned manufacture)

Istisna'a is a new concept in modern Islamic finance that offers a number of future structuring possibilities for trading and financing. In this contract, one party buys the goods and the other party undertakes to manufacture the goods, according to agreed specifications. Islamic financial practice holds that the contract is binding on both parties at the outset. Islamic banks frequently use istisna'a to finance construction and manufacturing projects.

Quard-hasan (interest-free loan)

The quard-hasan mechanism effectively amounts to an interest-free loan either to corporate customers in financial distress, (which later might be converted into an equity stake in the enterprise), or to individual clients for welfare purposes. In making the loan available, the bank may take security for the loan (e.g. mortgage over the customer's premises) and some may charge a nominal fee. The service charges are not for profit; they are the actual costs recovered under one important condition (to prevent the charges from becoming equivalent to interest): that the charge cannot be made proportional to the amount or to the term of the loan.

Takaful (mutual insurance)

The model of takaful offers clear guidelines for the establishment of Islamic banking insurance that substitutes its conventional counterpart. The modern conventional system of insurance is contrary to the Shariah because of its unjust, interest-based nature. Takaful aims to provide security and protection to its participants in a way that is seen to be socially responsible and fair. It refers to the pool of payments by a group of participants of an agreed sum into a common fund that will be managed in accordance with Shariah, particularly the mudaraba contract. In case of the occurrence of the insured event, the participant benefits through claiming compensation from the fund. In the absence of the claim, the participants share the surplus of the invested funds. Conventional insurance companies manage the funds of its clients on their behalf. Similarly in takaful, the Islamic bank is a trustee (not to be confused with the legal concept of trustee under English law) managing the funds of the participants for a fee. Thus, each participant retains title over its share of the funds, and under certain conditions may withdraw its share.

Islamic Instruments for Primary Markets

Islamic finance is constantly developing mechanisms to enter into the primary market. The most common Islamic financial mechanisms are as follows:

Mudaraba funds

Many investors become shareholders in large financial projects through the mechanism of the mudaraba. The Islamic bank's role in these funds is to act as the mudarib to use these funds to finance a large project. This mudaraba fund can be used by the bank in conducting its business using any of the Islamic contracts, such as murabaha, ijara'a, salam or istisna'a.

Companies with common shares

On a worldwide basis, companies that issue their shares as stocks generate investment securities. Purchasing stocks in companies with common shares is similar to purchasing shares of public joint stock companies. The OIC has approved the purchasing of shares of such companies; provided that these companies are not formed for anti Islamic purposes, such as pork trade, liquor production, etc. In order for this to work, the western legal principles of the limited liability of shareholders and the artificial personality of companies have been accepted.

Muqarada bonds

This is similar to a revenue bond. An existing company (a mudarib) issues muqarada bonds to investors (who are rab-al-amal) to generate the finance required for a new project. This new project must be separate from the issuing company's general activities. Once the profits of this separate project are distributed, they are apportioned according to the percentages agreed between the mudarib and the rab-al-amal. The holders of such muqarada bonds may later become shareholders in the issuing company, depending on the terms of the issuance of the muqarada bonds.

Sukuk

One of the most successful Islamic capital market instruments is sukuk. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has defined sukuk as "a certificate of equal value representing undivided shares in ownership of tangible assets, 'usufruct' and services or in the ownership of the assets of particular products or special investment activities" (usufruct means the legal right to use and enjoy the advantages or profits of another's property). AAOFI also defined 14 types of sukuk. The main ones are:

• Ijara sukuk (leasing)
• Certificates of ownership of usufructs (e.g. sukuk manfa'at al-ijara)
• Salam sukuk (deferred commodity delivery)
• Istisna'a sukuk (manufacturing or project finance)
• Mudaraba sukuk (partnership/finance trusteeship)
• Murabaha sukuk certificate (joint venture)

Challenges Facing Islamic Finance in Product Design and Distribution

Can Islamic Investment and Banking Appeal to non-Muslims?

Islamic banking is also attracting non-Muslims and is growing aggressively. But can ethically based banking compete with the global debt-based system?

Some commentators consider judgments on the potential of Islamic banking to be premature as it is an industry in its infancy, while others consider Islamic financial practice to be the answer to problems created by the conventional debt-based money system. Which group is right? Could they both be right? And how realistic are Islamic bankers' dreams of penetrating non-Muslim markets as a global alternative to conventional finance?

At the risk of over simplifying, the essence of Islamic finance is that all parties engage in trade without any use of riba (interest). The Shariah rules governing the prohibition of riba are well known to most, and the values underpinning the rules are righteousness, benevolence and fair profit. Muslims and non-Muslims alike share these values, with most people wanting to govern their personal and business affairs in accordance with these basic, yet extremely important, ethics.

While the majority of conventional bankers will of course conduct their business in a principled manner, the nature of the interest-based money system is nonetheless at odds with Shariah. Conventional finance models treat money as a commodity, and the global Forex markets see billions of dollars traded every day, but the majority of these trades are speculative and are often underpinned by complex derivative structures. In reality these trades are 'virtual' trades and nothing more.

In contrast, Shariah prohibits the trading of money as a commodity for a number of different reasons. Firstly, money is considered not to have any intrinsic value. Secondly, whereas commodities can be of different qualities, the same cannot be said of money. Thirdly, units of money of the same denomination cannot be identified in any given transaction; i.e. the US$100 bill shown at the time of negotiating a sale need not necessarily be the same US$100 bill that is exchanged to consummate the transaction. In simple terms, Shariah distinguishes between money and commodities because the intended use of money is to act as a measure of value rather than to be the subject matter of a trade.

Debt begets debt

Goldsmiths of medieval Europe first employed the concept of creating money out of money. Through their simple system of lending gold, the goldsmiths realised that they had the ability to lend more than they actually had. Their lending was therefore increased in the form of gold deposit receipts. It is this basic principle that has been followed over the years and, as we see now, has evolved itself into the modern debt-based money system. Analysis of various economic data shows that the volume of coins and notes issued by some governments as debt-free money is much lower than the money actually in circulation, the balance being 'virtual' money that has been created in the form of loans advanced by institutions. In short, the debt-based money system creates money in parallel to an equivalent quantity of debt with interest.

The problem is that the impact of a debt-based money system has been devastating. The World Bank's Global Finance Development report shows that total debt continues to rise. Despite ever increasing payments, some countries' debt obligations far outstrip their total income, meaning that citizens of all religions and ethics suffer economically under their national debt burden. The list of shocking statistics in respect of debt and interest payments is long and well documented, yet relatively few alternative solutions have been offered, and often the best creditors can come up with is to restructure repayments or to waive portions of state debt in times of crisis.

The Shariah principles governing financial transactions, on the other hand, promote an equity-based and asset-backed financial system by abolishing the concept of money production and by prohibiting riba on the advancement of money. Islamic finance is built on the principles of exchange, rather than credit worthiness and the ability to repay loans. This means that a system based on Islamic principles will neither punish people who need access to capital for not having it already, nor allow them to take on the burden of debt.

Non-Muslim support for asset-backed practice

Conventional economists and writers have already recognised the benefits of some of the principles that the Islamic system of finance follows. John Tomlinson, an Oxford-based economist, is chairman of the Oxford Research and Development Corporation Limited, which explores the use of equity instruments and the development of equity markets for areas of finance currently served by debt. In his book, Honest Money, Tomlinson presents strong arguments for the conversion of the current system to an equity-based. In building his case for a change in the system, Tomlinson cites reasons that are similar to the principles present in the rationale employed for prohibiting riba, not least the value of focusing on real as opposed to theoretical assets.

Kahf, Ahmad and Homud (1998), in their paper 'Islamic Banking and Development: An Alternative Banking Concept, conclude that Islamic banking has a wider role to play than merely meeting the needs of the Islamic investor, and that this form of banking can and should be extended to the wider community by its practitioners.

Of course while Islamic banking could make excellent sense as the foundation of a new money system, the conventional debt-based system is deeply entrenched in every sphere of life, and an overhaul would take many years and would require substantive reviews of legal, accounting and regulatory structures. That said, if Islamic banks and institutions continue their aggressive growth and development of innovative and competitive products, then it will be difficult for the wider non-Muslim audience to ignore the benefits of such a system. It may be too late to entirely replace the debt system, but on the face of it there is no reason why the Islamic system cannot be offered in parallel and promoted as the preferred system. Non-Muslims who are fed up with punitive interest payments and who are attracted to a system that imposes ethical practices on business leaders, might well be the first to sign up for such services.

If the Shariah principles employed by Islamic banks have allowed them to be profitable, and more recently to achieve double-digit growth figures, then the argument for expanding the net of Islamic banking to the wider community is a compelling one.

Conclusion

On the investor front, market studies have repeatedly shown that if given the option to invest in Shariah products with competitive performance, Muslims prefer to do so. As the Shariah sector moves forward, advancing financial education for investors and improving product distribution will stimulate a response from the retail sector. Today, the institutional market and the ultra high net worth in numerous family offices already deploy assets according to Shariah, many in the real estate and private placement market.

A breakout opportunity for the Islamic asset management business is possible, particularly after 2007, which is a 'stage setting' year for many financial institutions in both the capital markets and asset management businesses. General market consensus suggests growth rates in the 15-20% range; Celent feels the global market could average 38% over the 2007-2010 periods, with greater momentum in 2009.

Equity fund assets expected to jump from US$15.5bn to US$53.8bn by 2010, not including the vast amount that will make its way to private placements in alternative investments by institutions and family offices.

More financial firms implementing investment programs, growing awareness of investment options and a cash rich investor are the drivers of this growth. The Shariah-compliant industry is formalising its infrastructure, building-up assets quickly, and will become a significant and profitable component of the financial services industry globally.

Article by Khorshid has been involved with financial institutions for over three decades with comprehensive skills and knowledge in Islamic finance. He is a recognised expert on Shariah compliant finance, Islamic moamlat, and Islamic contracts. Dr Khorshid started his carrier with international marketing and trade. He served as a Shariah board member of Al-Baraka Bank (The first Islamic bank in the UK) and dealt with the UK treasury and Bank of England departments in relation to the regulatory of Islamic banking issues. Dr Khorshid has a Master's degree in management, and a PhD in Islamic economics from the University of Leeds (UK). His Publications includes, Islamic Insurance.