This guide is a guest post written by Abdullah Masood, Senior Islamic Product Manager – Global Trade and Receivables Finance. The views and opinions represented in this guide are those of the author and do not necessarily represent the views of the ICC or ICC Academy.
Islamic finance is an evolving branch within the finance industry which derives its roots from Islamic jurisprudence.
The initial idea behind the inception of Islamic finance was to provide an avenue for the 1.8 Billion Muslim population of the world to conduct their financial matters in a Shariah compliant way, factoring in the prohibition of Riba/Interest/Usury in Islam. However, with time, Islamic finance has become more important on a global level due to its:
- Growth potential
- Wide acceptance
- Suitability for real world financial challenges
- Freedom from speculation
- Sustainable model during a global crisis
- Natural fit for structured finance
- Variety of participation models compared to conventional finance where lending is the core of all financial activities
- Closeness to day to day financial activities
In this guide, you will learn the history of modern Islamic finance, the different modes or instruments used in Islamic finance as well as how it fits in with international trade. At the end of the guide we have also provided a glossary of key terms.
Let's get started.
Where did Islamic finance come from?
Islamic Finance is based on principals rooted in Islam and sourced from:
- The Holy Quran
- The Sunnah (teachings, acts or quotes of the Prophet Mohammad PBUH)
While these are the primary sources for Islamic finance, to have a consensual approach and facilitate logical thinking, the following are also allowed:
- Ijma (Consensus)
- Qiyas (Analogy)
- Ijtihad (Independent Reasoning)
Islamic finance is continuously evolving to meet the rising challenges of the global financial system.
A brief history of modern Islamic finance
While Islamic finance is as old as the religion itself, the establishment of dedicated financial institutions and banks happened in the 20th Century.
Here are some of the key historical events that led to the evolution of today’s modern Islamic finance system:
- 1950s: The first, experimental, local Islamic bank was established in the late 1950s in a rural area of Pakistan which charged no interest on its lending.
- 1963: The first modern Islamic bank on record was established in rural Egypt by economist Ahmad Elnaggar to appeal to people who lacked confidence in state-run banks.
- 1973: The influx of "petro-dollars" and a "general re-Islamisation" following the 1973 oil crisis encouraged the development of the Islamic banking sector, and since 1975 it has spread globally.
- 1975: The Islamic Development Bank was set up with the mission to provide funding to projects in the member countries.
- 1979: The first modern commercial Islamic bank, Dubai Islamic Bank, was established as well as the the first Islamic insurance (or takaful) company — the Islamic Insurance Company of Sudan..
- 1980 to 1985: Islamic investments underwent a large expansion throughout the Muslim world, attracting deposits with the promise of "great gains" and "religious guarantees" supplied by Islamic jurists who issued fatwas denouncing conventional banks and recommending their Islamic rivals.
- 1986: The Amana Income Fund, the world's first Islamic mutual fund (which invests only in sharia-compliant equities), was created in Indiana.
- 1990: An accounting organization for Islamic financial institutions (Accounting and Auditing Organization for Islamic Financial Institutions, AAOIFI), was established in Algiers by a group of Islamic financial institutions (currently headquartered in Bahrain). The Islamic bond market also emerged in 1990, when the first tradable sukuk — the Islamic alternative to conventional bonds — were issued by Shell MDS in Malaysia.
- 1995: 144 Islamic financial institutions had been established worldwide, including 33 government-run banks, 40 private banks, and 71 investment companies.
- 1996: The large US-based Citibank began to offer Islamic banking services when it established the Citi Islamic Investment Bank in Bahrain.
- 1999: The first successful benchmark for the performance of Islamic investment funds was established, with the Dow Jones Islamic Market Index (DJIMI).
- In 2002, the Malaysia-based Islamic Financial Services Board (IFSB) was established as an international standard-setting body for Islamic financial institutions.
Two decades on and global Islamic finance assets have increased to USD 2.8 trillion in 2019 and forecasted to reach USD 3.7 trillion by 2024 according to Islamic Finance Development Report 2020.
Prohibitions of Islamic Law
Islamic finance is different in many ways from conventional finance, including the prohibitions listed below:
- Riba (Usury)
- Gharar (Uncertainty)
- Maysir & Qimar (Gambling)
- Unlawful contract
However, the one key differentiator is the concept of Riba/Interest/Usury (referred to as Riba from now onwards.).
Riba is defined as:
“Every loan that attracts any kind of gain (monetary or non-monetary) is Riba”
While Riba is prohibited in Islam and is related to loans primarily, there are other ways and modes of performing financial transactions, which are permissible in Islam such as:
- Partnership e.g. Musharakah, Mudarabah
- Sale e.g. Murabaha, Musawamah, Istisna, Salam
- Agency e.g. Wakalah
- Guarantee e.g. Kafalah
- Lease e.g. Ijarah
This guide will cover each of these in turn.
Modes of Islamic finance
In today’s finance industry, all the aforementioned modes of Islamic finance are available and actively used in line with client’s requirements and feasibility as per the business model.
Musharakah – This is a type of partnership where all partners contribute capital to do business. However, business can be managed by one or all of the partners. Profit sharing ratio is to be agreed at the beginning of the partnership and can be different from the share of investment. However, any loss shall always be shared pro-rata according to the share of investment.
Mudarabah – This is a type of partnership where one partner brings capital, while the others provide expertise. The profit sharing ratio is agreed at the beginning of this partnership. However, in case of loss, the partner who brings capital will lose money whereas the other partner just loses their time and effort.
In both of these types of partnership, an absolute profit cannot be agreed and only a profit sharing ratio on the basis of the resulting profit from the partnership can be agreed.
Murbaha – This is a kind of sale where the cost of the underlying goods is disclosed by the seller to the buyer i.e. selling price is communicated as cost plus profit. It means the buyer is aware what the cost of the sale is to the seller.
Muswamah – This is where the cost of underlying goods is not disclosed and sellers only communicate the selling price to the buyer.
Istisna – This describes a sale where the underlying goods need to be manufactured i.e. it is an order to manufacture. As per Shariah law, the buyer has an option to either make no advance payment, partial payment or full payment in advance at the time of order, whereas the seller has to manufacture and deliver goods in the future.
Salam – Used for the sale of homogeneous goods, mostly in agricultural transactions. The goods to be sold are not existing at the time of sale and have to be delivered on a future date. In this kind of sale, the buyer has to make 100% advance payment at the time of order whereas the seller has to provide goods in the future. A reasonable time for delivery is to be agreed, especially if the commodity or goods are seasonal in nature.
Important note: In line with Islamic rules for sale, a sale cannot be concluded if the object of sale is not existing at the time of sale. However, Istisna and Salam are the two exceptions to this rule.
Another important rule is that the price of goods shall be fixed at the time of sale/order and cannot be changed once a sale is concluded
Wakalah – is an agency arrangement where one party (principal) can employ another party (agent) to provide a particular service based on the expertise of the agent. In return, the principal agrees on a commission with the agent for the service.
If the service is provided as agreed by the agent, the principal has to pay due commission to the agent, irrespective of whether the service benefits the principal or not. However, in cases where the negligence of an agent is proven, then the agent needs to compensate the principal for the loss incurred.
Kafalah – this is a term used for guarantees where the guarantor can charge a fee for associated services related to providing a guarantee for an applicant.
Ijarah – this mode is used when one party (owner) rents something to the other party (tenant). Ijarah can be used for tangible goods (like renting houses) as well as intangible (like providing a service, similar to Wakalah).
Unlike a sale, where the price cannot be changed once a sale is concluded, Ijarah arrangements have the flexibility of keeping rent/commission as fixed or floating.
 The Historic Judgement on Interest Delivered in the Supreme Court of Pakistan, 1999
Role of Islamic finance in international trade
Banks and financial institutions play a critical role in international trade by connecting buyers and sellers of goods and services. Although, it seems very simple it involves many stakeholders for a good or service to move from the seller (exporter) to the buyer (importer), such as customs, shipping companies, freight forwarders, warehousing agents etc.
All these stakeholders use different trade products including letters of credits, documentary collections, open account trade, import loans, bill discounting, pre/post shipment finance, discounting, guarantees and structured solutions like receivables finance or supply chain finance etc.
While Islamic banking alternatives to all the solutions provided by conventional banks are available, well established, and operationally similar, a key differentiator for Islamic finance is assigning responsibilities to different parties involved and sharing risk/return. This is unlike conventional finance, where the financial institution is primarily a lender without sharing any risk.
Suppose a customer based in Dubai wants to open a letter of credit (LC) to import machinery from China.
A conventional bank will open an LC for a commission for its client without assuming any risk related to the underlying goods. In case a client needs follow on financing against the imported machinery, an import loan will be provided.
An Islamic Bank can provide 3 types of solutions based on different scenarios:
Wakalah LC – Where the bank will act as client’s agent to import machinery for a fee. This is suitable when a client does not need financing.
Murabaha LC – Where the bank will act as owner of the machinery, assume the risks associated with import and will sell the machinery on spot (in case no financing is required), in installment or on deferred payment to the client as per requirement of the client. Alternatively, the bank can also give machinery on rent (Ijarah) to the client for a defined period.
Musharakah LC – Where the bank acts as a partner with the client for the import of machinery. This mode is suitable if the client needs partial financing. On arrival of documents, the bank can sell its share on spot, in installment or on deferred payment to the client or give its part of ownership on rent (Ijarah) to the client.
Everything that the Islamic bank offers is also achievable through conventional finance. However, as you can see in this example, an Islamic bank will not be merely a lender, rather the relationship is based on risks and rewards.
Alternatively, we can say that Islamic banking solutions primarily facilitate transactions involving assets (both tangible and intangible) and spur economic activity, while discouraging speculation, ghost trade, trade-based money laundering as well as mitigating the risk of manipulation.
The future of Islamic finance
Islamic finance is dynamic and continuously evolving with the changing macro-economic environment. Keeping in view the upcoming challenges in a post pandemic (COVID) world, Islamic banks are changing their ways of doing business by making use of technology.
For example, Islamic banks are required to physically inspect stocks in certain modes like Murabaha, Musharakah, Istisna, Ijarah and Salam where the bank acts as owner of the goods. However, these were replaced with virtual visits in order to follow SOPs.
Similarly, banks are now exploring various blockchain solutions to minimize physical interaction for the submission of requests, documents and sale contracts. This is in addition to increasing the use of proprietary, dedicated online platforms.
Banks are also moving towards electronic document solutions and an important aspect of this is moving towards electronic bills of lading, which will be a paradigm shift in terms of operations by key stakeholders i.e. shipping lines, customs and banks.
Ijarah – leasing of an asset by the owner to the tenant
Islamic – Governed by Shariah jurisprudence
Istisna – Sale of goods which currently do not exist and need manufacturing
Kafalah – A guarantee issued by a guarantor on behalf of the applicant
Mudarabah – Partnership where some partners contribute capital and others contribute services
Murabaha – Sale where the cost to the seller is disclosed to the buyer
Musawamah – Sale where the cost is not disclosed by the seller to the buyer
Musharakah – Partnership where all partners contribute capital
Riba – Gain (monetary or non-monetary) over and above loan
Salam – Sale of homogeneous goods against 100% advance payment when goods don’t currently exist.
Sale – exchange of one thing of value with another thing of value with mutual consent
Sukuk – Islamic bonds using Shariah compliant underlying modes
Tawarruq – Also called commodity murabaha, where a sale is used to generate capital, though the underlying goods are not required by the buyer
Wakalah – An agency arrangement where an agent provides services for a fee
About the author
This guide is a guest post written by Abdullah Masood, Senior Islamic Product Manager – Global Trade and Receivables Finance. He has previously held roles as the Unit Head – Product Development and Shariah Compliance Department for Meezan Bank Limited as well as Unit Head for HSBC Bank Middle East Ltd in Pakistan.
The views and opinions represented in this guide are those of the author and do not necessarily represent the views of the ICC or ICC Academy.