The Islamic economic model has developed over time based on the rulings of Sharia on commercial and financial transactions. The Islamic finance framework is based on:
equity, such that all parties involved in a transaction can make informed decisions without being misled or cheated
pursuing personal economic gain but without entering into those transactions that are forbidden (for example, transactions involving alcohol, pork‐related products, armaments, gambling and other socially detrimental activities). Also, speculation is also prohibited (so options and futures are ruled out)
the strict prohibition of interest (riba = excess).
As stated above, earning interest (riba) is not allowed.
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channelled into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in that profit, after a management fee is deducted by the bank.
A typical illustration would be how an Islamic bank may purchase a property from a seller and resell it to a buyer at a profit. The buyer will be allowed to pay in instalments. Compare this to a typical mortgage where the bank lends money to the buyer and charges interest.
Hence, returns are made from cash returns from a productive source – for example, profits from selling assets or allowing the use of an asset (rent).
In Islamic banking there are broadly two categories of financing techniques:
‘fixed Income’ modes of finance – murabaha, ijara, sukuk
equity modes of finance – mudaraba, musharaka.
FIXED INCOME MODES
(a) Murabaha
Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan is that, with a murabaha, the bank will take actual constructive or physical ownership of the asset. The asset is then sold to the ‘borrower’ or ‘buyer’ for a profit but they are allowed to pay the bank over a set number of instalments.
The period of the repayments could be extended, but no penalties or additional mark‐up may be added by the bank. Early payment discounts are not within the contract.
(b) Ijara
Ijara is the equivalent of lease finance. It is defined as when the use of the underlying asset or service is transferred for consideration. Under this concept, the bank makes available to the customer the use of assets or equipment such as plant or motor vehicles for a fixed period and price. Some of the specifications of an Ijara contact include:
the use of the leased asset must be specified in the contract
the lessor (the bank) is responsible for the major maintenance of the underlying assets (ownership costs)
the lessee is held for maintaining the asset in proper order.
An Islamic lease is more like an operating lease, but the redemption features may be structured to make it similar to a finance lease.
(c) Sukuk
Companies often issue bonds to enable them to raise debt finance. The bond holder receives interest and this is paid before dividends.
This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukuk holder is a partial owner in the underlying assets and profit is linked to the performance of the underlying asset. So, for example, a sukuk holder will participate in the ownership of the company issuing the sukuk and has a right to profits (but will equally bear their share of any losses).
EQUITY MODES
(a) Mudaraba
Mudaraba is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner (who is called ‘rab ul mal’), while the management and work is an exclusive responsibility of the other (who is called ‘mudarib’).
The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre‐agreed ratio. In a Mudaraba only the lender of the money has to take losses.
This arrangement is therefore most closely aligned with equity finance.
(b) Musharaka
Musharaka is a relationship between two or more parties that contribute capital to a business, and divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital. All
providers of capital are entitled to participate in management, but are not required to do so. The profit is distributed among the partners in pre‐agreed ratios, while the loss is borne by each partner strictly in proportion to their respective capital
