Islamic financing might once mainly have been limited to the Middle East, but that’s no longer the case. It is growing in size and influence across the world — now too big for leaders of traditional businesses to ignore.
Globally, Islamic finance markets (those governed by Islamic code) totaled $2 trillion as recently as 2017, according to the Research and Markets website. That is a figure that has been growing by up to 20 percent a year, according to a forthcoming technical note from Darden Professor Marc Lipson and Aaron Fernstrom, director of the Richard A. Mayo Center for Asset Management.
Below, Lipson and Fernstrom provide an introduction to the key terms and structures of Islamic finance. While there are many similarities with western finance, there are essential differences that savvy business leaders should understand.
Riba and Other Basics
Fundamental to all Islamic finance is the prohibition on charging interest, also known as riba. That rule, which is an absolute, stems from the Quran, Islam’s holy book. However, no clear or agreed-upon definition of riba exists. That lack of clarity is exacerbated by the fact that there is no single religious authority to provide a definitive ruling. In other words, there’s room for interpretation.
Instead, the following set of guiding principles are used to ensure any Islamic finance transaction adheres to the rules. Using these rules helps make sure the financing is “Sharia-compliant,” meaning it sticks to the Islamic code.
- Profit and loss risks should be shared.
- Financial leverage should be kept to a minimum.
- All financial transactions must have a clear and transparent social or development goal.
- Financial innovations are to be “monitored” by religious scholars.
- Transactions cannot involve religiously banned activities (e.g., investments in alcohol or tobacco).
- When interest (riba) would normally be charged for financial products such as loans, other structures are used.
Many different financing structures have been developed to help ensure Sharia compliance, and they get used for various needs. Here are descriptions of a few basic structures. Note that some structures are routinely combined to add flexibility and that the following list is not exhaustive.
Musharaka is one of the oldest forms of Islamic finance. Under this arrangement, a bank and a customer become joint owners in a new project. One classic example of how this can work is with a mortgage. The bank gradually transfers ownership of the real estate to the other party in exchange for a pre-agreed set of payments.
Bank deposits are usually under a mudaraba structure, although it can be used for other ventures. One party, in this case, the depositor/investor, provides the capital to the other who has technical abilities. In exchange for the cash, the depositor/investor gets a share of the profits.
A wakala is a structure that utilizes the idea of principal and agent theory. The principal provides the capital, and the agent gets hired to provide expertise and labor. Under a wakala, the capital provider receives the profits from the venture, less an agreed-upon fee that goes to pay the agent. Bank deposits can also be structured as a wakala.
Murabaha is a common form of financing in the Islamic world. It involves the sale of an asset, such as a machine, via a middleman. The buyer agrees with the middleman to make a stream of deferred payments, which include an agreed markup. Murabaha appears similar to buying a car on credit from a finance company.
Conventional insurance isn’t allowed in Islamic finance because it doesn’t have mutually shared risks, according to scholars. Instead, a takaful structure is used. It involves participants making contributions to a fund, which is then managed by a takaful operator who pays out the claims and manages the assets.
Unlike with conventional insurance, the risks of a takaful structure are shared between all participants (not just the insurance company). Also, the participants own the assets and have responsibility for the liabilities collectively. The takaful participants, not the insurance company, own the profits.
Leases, whether operating or financial, are conducted using an ijara structure. The asset sold, such as an aircraft, will be sold by the manufacturer and then leased by the finance company to the lessee.
Sukuk is a form of a Sharia-compliant bond or fixed-income security. These equal-value shares, which have a life of up to 15 years, typically, can be traded. They are not technically bonds but rather represent an interest in the ownership of the company’s underlying assets.
Salam and Parallel Salam
Salam originated as a way for farmers to finance their crops. These contracts involve lenders extending credit in exchange for being allowed to buy the produce at a stipulated discount in the future.
Unlike the traditional futures markets, the salam contract cannot be sold or assigned. That makes it hard for either the bank or the farmer to hedge against the risk of price movements. To get around that problem, the parties enter into parallel salam contracts with banks. These parallel contracts involve the bank selling the commodities at a premium price.
Boards of Directors in Sharia-compliant Companies
A board of directors can be held responsible for negligence or malfeasance by the management of a company, not just their actions. One challenge for all Sharia-compliant boards is the lack of Islamic scholars who also have financial market savvy.