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The Islamic financial services industry has experienced phenomenal growth over the past three decades. From a highly specialised niche market, Islamic finance has crystallised into a multi-billion dollar global industry, working alongside – and often in conjunction with – its larger, non-Islamic counterpart. With that track record, plus territorial coverage of over 75 countries, such success begs the most simple of questions: what exactly is Islamic finance?
In its broadest sense, Islamic finance is a philosophy or paradigm established to pursue the wider objectives of Sharia – the establishment of justice for all mankind – in the arena of business and commerce. Essentially, it is a financial model based upon the core beliefs of Islam. These beliefs encompass all aspects of a Muslim’s life, outlining the relationship between God and human beings. The financial arena is no exception. Islamic law, or Sharia – as derived from the Quran and Sunnah (the sayings and practices of the Prophet Muhammad) – governs all economic and social activities of Muslims.
While some of these underlying principles and rules are based on clear and explicit rulings, others are derived from Sharia scholars’ interpretations and understanding of the law, known as Fiqh. Some of these principles are set out below:
Sharing (profit, loss and risk)
The Islamic economic model is based on a risk and profit-sharing philosophy. In this respect, transactions are similar to, if not the same as, equity-based transactions in rewarding performance. As profit cannot be assured, an Islamic financial institution must assume at least part of the risk of a given transaction. There can be no guarantee of a fixed return. Equally, depositors with Islamic institutions may not invest on the basis of a guaranteed return. Taking security is however permissible in order to guard against negligence, willful wrongdoing or breach of contract by parties to the contract.
No unfair gain
The charging of interest, or riba (its Arabic term), is strictly outlawed. Any return on money employed must be linked to the profits of an enterprise. The concept of riba extends beyond that of ‘interest’ to include the idea of exploitation or unfair gain.
Under Sharia, transactions relying on chance or speculation (maisir), rather than on the effort of the parties to produce a return, are unlawful. Sharia does not, however, prohibit ordinary commercial speculation or risk-taking. Transactions involving swaps and options, for example would need to be considered carefully to check whether the commercial substance of the transaction complies with this principle.
The Islamic Law of Contracts plays a pivotal role within the Islamic financial system. The existence of uncertainty (gharar) in a contract is prohibited as it requires the occurrence of an event that may not occur. The Islamic economic model emphasises fairness. Any type of transaction where the subject matter, the price or both are not determined and fixed in advance is viewed with suspicion under Sharia.
No investments that are not in the public interest
Investments must be Sharia-compliant in essence. Certain products deemed harmful to humanity are prohibited; these include armaments, alcohol, tobacco, pornography and gambling. Institutions will usually work from a blacklist of prohibited investments developed with their Sharia board. Since public interest (maslaha) is a key jurisprudential Sharia principle, there is every reason for institutions to develop a ‘white list’ of positives – such as environmentally friendly projects – viewed with high Sharia merit.
No hoarding of money
Trade and enterprise, which can generate real wealth for the benefit of the community, is encouraged between partners sharing profits and losses. The contrasting practice of hoarding money is strongly condemned by Sharia; money is merely a means of exchange and should not be treated as a commodity to be accumulated.
With rare exception, the underlying model of conventional finance is ‘caveat emptor’ (let the buyer beware). By contrast, the Islamic model prescribes ethical conduct at all times. As such, an Islamic bank should not ‘lend’ money to customers if such ‘borrowing’ is not in their best interests. This would, for example, apply to the provision of Sharia-compliant housing finance to sub-prime borrowers who could not afford the cost once any low-cost introductory period had elapsed.
ISLAMIC FINANCE AND GLOBALISATION
Reaching beyond the Muslim market, it’s worth noting the interest that the industry has received from non-Muslims. In Malaysia, for example, a growing number of Sharia-compliant retail products are being taken up by non-Muslim customers, particularly if the products are priced competitively. Ethical investors are also attracted to the emphasis on justice and on the promotion of publicly beneficial activity and services, such as environmentally-friendly projects.
The industry is currently valued at around US$500bn globally, and with over 300 Sharia-compliant financial institutions in operation around the world, conservative estimates place the annual growth rate at 10%-15%. Compared with the size of global banking, the current success of Islamic banking is humble – but at its current rate of progress, the industry is easily expected to reach a valuation of US$1 trillion in the next decade.
Not bad, for a ‘niche area’!
Cherine Hamid is a freelance writer specialising in Islamic-finance matters and former transaction manager at Norton Rose
GUIDANCE FOR A GLOBAL CENTRE
UK legislation for Islamic finance
With the UK fast emerging as a global ‘hub’ for Islamic finance, it is well placed to share in the sector’s sizeable valuation. Evidence of the UK’s growing role in Islamic finance is demonstrated by the country’s number-eight placement in a recent ranking of Sharia-compliant assets by country – dwarfing some Muslim-majority countries. Assisting this growth are several pieces of UK legislation, which have addressed numerous Islamic-finance products. These are:
Finance Act 2003
Removes the levy of stamp duty land tax (SDLT) for murabaha and ijara-based home financings
Finance Act 2005
Clarifies tax treatment of payments made under murabaha and mudaraba contracts. Removes the levy of SDLT for diminishing-musharakah-based home financings
Finance Act 2006
Clarifies tax treatment of payments made under diminishing-musharakah-based real-estate transactions to all entities including companies
FSMA 2000 (Regulated Activities) Order 2006
Diminishing-musharakah and ijara-based home financings now regulated by the FSA
Finance Act 2007
Clarifies tax treatment for sukuk
Finance Act 2009
Further clarification of tax treatment for sukuk. Introduced relieving measures for SDLT, capital gains and capital allowances rules for land transactions involved in connection with the issuance of sukuk