Tuesday, May 17, 2011

Basic Principles of Islamic Finance

By Suffiullah

Introduction:Basic Principles are derived from basic core principles that prohibit the charging of interest; but require the sharing of profit and loss as business partners; and forbid uncertainty or excessive risk, the following are the most common shari’ah compliant contractual instruments in Islamic financing. These are the seven basic principles of Islamic finance as following:

• Mudaraba (Partnership Financing)
• Musharaka (Equity Financing)
• Murabaha (Cost-plus Financing)
• Ijara (Lease Financing)
• Istisna’a (Commissioned Manufacture)
• Quard-Hasan (Interest-free Loan)
• Sukuk (Corporate Bound)

1. Partnership Financing (Mudaraba): A form of partnership, Mudaraba involes a financier who provides the capital required for a project and a borrower who assumes the responsibility for investing it. Adaptable to syndicated transactions.

2. Equity Financing (Musharaka): Similar to Mudaraba, except that the borrower parts of the equity. Profits are shared on a preagreed ratio, but losses are shared in exact proportion to capital invested.

3. Cost-plus Financing (Murabaha): Under this widely employed contract, an Islamic bank, at a client’s request, finances the purchase of and takes title to equipment or goods from a third-party supplier and then results the asset to its client at a pre-agreed mark-up profit. The mark-up covers the bank’s services, substituting for conventional interest.

4. Lease Financing (Ijara): Resembling a conventional lease, ijara covers the leasing, or rental, of machinery, equipment, buildings or other assets. The bank or special purpose entity, as lessor, buys and leases out an asset by its client, as lessee, for a rental fee, with an option to purchase at the end of the lease term.

5. Commissioned Manufacture (Istisna’a): A variant on murabaha, this contract covers the advance funding of major industrial projects or large assets such as ships or airplanes.

6. Interest-free Loan (Quard-Hasan): Essentially an interest-free loan to corporate customers in financial distress or a welfare loan to individual client experiencing financial hardship.

7. Corporate Bound (Sukuk): Sukuk is the Arabic name for financial certificate. Among the 14 available sukuk products, the most popular is the sukuk al ijara, based on Islamic leasing and resulting in a tradable certificate with constant returns based on rent instead of interest.

Mainly Islamic financing two categories:

• Islamic Banking
• Islamic Financial Institutes

Definition of Islamic Banking System: Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic law prohibits usury (Riba), the collection and payment of interest, also commonly called riba in Islamic discourse. Generally, Islamic law also prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered haram (such as businesses that sell alcohol or pork, or businesses that produce un-Islamic media). In the late 20th century, a number of Islamic banks were created, to cater to this particular Banking market.

History of modern Islamic banking: The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was outrage to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in the country.

Islamic Financial Institutes: It is taking about so many things such as Islamic Insurance, Mortgage, Loan and so on & so on. But I am taking about only Takaful. Takaful is the Arabic name and it mean Islamic Insurance.

Takaful (Islamic Insurance): Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. The concept of takaful is not a new concept; in fact, it had been practiced by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1,400 years ago. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers.

From Qur`an: And that which you put aside in interest (Riba, as your own to be spent) to grow by using the property of (other) people, (that) will have no increase with Allah: But that which you give for charity, in search of Allah’s Holy Face, that will grow: There (are the people) who will get a reward many times larger. (Sura Ar-Rum: 30:39)

Islamic laws on trading: The Qur'an prohibits gambling (games of chance involving money). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk").

Method of Concepts in Islamic Banking System:

• Sale and Buy Back Agreement (Bai' al-Inah)
• Deferred Payment Sale (Bai' Bithaman Ajil)
• Credit Sale (Bai muajjal)
• Contract in which advance payment (Bai salam)
• Necessary for the validity (Basic Features & Conditions of Salam)

• Gift (Hibah)
• Lease Financing (Ijarah)
• Hire Purchase (Ijarah Thumma Al Bai')
• (Ijarah-Wal-Iqtina)
• Commissioned Manufacture (Istisna'a)
• Profit Loss Sharing (Mudarabah)
• Cost Plus (Murabahah)
• General and regular kind of sale (Musawamah)
• Joint Venture (Musharakah)
• Benevolent Loan (Qardul Hassan)
• Islamic Bonds (Sukuk)
• Islamic Insurance (Takaful)
• Safekeeping (Wadiah)
• Agency (Wakalah)
• Islamic Equity Funds (Musharaka)

Board of Shariah: Islamic banks and finance institution that offer Islamic products or goods and services are required to establish Shariah advisory committees/consultants to advise them and to ensure that the operations and activities of the Islamic bank and finance institution comply with Shariah principles. What does mean of Shariah? It means of Islamic law. Shariah is the only Islamic lawful. Also Shariah Board works with Islamic Economics. Authority makes any decision by Shariah Board. Otherwise it has to be unlawful.

Conclusion: Islamic banking has the same purpose as conventional banking except that it claims to operate in accordance with the rules of Shariah (Islamic law), known as Fiqh al-Muamalat (Islamic rules on transactions). The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba´ (interest). Amongst the common Islamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijarah).

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