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ETHICAS HANDBOOK OF ISLAMIC FINANCE

2013 EDITION

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2013 Published by Ethica Institute of Islamic Finance 1401, Boulevard Plaza, Tower 1 Emaar Boulevard, Downtown Dubai P O Box 127150, Dubai, United Arab Emirates www.EthicaInstitute.com info@EthicaInstitute.com All rights reserved. Aside from fair use, meaning a few pages or less for nonprot educational purposes, review or academic citation, no part of this publication may be reproduced without the prior permission of the Copyright owner. Disclaimer: Content in this e-book and available at www.EthicaInstitute.com is provided for education and informational purposes only, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or tness for any particular purpose. The information contained in or provided from or through all of Ethicas content is general in nature and not specic to you or anyone else and is not intended to be and does not constitute nancial, legal, investment, trading or any other advice. You understand that you are using any and all information available on or through this and other Ethica content at your own risk. If you are the owner of publishable content that you would like included in the next edition of Ethicas Handbook of Islamic Finance, please contact us at contact@ethicainstitute.com. Cover photo: Copyright Sohail Nakhooda

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Ethicas Handbook of Islamic Finance is a free book designed for you. Everyone is welcome to copy, forward, store, or share all or part of this book for non-commercial use. We only ask that the words be left as they are and that the source be attributed and acknowledged with a link to our website (www.EthicaInstitute.com). This version is only a preview. You may download the full 700 page original e-book from: http://bit.ly/EthicaEbook. Click here to receive regular updates and the 2014 edition of Ethicas Handbook of Islamic Finance.

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Corruption has appeared in the land and sea, for that men's own hands have earned, that He may let them taste some part of that which they have done, that haply they may return.
Quran (30:41)

"All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors' interest rates. If you ask me what is the worst thing in the world, I will say it is compound interest."
President Obasanjo of Nigeria, G8 summit, Okinawa, 2000

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TABLE OF CONTENTS
We Believe... Speech Use this speech or the accompanying video at your conference, training session, bank or university. Petitions Use these sample petitions to bring standardized Islamic nance into your community. Articles Use these articles to inform yourself and others about the basics of Islamic nance. Meezan Bank's Guide to Islamic Banking by Dr. Imran Usmani Use this section for a more detailed understanding of the industrys core products from one of its leading scholars. Islamic Finance Contracts Use these sample contracts to educate yourself and your bank about Islamic nance instruments. CIFE Study Notes Use these study notes to help you prepare for Ethicas Certied Islamic Finance Executive (CIFE) program. Recommended Reading for Practitioners Use this reading list to help develop your worldview on nance. Recommended Reading for Entrepreneurs Use this reading list to help you jump start your Islamic nance idea. Islamic Finance Questions and Answers Use this database of 1,000+ scholar-approved answers to guide your commercial dealings. Glossary of Commonly Used Terminology Use this section to understand the industrys most commonly used terminology. About Ethica Institute of Islamic Finance About the Certied Islamic Finance Executive (CIFE) Press Releases Subject Index Use this detailed index to quickly search the entire e-book. Contact Ethica 6 8

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WE BELIEVE...
We believe that interest is the root cause of most of the worlds problems. If we did not have compound interest, we would not need compound growth. And if we did not need compound growth, we would not have most of the debt-induced poverty, resource-hungry wars, and runaway climate change we now see. All interest whether simple interest or compound interest, whether at very low rates or very high rates grows so fast that we simply cannot keep up. Need an example? Brazil is home to the beautiful Amazon rainforest. This lush wonder supplies us with a quarter of the worlds oxygen. Thats one in every four breaths. Unfortunately, this forest will vanish in our lifetimes. Why? So Brazil can pay off $200 billion of debt. How? With lumber. Or take an example closer to home. Are you or someone you know crushed under growing personal debt? We believe there is a connection between interest and many of the worlds problems. And we believe that Islamic nance can help solve some of these problems. But for this to happen we need two things: the letter of the law and the spirit of the law. For the letter of the law to work, Islamic nance needs to follow some basic minimum standards. Standards that wont be taken seriously unless central banks start pulling some licenses. The best standard in the industry de facto in over 90% of the worlds Islamic nance jurisdictions is AAOIFI (pronounced a-yo-fee), which stands for the Accounting and Auditing Organization for Islamic Financial Institutions. AAOIFI brings together scholars from all over the world who agree on Shariah standards. If it isnt AAOIFI-compliant, it probably isnt Shariah-compliant. We believe that following AAOIFI Shariah Standards and questioning whether your bank, scholar, or trainer is following them is a good starting point for following the letter of the law. But we cant stop there. Islamic nance needs to follow the spirit of the law as well. We need to promote equity-based structures like Musharakah and Mudarabah and reduce our dependence on expedient structures like Murabaha. We need to eliminate Tawarruq. And at a broader level, we need to address the larger problem of fractional debt-reserve banking. Why do banks get to lend money they dont have? And make money on money that doesnt exist? Does this make sense? While the reality is that banks arent going away anytime soon, a rst step to challenging fractional debt-reserve banking is establishing a globally recognized gold-based currency. This immediately forces the market to tie transactions to assets rather than base them on mere numbers inside computers. So where do we start with promoting the law in letter and spirit? We believe it starts with you and me.
Manifesto

www.EthicaInstitute.com If youre a banker, you can start doing two things at your bank: 1) check that your banks products comply with AAOIFI. The latest standards are available at www.aaoi.com; and 2) start switching to Musharakah and Mudarabah for a variety of activities ranging from liquidity management to trade nance. And if your bank doesnt offer Islamic nance, start asking why. If youre a regulator and Islamic nance is already practiced in your jurisdiction, pressure banks to follow AAOIFI or risk having their licenses suspended. At a broader level, support the Islamic micronance industry. If Islamic nance hasnt yet reached your jurisdiction, promote awareness with training and educational initiatives. If youre an entrepreneur, you probably have a skill the Islamic nance industry could use. Dream big: create a company, a community-based institution, a local currency, an ecologically-minded village, or an innovative product. In most countries, people still lack interest-free alternatives to home, education, and healthcare nancing. Why is it easier to issue a billion dollar Sukuk than it is to raise a single penny for a Shariah-compliant education nancing? How can we better operationalize Zakah? How do we build Waqf-based community-owned trust models? The recommended reading list for entrepreneurs later in this book gets you started with your idea. And if youre a student, learn Islamic nance. Think beyond the standard career path and seriously consider starting something on your own. Do what you love and success will follow. We believe this century indeed, the coming years will be like nothing before. Global heating will mean less food and water. Peak oil will mean less energy. And repeated nancial crises will mean less certainty. We can throw our hands up and walk away in resignation. Or we can identify the root problems and do something about it. God only makes us responsible for our actions. He takes care of outcomes. We believe that its time to openly question the interest-based paradigm and promote interest-free nance as the proven alternative. But the rst step to questioning a paradigm and offering an alternative is to educate yourself. Only then will you believe. And thats what this book is all about: conviction. Because if you believe, then so will everyone else.

Manifesto

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SPEECH

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SPEECH: WHY ISLAMIC FINANCE?

You are free to read all or part of this speech or play the video at conferences, training sessions, banks and universities. What do President Obasanjo of Nigeria, Nick the UK homebuyer, and Faisal the American college student all have in common? Theyre all trying to pay off loans that seem to increase every single day. What started off with a seemingly small interest rate ballooned into something completely unattainable. Well look at each of their examples a little later. First, lets answer the big question on everyones mind: How is Islamic nance different from conventional nance? It looks the same. The result is often the same. Whats the difference?

PLAY NOW

Well, the best way to nd out is with a simple, real-world comparison. Lets take $10,000, for instance. And let's compare what a conventional bank can do with this $10,000 and what an Islamic bank can do. First, the conventional bank. The conventional bank nds a credit worthy customer and lends at 5% interest. The bank is not particularly concerned about what happens to this money other than that it gets repaid. The customer, on the other hand, has already found a borrower willing to pay 7%. This borrower runs a small credit co-op for students and lends at 10%. One of these students is enterprising enough to lend to his unemployed brother at 15%. Who has just discovered the power of compounding interest and now lends to street vendors at 25%. We could go on. But you get the idea. As we speak, there are poor people paying upwards of 40%...per month! Now obviously we cant blame conventional banks for everything that happens after theyve made the initial loan. But we can blame the power of compounded interest. Interest, and the fact that you dont need actual cash to lend money means that the original $10,000 could keep passing hands until we pump out over $100,000 of articial wealth. Articial is right. How much actual cash is there? Only $10,000. With interest, we managed to turn $10,000 into much more.

Speech: Why Islamic Finance?

www.EthicaInstitute.com Now what happens if the street vendors go out of business? Or the unemployed brother doesnt nd his job? Or the credit co-op goes bankrupt? Thats right. Loans dont get repaid. And if enough people cant repay their loans, lenders get into all sorts of trouble. This vicious cycle sets off a domino effect of defaults. And imagine that instead of a $10,000 personal loan, its a million dollar business loan, or a billion dollar World Bank loan. Compounding interest grows so fast that borrowers are often unable to repay. People, economies, and the environment pay the price as we grow more desperate to meet rising debts. So are we surprised when billions of dollars vanish into thin air? Lets take the example of the Islamic bank. With this $10,000 the Islamic bank only invests in actual assets and services. It might buy machinery, lease out a car, or invest in a small business. But, throughout, the transaction is always tied to a real asset or service. And this is the central point: we cant simply compound assets and services like we can compound interest-based loans. An asset or service can only have one buyer and one seller at any given time. Interest, on the other hand, allows cash to circulate and grow into enormous sums. Thats the difference between Islamic nance and conventional nance: the difference between buying and selling something real and borrowing and lending something eeting. In recent years weve witnessed the most dramatic global nancial downturn seen in decades. What began as a housing bubble soon became a sub-prime credit crisis. And what many thought would remain a credit crisis soon spread into a global nancial meltdown. It devastated every corner of the world. And while these events affected most of us negatively, there was one silver lining: people nally gave a serious look at alternative forms of nance. And many people stopped believing that interest could solve all problems. Understanding what caused these events serves as our starting point for understanding Islamic nance, and how it differs from conventional nance. What conventional nance enables is the ability to sell money when there is no money. To sell assets before there are any underlying assets. And to allow debts to grow unchecked while borrowers become more desperate. Interest creates an articial money supply that isnt backed by real assets. The result? Increased ination, heightened volatility, richer rich, and poorer poor. Lets look at 3 practical examples that show just how Islamic nance is different from, and better than, conventional nance. And while Islamic nance parts ways with conventional nance on more than just being interest-free, well focus on interest in this talk.

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www.EthicaInstitute.com Well look at 3 people in 3 very different, real-world situations: the rst is the leader of a developing country: President Obasanjo of Nigeria; the second is Nick, a homebuyer in the UK, and the third is Faisal, an American college student. Debt-Laden Country: Nigeria We begin by quoting President Obasanjo who said these words after the G8 summit in Okinawa in 2000: "All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors' interest rates. If you ask me what is the worst thing in the world, I will say it is compound interest." It seems unbelievable but, sadly, its typical. Developing countries start off with relatively small loans and remain saddled with huge amounts of growing debt for generations. And remember, this could be Nigeria, or any other poor country. To give just one other example, during the years leading up to the 1997 Asian collapse, Indonesias foreign debt as a percentage of GDP was over 60%. So Nigeria is certainly not an isolated example. There are countless more. How did borrowing just $5 billion end up in having to pay $44 billion in total? Let's open up a spreadsheet and nd out. For the sake of simplicity well just grow $5 billion into $44 billion between 1985 and 2000 and see what interest rate we get. It must've been a very high interest rate to get to $44 billion in such a short period of time. So lets start off with 40% per annum. No that's not right. Table 1: $5 billion growing at 40%
Year 1985 1986 1987 1997 1998 1999 2000 Debt 5,000,000,000 7,000,000,000 9,800,000,000 283,469,561,876 396,857,386,627 555,600,341,278 777,840,477,789

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www.EthicaInstitute.com Let's try 30%. That still gives us a very high number. Table 2: $5 billion growing at 30%
Year 1985 1986 1987 1988 1997 1998 1999 2000 Debt 5,000,000,000 6,500,000,000 8,450,000,000 10,985,000,000 116,490,425,612 151,437,553,296 196,868,819,285 255,929,465,070

It turns out that to grow $5 billion into $44 billion takes an interest rate of only 15.6%. Now on the face of it around 15% doesn't sound exorbitant. It doesn't seem unfair, and technically it isn't even illegal according to international law. In fact, we personally know of banks that charge high-risk credits upwards of 30% interest rates. But every day numerous countries nd themselves in the same predicament as Nigeria. UNICEF estimates that over half a million children under the age of ve die each year around the world as a result of the debt crisis. But as weve seen, its not the debt thats the problem. Its the compounding interest. Now how would Islamic nance handle things differently? Using the $5 billion example, Islamic banks could provide $5 billion of nancing for infrastructure, literacy, healthcare, or sanitation programs, to name a few. An Islamic bank could have arranged for the $4 billion construction of a natural gas pipeline and delivered it to Nigeria for $5 billion using an Istisna. Or taken an equity stake in a highway project and shared in prots and losses using Musharakah or Mudarabah. Or purchased commodities and sold them at a premium using a Murabaha. Or structured a project nancing using an Ijarah Sukuk.

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www.EthicaInstitute.com These names may sound new to you, but as we explain them in our training modules, theyre much like conventional equity, trade, and lease-based instruments already familiar to most bankers. Islamic nance, after all, permits legitimate prot. Were not asking that everything be changed. Just the harmful parts, and eliminating interest would be the rst step. In all of these cases the bank could not have charged more than the initial nancing premium. So if the Islamic bank was owed $5 billion, that could never turn into $44 billion or even $6 billion. The debt would have to be xed. Throughout our training modules well show you how these and other Islamic nance products operate. Let's take another example of how Islamic nance is different from conventional nance. This time let's make it a little bit more relevant to our day-to-day lives.

Nick The Homebuyer Nick has lost his job, his house, and all the money he had spent paying off his mortgage. The property bubble that triggered the global nancial meltdown could not have happened if the properties had been nanced Islamically. Why? Because a conventional bank merely lends out cash. Legally, it can keep lending this cash over and over. Well above its actual cash reserves. An Islamic bank, on the other hand, has to take direct ownership of an actual asset. Whether for a longer period in a lease or partnership, or a shorter period in a sale or trade, Islamic nance always limits the institution to an actual asset. The next time anyone wonders whether Islamic banking is just dressed up conventional banking, ask them to show you a single major consumer bank that co-owns actual properties with their customers. Of course, theres no excuse for Islamic banks that are Islamic in name only. But if the transaction complies with internationally recognized standards like AAOIFI, for instance, then theres no reason for it to have the many side effects associated with interest-based banking. To provide just one example of how Islamic banks get directly involved in asset purchases, lets look at how a Diminishing Musharakah works. The word Musharakah refers to a partnership in Islamic nance.

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www.EthicaInstitute.com And its called a Diminishing Musharakah because the banks equity keeps decreasing throughout the tenure of the nancing, while the clients ownership keeps increasing through a series of equity purchases. Eventually, the client becomes the sole owner. If Nick had lost his job with a Diminishing Musharakah, at the very least he would still have an equity stake in an actual property that he could monetize. Pay close attention to this example because this is something you may want to suggest to your own local bank. Theres no reason why they cant do it. Weve kept all the numbers and calculations very simple and straightforward for illustration purposes. Lets take a $220,000 house. And lets say the customer puts down $20,000 and nances the remaining $200,000 from the Islamic bank. Lets also say that the nancing lasts 20 years and the bank sets a 5% prot rate. For the sake of simplicity, well make it 20 annual repayments. In the rst column (see Table 3) we have the year. In the second column we have the homebuyers equity purchase, which is how much the buyer pays every year for buying the propertys actual equity. Its his way of increasing his ownership in the property, while diminishing the banks ownership, shown in the third column. The fourth column, called Rent, is what the homebuyer pays the bank for that portion of the property he doesnt yet own, a number that keeps decreasing as the banks share also decreases. The nal column shows what the homebuyer pays in total every year. Lets explain to you how we got these numbers, and how simple it is for most banks to put this together with just the will to take real ownership of an asset. Lets go through each column one by one. The homebuyers equity purchase of $10,000 is a simple straight line calculation of the $200,000, divided by the number of years for the nancing, 20 years. We subtract this $10,000 each year from the banks total balance, to get the next column, the banks ownership, which, as we see, keeps going down each year until the bank owns none of the property. Table 3: Nicks Diminishing Musharakah
Homebuyer's Equity Purchase ($) 10,000 10,000 10,000 10,000 -

Year 1 2 3 4 5

Bank's Ownership ($) 190,000 180,000 170,000 160,000 -

Rent ($) 10,000 9,500 9,000 8,500 -

Homebuyer's Payment ($) 20,000 19,500 19,000 18,500 -

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Year 6 7 16 17 18 19 20

Homebuyer's Equity Purchase ($) 10,000 10,000 10,000 10,000 10,000

Bank's Ownership ($) 40,000 30,000 20,000 10,000 -

Rent ($) 2,500 2,000 1,500 1,000 500

Homebuyer's Payment ($) 12,500 12,000 11,500 11,000 10,500

Next, we calculate the homebuyers rent. This is equal to the banks ownership for that period multiplied by the banks prot rate. This number also keeps declining each year, because as the banks ownership declines, so does the homebuyers rent. Lastly, we calculate the homebuyers total annual payment. This is simply the homebuyers equity purchase plus his rent. This number also keeps declining each year until the homebuyer eventually becomes the homeowner. At no time does the homebuyer pay any interest. And, certainly, at no time does any payment compound. The homebuyer just pays for two things: the house, in small payments, little by little. And the rent, for the portion of the house he doesnt yet own. This simple structure is something that just about any conventional bank can offer today. It takes a leap of faith for banks accustomed to interest-based lending to suddenly become direct stakeholders in property. But as the growth of Islamic banking shows, these concerns are misplaced. Call it Islamic nance, ethical nance, or conventional nance, when a bank takes real ownership of an asset, economies dont fall apart like a house of cards.

Faisal The Student Now our nal example. Talking about indebted countries and property bubbles may seem removed from our immediate predicament. What are we talking about? Thats right: personal debt. In the US alone, credit card holders have amassed over $1 trillion of personal debt. And thats just credit cards. Let's take Faisals student loan for example.

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www.EthicaInstitute.com His education cost him about $30,000 a year for four years. That's $120,000. And Faisal had no savings to start off with. He got an interest rate of 10%, which is fairly typical for many students, and he began borrowing $30,000 at the beginning of each year. Three years after graduation he began paying off his student loans at the rate of $20,000 per year. Can you guess how long it took Faisal to pay off his entire loan? Thats right. Itll take him over 25 years to pay off his loan. And in the end he spends over $400,000 to pay for his $120,000 education. And thats assuming Faisal keeps his well-paying job. If hes unemployed, the debt just gets bigger. An Islamic bank, on the other hand, could structure a service-based Ijarah to lease out the universitys credit hours. Faisal ends up paying about 20% or 30% more; but with the interest-based loan, he pays about 400% more. Islamic nance never can, and never will be able to grow Faisals debt once its xed. Principles of Islamic Finance Lets now step back for a moment and ask: so how does Islamic nance make any money? Lets take a moment to compare banking in general with Islamic nance. All banking products can largely be divided into the following 4 categories: 1. 2. 3. 4. Equity Trading Leasing, and Debt

Equity refers to direct ownership, trading refers to buying and selling, leasing refers to giving an asset or service out on rent, and debt refers to providing an interest-based loan. Simply put, Islamic nance permits equity, trade, and lease-based transactions, but forbids debt. And in many ways were already familiar with these kinds of transactions. Heres most of Islamic nance in a nutshell: Mudarabah, Musharakah, and Sukuk are all equity based

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www.EthicaInstitute.com Murabaha, Salam, and Istisna are trade based And Ijarahs are lease based

Lets look at some of the basic principles that guide Islamic banks. These are that transactions must: 1. Be interest free 2. Have risk sharing and asset and service backing 3. Have contractual certainty 4. And that all the elements of the transaction must, in and of themselves, be ethical Lets look at each of these 4 guiding principles. First, the transaction must be free of interest. The Islamic ban on interest is not new. For centuries banned by Christians and Jews, the Shariah, or Islamic Law, prohibits paying or earning interest, irrespective of whether it is a soft, development loan or a monthly consumption loan. In fact the Vatican itself has said, The ethical principles on which Islamic nance is based may bring banks closer to their clients and to the true spirit which should mark every nancial service. The examples weve seen clearly show the harms of interest, not only to banks and governments but also to individuals. Islam is concerned with the well-being of society, sometimes at the immediate expense of the individual. A single interest-based loan may seem harmless, but an entire economy based on interest can have devastating consequences. The second principle that governs Islamic nance transactions is the element of risk sharing and asset and service backing. The central juristic principle in the Shariah that informs our concept of risk-sharing states: al ghunm bil ghurm, meaning there is no return without risk. Bankers know that the concept of risk sharing is common to all equity-based transactions. Islamic nance is no different, where prot and loss distribution is commensurate with investment proportions. Lending cash on interest is not the kind of risk sharing were talking about. In a conventional loan the bank doesnt directly involve itself in how the cash is spent. Heres the cash. See you in a few months with some extra cash. Thats all. Even with a secured loan, in which the bank takes security and gets more involved, there is still no direct equity position. The bank still doesnt own anything. An Islamic bank, on the other hand, actually takes a direct equity position, or buys a particular asset
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www.EthicaInstitute.com and charges a premium through a trade or a lease. It uses risk mitigants, but not without rst taking ownership risk. There must also be contractual certainty. Contracts play a central role in Islam. And the uncertainty of whether a contractual condition will be fullled or not is unacceptable in the Shariah. Contractual uncertainty happens when the basic prerequisite or integral of a contract is absent, such as the existence of the subject matter, the xing of a delivery date, or the agreement on a price. Conventional insurance, interest, futures and options all contain an element of contractual uncertainty and are thus prohibited. And lastly, Islamic nance transactions must be ethical, which means that there is no buying, selling, or trading in anything that is, in and of itself, impermissible according to the Shariah. Examples include dealing in conventional banking and insurance, alcohol, and tobacco. With these basic principles in mind, we invite you to try our introductory training modules before progressing onto more advanced topics. At Ethica Institute you learn at your own pace. Play, pause, stop. Anytime, anywhere. We blend live online training sessions and webinars with convenient e-learning modules, case studies, quizzes, and the worlds largest database of Q&As available online. We bridge the gap between scholars and bankers by mixing theory with practical examples; by complementing authentic Shariah knowledge with real-world banking expertise. And we ensure that everything you learn complies with the Accounting and Auditing Organization of Islamic Financial Institutions, or AAOIFIs, latest Shariah Standards. And best of all, we provide you with the only Islamic nance certicate available 100% online. We look forward to you joining the Islamic nance community. We look forward to seeing you at EthicaInstitute.com.

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CONTACT ETHICA
Ethica Institute of Islamic Finance Level 14, Boulevard Plaza - Tower One Emaar Boulevard, Downtown Dubai PO Box 127150, Dubai, UAE

Emails are responded to within the same working day, usually in a few hours. New inquiries about Ethica's training and certication: contact@ethicainstitute.com Technical help: support@ethicainstitute.com Islamic nance questions: questions@ethicainstitute.com We take calls Sunday to Thursday from 9am to 5pm Dubai time: +9714 455 8690 Fax? If you insist: +9714 455 8556

This version is only a preview. You may download the full 700 page original e-book from: http://bit.ly/EthicaEbook. Click here to receive regular updates and the 2014 edition of Ethicas Handbook of Islamic Finance.

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