Introduction

Islamic financing has been a viable alternative to western

banking since the early 1970s and complies with the major
concepts of Shari law, namely that:
interest (usury) should not be charged or collected;
no form of gambling be undertaken; and
no investment should be made in a business
which is deemed to be unlawful under Shari law.

Islamic finance involves structuring

financial instruments and financial
transactions to satisfy traditional Muslim
strictures against the payment of interest
and against engaging in gambling. It is a
field of growing importance for
conservative Muslims, especially in the
Middle East, who are uncomfortable with

Western-style bonds and banking that

involve explicit payments of interest.

Basic concepts
The essential basic concepts of Islamic financing are:
I.

Debt financing

Ijarah Leasing
Ijarah structure entails the lender creating a special
purpose vehicle (SPV) to purchase asset(s) that is the
subject of the financing. In turn, borrower agrees to enter
into a lease agreement to lease the asset(s). Lease
payments act as part rental payments (the profit
component) for use of asset and part repayment of
principal debt.

: Ordinarily transaction will take on the following

elements

(i) borrower and lender enter into a purchase contract to

buy asset that is the subject of the financing;
(ii) borrower and lender enter into a lease contract under
the terms of which borrower agrees to lease asset that is
the subject of the financing;
(iii) on completion of the lease term, borrow can either
make a balloon payment to purchase asset or, alternative,
if the rental has included part principal payments, can pay
a small sum to the lender in exchange for ownership of
asset.
This type of Islamic financing structure is very similar to
hire purchase contracts. As such, assets that are
commonly the subject of this type of Islamic financing
include motor cars, home appliance, electronic goods, etc.
Murabaha - Cost-plus financing / buy-sell arrangement
Essentially works by borrower asking lender to purchase
asset on the understanding that after lender has
purchased asset, borrower will purchase asset from
lender.
Agreement is made that lender on-sells asset to borrower
at an increased price.
Repayment can either be in one balloon payment or by
way of installments over a period of time. If repayment is
a balloon payment, more commonly known as a Bai
Bithaman Ajil or deferred payment sale agreement.

Popular structure for purchasing real estate property. It

should be noted, however, that as lender on-sells property
to borrower, all land title deeds, etc. vest with the
borrower. Thus, security provisions of such an
arrangement need to be considered carefully so that the
lender can adequately protect themselves.
Components of this type of Islamic financing include:
(i)

on-sell arrangement;

(ii)

agreed mark-up on on-sell price;

(iii)

asset must be Shari compliant;

(iv)
asset must exist at the time of the
transaction; thus, this cannot be utilized in futures trading
transactions;
(v)
all terms and conditions of the arrangement
must be known by all parties at the time of entering into
the arrangement;
(vi)
reoccurring expenses cannot be passed on
to the borrower.

Bai al-Inah Sale and buy-back

Similar concept to Murabaha. However, due to security
concerns on default, structure is changed slightly. Lender
purchases asset on behalf of borrower. Borrower

purchases asset from lender on deferred payment basis.

Asset is immediately resold to lender for cash at discount.
Preferred financing mechanism if there is any danger that
lender will become insolvent.

Musharakah - Partnership
or joint venture financing
An arrangement between a lender and a borrower where
both parties agree to make a capital contribution towards
financing a commercial operation.
Parties agree to share profits from the arrangement at a
pre-agreed ratio.
Losses from the arrangement need to be shared pro-rata
to the capital contributions of each of the parties.
Tawarroq finance - Monetary finance
Lender agrees to purchase a commodity on behalf of the
borrower.
Lender sells commodity to the borrower.
Borrower sells commodity to a third party buyer.
Cash payment from third party buyer acts as monetary
financing element of the transaction.

Borrower repays lender in installments.

Qardul Hassan Benevolent loan
Consists of a loan given to a borrower on a goodwill
basis, i.e. no interest or fees are charged
Borrower may, at their discretion, repay more than they
borrowed
Seen as being the only pure form of Islamic financing
loan as, unlike all the other financing structures, it makes
no attempt to charge riba (interest), which is prohibited
under Islam.
Mudharabah - Profit sharing
Islamic investors agree that a Mudhareb (trustee) will
provide skill and expertise.
Mudhareb agrees to hold and manage the assts for
Islamic investors.
In return for providing services, Mudhareb earns an
agreed share of profits from the assets managed on behalf
of Islamic investors.
Mudhareb cannot claim any right to the assets - merely
acts as manager and trustee of assets.

II.

Commodities financing

Salam Advance payment

Under this Islamic financing structure, purchaser agrees to
make advance payment for asset/goods to be delivered at
a future date.
It is essential that purchase price be paid at the time of
making the agreement, and not on delivery of the
asset/goods - failure to comply with this requirement would
alter the nature of the agreement to that of a sale of debt
against debt, which is prohibited under Shari law.
As Shari law stipulates that items must exist at time of
contract, i.e. no futures contract, asset to be purchased
must be clearly stated in the purchase agreement and the
quantity and quality of the purchased asset must be
capable of being specified exactly there can be no room
for dispute.
Assets must be goods and cannot not include
commodities; such as gold, silver or money.
The exact date and place of delivery of the asset/goods
must be specified in the agreement.

Istisnaa is another Islamic financing structure that follows

almost exactly the same concept as found here
III.

Deposit taking functions

Wadiah - Safe-keeping
Agreement between two parties where on agrees to look
after the property of another.
Concept is used to take deposits of money, where bank
acts as custodian of money deposited by customer.
Bank agrees they will refund sums deposited on call, i.e.
on demand.
Hibah - Gift
Hibah literally means a gift. This is used by banks to
compensate depositors for lost earnings (interest) on their
deposits. It can also be used by borrowers who have
been granted Qardul Hassan loan mention above.
No agreement to provide Hibah can be made its an
arbitrary payment made at the discretion of the person
making it.

IV.

Bonds

Fixed-term, fixed-income, interest-bearing securities

cannot be issued under Shari law.

Sukuk Islamic bonds

Although fixed-income, interest-bearing bonds cannot be
issued under Shari law, it is estimated that over $500
billion in corporate and government bonds issues have
been made using Sukuk (Islamic bonds) mechanism.
Essentially, Sukuk bonds are long-term bond issues made
by SPVs where the bond sale proceeds are used to
purchase assets that are then leased back to the issuer in
return for rent. Rental payments constitute part repayment
of the principal and part profit revenue to the bondholders.
Salam bonds
In certain circumstances, short-term bond issues can be
made using the same mechanism concepts found in
Salam transactions. It should be noted, however, that due
to the precise nature of the assets/goods that are the
subject of a Salam transaction, these types of bond issues
are rare and for very short-term periods.

Laws in Islamic finance;

Sharia: Islamic law. Islamic finance thus often is
also called sharia-compliant finance.

Sukuk: Sukuk are financial instruments that serve

much the same purpose as debt, but which are
structured to avoid the payment of interest.
Riba: Interest, which strict Muslims avoid paying
or receiving.
Ijara: Sale and leaseback transaction employed to
generate income that can be classified as rent,
rather than as interest.
Gharar: Gambling, which strict Muslims also
avoid. Certain highly speculative investment
products, such as some futures contracts, option
contracts, derivatives and securities linked to
market indexes, can run afoul of the prohibition
against gambling.
Takaful: Sharia-compliant insurance, structured
as mutual aid and risk sharing. Estimates vary, but
as little as 4% of the insurance sold Muslim
countries is takaful or sharia-compliant.
Tawarruq: Translates as "turns into silver." A
method used by Islamic banks to make loans and
avoid the appearance of collecting interest on
them. The bank sells a hard asset (such as a nonprecious metal) to a client at a marked-up price,
but does not collect payment until a future date,
which is effectively the maturity date of the loan.
The client immediately sells the asset back to the

bank at a lower price, and collects the money

immediately. The client's future payment to the
bank thus includes the return of this cash amount
plus a markup that is, effectively, a payment of
interest. An increasing number of Islamic scholars
are criticizingtawarruq transactions as thinly-veiled
interest-bearing loans

Variations in Islamic
Finance: Islam is decentralized, with at least two
major subgroups (Sunni and Shia), with various
national differences within them, and with no
centralized, unified hierarchy among the clergy.
Thus, developing sharia-compliant financial
instruments and structures that are acceptable to
all shades of opinion among Muslims is difficult. For
example, Muslim clergy and scholars in East Asia,
most notably Indonesia and Malaysia, tend to be
less strict in their interpretations than their
counterparts in the Middle East.

Scope of Islamic
Finance: According to a special report, "The
Future of Islamic Finance," in the December 8,
2009 issue of the Financial Times:

Sharia-compliant financial instutions: 1,124

Assets in Islamic finance: between $822 billion

and $1 trillion

Increase in such assets in 2009: 29%

Worldwide Muslim population: approximately

1.6 billion

Percent who use banks: approximately 14%

Islamic mutual funds: 473

Islamic money market funds in this total: 79

Islamic real estate funds in this total: 28

Assets in Islamic mutual funds: $35 billion

Conclusion
The growth of Islamic financing in the past decade has
been stellar. Given the large amounts of cash available in
the oil rich Middle-East, it is likely that the growth of
Islamic financing will continue. Moreover, as investors in
the Middle-east look to break-out an invest elsewhere, it is

certain that governments around the world will need to

familiarize themselves with the principal concepts of
Islamic financing, and to regulate for such, if they wish to
take advantage of this growth industry.