An unconventional Economic Notion

A look at the financial products available in an Interest-free banking system

Written by Mashud Abukari

 

 

ABSTRACT

This paper highlights Islamic Finance as a viable alternative or a sustainable substitute to the current conventional model of finance. This paper attempts to examine the current interest based products and compares it with the alternative interest-free product central to Islamic Finance. The fundamental concept that distinguishes Islamic economic and western economic system is the prohibition of charging interest, and the emphasis on social benefits in transactions. This paper will analyze some of the permissible forms of financing within Islamic Finance such as Musharakah (Partnership: joint enterprise), Mudarabah (Partnership: work partnership), Murabahah (Cost-plus sales), Ijarah (Leasing), and Sukuk (Islamic Bond), and contrast them with their conventional counterpart.

 

INTRODUCTION

Interest-free banking or Islamic Finance is a system of banking that is compliant with Islamic law. Islamic law prohibits the charging and collection of interest, which can be broadly described as comprehensive prohibition of usury. Islamic mode of financing is based on asset-backed financing while capitalist or conventional concepts of financing allow banks and financial institutions to deal in money and paper currency only[1]. Therefore, traditional banks in a capitalist economy are barred from trading in goods and maintaining inventories. Whereas in Islamic economic, money has no intrinsic utility and it’s only a medium of exchange. In addition, banks are not prohibited from trading in tangible goods and holding inventories.

Many conventional banks around the world have opened up Islamic financing windows to accommodate customers interested in ethical Islamic financial products. Examples of such financial institutions are HSBC, Standard Chartered, Barclays Capital, Deutsche bank, JPMorgan Chase and Citibank  The industry has had a compound growth rate of 20 percent over the past three years, compared to 9 percent growth in conventional finance. The industry’s global assets are expected the reach $1.1 trillion by the end of the 2012, a 33% rise from 2010 levels, according to a report by consultants Ernst & Young. The industry is also expected to continue the impressive expansion in the forthcoming years.

 

 

I.     PARTNERSHIPS (MUSHARAKAH AND MUDARABAH)

        i.     MUSHARAKAH (Joint Enterprise)

Musharakah is a joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses.[2]

It is a kind of partnership in which partners mutually agree to engage in a business venture, and to distribute profit or loss among each partner. It is an ideal alternative to an interest-based financing as it has far reaching effects on both production and distribution in an economy. It meets the financial requirements of productive sectors of the economy and achieves the social-economic objectives of Islamic ethics. Musharakah is an ideal form of financing since the returns to the partners are based on the actual profit earned by the joint venture. The ratio of profit distribution is equal to the proportionate initial investment in the partnership.

 

COMPARING MUSHARAKAH WITH INTEREST-BASED FINANCING

In interest-based financing, the financier does not suffer a direct loss in the event of the business failure, as the debtor is under obligation to repay the financier. On the contrary, the financier under a Musharakah contract will suffer losses if the joint venture fails, since the investment returns to the financier is proportional to the actual profit earned by the business. When the debtor or business manager suffers a loss in the business, it is inequitable on the part of the creditor to claim a fixed rate of return from the debtor while the business is not generating any profit.

Alternatively, when the debtor gains high rates of profit, it is inequitable for the creditor to be given only a small portion of the profit while the debtor exclusively enjoys the full benefits of the profit although the initial financial investment of the creditor maybe minimal.

Musharakah (joint enterprise) results in a fair treatment of both the creditor and the debtor as opposed to lending on interest.

 

ii.     MUDARABAH (WORK-PARTNERSHIP)

Mudarabah (Work-Partnership) is a special kind of partnership in which one partner gives funds to the other partner for an investment in a commercial enterprise. One partner becomes the manager of the business and the other partner becomes the financier of the project.

 

DIFFERENCES BETWEEN MUSHARKAH (JOINT ENTERPRISE) AND MUDARBAH (WORK-PARTNERSHIP)

The difference between Musharakah and Mudarabah can be summarized as follows: (1) The investment in Musharakah contract comes from all the partners, while in a Mudarabah contract, the investment fund comes from only one partner. (2) In a Musharakah contract, all partners can participate in the management of the business. Partners are also allowed to work in the business, while in a Mudarabah contract, the financier cannot participate in the management. (3) In a Musharakah contract, all partners share the loss according to the ratio of investment, while in a Mudarabah contract, the tangible loss is suffered by the financier only. Nevertheless, the other partner (the manager, non-financier) can face liabilities if there is evidence of negligence or misconduct. (4) Under a Musharakah transaction, liability is generally unlimited for the partners while under a Mudarabah transaction, the financier’s liability is limited to his or her investment. (5) Under Musharakah transactions, assets of the business are jointly owned by all the partners proportionate to investment. In Mudarabah, all assets purchase during the course of the business is owned by the financer or the partner who provides the initial funds.

The basic principle that surrounds Musharakah and Mudarabah financing model as mentioned by Muhammad Taqi Usmani, a scholar in Islamic finance can be outlined as follows:  (1) Financing through Musharakah and Mudarabah does not mean advancing money on credit. Rather, it means participation in the business and in the case of Musharakah, sharing in the assets of the business to the extent of initial financing ratio. (2) Investors or the financiers share the loss incurred by the business to the extent of the initial investment. The loss suffered by each partner is exactly proportional to investment. (3) Partners are at liberty to determine, with mutual consent, the ratio of profit allocated between each other, which may differ from the ratio of initial investment.

 

DIFFERENCES BETWEEN ISLAMIC PARTNERSHIP CONTRACTS AND LENDING ON INTEREST

Lending on Interest	Musharakah & Mudarabah (Partnership/ /Joint Enterprise)
The financier requires a fixed rate of return regardless of actual profits earned by the business.	The returns to the financier are tied to actual profits earned by the business.
The financial institution gets a portion of profits from the business through the interest payment but not losses associated to the business.	The financier shares the rewards as well as the losses associated with the business venture.
The financiers does not share any losses related to the business but expects a fixed interest payment[3].	The financier achieves returns proportionate to the actual profit earned by the business.

 

II.            MURABAHAH (COST-PLUS SALES)

Murabahah has been adopted as a mode of interest-free financing by many Islamic financial institutions as an alternative to interest-based financing. Murabahah is a kind of sale where the cost of goods sold and the profit margin or the mark-up price is known to both parties i.e. the buyer and the seller. Murabahah mode of financing can be used to finance the purchase of various items, including commercial and consumer goods. It can be used to finance the purchase of consumer goods, capital goods, real estate, raw material machinery, equipment etc. It is very suitable for providing short-term capital for financing projects but not suitable for long-term investments.

 

CONDITIONS OF A VALID MURABAHAH TRANSACTION

Murabahah transactions are valid when the following conditions are met: (1) An explicit mention of the actual cost by the seller to the buyer. (2) The existence of the property at the time of sale. (3) Ownership of the property by the seller. (4) Physical or constructive possession by the seller (5) Absence of uncertainty of the actual property and the certainty of price.

Murabahah was originally a type of sale transaction and not necessary a mode of financing. The more ideal modes of financing are Mudarabah (partnership: joint enterprise) and Musharakah (partnership: work-partnership). However, Murabahah (cost-plus) transactions are accepted as a transitional model of financing.  Murabahah is a permissible alternative financing model when the use of Mudarabah (partnership: joint enterprise) or Musharakah (partnership: work-partnership) is not practicable.

The current state of the U.S economy and the regulatory environment makes it impractical to finance a project using Mudarabah and Musharakah transactions; therefore Murabahah can serve as an alternative to the more ideal Islamic form of financing such as Mudarabah.

 

APPLICATION OF MURABAHAH CONTRACT IN BUSINESS

Under Murabahah, the financial institution purchases goods from a third party as required by the client and then re-sells the goods to the client at a mark-up price on a deferred installment payment. For example, a financier buys a good at $100, and then re-sells to the client with a mark-up of 10% at $110.

The profit to the financial institution is derived from the ownership of the goods and the exposure to risk while holding the title of the goods during the purchase and resale period.

The mark-up price remains fixed for the entire period of the deferred payments. The price does not increase due to late payment as opposed to conventional banks which charge fees for late payment. Nonetheless, Murabahah allows for other techniques to discourage late payment which does not include charging late fees as an additional income for the financial institution.

 

ILLUSTRATION OF THE MURABAHAH CONCEPT

 

Figure 1 Murabahah Transaction

 

DIFFERENCES BETWEEN MURABAHAH AND LENDING MONEY ON INTEREST

Lending on Interest	Murabahah (Cost-Plus )
Bank lends money to a client on interest and requires payment of an amount greater than borrowed.	The Islamic bank buys an item at one price and sells it to the client at a higher price, allowing the client to pay the amount over time.
Involves an exchange in a form of a loan.	Involves an exchange of commodities, thus participate in a genuine commercial activity.
It allows for increase in loan amount or an additional profit to the bank from late payments, changes in interest rate etc.	Additional charges on the installment payment such as late fees are not allowed.

 

 III.            IJARAH ( ISLAMIC LEASING)

Ijarah is similar to conventional form of lease whereby, the owner (lessor) leases out a property to a client (lessee) at an agreed upon rental fee for a pre-determined lease period. The financial institution (lessor) purchases the asset through the lessee by offering the capital to purchase the property directly from the vendor or offering the funds to the lessee to purchase the asset on its behalf. The rental payment for the lease transaction is charge upon delivery of the asset to the lessee in return for the right to use the asset for a specified period. The ownership of the property remains in the hands of the lessor and only the usufruct is transferred to the lessee.

 

COMPARISON BETWEEN ISLAMIC LEASES AND CONVENTIONAL LEASES

The distinction between conventional lease and Ijarah (Islamic lease) is that rental period starts after the delivery of the property to lessee and not before delivery. The lessee’s liability starts only after the lessee has taken delivery of the asset and not when the price is paid by the lessor. Therefore, if the supplier delays the delivery after receiving the full price, the lessee would not be liable for the rent on the delay period.

A principle in Islamic law is that an individual cannot claim a profit or a fee for a property of which risk was never borne. Liabilities arising from ownership are borne by the lessor and the liabilities relating to the use of the leased property is borne by the lessee. The lessee is responsible for any loss caused to the property by the lessee’s misuse or negligence. However, the lessee is not liable to losses caused by the factors beyond the lessee’s control. The lessor assumes the full risk and liabilities of the corpus of the leased property. If the asset is destroyed during the lease period and it’s not due to the lessee’s misuse or neglect, the lessor bears the liabilities for the loss. If the leased property loses its usufruct by no fault of the lessee through misuse or neglect, then the lessee is not obligated to pay rent or the fees for the usufruct.

In interest-based financing, the financier is entitled to receive interest even if the debtor does not benefit from the money borrowed. Ijarah (Islamic lease) allows for a more equitable arrangement for both lessor and lessee.

 

DIFFERENCES BETWEEN CONVENTIONAL LEASE AND IJARAH

Conventional Leasing	Ijarah (Leasing)
In conventional lease, the liability for rent obligation starts after the lessor pays for assets regardless of the delivery to the lessee.	The rent obligation starts when the lessee takes possession of the asset and not before asset is delivered to the lessee.
The lessee bears all risk during the transfer of asset from the vendor even before delivery.	The liabilities is borne by the financial institution until delivery to the lessee
The bank is entitled to lease payment even after the usufruct becomes unusable.	The lease is terminated when the lease asset becomes unusable.
Allows for lease in intangible assets.	Only tangible assets with usufructs can be leased.
May allow the lessor an unrestricted power to terminate the lease unilaterally.	The contract can only be terminated with mutual consent or except if the lessee breaks the terms of the agreement.

 

 IV.            SUKUK (ISLAMIC BOND)

Sukuk is an Islamic equivalent to a conventional bond. A sukuk certificate represents a proportional ownership and the cash flow in tangible assets. It can be described as a trust certificate or a participation security that grants an investor a share of an asset along with the cash-flows and risk proportionate with ownership.

The central feature of a Sukuk structure is that it is based on real underlying assets as opposed to conventional bond. A Sukuk structure discourages over-exposure of debt beyond the value of the underlying asset as opposed to conventional bonds which allow for leverage in excess of an assets value. Sukuk transactions can be structured along the lines of Mudarabah, Musharakah, Murabahah, Ijarah and other acceptable modes within Islamic finance.

 

DIFFERENCES BETWEEN SUKUK AND CONVENTIONAL BONDS

Conventional Bonds	Sukuk (Islamic Bonds)
A bond represents a contractual debt obligation to pay the bondholders interest and principal on certain specified dates.	A sukuk represents a share of ownership in an income generating assets along with cash flows and risk commensurate with the ownership.
The issuer of the bond is under obligation to make payments regardless of the profitability of the enterprise.	Sukuk holders are entitled to share in the revenues generated by the sukuk assets. A sukuk holder claims an undivided beneficial ownership in the underlying assets.
A bond represents a debt obligation.	Sukuk represents equity share in a particular business or investment portfolio.

 

 V.            SPECIFIC EXAMPLE OF THE APPLICATION

 

MORTGAGE FINANCE

Mortgage financiers in Islamic banking can use a derivative of the Musharakah (partnership) transaction to finance the purchase of houses, automobiles, plants, machinery, etc. This derivative of Musharakah is referred to as Diminishing Musharakah (diminishing equity share)

Diminishing Musharakah is a form of Musharakah where a financier and the client participate in a joint ownership of a property. The shares of the financier are then further divided into a number of units which can then be purchased by the client on a periodic basis until the client becomes the sole owner of the property.

If a home buyer wants to purchase a house but does not have the necessary funds to make the purchase. The home buyer can approach an Islamic financial institution to finance the purchase of the house under a Diminishing Musharakah transaction.

For example, if the home buyer has 30% of the price required to purchase the house, then the Islamic financial institution would finance 70% of the price of the house. After the purchase of the house, the property becomes jointly owned by home buyer and financier at the proportion of 30% and 70% respectively. The home buyer uses the property to meet his or her residential requirement and pays rent to the financer for the portion of the financier’s ownership. Over the term of the transaction, the home buyer purchases the unit ownership share of the financier on a periodic basis until the financier’s ownership is reduced to zero percent.

 

DIFFERENCES OF MORTGAGE TRANSACTION BETWEEN THE TWO MODELS

Mortgage Financing	Mortgage Financing under Islamic Banking
The financing involves an interest-bearing loan	The financing involves an investment in a joint ownership of property.
Interest charged is determined on the basis of supply and demand of capital.	Rent charged is determined on the basis supply and demand of real asset.
The bank does not own the underlying assets.	Joint ownership of the property with shared risk and benefits.
The bank is not required to share any loss due to the damage incurred to the underlying property.	The bank shares a proportional loss incurred to the property if the property is damaged since there is a co-ownership of the property.
The liability for payments starts on the date the loan is extended regardless of whether the property is ready for use.	The payment obligation starts only when the property is ready for use either through acquisition or through constructive possession.
The bank is entitled to installment even if the property is not usable or needs repairs.	The bank is entitled to rent payment only if the property is usable.

 

AN ALTERNATIVE MODEL TO DEBT FINANCING

Islamic financing concepts can be used in the case of project financing and capital acquisition by organizations. An alternative to debt financing model under interest-free banking can be applied to finance income producing assets.

 

Project Financing

In the case of project financing, an Islamic model can serve as a viable alternative to the conventional interest-based financing.  For example, when a municipality wants to build a new bridge but lacks the adequate funds necessary to finance the entire project. It can approach an Islamic financial institution to provide the additional needed funds. The Islamic financial Institution would finance the project using Mudarabah or the like transaction which is void of interest.

The returns to the investors would be generated from the tangible assets backed from the project similar to returns investors would expect from an interest-based bond. The distinction in this model is that the returns to investors are directly tied to the revenues from the assets, i.e. bridge tows and fees. The revenues from the bridge tows and fees will be distributed among the Islamic financial Institutions and the municipality based on percentage of ownership. The ownership of the financing company will be further divided into small units to allow the municipality to repurchase the ownership from the Islamic finance institution over the course of the transaction arrangement.

The characteristics of this model can be summarized as a follows: (1). Joint partnership in the property (2). The fixed income to investors is derived from income producing assets (3). Promissory contract to purchase back asset from the financier by the organization.

 

Conclusion:

This paper has compared and contrasted some of the financial product within Islamic economics. The author hopes to present Islamic financial concepts as alternative worth considering and further exploring.

 

 

 

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