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Islamic Finance

Sameer Medhekar (Student) (4140 Points)

07 December 2008

What is Islamic Finance?

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Jeet Biswas (ACMA (in Service)) (5073 Points)
Replied 07 December 2008

Islamic finance: What it is, and how it works

According to law: A file photo of an Islamic bank in Pakistan. Though forms of Islamic finance are still a small niche within the world of financial services, there is a wide variety amongst them.

S. Ramachander

You do not usually associate routine Rotarian get-togethers with talks on such arcane subjects as Islamic finance and banking, from a specialist such as Dr V. Sundararajan, a former Deputy Director with the IMF. Yet, thanks to the Rotary Club of South Madras, one received an opportunity to peep into a fascinating territory recently. This piece is purely a layman’s account on the subject and there are of course many sources, including the Internet.

To understand Islamic banking, you must forget what you learnt in the first year economics course that banks borrow cheap from the depositor, and lend high to the borrower; and run a profitable business out of the difference. It is a game of money creating more money, sometimes not even on paper, and often unrelated to a direct physical asset. And the greater the credibility and efficiency of the bank, and the greater the demand-supply gap on either side, the more profitable the business outcome.

The first point of difference in an Islamic bank is that the object of the contract should exist, specific and free of any ambiguity, and of course be permissible under Shari`ah. So, in effect, the bank cannot lend but make an investment. It cannot be neutral about what the borrower does with the money. In this sense it is closer to a mutual fund; all the more so because the reward for the borrower too is given in the same spirit, i.e. he is not a mere lender or depositor, but one who, as it were, partners the bank in assuming possession of the asset and, therefore, gets a profit share from it.

The core and principles of Islamic banking are derived from Shari`ah rules and the larger value system embedded in Islam. This includes discouraging forbidden activities such as gambling and alcohol. The most widely known rule is against usury or riba, the charging of interest. Any form of concealment, fraud, or attempt at misrepresentation violates the principles of justice and fairness. More significant is the specific mention of promotion of clarity and public interest. The basic guideline is captured in the ideal: avoidance of gharar, preventable ambiguity and uncertainty, and “do not consume one another’s wealth unjustly, and be aware that lawful gain should only be through business-based on mutual consent among you, and do not destroy one another.”

If one thinks about it another way, this is not at all far conceptually from a producer’s co-operative. In Amul Dairy for example, the milkman is neither merely a lender/seller nor a simple shareholder; he provides the milk, which is the source and purpose of the organisation’s main activity – and gets a dividend from it. As Dr Kurien used to proudly point out, he was an employee of a million milkmen who owned the dairy. This form of banking is, however, of more recent origin and practised in varying degrees even in the explicitly Islamic societies. Dr. Sundararajan says that the most complete form of this is found in one of the least developed economies, Sudan.

Islamic finance forms are still a relatively small niche within the world market of financial services, although there is already a wide variety amongst them: institutions offering Islamic financial services, full-fledged Islamic banks, and those with so-called Islamic Windows. Islamic capital markets, and Islamic Investment Funds, Islamic insurance/Takaful (life, non-life, and re-Takaful) as well as non-bank financial services such as leasing companies, finance companies, micro-finance have also grown. Mutual funds have assets totalling $300 billion, and investment funds of about $250 billion in assets. Islamic Windows hold $200 billion, which is still small compared to the size of the conventional market for funds.

There is no doubt that there is an enormous opportunity in this particular mode of banking because much of the money originates in the region where Islam is the most influential. However, the oil billions have obviously not yet entered this market in a significant way. One of the concerns is, of course, how to integrate with the investment opportunities which exist in the non-Islamic world. The windows approach is one where a part of the assets of a regular bank are held in Shari`ah compliant businesses, but it is not quite the real thing. Yet another real hurdle is the way the changed banking mode is actually implemented. The depositor-as-business partnership principle demands that the books and the transactions of the bank be open to the depositor to an unusual degree. In reality, the management, according to the expert, treats the depositor much as your neighbourhood bank does now. He gets an interest-like dividend, so to speak, which is close enough to the prevailing market rate of interests in the regular banking sector.

This suggests that the issues of trust and transparency are no different in this sector and human nature, where money is concerned, eventually finds its own ways of dealing with risk and return. Nonetheless, the future is bound to see a remarkable growth in the funds allocated to this type of financial instrument approved by the code.

Dr Sundararajan for one identifies an immediate agenda for regulators and policy makers — offering opportunities for private sector to innovate; greater strategic focus and appropriate regulation; building financial infrastructure institutions; and above all policy commitment, which is still not widespread in many countries, including India. There is little specific attention paid to Islamic banking and the sector is left pretty much to its own devices.

src: https://www.blonnet.com/manager/2007/12/03/stories/2007120350351000.htm

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sara corner (Stock Trading) (41 Points)
Replied 10 December 2008

Islamic banking refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment of fees for the renting of money (Riba) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haraam). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.