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Introduction to Islamic Finance Products

Islamic banking offers a broad range of products that meet the real needs of people in society. Thats because Allah the Greatest and All knowing has defined the boundaries of what’s acceptable (halal) and what’s not acceptable (haram). Accordingly, it does not befit a Muslim who sincerely believes in Islam to object to the prohibitions set by Allah or to make excuses that the laws of Islam are outdated and inapplicable in this modern age. On the other hand, it is obligatory for a Muslim to believe that the religion is complete and addresses all aspects of human life.

Islam is a universal religion for all people and all times. Allah the Almighty says in the Qur’an (Muslim holy book): “This day I have perfected your religion for you and completed My favour upon you and have chosen Islam as religion for you”. (Al Qur’an, 5:3) The Qur’an was revealed over a period of 23 years and addresses all aspects of human life including a comprehensive commercial law which is sufficient even in todays society providing solutions to financing, leasing and partnerships (Billah, 2006).

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Modern day banking systems are founded upon the core principle of charging interest. Islamic banking however is based upon 2 core principles. The most fundamental of all is prohibiting the collection and payment of interest. And the second principle is based on fairness; the sharing of risk, profit and loss (Usmani, 2007).

The teachings of the religion of Islam promotes the use of reason and intellect. Islam is a very practical religion. In particular, Islamic law (Shari’a) is flexible as one of the principles of commercial law is that all daily life commercial transactions are allowed as long as there are no evidences from the Qur’an and Sunnah (sources of Islamic law) prohibiting it. Due to this flexibility, there is room for innovation and creativity in the development of new products within Islamic finance. A brief overview will now be given about some of the most common methods that are used to formulate a large number of products within Islamic banking.

Murabaha One of the most common methods for financing in the private sector is based on the murabaha principle. In short, murabaha is a sale with an agreed-upon profit margin. Where the financier buys the product based on an understanding with the seller to sell it to him/her with a profit. Murabaha, in it’s simplistic form is a sale but is often used in Islamic finance as a mode of financing. The only distinguishing feature from a normal sale is that the seller is willingly telling the purchaser how much profit he is going to charge in addition to the purhcase price paid. This mode of financing is commonly used in Islamic banking as there is minimum risk involved due to the fact that the client makes a promise to buy the asset and this is clearly stated in the contract (Billah, 2006).

Here, we have two specific problems amongst the traditional Islamic scholars regarding this mode of finance. Firstly, some scholars doubt the permissibilty of this type of financing contracts because they see the violation of the prohibition of selling what is not owned (not allowed in Shari’a law). Other scholars argue this point by saying that the client doesn‘t really buy the asset but promise to buy it in the future, which is acceptable. Secondly, once the contract has been signed between the financier and the buyer (client), the financier goes ahead and buys the asset (for example a house or a car) and sells it to the client with a profit. The client most of the time doesnt pay the full amount immediately but a higher price on installments with an agreed fixed timeframe and fixed monthly payments.

The vast majority of the scholars agree that it is allowed to pay a higher price for installments providing that this is stated in the agreement from the beginning, however the minority opinion is that this is not allowed (Qasmi and Usmani, 2009). The above forementioned differences in opinion can cause doubt to the legitimacy of certain products such as Islamic deposit bank acounts, home finance programs and lease-to-buy car programs which are often based on the murabaha concept. Irrespective, banks in UK (e.g. Ar Rayyan) and Germany (e.g. Kuvyet Turk) use the murabaha principle.

Diminishing Musharakah This is essentially an Islamic partnership model. According to this concept, a financier and his client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise (Usmani, 2007). The share of the financier is further divided into a number of units agreed in advance and it is understood that the client will purchase the units of the share of the financier one by one periodically over a period of time. The effect of this is that the client continues to increase his/her own share untill all the units of the financier are purchased by him/her such that he/she eventually becomes the sole owner of the property or the commercial enterprise. In the case of a house purchase plan based on the diminishing musharaka model, the financer generates profit by charging a rental fee on the portion of the property he/she owns. The client’s repayment is based on the rental fee plus an amount that is paid towards acquring the property itself. There is a general consensus amongst Islamic jurists that diminishing musharaka is acceptable under Shari‘a law providing that the regular conditions of a valid musharakah contract are met.

Tawarruq This is a financial instrument in which a buyer purchases a commodity from a seller on a deferred payment basis, and the buyer sells the same commodity to a third party on a spot payment basis (meaning that payment is made on the spot). The buyer basically borrows the cash needed to make the initial purchase. This is referred to as tawarruq al fardi, which is generally accepted by the vast majority of Muslim jurists. However, Muslim jurists have explained that tawarruq that is being practised by banks today is different (tawarruq al masrifi al mundadham). This variation is somewhat controversial as the intention of the commodity purchases isn’t for the buyer’s use or ownership. It is due to this point that certain scholars believe that the transactions aren’t Sharia-compliant (Ahmed, 2009).

Their core argument is that the absence of any real economic activities creates interest, which is prohibited in sharia. Despite this difference of opinion some Islamic banks or windows of Islamic banking use the concept of tawarruq to provide products such as Shari’a compliant credit cards.

Ijara Is the term used for leasing under Islamic law. In essence, an ijara contract represents a transaction in which a known benefit (usufruct) connected to a specified asset is sold on for a payment. In the normal course of the sale of the usufruct, ownership of the asset remains with the owner and is not transferred. This type of ijara contract (referred to as an operating lease) doesn’t include any promise to purchase the asset at the end of the contract. Basically, this setup is a simple hire arrangement with the lessor. In the case of a bank, it takes title of the asset at the end of the lease term. The other alternative ijara mechanism is the lease to own method. In this type of ijara agreement, the lessee owns the leased asset at the end of the lease period. This lease contract allows the lessee to agree, at the outset (a promise), to buy the assets in question at the end of the lease period. This type of contract under Sharia law is specifically known as ijara wa iqtina (Qasmi and Usmani, 2009). With this type of lease contract, Islamic jurists agree that it is valid under Shari‘a however, with certain

conditions. One specific condition that could make the contract void is the issue of having both the leasing and buying stated in one contract. The vast majority of Islamic jurists agree that the lease and buying must both be in separate contracts. In summary, these are the two primarily types of ijara arrangements that can exist according to Shari’a principles and are most commonly used by Islamic banks or Islamic windows to offer customers home and car financing.