The most important difference between Islamic and conventional banking is that Islamic banking must follow the Shariah. Islamic banking must also avoid activities such as riba’ or gharar (excessive uncertainty). For example, instead of charging interest on financing given out, Islamic banks give financing based on Musyarakah (Partnership Agreement) and will share any profit and loss.
Simply, riba is interest. "Any amount, big or small, over the principal, in a contract of loan or debt is 'riba' prohibited by the Holy Quran, regardless of whether the loan is taken for the purpose of consumption or for some production activity."
The rationale behind the prohibition of interest in Islam suggests an economic system where all forms of exploitation ("neither wrong nor be wronged") are eliminated. In particular, Islam wishes to establish justice between the financier and the entrepreneur: the financier should not be assured of a positive return without doing any work or sharing in the risk, while the entrepreneur, in spite of his management and hard work, is not assured of such a positive return.
In Shariah, there are many ways to share profit or returns between a bank and its customers. For example, in a deposit product, profits from a deposit arrangement will be shared between a bank and its depositors based on an agreed ratio and paid as dividends. Shariah also allows a bank to give hibah (gift) to its depositors as it deems fit.
There are global bodies of Shariah scholars that work towards promoting consistency and standardization though there are no central authority to standardize the Islamic banking industry. Examples of such global bodies of Shariah scholars are the Shariah Board of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the OIC (Organisation of the Islamic Conference) Islamic Fiqh Academy. The Shariah Board of AAOIFI has issued Shariah Standards that are widely followed within the Islamic banking industry. Meanwhile, it is expected that the general acceptance of Shariah standards will over time create a market precedent and consistency.
The International Financing Reporting Standard (IFRS) with related local standards are being successfully applied for the recognition of Islamic finance product in a number of territories including Malaysia, the Middle East and the UK. In Malaysia, the accounting framework is based on IFRS and is adopted locally as the Malaysian Accounting Standards Board (MASB) Standards. Rather than issuing specific Islamic standards, the MASB provides technical releases to explain how best to accommodate Islamic transactions. Further guidance comes from the Bank Negara Malaysia.
The entire of the Shariah is not a codified legal system in most countries. While there are issues on which all the Shariah scholars would agree, they may disagree on certain other issues. Their disagreement is based on the interpretation of evidences available from the Quran and Sunnah (Prophetic traditions).
Using conventional market as a benchmark is permissible. Let's take the example of home finance based on Ijarah. According to the Shariah, the rent in an Ijarah transaction can be set at any value agreed between the buyer and seller. There is no particular reason why a house financed by this method should be any more or less expensive than a house financed by a conventional mortgage. If not ideal, it is certainly halal (permissible) to use the prevailing interest rate as a benchmark for this rate. The criterion for acceptability by the Shariah is that the transaction is compliant with the Shariah, regardless of the price of the goods or how that price is determined.
We may charge an administration fee for any late or partial payments but this cannot be charged to cover opportunity cost. Such a fee can be charged in order to encourage financial responsibility and to recover administrative expenses. This charge is not interest, and does not reflect the interest rate. If the fee paid is more than the actual expenses incurred due to the late payment or default, or will be channeled out to a public charity under guidance from Shariah Committee.
Ijarah can be defined as a contract "to transfer the usufruct of a particular property to another person in exchange for a rent claimed from him." In other words, the term Ijarah is comparable to a conventional leasing mode of financing. You pay rent for the use of the property, instead of paying interest on the loan amount. Bank purchases the property either from the Seller, or customer in the case of refinance, and then lease it to the customer over an agreed term.
The distinguishing feature of this mode is that the assets remain the property of the Bank. Over the term of the finance, the Bank become landlord and the customer assume the role of tenant. The Shariah allows earning profit through renting out of fixed assets provided that the lessor bears all the ownership related risks attributable to those assets.
The Muslim jurists have allowed unilateral promises to be enforceable based on the principle that "the promise can be made enforceable at a time of need". The unilateral promise that is given in a particular structure is independent of the underlying transaction and is not a condition for the enforcement of that particular structure. Hence, if the sale is without any condition, but one of the two parties has promised to do something separately, then the sale cannot be held to be contingent or conditional upon fulfilling of the promise. A sale will take effect irrespective of whether or not the promisor fulfills his promise. This makes it clear that a separate and independent promise to purchase does not render the original contract conditional or contingent. Therefore, it can be enforced.
Sukuk is a trust certificate whereas a bond is a contractual debt obligation. Generally, Sukuk represents a beneficial ownership interest in the underlying asset. Returns on Sukuk are tied to the returns earned through the underlying assets. For bond, the issuer is contractually obliged to pay bond holders, on certain specified dates, interest and principal.
The structure of Sukuk must be approved by a Shariah adviser appointed by the Issuer. In the case of ringgit Sukuk issuances, the Sukuk can be structured by applying various Shariah principles and concepts endorsed by the Securities Commission Shariah Advisory Council (SAC). For new Shariah principle structure which has yet to be introduced in the market, the SAC’s approval is required.
For non-ringgit issuances, Malaysia will accept the Shariah opinion of other jurisdictions and the issuer need not obtain a Shariah endorsement from the SAC.
Sukuk is based on an underlying transaction which creates a close link between financial and productive flows. The financing must be channeled for productive purposes such as project financing, rather than for speculative activities. Thus, the risk exposure is to the project and not to the uncertainties or activities that have no real economic benefits. This contributes to greater stability of the financial system. Moreover, under the risk sharing principle required, there is an explicit sharing of risk by the financier and the borrower. This arrangement will entail the appropriate due diligence and the integrating of the risks associated with the real investment activity into the financial transaction. The real activity is expected to generate sufficient wealth to compensate for the risks.
In contrast, conventional bonds generally separate such risks from the underlying assets. As a result, risk management and wealth creation may, at times, move in different or even opposite directions. Conventional bonds also allow for the commoditization of risks. This has led to its proliferation through multiple layers of leveraging and disproportionate distribution, in turn, which could result in higher systemic risks, thus, increasing the potential for instability in the financial system.
In addition, transparency represents a basic tenet underlying all Islamic financial transactions. The profit-sharing feature of Islamic financial transactions imposes a high level of disclosure in the financial contract. The accountabilities of the respective parties involved in the transaction are clearly defined in the contract.
Issuing Sukuk also give access to a wider investor base as the instruments attract not only the Islamic investors but also conventional investors. It was reported that more than 80% of Sukuk investors are conventional institutional investors. Sukuk is also considered as a new asset class with a relatively attractive pricing. The growing demand for Sukuk is attributed by growing awareness, increased in petrodollars, wealth and reserves as well as the massive development of infrastructure projects.
You can issue Sukuk in any part of the world as long as the local investors understand the product. There is no specific law governing Islamic finance transaction. For instance, in Malaysia, only recently are Islamic finance transaction referred to the Shariah Court but for UK, there is no law governing and hence any disputes are resolved using contractual and common law.
Malaysia maintains a liberal foreign exchange regime. Foreign issuers are free to issue Sukuk in any currency. They are also free to repatriate the proceeds from raising Ringgit or foreign currency Sukuk to any country outside Malaysia and free to swap to other currencies and hedge their positions.
Any institution or company can issue a Sukuk so long as its activities are considered as permissible activities under Shariah. Some prominent non-Islamic companies that have issued Sukuk in Malaysia are Shell MDS, Nestle, the World Bank, Tesco and AEON Credit, a Japanese-based company.
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