Overview:

Almost three decades ago, the concept of Islamic finance was considered wishful thinking.
Today, more than three hundred Islamic financial institutions are operating worldwide, estimated
to be managing funds in the region of US$ 200 billion. Their clientele are not confined to
citizens of Muslim countries, but are spread over Europe, the United States of America and the
Far East. Muslims now have the opportunity to invest their financial resources in accordance
with the ethics and philosophy of Islam.

Islamic finance is increasingly entering the mainstream of financial services around the globe.
The rate of growth is unprecedented, and despite the effects of the financial crisis, estimates
suggest that the global size of the industry had reached $951 billion at end of 2008 – 25% up
from $758 billion in 2007.3

A large proportion of the Shari’a-compliant assets that make up the $951 billion are held by
Islamic financial institutions (IFIs) spread across a number of key centres. These are
concentrated in South-East Asia and the Middle East, with Malaysia and Bahrain, in particular,
renowned for well-developed sectors and increasingly robust regulation. In recent years, the
profile of Islamic finance in the UK has also accelerated, largely facilitated by the ready-made
professional expertise in the City of London, as well as positive regulatory changes by the
national government

Although Muslim-owned banks were established in the 1920s and 1930s, they adopted similar
practices to conventional banks. In the 1940s and 1950s, several experiments with small Islamic
Banks were undertaken in Malaysia and Pakistan. The first great success was the establishment
of an Islamic Bank in the Egyptian village of Mit Ghamr, in 1963. Other successes include the
establishment of the Inter-Governmental Islamic Development Bank in Jeddah in 1975, and a
number of commercial Islamic Banks such as the Dubai Islamic Bank, the Kuwait Finance
House and the Bahrain Islamic Bank in the 1970s and 1980s. Commercial banks have also
realised the potential of this new field, and a number of major worldwide institutions have
grasped Islamic banking as a significant mechanism for more diversified growth.

ISLAMIC FINANCE and SHARIÁ LAW

What is Shari’a Law?

Islam, the religion of Muslims, is a complete way of life that has a set of goals and values
encompassing all aspects of human life including social, economic and political issues. It is not a
religion in the limited sense of the word, interested only in man’s salvation in the life to come;
rather it is a religion that organizes life completely. The body of Islamic Law is known as
“Shari’a”, and the exact literal translation of “Shari’a” is “a clear path to be followed and
observed”.
The Shari’a is not a codified law. It is an abstract form of law capable of adaptation,
development and further interpretation. The Shari’a does not prescribe general principles of law,
instead, it purports to deal with and cover specific cases or transactions and sets out rules that
govern them.

The Shari’a developed through four major Islamic juristic schools (Hanafi, Maliki, Shafi and
Hanbali) and is derived from two primary sources, the Quran (the transcription of God’s
message to the Prophet Mohammed) and Sunna (the living tradition of the Prophet Mohammed),
in addition to two dependent sources, namely ijma (consensus) and ijtihad /qiyas (individual
reasoning by analogy). The recent surge of religious conciousness amongst Muslims has
provided the drive towards implementing and adopting Islamic principles in financial
transactions. In an attempt to purify assets in the eyes of Islam, Muslims are seeking a greater
balance between their lives in the modern technological world and their religious faith and
beliefs. Among the most important teachings of Islam for establishing justice and eliminating
exploitation in business transactions, is the prohibition of all sources of unjustified enrichment
and the prohibition of dealing in transactions that contain excessive risk or speculation.
Accordingly, Islamic scholars have deduced from the Shari’a three principles that form the
benchmark of Islamic economics and which distinguish Islamic finance from its conventional
counterpart. These are briefly as follows:

The Prohibition of Interest (Riba)

The prohibition of usury or interest (Riba) is clearly the most significant principle of Islamic
Finance. Riba translates literally from Arabic as “an increase, growth or accretion”. In Islam,
lending money should not generate unjustified income. As a Shari’a term, it refers to the
premium that must be paid by the borrower to the lender along with the principal amount, as a
condition for the loan or for an extension in its maturity, which today is commonly referred to as
interest.

Riba represents, in the Islamic economic system, a prominent source of unjustified advantage.
All Muslim scholars are adamant that this prohibition extends to any and all forms of interest and
that there is no difference between interest-bearing funds for the purposes of consumption or
investment, since Shari’a does not consider money as a commodity for exchange. Instead,
money is a medium of exchange and a store of value.

The UAE Federal Law No. 5 of 1985 Concerning Civil Transactions (the ‘Civil Code’), which
was issued with the aim of achieving maximum compliance with the Shari’a, recognizes this
principle, and states in Article 714:

“If the contract of loan provides for a benefit in excess of the essence of the contract otherwise
than a guarantee of the rights of the lender, such provision shall be void but the contract shall
be valid.”
• Profit and Loss Sharing (PLS)

PLS financing is a form of partnership, where partners share profits and losses on the basis of
their capital share and effort. Unlike interest-based financing, there is no guaranteed rate of
return. Islam supports the view that Muslims do not act as nominal creditors in any investment,
but are actual partners in the business. It is comprised of equity-based financing. The justification
for the PLS-financier’s share in profit is his effort and the risk he carries, since his profit would
have been impossible without the investment. Similarly, if the investment has made a loss, his
money would be lost.

• Gharrar

Any transaction that involves Gharrar (i.e. uncertainty and speculation) is prohibited. Parties to a
contract must have actual knowledge of the “subject matter” of the contract and its implications.
An example of an agreement tainted with Gharrar is an agreement to sell goods which have been
already lost.

ISLAMIC FINANCE:

Islamic Finance refers to a system Financing and/or banking activity that is consistent with the
principles of Islamic law (Sharia) and its practical application through the development
of Islamic economics.

EVOLUTION of ISLAMIC FINANCE……….(wala pay koy research)..

Defintion of Terms:

Mudaraba (Trust Financing)

Mudaraba is a form of partnership in which one partner provides the capital required for funding
a project (Rabul-amal), while the other party (known as a Mudarib), manages the investment
using his expertise. Although similar to a partnership, it does not require a company to be
created, so long as the profits can be determined separately.

Profits arising from the investment are distributed according to a fixed, pre-determined ratio. The
loss in a Mudaraba contract is carried by the capital-provider unless it was due to the negligence,
misconduct or violation of the conditions pre-agreed upon by the Mudarib.

In a Mudaraba, the management of the investment is the sole responsibility of the Mudarib, and
all assets acquired by him are the sole possession of Rab-ul-amal. However, the Mudaraba
contract eventually permits the Mudarib to buy out the Rab-ul-amal’s investment and become
the sole owner of the investment. Mudaraba may be concluded between the Islamic bank, as
provider of funds, on behalf of itself or on behalf of its depositors as a trustee (please note this
has a different meaning to the English law concept of trustee) of their funds, and its business-
owner clients. In the latter case, the bank pays its depositors all profits received out of the
investment, after deducting its intermediary fees. It may also be conducted between the bank’s
depositors as providers of funds and the Islamic Bank as a Mudarib.

Mudaraba can either be restricted or unrestricted. Where unrestricted, depositors authorize the
bank to invest their funds at its discretion. In the restricted Mudaraba, the depositors specify to
the bank the type of investment in which their funds should be invested.

Mosharaka (Partnership Financing)

Mosharaka is often perceived as an old-fashioned financing technique confined in its application

to small-scale investments. Although it is substantially similar to the Mudaraba contract (see
above), it is different in that all parties involved in a certain partnership provide capital towards
the financing of the investment.

Profits are shared between partners on a pre-agreed ratio, but losses will be shared in the exact
proportion to the capital invested by each party. This gives an incentive to invest wisely and take
an active interest in the investment. Moreover, in Mosharaka, all partners are entitled to
participate in the management of the investment, but are not necessarily required to do so. This
explains why the profit-sharing ratio is left to be mutually agreed upon and may be different
from the actual investment in the total capital.

In a typical Mosharaka between a bank and a customer (i.e., partner), at the time of distribution
of profits, the customer pays the bank its share in the profits and also a pre-determined portion of
his own profits, which then reduces the bank’s shareholding in the investment. Eventually, the
customer becomes the complete and sole owner of the investment.

Morabaha (Cost-plus Financing)

Morabaha is the most popular form of Islamic financing techniques. Within a Morabaha
contract, the bank agrees to fund the purchase of a given asset or goods from a third party at the
request of its client, and then resells the assets or goods to its client with a mark-up profit. The
client purchases the goods either against immediate payment or for a deferred payment.

This financing technique is sometimes considered to be akin to conventional, interest-based

finance. However, in theory, the mark-up profit is quite different in many respects. The mark-up
is for the services the bank provides, namely, seeking out, locating and purchasing the required
goods at the best price. Furthermore, the markup is not related to time since, if the client fails to
pay a deferred payment on time, the mark-up does not increase due to delay and remains as pre-
agreed. Most importantly, the Bank owns the goods between the two sales and hence assumes
both the title and the risk of the purchased goods, pending their resale to the client. This risk
involves all risks normally contained in trading activities, in addition to the risk of not
necessarily making the mark-up profit, or if the client does not purchase the goods from the bank
and whether he has a justifiable excuse for refusing to do so. However, the Organisation of the
Islamic Conference (“OIC”) has declared that a customer’s promise to purchase the goods in a
Morabaha is an ethically binding promise. Accordingly, the OIC Academy has held that the
customer is bound to compensate the bank for any out of pocket expenses the latter incurs as a
result of the refusal of the customer to purchase the goods.

The purchase of goods under the Morabaha contract may be funded by the Islamic Bank either
from its own funds, or from the funds of its depositors. In the latter case, the bank acts as its
depositors’ agent, retaining its fees from the mark-up profits. In such circumstances, the
depositors will own the purchased goods during the period pending its resale, and therefore
assume its risk.

Ijara (Leasing)

Ijara is defined as sale of Manfa’a (i.e., sale of right to utilise the goods for a specific period).
The Ijara contract is very similar to the conventional lease. Under Islam leasing began as a
trading activity and then much later became a mode of finance. Ijara is a contract under which a
bank buys and leases out an asset or equipment required by its client for a rental fee. The jargon
accorded to the financier, that is the bank, is “lessor”, and to the client, “lessee”.

During a pre-determined period, the ownership of the asset remains in the hands of the lessor
who is responsible for its maintenance so that it continues to give the service for which it was
rented. Likewise, the lessor assumes the risk of ownership, and in practice seeks to mitigate such
risk by insuring the asset in its own name.

Under an Ijara contract, the lessor has the right to re-negotiate the quantum of the lease payment
at every agreed interval. This is to ensure that the rental remains in line with prevailing market
leasing rates and the residual value of the leased asset.

Article 742 of the UAE Civil Code defines the Ijara as –

“A hire shall be the conferring by the lessor on the lessee of the right of use intended for the
thing hired for a specified period in consideration of an ascertained rent.”

Under this contract, the client does not have the option to purchase the asset during or at the end
of the lease term since this is considered under the Shari’a to be tainted with uncertainty. Yet,
this may be reached under another contract, very similar to Ijara (known as an Ijara wa Iktina
(Hire-purchase)) except that there is, at the outset, a commitment from the client to buy the asset
at the end of the rental period at an agreed price with the rental fees previously paid constituting
part of the price.

Salam (Advance Purchase)

Salam is defined as forward purchase of specified goods for full forward payment. This contract
is regularly used for financing agricultural production.

Article 568 of the UAE Civil Code defining Salam states:

“A forward sale is for property, the delivery of which is deferred, against a price payable
immediately.”

Article 569 of the UAE Civil Code states its requirements:

“The following conditions must be satisfied for a forward sale to be valid:

1. The property must be such as can be specified by description and quantity, and it must
normally be available at the time of delivery; and

2. The contract must contain particulars of the nature, type, description and amount of the
goods, and the time at which they are to be delivered.

Istisna’a (Commissioned Manufacture)

Istisna’a is a new concept in modern Islamic finance that offers a number of future structuring
possibilities for trading and financing. In this contract, one party buys the goods and the other
party undertakes to manufacture the goods, according to agreed specifications.

Islamic financial practice holds that the contract is binding on both parties at the outset. Islamic
banks frequently use Istisna’a to finance construction and manufacturing projects.

There is no specific article in UAE law that expressly refers to and deals with Istisna’a, however,
the official commentary to the UAE Civil Code stipulates that the Shari’a principles of Istina’a
are to apply in the case of construction contracts (Muqawala) as defined in Article (872) thereof,
that states:

“A muqawala is a contact whereby one of the parties thereto undertakes to make a thing or to
perform work in consideration which the other undertakes to provide”.

Quard-Hasan (Interest-free Loan)

The quard-hasan mechanism effectively amounts to an interest-free loan either to corporate

customers in financial distress, (which later might be converted into an equity stake in the
enterprise), or to individual clients for welfare purposes.

In making the loan available, the bank may take security for the loan (e.g. mortgage over the
customer’s premises) and some may charge a nominal fee. The service charges are not for profit;
they are the actual costs recovered under one important condition, (to prevent the charges from
becoming equivalent to interest), that the charge cannot be made proportional to the amount or to
the term of the loan.
Takaful (Mutual Insurance)

The model of takaful offers clear guidelines for the establishment of Islamic banking insurance
that substitutes its conventional counterpart. The modern conventional system of insurance is
contrary to the Shari’a because of its exploitative, interest-based nature.

Takaful aims to provide security and protection to its participants in a way that is seen to be
socially responsible and fair. It refers to the pool of payments by a group of participants of an
agreed sum into a common fund that will be managed in accordance with the Shari’a,
particularly the Mudaraba contract. In case of the occurrence of the insured event, the participant
benefits through claiming compensation from the fund. In the absence of the claim, the
participants share the surplus of the invested funds.

Conventional insurance companies manage the funds of its clients on their behalf. Similarly in
takaful, the Islamic Bank is a trustee (not to be confused with the legal concept of trustee under
English law) managing the funds of the participants for a fee. Thus, each participant retains title
over its share of the funds, and under certain conditions may withdraw its share.

However, in practice, it is seen that the pure Islamic nature is detracted from concept of takaful.
The reason behind this is that the takaful funds are currently reinsured on a conventional basis
due to the lack of a developed Islamic reinsurance market.

The Islamic Finance and IFRS Convergence:

As Islamic finance moves beyond its natural boundaries and increasingly becomes a mainstream
form way accessing finance around the world, greater standardized financial reporting will be
important for both Islamic finance and the institutions offering it to reach their full potential.

Since Islam is the religion of the United Arab Emirates as stated in the UAE Constitution, the
UAE is ideally placed to play a leading role in Islamic finance. In addition, implementing
Islamic financial mechanisms are well suited to the legal system as it is always better to be an
owner rather than a security holder in any transaction.

Further, the UAE Civil Code has a very strong Shari’a foundation which supports the proper
regulation of Islamic financial mechanisms. Finally, the judges in the UAE come from an Islamic
background familiar with Islamic concepts and contracts. This fact will eventually lead to the
speedy conclusion of matters as cases will not be required to be referred to experts as frequently
as in the past. Accordingly, judgments will become more predictable leading to more certainity
in Islamic banking transactions.

With institutions reporting and disclosing similar transactions in different ways, problems of
market confidence and competitiveness become more acute for those institutions themselves as
well as for the development of Islamic finance in general. It is important that all stakeholders
across the global markets come together and harmonize financial reporting of Islamic finance.