Islamic banking is growing at a fast rate and is reportedly worth approximately US$1 trillion globally. Despite this trend, the Western World is only just beginning to tap into the potential that Islamic banking presents. The Australian Government recognises that Islamic finance has potential for creating jobs and wealth and it is keen to ensure there are no unnecessary hurdles to its development. It helps that Australia is well-placed geographically to service the growing Islamic finance market.
What is Islamic finance?
It is a type of finance that is consistent with Shariah or Islamic law, as set out in the Qur’an and sourced from the Sunnah - the sayings and acts of the Prophet Mohammed. Islamic law also comes from secondary sources such as opinions collectively agreed among Shariah scholars and analogy.
All Islamic banks and commercial banks offering Islamic banking products and services have set up or have access to Shariah boards or committees to guide them and ensure that they function in a manner that is in line with the principles of Islamic law. The law is open to interpretation and Shariah committees often have differing views on key issues. This can lead to inconsistency across various boards, and means that there is no over-riding precedent or standard for what constitutes an acceptable Islamic financial product.
Islamic finance is not solely for Muslims. It can be used by all individuals regardless of their religious beliefs.
What are the main features and principles of Islamic finance?
The main features and principles of Islamic finance are:
- the prohibition of paying and receiving interest, otherwise known as riba;
- rather than interest, there is either a profit and loss sharing arrangement between a bank and its customer or fee-based returns;
- the prohibition of uncertainty in contractual terms and conditions;
- the prohibition of investments or financing in businesses that contravene Islamic law, such as alcohol, gambling, drugs, weapons, prostitution or pornography; and
- a requirement that all financial transactions are underpinned by the existence of a tangible asset.
Common contractual relationships in Islamic finance
Generally, all contractual relationships under Islamic banking involve some type of partnership where there is a sharing of profits and losses, a fee or a fixed charge. Some of the most common contractual relationships are:
This is a profit sharing contract between two parties. One party provides the capital and the other party provides the skill or labour. Profits are shared between the parties according to a predetermined ratio. The losses are borne by the party providing the capital.
This type of contract is often used for investment funds, with the capital provider taking a management fee, and for large-scale infrastructure projects.
The mudaraba contract is a risky investment for the capital provider because losses are not recoverable from the other party unless negligence or breach of contract can be established.
This is a form of asset financing and involves a contract pursuant to which a bank purchases an agreed asset and then sells it to its customer at a higher price with deferred payment terms. Instead of paying interest, the customer pays a marked-up sale price, which can be either a percentage of the purchase price or a lump sum. The profit mark-up is fixed in the contract and cannot be increased.
A murabaha contract is sometimes referred to as an Islamic mortgage.
Musharaka means sharing. Under such a contract, both profits and losses are shared. Both parties to the contract must contribute capital and either both or one party manages the venture. Alternatively, both parties can create a special purpose vehicle or appoint a third party to manage the venture. Profit is distributed according to a predetermined ratio. Any losses are shared in proportion to the capital contributed by each party.
These are financial certificates of investment that are similar to asset-backed bonds that represent the ownership of the holders. Returns are paid to the investors in proportion to their ownership.
An ijara contract is similar to a hire purchase agreement. The bank buys the asset and leases it to its customer for a rental fee. The amount and timing of the rental fee is agreed in advance, but the amount may be adjusted during the term of the contract in accordance with a predetermined formula.
Wadiah means custody or safekeeping. In such an arrangement, a customer deposits cash or other assets
in a bank for safekeeping. The bank guarantees the safety of the items kept by it. The customer is not permitted to receive interest on any funds it deposits. However, the customer may receive, at the bank’s discretion, a sum as a gift, or hiba, as a reward for the customer using the bank’s services and allowing the bank to use the customer’s funds in its everyday banking operations.
Takaful is a type of insurance arrangement and involves a group of individuals paying money into a fund, which is then used to cover payouts to members of the group when a claim is made.
Islamic finance has expanded dramatically during the recent past and will continue to do so. The growth of the Islamic finance sector in Australia will depend on how easily Islamic products and services are accepted, understood and accommodated within Australian’s legal and regulatory framework.