Abstract:

To many in the West, Islamic financing is shrouded in mystery, but certain Islamic financing techniques are very similar to those used in the West. The Islamic finance movement has grown dramatically in recent years and it is estimated that international Islamic financial institutions now manage or control funds worth some $60 billion. The majority of Islamic financial institutions appear to have excess liquidity, which is encouraging Western institutions to consider Islamic financing. Islamic principles disallow Riba, which is not restricted to usury but encompasses interest as well. However, Islamic principle actually encourages investments in order that the community may benefit. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. Some of the common forms of Islamic financing instruments are partnership, sale with state profit, lease, and trust financing.

Full Text:

Copyright Euromoney Publications PLC Nov 1993

To many in the West, Islamic financing is shrouded in mystery. While the prohibition on interest is widely known, issues such as alternatives to interest (ie, participation in profits and the mark-up system) or associated issues such as the taking of security and insurance are not widely understood. Furthermore, the various forms of Islamic financing that are commonly employed are also not known and are often viewed with misgivings when, in fact, certain Islamic financing techniques employed by Islamic institutions are very similar to those used in the West.

The Islamic finance movement has dramatically grown in recent years and it is estimated that international Islamic financial institutions now manage or control funds worth some $60 billion. In addition to Pakistan, Iran and Sudan, three Muslim countries where Islamic banking is mandatory, it is being practiced voluntarily by individual institutions in almost every Muslim country. Unlike many Western financial institutions, the majority of Islamic financial institutions appear to have excess liquidity. Their problem seems to be finding uses for the employment of these funds in ventures that are Islamic in nature and profitable. Indeed this situation is encouraging Western institutions to consider Islamic financing in terms of, for example, using their international contacts to arrange Islamic financial transactions.

QURANIC COMMANDS

It is important to understand certain principles of Islam that underpin Islamic finance. The Shariah consists of the Quranic commands as laid down in the Holy Quran and the words and deeds of the Prophet Muhammad. The Shariah disallows Riba and there is now a general consensus among Muslim economists that Riba is not restricted to usury but encompasses interest as well. The rules regarding Riba are quite simple and can be summed-up as follows:

(a) Any predetermined payment over and above the actual amount of principal is prohibited.

This is of fundamental significance so that, while profit is legitimately allowed, the parties cannot predetermine a guaranteed profit. This is based on the principle of 'uncertain gains' Which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. Islam allows only one kind of loan and that is quard-e-hasan (literally a good loan) whereby the lender does not charge any interest or additional amount over the money lent. Traditional Muslim jurists have construed this principle so strictly that, according to one commentator, '[t] his prohibition applies to any advantage or benefits that the lender might secure out of the quard [loan] such as riding the borrower's mule, eating at his table, drinking his coffee or even taking advantage of the shade of his wall'. The principle expounded in the above quotation is that associated or indirect benefits are prohibited.

One school of Islamic scholars disapproves the indexation of indebtedness to inflation and explains this prohibition within the framework of quard-e-hasan. According to this school, the creditor advances the loan to win the blessing of Allah (God) and expects to obtain the reward from Allah alone. Under the terms of quard-e-hasan, the lender is not to receive any additional payment other than in respect of principal. It is argued that, at the time of the advance, the lender was well aware that there would be no additional payment and that the real value of the loan may decline over time. The very fact that the lender still went ahead and made the loan is evidence that the risk of devaluation was factored into the decision to extend the loan and, accordingly, no compensation in the form of indexation should be allowed.

(b) The lender must share in the profits or losses arising out of the enterprise for which the money was lent. Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. Following this line of argument, some Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (ie, interest).

Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods or services.

The principle, which thereby emerges, is that Islam encourages investments in order that the community may benefit. However, it is not willing to allow a loophole to exist for those who do not wish to invest and take risks but are rather content with hoarding money or depositing money in a bank in return for receiving an increase on those funds for no risk (other than the bank becoming insolvent). Accordingly, under Islam, either people invest with risk or suffer loss through devaluation by inflation by keeping their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective is that high risk investments provide a stimulus to the economy and encourage entrepreneurs to maximize their efforts.

FINANCING VEHICLES
Some of the most common forms of Islamic financing instruments are:

* Musharaka (partnership);

* Murabaha (sale with stated profit);

* Ijara (lease); and

* Mudaraba (trust financing).

Musharaka. As the diagram illustrates, this can take different forms.

Sharikdt'aqd (contractual partnership) can be one of the following:

* Sharikat mal or finance partnership

* Sharikat a' mal or labour partnership

* Sharikat wujuh or credit partnership (credit alone is used for partnership)

 Under musharaka transactions, Islamic financial institutions predominantly use 'inan sharikat mal or 'finance-limited investment partnership' whereby money is the main investment. The Islamic institution funds the working capital requirements of an entrepreneur. Profits are shared under previously agreed terms and losses are shared in proportion to the capital subscribed.

Murabaha. This is the sale of a commodity at a price which includes a stated profit known to both the vendor and the purchaser. This can be called a cost plus profit contact. The price is usually paid back by the buyer in deferred payments.

It is important to note that only a legitimate profit in addition to the actual price is considered lawful under Islamic law. Any excessive addition on account of deferred payments will be disallowed as it would amount to a payment based on the value of money over time ie, interest.

There is disagreement amongst the four schools of Islamic jurisprudence as to what amounts to a legitimate addition or profit over and above the price actually paid. All the schools have different approaches to this issue.

However, remedy is available to the purchaser if he discovers that the price has been unduly inflated. Remedies provided by various schools are quite similar. One is that the purchaser can keep the goods at the stated price or he can rescind the contract asking for the return of his money although, if he is no longer in possession of the goods, he cannot use this option. Another jurist says that the purchaser can confirm the transaction and claim back the excess amount.

Ijara. This is a lease contract. In the context of Islamic financing, it is a contract under which the financial institution leases equipment or a building to one of its clients in return for a fixed amount. The use of the commodity should be lawful ie, not a practice disallowed by Islam like the use of a building for gambling. There is another form of ijara called Ijara Wa iqtina or lease purchase contract. This has been used for major asset financings ie, aircraft.

Mudaraba. This implies a contract between two parties whereby one party, the rabb al-mal (beneficial owner or the sleeping partner), entrusts money to the other party called the mudarib (managing trustee or the labour partner). The mudarib is to utilize it in an agreed manner and then returns to the rabb al-mal the principal and the pre-agreed share of the profit. He keeps for himself what remains of such profits. The following characteristics of mudaraba are of significance:

* The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump- sum or guaranteed return;

* The investor is not liable for losses beyond the capital he has contributed;

* The mudarib does not share in the losses except for the loss of his time and efforts.
The mudaraba is being very widely used in Pakistan by the mudaraba companies which function like the Western investment companies. The mudaraba companies receive deposits from investors and, in return, issue them mudaraba certificates which are traded on the Stock Exchange. These companies pass on this money to entrepreneurs for use in ventures not prohibited by Islam. The mudaraba company retains a commission or service charge out of the profits and advances the balance to the investors.

THE PAKISTANI EXPERIENCE

The Pakistani religiously approved standard forms offer some guidance as to what provisions are likely to be found in various types of Islamic financing agreements and can be summarised as follows:

(a) Murabaha sale agreement

* This is used when a customer of a financial institution wishes to finance, for example, the purchase of raw materials or machinery.

" The customer fills in an application requesting the bank to purchase the required goods and then onward sell them to the customer.

" The supplies order is approved by the bank's customer.

" The murabaha sale price will be the purchase price of the goods plus all expenses (ie, taxes, customs duties, administrative expenses) plus a return (profit) at a figure agreed between the institution and the customer.

* The client agrees to execute the purchase order with the bank upon the goods arriving at the port although the model agreement allows the customer to inspect the goods to ensure they meet with the specifications. This leaves open the issue of what will occur if they are refused with the bank then still holding the goods and being obliged to pay the supplier or at least itself having to reject them vis-a-vis the supplier.

* It should be noted that the model agreement does not expressly include a deferred payment mechanism but invariably in practice it is understood that such a provision will be included.

* Security such as guarantees and collateral is permitted.

* Liquidated damages are specified. Although in some other agreements it is stated that damages will be used for charitable purposes.

* Arbitration is specified.

The form of the agreement is simple but does raise certain risk issues for a financial institution. In particular, the fact that it takes title to the goods means that it could be argued that it is trading, which may be beyond its corporate authority. In addition, if any damage or injury was subsequently caused by the goods, it is not beyond imagination that, in any ensuing litigation, the financial institution may be a named party in view of it being perceived to be a deep pocket.

(b) Lease agreement

* Under this contract the title to the leased goods or property remains with the lessor (ie, the financial institution). The customer is the lessee.

*On execution of the lease, the lessee pays to the lessor an amount to be mutually agreed upon by the parties as a security deposit and the lessor can use it in any manner it wishes in case of a rent default.

* The lessee agrees to indemnify the lessor for all costs, liabilities and obligations whether or not due to its default.

*The monthly rent is paid by the lessee in advance and, in the event of a late payment, there will be a per day penalty which goes into a penalty account which is to be spent for charitable purposes. The model agreement has left open the rate for late payment charges. In practice it appears that, in the case of late payment, the lessee pays liquidated damages at the rate of around 2% per month for the period of delay.

* The lease can be terminated at any time by the lessor after twelve months. In addition, the lessor can terminate without notice on grounds of default, breach of the terms of the agreement or abusive use of the goods. Upon termination of the lease, the goods or the property must be returned to the lessor when there will be a joint inspection by the lessor and the lessee to make sure that the property is in good condition.

* In case of the bankruptcy or insolvency of the lessee, the lessor has the right to take immediate possession of the property and may thereafter sell it and keep the proceeds as liquidated damages and not as a penalty. The impact of relevant local law in relation to liquidation and bankruptcy laws may, however, override these contractual provisions.

* The lease cannot be assigned by the lessee without the consent of the lessor.

* The lessor will arrange for insurance coverage for the leased goods and will pay the premiums. The lessee must, however, reimburse the lessor for this expenditure in advance both in respect of the initial and subsequent premiums.

* The lessor delivers the goods to the lessee and the expenses for the delivery must be borne by lessee. All maintenance charges, taxes and other expenses arising out of or in relation to the leased items must be borne by the lessee.

* There are detailed undertakings by the lessee that it will use the leased goods for normal business use, that it Will ensure that the use of the goods will not vitiate the insurance policy, that it will not sub-lease or hire out the goods, that only properly trained personnel will use the goods, that the goods will be properly operated and maintained, and that it will return the goods at the end of the lease in good condition, fair wear and tear excepted.

* Although there is no mention of a lease-purchase option in the model agreement, in practice the lessor will often grant the lessee an option to purchase the goods or property at the end of the lease period provided all the conditions in the lease agreement have been complied with.

* This agreement has left open the issue of the rate of the monthly lease rentals which has to
Be agreed upon between the parties. According to some commentaries, current Pakistani business practice results in monthly lease rentals generally working out to be equal to instalments of principal plus about an amount equivalent to interest of 22% per annum.

(c) Musharaka

* Musharaka finance is used for the provision of working capital to a company by subscribing to its redeemable capital.

* Based on past experience and other available data, the company requiring the finance prepares a projection of the monthly rate of pre-tax profits taking into account the Musharaka investment (Projected Rate of Profit).

* Based on the Projected Rate of Profit, the projected annual profit that will arise on the Musharaka investment (Provisional Profit) will be calculated.

* The company opens a bank account (Musharaka Account) and authorizes the investor to debit from it at the end of each quarter an amount equal to the Provisional Profit relating to that period.

* At the end of each quarter, the company must provide a financial report on the companys performance in. that quarter. At the end of the financial year, the profits are calculated. If air amount is due to the investor in excess of the Provisional Profit already debited from the Musharaka Account, the excess amount will be credited to a special reserve (Participation Reserve) which the company will create in its books. Likewise, if the amount debited from the Musharaka Account in respect of the Provisional Profit is in excess of investors share of the audited profits, the excess will debited to the Participation Reserve.

* Upon the termination of the contract, a final profit and loss account is prepared and at that time any amount in the Participation Reserve will be distributed among the two parties in the ratio provided in the contract.

* If, during a financial year, losses exceed profits and the Participation Reserve is insufficient to make good such losses, the company may ask the investor for a refund (in whole or in part) in respect of the amount it had debited from the Musharaka Account. The model agreement has laid down a time limit for this refund request; otherwise the claim will be time barred.
* Any breach of a covenant or the undertaking of any unauthorized business by the company which may jeopardize the interests of the investor is a breach of contract which entitles the investor to terminate the agreement. In these circumstances the investor is entitled to the return of its share of the redeemable capital in the company together with, it appears, its share of the Provisional Profit. II the company is unable to pay these amounts, liquidated damages equal to twenty percent of the unpaid amount becomes due.

* If the investors share of profit in any two of the preceding three years, is less than the Provisional Rate of Profit, the investor may convert not more than 20% of its investment into ordinary shares based on the breakup value of the company.

* If the investor suffers losses owing to the negligence or the mismanagement of company, itmay liquidate the company.

*The investor can take security such as a mortgage, hypothecation or a pledge.

The growing number of Islamic institutions internationally offer the opportunity for creative international financing techniques. Clearly the debate as to what will or will not be Islamic will continue with differing views and opinions and it is likely, therefore, that Islamic financing will continue to undergo developments and changes.