Understanding Islamic Finance

How is Islamic finance different from conventional finance ?
It looks the same; the result is often the same. What is the difference ?

Let’s take a real world comparison. Let’s take $ 10,000 for
instance and compare what a conventional bank can do with this and what an
Islamic bank can do.

The conventional bank finds a creditworthy customer and lends
at 5% interest. The bank is not particularly concerned about what happens to
this money other than that it gets repaid. The customer on the other hand has
already found a borrower willing to pay 7%. The borrower runs a small credit
co-operative for students and lends at 10%. One of these students is
enterprising enough to lend to his unemployed brother at 15% who has just
discovered the power of compounding interest and lends to street vendors at 25%.
We can go on. But you get the idea. There are poor people today paying upwards
of 40%.

The problem with artificial wealth creation based on interest
and the fact that you do not need actual cash to lend money means that the
original $ 10,000 could keep passing hands until we pump out over $ 100,000 of
artificial wealth. So how much actual cash is there ? Only $ 10,000. With
interest, we managed to turn $ 10,000 into much more. So are we surprised when
billions of dollars vanish into thin air ?

The Islamic bank only invests in actual assets and services.
It might buy machinery, lease out a car, or invest in a small business. But
throughout, the transaction is always tied to a real asset or service.

That is the difference between Islamic finance and
conventional finance. The difference between buying something real and borrowing
and lending something fleeting. What conventional finance enables is the ability
to sell money when there is no money; to sell assets before there are underlying
assets and to allow debts to grow unchecked while borrowers become more
desperate.

Interest creates an artificial money supply that is not
backed by real assets. The result is increased inflation, heightened volatility,
richer rich, and poorer poor.

It seems unbelievable but sadly it is typical. Developing
countries start off with relatively small loans and remain saddled with huge
amounts of growing debt for generations. This could be Nigeria, or any other
poor country. To give just one other example, during the years leading up to the
1997 Asian collapse, Indonesia’s foreign debt as a percentage of GDP was over
60%. So Nigeria is certainly not an isolated example.

UNICEF estimates that over one-half million children under
the age of 5 die each year around the world as a result of the debt crisis. But
as we have seen, it is not the debt that is the problem; it is the compounding
interest.

In 2009, Nick lost his job, his house and all the money he
had spent paying off his mortgage. Let us consider that Nick availed a
Diminishing Musharakah (Partnership) facility with the bank.

Under a Diminishing Musharakah, the bank’s equity decreases
throughout the tenure of the financing, while the client’s ownership keeps
increasing throughout a series of equity purchases. Eventually, the client
becomes the sole owner.

Nick, having lost his job, would still have an equity stake
in an actual property that he could monetize.

Assume he purchased a $ 220,000 house and put down $ 20,000,
financing the remaining $ 200,000 from the Islamic bank. The finance is to last
20 years and the bank sets a 5% profit rate. For the sake of simplicity we will
make it 20 annual instalments. (Refer Table)

In the second column of the Table we have the homebuyer’s equity purchase, which is how much the buyer pays every year for buying the property’s actual equity. It is his way of increasing ownership in the property while diminishing the bank’s ownership as shown in the third column of the Table. The fourth column of the Table called rent is what the homebuyer pays the bank for the portion of the property he does not yet own, a number that keeps decreasing as the bank’s share keeps decreasing. The final column shows what the homebuyer pays in total every year.

At no time does the homebuyer pay any interest. And certainly at no time does any payment compound. The homebuyer pays for just two things: the house in incremental payments, and the rent for the portion of the house he does not yet own. Call it Islamic finance, ethical finance, or conventional finance; when banks take real ownership of an asset, what can only truly be called real risk, economics do not fall apart like a house of cards.

So how could Islamic finance have helped former President Obasanjo of Nigeria?

Using the $ 5 billion from their initial borrowing, Islamic banks could provide $ 5 billion of financing for infrastructure, literacy, healthcare and sanitation programmes to name a few.

An Islamic bank could have arranged for the $ 4 billion construction of a natural gas pipeline delivered to Nigeria for $ 5 billion using an Istisna financing.

Or taken an equity stake in a highway project and shared in profits and losses using a Musharakah partnership.

The next time one wonders whether Islamic banking is just dressed-up conventional banking, see if one finds a single major consumer bank that co-owns actual properties with their customers. An Islamic bank takes direct ownership of actual assets, whether for a long period such as in a lease or equity partnership, or for a short period, such as in a sale trade.

Simply put, Islamic finance permits equity, trade, and leasing, but forbids debt.

Principles guiding Islamic banks:

Islamic banking transactions must be:

The Islamic ban on interest is not new. For centuries banned by Christians and Jews, Islamic Law prohibits paying or earning interest irrespective of whether it is a soft development loan or a monthly consumption loan.

The Bible contains the following verse:

“If you lend to one of my people among you who is needy, do not be like the money-lender; charge him no interest.”
— Exodus 22:25-27

In March 2009, the Vatican came out with the following statement : “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

Today, Islamic finance is no longer a niche market. With global assets estimated at USD 1 trillion, asset growth has kept steady in most countries at over 15% per annum. Apart from Muslim countries, Islamic finance has penetrated into countries like Singapore, China, Australia, Thailand, Canada, United Kingdom, France, Korea, Japan, Switzerland, and Luxembourg.

Conventional banks with extensive Islamic banking operations include Citigroup, HSBC, Deutsche Bank, UBS, ABN-Amro, and Standard Chartered.

Standardised accounting and product standards promulgated by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) provide regulated standards and common bases for global convergence. Islamic market indices like the Dow Jones Islamic Market Index comprise 69 country indices including India’s.

India is on the threshold of launching key Islamic finance initiatives with the Reserve Bank of India considering landmark policy changes. Companies like TATA AIG, Bajaj Allianz, and Taurus have already started to tap this segment of the market by offering Islamic-friendly products. With over 160 million Muslims in India, and with its strong position in global capital markets, India stands poised to become a major Islamic finance hub in the coming years.