This article considers the most common structures employed in Islamic finance and deals with some of the criticisms surrounding its practice.
Islamic finance is one of the fastest developing areas of finance which has grown at between 10 to 15 percent annually over the last decade. In addition to Muslim majority states, Islamic finance continues to expand into an increasing number of non-Muslim countries. Over the past decade, legislative reforms have been introduced in several jurisdictions, including major financial centers such as the UK, Hong Kong and Singapore, to place Islamic finance on an equal footing (from a regulatory and tax angle) with its conventional counterpart.
Islamic finance is considered as being a more ethical form of finance and some practitioners have argued that due to the prohibition on gharar (uncertainty) and maysir (speculation) in Islamic finance, its expansion may act as a stabilizing force in times of volatility in global financial markets. Whether this is correct remains to be seen, but it is clear that the
structuring constraints within Islamic finance meant that Islamic banks were less exposed to some of the more speculative forms of investment which led to the 2008 global financial crisis, and were therefore not as severely affected.
So what is Islamic finance and how does it differ from conventional finance? It could be argued that on a practical level, Islamic finance is not different from its conventional counterpart and has the same economic effect as a conventional loan. However, at a conceptual level, the principles and transactions in Islamic finance make it an altogether different form of finance.
As is well known, Shariah prohibits riba (interest) and therefore an Islamic financier cannot simply rent money like a conventional bank.1 The provision of finance in a shariah compliant manner therefore has to enable the financier to earn a return but without charging interest. An Islamic financier therefore makes funds available to its customers by entering into a real underlying transaction; the entry into such transaction forms the basis on which funds are advanced to the customer. In turn, the Islamic financer earns a return by being a party to this transaction, either by charging a profit or mark-up on the sale of an asset, via a profit sharing arrangement or by renting a tangible asset to the customer.
A conventional loan agreement can broadly be divided into five parts; (1) the facility disbursement and repayment mechanics; (2) the yield protection clauses; (3) commercial provisions dealing with warranties, covenants and events of default; (4) syndication provisions; and (5) boilerplate clauses. Of these, Islamic facilities differ only in respect of the first two, and to an extent, the syndication mechanics. The commercial and boilerplate provisions have less to do with shariah principles and are subject to agreement among the parties, and therefore tend to be similar to conventional facilities.
This article, which assumes familiarity with Islamic finance concepts and LMA loan documentation, explores the similarities and differences between Islamic and conventional finance. The discussion below focuses primarily on ijara (lease) and murabaha (cost plus sale) financing structures, being the two most commonly adopted ones in recent years. Other participation based financing structures such as mudaraba and musharaka have become relatively less prevalent following the criticism of the use of fixed price purchase undertakings in such structures by AAOIFI's chairman in 2008 (although they are still used in many IF transactions). The following sections compare the mechanics of an Islamic facility with a conventional loan.
Disbursement and repayment mechanics
The shariah prohibition on interest necessitates that the Islamic facility must be made available by participation of the customer and Islamic financier in an underlying "transaction", as a consequence of which the financier makes funds available to the customer. This transaction may take the form of a sale (murabaha or tawarruq), a leasing arrangement (ijara), an equity or agency based participation interest (mudaraba, musharaka or wakala) or a procurement contract (istisna or salam). For example, a murabaha transaction involves the financier acquiring an asset for the customer, followed by the sale of the asset to the customer at a pre-agreed mark-up. The financier purchases the asset on spot and sells it to the customer on deferred payment basis. The purchase and sale of an asset or commodity forms the basis on which the customer becomes indebted to the financier. The cost price of the asset is equivalent to principal whereas the mark-up forms the equivalent of interest in a conventional loan. The mark-up is calculated in a manner similar to interest and is indexed by reference to an interest rate benchmark. The tawarruq, a variant of the...