Over the last few years, and especially since the financial crisis of 2008, the concept of Islamic financing or banking has been gaining momentum as an alternative financial model for lending and banking. In the UK for example, since 2013, there has been a wider acceptance of this model of financing, and in fact there has been a wide push by the government for the creation of Islamic compliant investment opportunities, both for the domestic market’s consumption, and as a means of attracting foreign investment in the UK financial market.
Here in North America the model has garnered some attention, and in fact currently there are few lending companies that offer Islamic compliant financing options, however the model has not been seen as attractive enough or in demand enough to be created and offered as a product.
The attraction to this model of financing and banking is primarily due to the fact that Islamic financing puts emphasis and operates on the notion of shared risk between the lender and the borrower, as oppose to the traditional western style banking and financing. That is why this model garnered more attention after the financial crisis of 2008.
Islamic financing operates and is governed by Sharia (Islamic law) and its practical application through the development of Islamic economics. Central to this system of finance is the fact that money itself has no intrinsic value, rather, it is simply a medium of exchange. Muslims are not allowed to make profit by exchanging cash with another person. Therefore, an Islamic compliant lender cannot make profit by lending or receiving money from someone else. Simply put, this means that earning interest on a loan is not allowed, regardless of whether the lender is an individual or a bank.
This then raises the question of how do Islamic compliant financial products work, and how do the lenders/ banks make profit through this financial model?
There are several ways by which lenders and banking institutions structure sharia compliant financing options:
IJARA: works as a leasing arrangement, whereby the lender purchases the property/asset and leases it back to the borrower. In some instances the financing deal maybe structured so to allow for part of the instalment payment to go toward the final purchase. This form of financing is usually used in financing of car or business equipment.
MURABAHA: works by way of supplying of goods for resale to the customer at a price that includes a margin above the cost of purchase, and allows for repayment in installments. This model is often used to provide a mortgage on a property. Please note that the property will be registered in the name of the borrower from the commencement.
MUSHARAKA: can be considered a joint venture between the borrower and the lender, wherein the borrower and the lender both contribute funds towards the purchase and agree to share the profits in proportion to their investment. Of course while the borrower and the lender share the profits in this model, they also share the risks as well.
WAKALA Islamic financial institutions also act as agents for their customers by providing investment opportunities in sharia-compliant trading activities. This is achieved by the financial institution entering into an agreement with the customer to use their cash to make investments and generate a target profit for their customer. Since it’s Islamic, that also means that financial trading is off-limits for things that are forbidden even if no interest is charged – so investments can’t be made in alcohol, tobacco, non-halal meat products such as pork, pornography or gambling companies.
So how does an Islamic mortgage work? Islamic mortgages either take the form of an Ijara model, described above, where the borrower technically is leasing the property from the lender or diminishing Musharaka, where the borrower and the lender purchase the property in partnership and the monthly repayments gradually buyout the lender’s share in the property. The basic requirements of a standard mortgage still apply as the borrower is required to have a deposit, property will still need to be appraised, and income verification will also be required. The borrower and the lender can agree to a fixed the monthly payment amount based on the deposit. Therefore, in both models, the lender is repaid its share of the investment at a profit, while not charging the borrower interest on the amount of the investment.
Rules of enforcement are also different with Islamic mortgages. In this model, non-payment which is tantamount to a breach of contract does not automatically result in the initiation of enforcement proceedings by the lender against the borrower. Rather, the lender based on the rules of sharia will evaluate the cause of the borrower’s failure to comply with the repayment agreement. If the underlying cause of the breach by the borrower is one that is considered to be allowable under the rules of sharia (usually for causes such illness and etc.) then the lender will come to an agreement with the borrower in order to resume the repayment on a more mutually beneficial terms. Certain institutions that offer such products have put in place as counsel individuals with expertise on sharia law as it pertains to financial transactions. These individuals, on a case by case basis, decide whether the underlying cause of the breach is acceptable or not. If the cause is not one that is acceptable under the rules, then the lender may choose to resort to the remedies available to it.
To conclude, Islamic financing is all about sharing risk between lenders and their borrowers. The parties are tied together into long term financial relationships, where parties shares the profits, losses and the risk involved.