The dos and don'ts of Islamic finance

Author: | Published: 1 Apr 2007
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As many people are aware, Islamic finance does not accept the lending of money against a pre-determined risk free/guaranteed growth (interest). To avoid the pure lending of money against interests (known as riba), Islamic contracting and finance are structured on asset-based finance, partnership, and shared risk and reward principles.

Islamic finance has a basic ethical understanding that is quite universal (for example, no investment in gambling, prostitution, or arms manufacturing). Generally, doing business and making profits is allowed and even encouraged. The surplus created should be used to support the family and be distributed equally to charities.

The combination of those rules gives rise to special types of contracts, special clauses and restrictions that differ somewhat from conventional contracting, but do not necessarily conflict with it. Contracts should also be clear and transparent, free of any uncertainties and the rights and obligations of the parties should be clearly stipulated.

Contracts for partnerships and specific sales contracts are the basic tools with which a lawyer working in this field should be knowledgeable. They can often be easily inserted into one's own legal framework, respecting the specific restrictions of the Islamic way of thinking

Contrary to general western belief and understanding, Islamic thinking is not static, but is always evolving. Interpretations of rules regarding finance and other areas can be different and based on place and time.

Murabahah

The murabahah contract is a simple sales contract where the transaction is concluded with immediate delivery of the goods, but the payment can be deferred to a later time (bai'mu'ajjal variation). The murabahah contract then is not a loan (and certainly not in violation of the prohibition on interest), but a pure sale (business transaction). The sale is concluded at a fixed price that may give rise to an agreed mark up.

If an Islamic finance institution is involved in the sales transaction, the financial institution will acquire the commodity first and then sell it through to the client with (or without) deferred payment at original price plus the mark up.

Ijarah

The ijarah is the Islamic counterpart of the conventional lease contract. It involves transfer of the usufruct only. The risk and liabilities associated with the use of the asset will be borne by the client. At the same time, all the risks and liabilities connected with the ownership of the assets (such as loss or destruction) rest with the owner /financial institution.

The ijarah can become an ijarah wa iqtina (financial lease) when the user/client has the option to acquire the commodity at the end of the lease period (normally at down payment of a certain price).

Salam

One of the basic rules for Islamic contracting is that nothing can be sold that does not already exist and is not in the (constructive) possession of the seller. Sometimes, however, pre-financing is necessary to allow production. For these situations the bai al salam (in short, salam) may be used.

The salam was intended to finance agricultural exploitations and was used in this manner to allow farmers to receive financing that allowed them to buy the materials needed for their future crops. For this, contracting over future goods is allowed, but quantity, quality and time of delivery have to be specified.

The commodity must exist in units with homogenous characteristics that are traded by counting, measuring or weighing according to usage and customs of trade (excluding precious stones of which quality can differ). Payment must be immediate.

Istisna

Istisna in many regards appears the same as a salam, but relates to goods for manufacture. The difference between salam and istisna is that:

  • the payment of the price is not necessarily immediate (deferred payment is possible); and
  • it envisions individualized goods for manufacture.

If the manufacturer is acquiring the goods that it will use to make the commodity from the buyer/financial institution – so its only contribution is labour –an istisna in general is not permissible (for instance a rent of labour contract can then be used).

Musharakah

This contract refers to a joint business enterprise in which the partners (two or more persons) undertake to share all the profit/losses of a specific venture. The way profit will be shared must be agreed at the outset and any periodical advance for one or more partners will be off-set at the settlement of the accounts/closing of the partnership.

The profit sharing must to be in relationship to the input of capital, but it can be agreed that one partner gets a bigger share (for example, if it provides more labour) provided that a non-working partner (silent partner) to the musharakah can only be granted ratio of the profit that is maximum equal to its input in the capital.

It is not permissible to establish a fixed and guaranteed return to be allocated to a partner, because this would suggest the loan of money and/or would mean that a partner does not take its share risk in the enterprise.

Buyout clauses (unit by unit) can be built into a contract. Consequently, one partner will slowly buy out the other partner and in the end own the entirety. This technique is usually used for investment purposes, where the financial institution partners up with a client, leases the goods to the client (through ijarah) and slowly exits from the project.

Mudarabah

In this type of partnership, the silent partner, rabb al-mal, only invests money and the working partner, mudarib, only invests labour/expertise. This arrangement is generally used when a party only needs a certain amount of capital input.

The mudarib will manage the partnership for all matters that concern the regular course of business. Besides its labour, the working partner cannot suffer loss (excluding responsibility for fraud, negligence, misconduct or wilful wrongdoing or contravention of its mandate). It can be rewarded an agreed-upon share of the profit, wherein advances are allowed, which can be subject to ultimate payback. The rabb-al-mal risk is limited to capital itinvests.

It can take some time to get used to the different contracts (and their combinations) within Islamic finance, but the attentive reader will feel that nothing really new has been introduced. After all... a sale is a sale. When the lawyer is aware of the dos and don'ts and the rational behind those rules, Islamic contracting usually is easily adapted to most finance, corporate and construction needs. The ethical conditions also make for cleaner contracting than conventional structures. The need for basic rules of this kind is felt worldwide.

Turkey's Islamic finance market

The participation banks (local terminology for Islamic finance banks) have grown considerably, especially since the crisis in 2001. Growth is at an average annual rate of 46% in terms of asset size, 61% in terms of funds placed, 47% in terms of funds raised (between 2001 and 2005).

The Islamic finance sector as a whole operated at the end of 2006 about 340 branch offices (up on 290 branches at the end of 2005) and expects to grow at a rate of 50 new units a year. Combined staffing grew from 5,740 (in 2005) to 6,565 (September 2006). Compared to 2005, deposit/investment accounts have grown by about 25%.

There are four fully fledged participation banks in Turkey:

  • Albaraka Türk Participation Bank (Albaraka Turk Katilim Bankasi), part of the Gulf-based Albaraka Banking Group, is said to be preparing for an IPO in 2007.
  • Kuveyt Türk Participation Bank (Kuveyt Turk Katilim Bankasi), part of the Kuwait Finance House. Depending on market conditions, it might be a candidate for an IPO in the coming years.
  • Türkiye Finans Participation Bank (Turkiye Finans Katilim Bankasi), of Turkish origin (Boydak and Ulker).
  • Bank Asya (Asya Katilim Bankasi), also of Turkish origin. In May 2006 it conducted probably the most successful IPO in Turkish history, raising $150 million for 20% of its shares, valuing the bank at $800 million (but with $7.5 billion worth of offers for an oversubscription of 50 times).

In addition, outside players have entered the Turkish market.

Dubai Islamic Bank has representative office in Istanbul.

The International Investor TII (Kuwait-based) is investing in the Turkish market.

ABC Islamic Bank (EC) intends to increase its financial activities in Turkey over the next years. Among others, it is gearing up for the new Turkish mortgage law (extensive knowledge available through its alburaq diminishing musharakah product line) and intends to offer overnight murabahah to Turkish financial institutions (through its ABC Clearing Company).

An increasing number of Islamic finance houses are showing a presence in Turkey. Institutions such as Amlak Finance, Dubai Bank and National Bank of Kuwait Capital have established representative offices, formed partnerships or are about to form partnerships to take a more active role in the development of the sector in the country.

Recently, in December 2006, the Qatar-based Doha Bank opened its representative office in Istanbul. This followed the strategic alliance (March 2006) between Dubai Bank PJSC and Daruma Corporate Finance (Turkey) to cooperate in originating and structuring, execution and distribution of shariah-compliant corporate finance and merchant banking services.

Several international banks such as BNP, Calyon, and Deutsche Bank have joined ABN Amro, Citigroup and HSBC in promoting Islamic finance as part of their mainstream product offerings and can be assumed to enter the local market in time.

Over the last decade, a substantial cross-border Islamic finance market has developed (initiated and still more or less dominated by HSBC). Originally a funding vehicle for the cash-strapped local banks by way of bank guaranteed financing to local corporations, the market has expanded to an annual estimated volume of roughly $500 million to $600 million, with corporate risk-based structures, often with security packages involving cheques, export receivables and credit card receivables.

Leasing operations are an inherent part of the licence of Turkish participation banks. So the traditional mark-up sales (murabahah) together with leasing (ijarah) are the main products available to local consumers, aside from the products offered by the conventional financial institutions that are considered to be compliant.

The cross-border syndications are handicapped on this issue and for the moment only use the murabahah, because leasing finance is subject to approvals that complicate the process.

Government sukuks are not available in Turkey, due to the lack of regulatory infrastructure. Government interests to regulate the sukuk have been postponed, mostly because of the present offer of inexpensive funding from the international conventional market.

Several private issuers have begun considering sukuk and are evaluating market conditions and the regulatory framework for their purposes.

It is estimated that the assets of the participation banks in Turkey will exceed $25 billion in the next decade and will make up 10% of the total banking system. Growth in the cross-border syndication market will follow at least at a comparable pace.

Source of statistical data: Association of Turkish Participation Banks

Paul Wouters is a member of the advisory board for Islamic Finance News (Malaysia) and holds the Islamic Finance Qualification SII, London

Company biography

Bener Law Office

Bener Law Office is a Turkish law firm with a strong western European understanding and a comprehensive, proven track record in central Asia and Europe. The firm provides cost effective services in Turkish, English, Italian, German, French, Dutch and Spanish. Its well-balanced and experienced team is eager to render the best possible legal service and design business-focused solutions.

Lawyers and professionals play active roles in the development of economic relations. Both the firm's local and international clients are offered premium quality (cross-border) legal advice. The firm also facilitates negotiations and designs various types of commercial contracts according to clients' needs and goals.