ISLAMIC FINANCE

Introduction

Almost three decades ago, the concept of Islamic finance was considered wishful thinking. Today, more than three hundred Islamic financial institutions are operating worldwide, estimated to be managing funds to the tune of USD 200 billion. Their clientele includes everybody and is not confined to people in the Muslim countries and to a specific religion. It is spread across Europe, the US, and the Far East, while offering investors an opportunity to invest their financial resources in accordance with the ethics and philosophy of Islam.

Expanding Frontiers Through Time

Early twentieth century - 1920s and 1930s - witnessed establishment of first Muslim-owned banks, but they adopted practices similar to conventional banks. The first thorough studies devoted to the establishment of Islamic financial institutions were made in the 1940s. In 1940s and 1950s, several experiments with small Islamic Banks were undertaken in Malaysia and Pakistan. However, the first great success in the field came with the establishment of an Islamic bank in the Egyptian village of Mit Ghamr in 1963. The discussion, debating the desirability of abolishing fixed interest rates and Islamization of financial systems, came up for the first time at a meeting of the Islamic Organization Conference (IOC) in Jeddah in 1973. Thereafter in 1974, Islamic Development Bank (IDB) was set up by the IOC to promote Islamic banking and provide funds for development projects in the member countries. The IDB provided fee-based financial services and profit-sharing financial assistance to member countries. Other successes followed quickly, including the establishment of Inter-Governmental Islamic Development Bank in Jeddah in 1975. Realizing the potential of Islamic banking, a number of Commercial banks worldwide leveraged the concept for more diversified growth. This led to the establishment of several Islamic Banks such as the Dubai Islamic Bank, the Kuwait Finance House, and the Bahrain Islamic Bank in the 1970s and 1980s.
Modern Islamic banking has undergone three phases of development. The first phase was during 1972 through 1975 as a surge in oil revenues resulted in great liquidity and a re-emphasis on Pan-Islamism. During the period from 1976 to 1980, Islamic banking expanded eastward from the Arabian Gulf to Malaysia, and westward to England. Simultaneously, Islamic banking associations or consultancy bodies broadened their operations. Post 1983, Islamic banking began to gain acceptance as the Arab world was confronted by economic setbacks, including slowdowns in oil revenues, relative strength of the US dollar, higher interest rates in the United States, and capital outflows from the OPEC nations. In order to mitigate the situation, Islamic banking began to spread its wings into countries like Pakistan and Iraq. It did not target only the Muslims, but was opened for everyone across religions. It expanded to markets like the UK, which is an international financial hub. Further, it did not aim merely at the 1.8 million Muslims living in the UK, but also others. With time, awareness of Islamic finance has significantly increased and it appears to be on the path to consolidating its position the world over.

The Principles of Islamic Finance

The recent surge of religious consciousness amongst Muslims has provided an impetus to adopt and implement Islamic principles in financial transactions. In an attempt to purify assets in the eyes of Islam, Muslims are seeking a greater balance between their lives in the modern technological world and their religious faith and beliefs.
Among the most important teachings of Islam, for establishing justice and eliminating exploitation in business transactions, is the prohibition of all sources of unjustified enrichment and dealing in transactions that contain excessive risk or speculation. Apart form this, Sharia’a allows only Halal activities and forbids activities like gambling, liquor, hoarding, and usury based lending - for example, the bank can not finance liquor manufacturing, transportation, storage or distribution companies. Accordingly, Islamic scholars have deduced three principles from the Shari’a that characterize Islamic economics, including:
Prohibition of Interest (Riba)The prohibition of usury or interest (Riba) is clearly the most significant principle of Islamic Finance. Riba translates literally from Arabic as “an increase, growth or accretion”. In Islam, lending money should not generate unjustified income and Riba represents, in the Islamic economic system, a prominent source of unjustified advantage. Shari’a refers to the premium that must be paid by the borrower to the lender along with the principal amount, as a condition for the loan or for an extension in its maturity, which today is commonly referred to as interest. All Muslim scholars believe that this prohibition extends to any and all forms of interest and that there is no difference between interest-bearing funds for the purposes of consumption or investment, since Shari’a does not consider money as a commodity for exchange. Instead, money is a medium of exchange and a store of value.
Profit and Loss Sharing (PLS)PLS financing is a form of partnership, where partners share profits and losses on the basis of their capital share and effort. Unlike interest-based financing, there is no guaranteed rate of return. Islam supports the view that Muslims do not act as nominal creditors in any investment, but are actual partners in the business. It comprises equity-based financing. The justification for the PLS-financier’s share in profit is his effort and the risk he carries, since his profit would have been impossible without the investment. Similarly, if the investment has made a loss, his money would be lost.
GharrarAny transaction that involves Gharrar (i.e. uncertainty and speculation) is prohibited. Parties to a contract must have actual knowledge of the “subject matter” of the contract and its implications. An example of an agreement tainted with Gharrar is an agreement to sell goods which have already been lost.

Reasons for Emergence of Islamic Finance

Islamic finance has been around for decades, but its wide acceptance, particularly in the GCC region, is a recent phenomena. One of the many reasons responsible for this are: First, wealth accrued by high oil prices in parts of the Middle East that are rich in oil reserves, whereby, the current account surpluses of oil exporting countries witnessed a healthy growth. Earlier in the 1970s, when oil prices touched new highs, the Arab world witnessed mushroom growth of Islamic institutions to absorb the surplus liquidity, benefiting the depositors (who are investors in Islamic finance). When oil prices picked up once gain post 2000 (ref the chart), the GCC countries rolled in high oil revenues, resulting in more liquidity and in turn excessive cash flow to the public in the region. Currently, rich Muslims are parking their funds with the Islamic financial institutions.

Excessive revenues in the region accelerated the execution of development plans and major infrastructure projects by the GCC Governments to boost the non-oil sector. The funds generated through Islamic banking institutions were channelized into these initiatives. This further boosted the confidence in the investment climate of the states. Substantial oil revenues, accompanied by growth in worldwide financial networks have fostered further expansion of Islamic banking.

Other Drivers of Islamic Finance
Muslim PopulationThe growing population of Muslims across the world has also been a major factor behind the success of Islamic finance. Since Muslims are inclined to follow Islamic traditions, there is a tendency to establish an Islamic economic system in every Islamic nation and to restore Shari’a law as the founding rock for legislation. Currently, Muslims account for around one-fifth of the world’s population. The average growth rate of the Muslim population, coming in at 1.9% (between 2000 and 2006), is far higher than the world’s average population growth rate, which is 1.22% for the same period - much faster than in any other religious group. According to the CIA, in 2006, globally the Muslim population stood at 1.6 billion, accounting for 22% of the world’s total population.

9/11 AttackPost-9/11, investors were reticent of too much exposure to the US and Europe. After September 2000, investors from the Gulf States took back billions of dollars of invested capital from the US and poured it into their own backyards. The concomitant rise of Islamic banking has given a good option to the GCC investors in their own home, where they can park funds for good returns.
Real Estate BoomThe huge current account surplus and solid liquidity in the Middle East (resulting from high oil prices) encouraged the Governments to take up several major infrastructure projects to boost the non-oil sector. Consequently, the real estate sector has experienced unprecedented growth rate of 15%-20% in the last few years. Interestingly, the real estate sector lends itself to Islamic finance as it is easier to formulate Shari’a compliant investment products.

Current Scenario

In 2005, there were around 270 Islamic banks worldwide with a market capitalization in excess of USD 13 billion, managing total assets worth more than USD 300 billion and financial investments above USD 400 billion. Islamic bank deposits are estimated at over USD 250 billion worldwide with an average growth of 20%. Additionally, Islamic equity funds have an estimated size of more than USD 3.3 billion worldwide. While a majority of those assets are held in the Middle East and Asia, a growing number of European and North American institutions involved in Islamic equity funds bears testimony to a rising trend in this emerging market. Islamic bonds, known as sukuk are currently estimated at round USD 30 billion and are hot issue in Islamic finance. The last five years have witnessed rapid growth of sukuk, and major western banks such as Citigroup, HSBC, Deutche, UBS and Merril Lynch have opened a window that offers Islamic banking services and products. Thus, Islamic finance is gradually eating into the market share of conventional banks, particularly, in the Middle East. In Saudi Arabia, more than 30% of banks’ assets are now classified as Shari’a compliant, while in other Gulf States it ranges from 10% to 20%. Meanwhile, in Malaysia, around 10% of the banking assets are Islamic.

As an industry, Islamic finance is expanding. Islamic banking licenses for financial institutions in Asia and the Middle East is on the rise. Kuwait and Malaysia have granted more than eight licenses in the past few years. Malaysia, the leader in Islamic banking, granted licenses to four foreign Islamic banks in 2004 alone, in order to become regional Islamic financial hub. Islamic banking is evolving in the West along the same lines as it did in the Muslim countries in the last decade. Conventional western financiers such as HSBC, Lloyds TSB, and UBS have all been attracted to the market, setting up their own Islamic banking operations or subsidiaries. Citibank has started “Citibank Islamic” in Bahrain and is now providing limited Islamic financing windows out of its international operations in New York & San Francisco. Such interest has arisen off the back of enhanced recovery and performance of global banking as a whole, as well as solely Islamic banking advances. These include the pace at which new Shari’a-compliant products are being brought into the market, and the willingness of borrowers to use Sukuk as a way of generating funds.

Islamic banks are expanding at a rapid rate, especially in Saudi Arabia, Kuwait, and Bahrain. In Pakistan, Iran, and Sudan, Islamic banking concepts have been supported by government action: in Pakistan, the government has ordered Islamization of banking practices; Iran has recently implemented an Islamic banking system; Sudan is applying Shari’a to many of its economic activities. Internationally, two banking conglomerates - Dar-al Maal Al-Islami (DMI) and AI-Barak.a - and the International Islamic Banking System (IBS) have established Islamic branch banks in different countries of Asia, Europe, and Africa.

An example of the expansion can be seen in the recent Dubai Ports World Sukuk issue. Dubai Ports Customs and Freezone Corporation raised USD 3.5 billion, with the issue initially intended to raise USD 2.5 billion only. This was due in part to the fact that the issue was oversubscribed heavily, to the tune of USD 11.5 billion. Similarly, the IPO of the Islamic bank Al Salam (Bahrain) which raised USD 111.4 million, closed on February 19, 2006 - over 63 times oversubscribed.

New methods of accepting deposits and providing financing without interest pose challenges for financial regulators. Consequently, there has been much debate about whether Islamic banks can be regulated in the same manner as conventional banks, or whether different criteria should be used. One perspective even questions if Islamic banks are actually banks, as their savings and investment accounts cannot be guaranteed and, therefore, arguably possess some of the characteristics of investment companies. Further, much Islamic financing involves trading and leasing rather than conventional lending and, consequently, the institutions involved could be regarded as trading and leasing companies rather than banks. Further, some Muslim scholars see Islam and banking as being incompatible. They object to the term “Islamic banking”, which is seen as using religion to promote banking. Therefore, in Kuwait, the largest Islamic financial institution - Kuwait Finance House - is designated not as a bank but as a finance house.

Political factors ultimately determine the regulatory environment. In some countries, notably in North Africa and in Libya or Morocco, Islamic banks are perceived as being linked to Islamic political parties, and are, therefore, refused banking licenses. Elsewhere, such as Egypt, Algeria, and Tunisia, the governments are extremely cautious. In contrast, there has been tremendous official support in Bahrain and Malaysia, reflected in the positive regulatory approach. Meanwhile, in Iran and in Sudan, all domestic retail and commercial banking has been made interest-free.

Doing Business – The Islamic Perspective
Through this article I will attempt to draw the attention to certain key aspects of doing business in the Islamic perspective, through a few pointers experienced by myself in my Business Career
Since the subject is very vast and diverse I will limit myself to the two basic ingredients required to be successful in the present competitive business environment.
1. Ethics
2. Financial Competence
Both of these issues are very Islamic in nature, or in my opinion they are absolute deen.Unfortunately we have grave misconceptions about Deen in our minds, and therby have a very limited view of what exactly construes as to what is true Deen.This is because we have compartmentalized the whole concept of Deen into illusory blocks.
So what is Deen? “Deen consits of five basic segments,”
1. Imaneeyat,Faith
2. Ibadat,- Salat,Hajj,Fasting,Zakat,physical Appearance
3. Ahklak,- Character & Conduct between two human beings
4. Masharat,-Environment,Building of society, equality and justice for all
5. Mumulaat,Dealings,More particularly Business ethics and Financial Dealings
Since Islam had identified the ills of an unjust Interest-based Economic system,the Quran came out very clearly against its prevalent use.The Quran did not just stop with an injunction on Interest but in the same sentence encouraged enterprise and trade.That Ayat in Surah Al-Imraan spell out Allah has permitted Trade and forbidden Interest Furthermore in another Ayat Allah glorifies a true Businessman by saying that:
“Their doing business does not stop them from the remembrance of Allah”
Similiarly according to one Hadith a Truthful Businessman has been giving glad tidings of being together with the Shuddah and Salaheen on the day of judgement.In a number of places the Quran and Hadith spell out the virtues of Business.Doing Business per say is not Fardh,or Wajib but if one is in that profession,then doing it exactly in accordance with Isalmic ethics and Shariah is absolutely Fardh Let me make it very clear Shariah has never and will never contravenes any Law of any country on the contrary it is complimentary to it.A huge number of Law makers have referred to the Quran, forconstruction of their legislature.Where are these laws Laws derived from? There are four main classically
accepted sources of Islamic Law:
􀂾 Quran
􀂾 Sunnah
􀂾 Ijmah-Consensus
􀂾 Qiyas-Analogy
In addition to these there are some other minor sources as well, from these roots of Law is derived the “Shariah” which means “the way or the path”
There are approximately 500 verses in the Quran which contains legal injunctions,out of which
􀂙 70 deal with Family Law
􀂙 70 deal with Civil Law
􀂙 30 deal with Penal Law
􀂙 13 on Jurisdiction and Procedures
􀂙 10 verses on Constitutional Law
􀂙 25 verses on International Law
􀂙 20 on the Economic and Financial Order
􀂙 50 on the source of Law in general
As aresult an entire Science of these interpretations developed into a full set of codes of Conduct in doing
Business, which is known as Fiqh-ul-Mumalat.
I have dwelled upon these issues,so as to impress upon ourselves and to help us understand the importance of trade and business within the Overall Islamic Fiduciary System
Today this Ummah,which gave to the world the earliest and the most enlightened concept of banking,where the lender and borrower were considered as partners in Business (Mudahrabah)has totally gone int oblivion from the international business scene
What happened to the followers of those pious Arab traders who were known for their Entrepreneurial
skills and who were pioneers of international trade when the world had not even mastered navigation and astronomy.
Yet today,we are not even considered a community of Business Repute. Why? What has reversed the course of our journey? We have badly falterd in our Islamic Trade Ethical practices. What are they?
Certain key practices are:
I. To accept sold goods back with Ikhlaas
II. Clearly mark any fault,blemish or distortion in the product.
III. Not to make any false claims or praise too much about one’s product
IV. Transperancy and standardization of the product
What an enigma?
This present day Western Business has just replicated the Islamic ethical practice and the result is in front of us. Any of us can just ponder into these businesses either through a Supermarket, Airline or any otherservice industry,we are more comfortable buying their product than any other. We need to apply the Mamulaat side of Deen immediately! Another key issue we need to address is long
inancial planning and management,how important long-term perspective is can be gauged from the
following quote of one Sahabi RA who says “live in this world as if you are to stay a thousand years and
prpare for the herafter as if you are going to die now.”
Financial discipline is the basic requirement, best of entrepreneurs have fail due to financial
mismanagement, and we need to capitalize all our resources onto our books, so that we can project strong
Net-worth. We need to evaluate our performance all the time using different financial models and various
financial ratios such as:
• Return on capital employed
• Return on networth
• Replacement costs
With the development of the Islamic Banking, taking hold around the world, even though it may still be in
a very nascent stage,we can utilize many innovative Islamically acceptable financial instruments to leap for
further growth.
We need to identify our core competency, constantly upgrading our facilities and systems, always applying
innovative new ideas, backed by a strong research and development arm and having a very long term
commitment to planning. I think with these qualities inculcated into us we will always grow and never
stagnate
I will conclude with a hadith of RASULLULAH SAW, which says to the near meaning
“That if you are planting a sapling and you here the trumpet being called out for the Day of
Judgement,Rasullah SAW says do not be disturbed by the call but continue in your work and finish the job
in hand”

Why the Muslims should invest in Equity Markets?
Every citizen should be able to take advantage of the boom in the Equity markets of the
country so that they are not left behind in the economic growth that is being witnessed
throughout the country. And it is going to last for years to come.
And in order to remain in the main stream of the economy, Equity stock markets (The
shariah way) provides the most cost effective investment solution for the Muslims.
Equity markets have proved that they are not only the most effective, transparent,
liquid and conducive to small and big size investors as a means of investment, but
history has also proved that it outperforms all other asset classes where return on
investments is the parameter considered. Hence Muslims must invest in the equity
market.
The following paragraphs below demonstrate the inherent advantage investments in
equities have over other forms of investments.
Fixed interest based investments like the saving bank deposit, Bank FDR; Postal savings,
Debentures, Bonds etc are not permitted in Islam. Hence Muslims stand to lose out and
their capital gets depleted over a period of time. Therefore, stocks (The shariah way)
are a far better option available to the Muslims.
Investment in Real estate/ properties, though permissible in Islam, has got inherent
disadvantages over equities. First, because of the unit size, it is not possible for every
individual to buy property since the cost involved is huge whereas, one can invest in
equity (the shariah way) for an amount as low as Rs. One thousand and there are no
upper limits. Secondly, property is subject to a lot of legal paper work and one has to go
through a very cumbersome procedure to acquire properties. However, it is very easy to
buy and sell shares by being a member of a Sebi registered broker. So buying and selling
shares is as easy as snapping your fingers. Finally, there is often a threat of
encroachment of the property which involves costly litigation. Equity shares have a big
advantage here since the stocks purchased get directly deposited in the investor's Demat
account where it is in the safe custody of the custodian and he can sell them whenever
and as much as he wants to sell.
Precious metals (gold, silver, platinum) investments are permitted in Islam. But from
the point of view of economics and return on investments, these precious metals can at
best beat the inflation and since they are globally traded with prices being affected by
global demand and supply, the price and value does not reflect the economic growth of
the nation. Hence, more often than not, it under performs the domestic economy
growth. And since the Indian economy is on a long term growth path, Muslims are
suggested to invest in shariah compliant stocks.
A further problem with precious metal is the warehousing because if they are not safely
stored, then it will always be susceptible to theft. Stocks are kept safely in the Demat
account held with the custodian.
One more point that goes in the favour of equity stock markets is the Capital gains tax
advantage. There is no capital gains tax for long term investors i.e. if the investment is
held for more then one year. And for the short term investments of less then a year,
investors have to pay only ten percent tax on its gains. Muslims must take advantage of
this benefit and invest in stocks that would help them create wealth in the long term
the shariah way.
There is a misconception that investment in stocks is not permissible in Islam and it is
often said that it is 'Haram'. Islamic scholars over a period of time have laid down
certain parameters for investing like the Economic activities and financial ratios. Stocks
which fulfill these parameters should be invested in by the Muslims the 'Shariah way'.
However the only disadvantage the equities have is the risk associated with them. In
order to overcome this risk, one needs to take guidance from Equity Research analysts
(shariah compliant) who can guide and advice them on what to buy and most
importantly when to buy and sell. If this part is efficiently and judiciously taken care
of, then there is no better option then equities for the Muslims

Opportunity of Islamic investment in India

Allah says: Allah made trade lawful and prohibited interest (2:275). At on other place
Allah says O who believer in me fear god and quit what remains of riba if you are
indeed believers; but if you do not, take notice of war from Allah and his
messenger.(2:278-9)
There is two ways of getting profit (1) which Islam permits (2) which Islam prohibits.
Islam has forbidden earning from interests. And has counted as big sin and among
the big sins there is no which forbidden in this manner; that notice a war from Allah
and his messenger. Can human being defeat Allah and his messenger?
In India Muslims are second largest population after Indonesia, Indian Muslims
population estimated to be around 150, millions. Inspite of this India is routinely
ignored in the vast majority of the books articles on the subject of Islamic banking
and or investments. Dow Jones has Islamic index, FTSE of Britain has not only
Islamic Index but also a full fledge Islamic bank, but unfortunately there is not a
single Islamic Product or an Islamic benchmark in Indian investment environment.
Even more bizarre India is not covered and not included for any of their research
work by any Islamic institution or bank .although India is the big market for Islamic
investments,and according to me no research work of any research institution could
be complete without including India. Although India has a good Islamic structure
which provides opportunity of riba free investment and finance which gives us lots of
benefit.
Since the 1991 liberalization reforms, India's GDP has consistently grown at over 5%
and has now crossed the 8% mark. In fact, India is expected to be one of the world's
two largest economies by 2050. The huge capital inflows into the country mirror the
confidence of foreign investors in the Indian economy's ability to match this
expectation.
India's institutional framework is well suited for the world economy. Corporate India
has been performing well and this factor, coupled with strong macroeconomic
fundamentals, growing industrial and service sectors, provides great potential for
investment in the Indian economy.
(1) Stock market:
Common people in our community believe that investment in stocks is prohibited. No
it is not true. Indeed there are some kind of stocks, which might be prohibited but
not all. So prominent Islamic scholars, and ulemas have defined all market
instruments and after that they have permitted with some conditions to have
investments in stock market and invest in it.
(a)The company’s activities should not include liquor, pork, hotel, casino, gambling,
cinema, music, interest bearing financial institutions, conventional insurance
companies, etc.
(b) The total interest bearing debt of the company at any point in time should remain
below one third of its average market capitalization during the last twelve months.
(c) Its aggregate of account receivables should remain below 45% of total assets.
(d) If company has any interest bearing income it should not be more than 10% in
any condition.
While Shariah compliant investment avenues are now becoming available in most
countries, India has not seen large-scale development.To gauge the scope of Islamic
investment opportunities in the Indian stock market, it is imperative to examine
stocks that conform to Islamic Shariah principles "Out of 6,000 BSE listed
companies, approximately4,200 are Shariah compliant. The market capitalization of
these stocks accounts for approximately 61% of the total market capitalization of
companies listed on BSE.This figure is higher even when compared with a number of
predominantly Islamic countries such as Malaysia, Pakistan and Bahrain. In fact, the
growth in the market capitalization of these stocks was more impressive than that of
the non-Shariah compliant stocks.
The software, drugs and pharmaceuticals and automobile ancillaries sector were the
largest sectors among the Shariah compliant stocks. They constitute about 36% of
the total Shariah compliant stocks on NSE. Further on examining the BSE 500 the
market capitalization of the 321 Shariah compliant companies hovered between 48%
and 50% of the total BSE 500 market capitalization.(Source:
www.islamicequity.co.in)
(2) Mutual funds:
Another opportunity is mutual fund which is based on 100% equity. These funds are
invested in different sectors like IT, automobile telecommunication, cement and a
few present in interest based financial institutes, almost 10 to 15 %. So investor has
to purify that amount from the profits. And also there are many sectorial funds which
invests only in a particular sector like automobile,Oil & Gas, etc
Here are some of the most common types of the sharia compliant funds and their
basic investment profile, which an investor must know before leaving his/her hardearned
money at their disposal:
Equity Funds : As the name suggests, equity funds invest the money pooled in from
the investors into stocks. Equity MFs are further classified into sub-categories
depending upon the asset classes such as large-cap, mid-cap and small-cap, sectors
or themes. Equity funds carry a bigger risk profile than the bond funds.
Sector Funds : Sector funds invest in the stocks of one particular sector and these
funds are generally conceptualized after some sector catches fancy of the market or
when there is any significant buzz for some major growth in a particular sector. For
example, the infrastructure sector is the current favourite in the MF circle, while a
few other sectors with exposure to the country’s infrastructure growth are also
finding favour.
However, sector funds do not offer the much-desired diversification to the MF
investors and often these funds enter the market after most of the growth has
already materialized in that particular sector. However, there are certain defensive
sectors like FMCG and pharmaceuticals, which consistently witness some modest
growth with limited volatility.
Index Funds: The index funds primarily invest in the constituent stocks of a
particular market index, such as Sensex and Nifty, and most often track the
movements of those indices. While during a bull run, index funds can give impressive
returns, the losses are also sharp during the bearish phases of the market. However,
the index funds are known to given good returns in the long term, as their portfolio
generally consist of stocks with proven track record.Here however you have to
consider purification as quite a few banking stocks are there in the current index.
Growth Funds: These funds invest in growth stocks, or the stocks of those
companies that are likely to see a sharp rise in their sales and profits. These funds
seek to cash in upon the rise in the share prices of these companies, driven by their
bulging sales and profit books.