Islamic Finance Law

The fastest growing area of international finance

Islamic finance has come a long way since an inauspicious birth five decades ago in Mit Ghamr, a devout village on the outskirts of Egypt’s teeming capital of Cairo. It is now a well-established, vibrant industry worth more than $1tn, with footholds across the world.

Growth has been particularly strong in the past decade. The ideas may have developed in Egypt, but Malaysia and the oil-rich Gulf have transformed a cottage industry into a small but thriving niche of the international financial system.

Islamic finance is seeing spectacular growth since 2008.  Just look at the mathematics. Islamic finance is growing 50 per cent faster than the traditional banking sector, and it has huge growth potential. A quarter of the world’s population is Muslim but only 1 per cent of the world’s financial assets are sharia-compliant. Across the Middle East and North Africa, less than 20 per cent of adults have a formal bank account.

Britain has more sharia-compliant banks than any other western European country. And it has more than a dozen universities or business schools offering executive courses in Islamic finance – including a new programme for senior executives at the University of Cambridge announced this month.

Growth is being driven by record-high oil profits, which in turn is driving Middle Eastern countries to create world-class financial centers such as Dubai, Bahrain, Abu Dhabi, Kuala Lumpur,... According to a McKinsey estimate, Middle Eastern countries will have a total of $9 trillion to invest by 2020. Further demand for Islamic banking will come from the growth in population and wealth of the world's 1.6 million Muslims. The ongoing global credit contraction provides an opportunity for Islamic financing to blossom. 

Key evolutions (Global Financial Development Report 2013):

  • 275: The number of Islamic financial institutions in the world.
  • 75: The number of countries where they have a presence.
  • US$1.357 trillion: The value of the global Islamic finance services industry by the end of 2011.
  • US$4 trillion: The projected value of the global Islamic finance services industry by 2020.
  • £200m: The value of the planned Islamic bond being unveiled by David Cameron in UK.
  • Sharia-compliant financial institutions: 1,124
  • Assets in Islamic finance: between $822 billion and $1 trillion
  • Increase in such assets in 2009: 29%
  • Worldwide Muslim population: approximately 1.6 billion
  • Percent who use banks: approximately 14%

What is Islamic Finance law?

Islamic Finance is one of the fastest growing areas of international finance. Lawyers are needed to structure transactions, albeit using principles based on Islamic law and precedent.

When it comes to financial matters, much Islamic law is based on the Qur'an, the Sunnah (religious precedents) and the Ijtihad (a method of decision making).  Since one of the tenets of Islamic law is that the payment of interest is forbidden, lawyers are often involved in devising and implementing structures that avoid the payment of interest.

Other common aspects of international finance, such as excessive uncertainty in contracts (gharar), gambling and chance-based games (qimar), and transactions involving unethical goods and services, are also prohibited in Islam. Broadly speaking, the Islamic financial model works on the basis of risk sharing between the participating parties, individuals’ rights and duties, property rights and the sanctity of contracts.

What is Sharia law?

Under Sharia Islamic law, making money from money, such as charging interest, is usury and therefore not permitted. Wealth should be generated only through legitimate trade and investment in assets. But investment in companies involved with alcohol, gambling, tobacco and pornography is strictly off limits.

How does Islamic finance work?

The overarching principle of Islamic finance is that all forms of interest are forbidden. The Islamic financial model works on the basis of risk sharing. The customer and the bank share the risk of any investment on agreed terms, and divide any profits between them. The main categories within Islamic finance are: Ijara, Ijara-wa-iqtina, Mudaraba, Murabaha and Musharaka. Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end of the contract. Mudaraba offers specialist investment by a financial expert in which the bank and the customer shares any profits. Customers risks losing their money if the investment is unsuccessful, although the bank will not charge a handling fee unless it turns a profit. Murabaha is a form of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis. Musharaka is an investment partnership in which profit sharing terms are agreed in advance, and losses are pegged to the amount invested.

As a result of these developments Islamic financial institutions have developed a vast range of products designed to serve the growing market. These cater for housing and consumer finance, business loans and project funding. Lately, Malaysia and Bahrain have been instrumental in launching tradeable securities. These should create much needed liquidity and a secondary market for institutional investors in the Islamic finance market.

Several “Islamic equity” investment funds have also been launched, with both FTSE and Dow Jones providing indices to monitor this growing market.

Bodies have already sprung up to address issues of accounting and auditing standards, Shari’a compliance, and central bank regulation. The Islamic Financial Services Board (IFSB) has been launched in Malaysia. This initiative of D-8 countries laid the foundation of the regulation of the Islamic Finance market on a consistent basis.

Islamic finance in non-Muslim countries

As was to be expected the major instruments utilized by the Islamic banks are those which approximate closely to those in the conventional banking market. In particular, there is still a dearth of pure risk sharing instruments where gains and losses are shared equitably between investors and operators. With the emergence of quoted tradable instruments this anomaly is expected to be addressed in the next generation of products.

In Western countries, much progress has been made towards launching mainstream housing and other consumer finance products compliant with the Sha’ria. Following a long period of consultation and advocacy, agreement is close to allow such products to be launched on a competitive basis in many countries. It is expected that within the next months one will see many such products being marketed from high street financial institutions in many non-Muslim countries. This is expected to be followed by similar initiatives amongst the twenty million Muslims in Europe and the United States.

As Islamic finance will arrive on the high streets of many countries, the challenge would be to operationalize the equity considerations of the Sha’ria and make this mode of financing widely accepted amongst a constituency which transcends Muslim communities Nearly all the traditional retail banking services expected from established High Street banks are available in a Sharia compliant format. Banks are hoping to attract business from Muslims living in their homeland.

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