Banking on principles.

Over the past decade growth in the Islamic banking system has outstripped that of conventional Arab banking. Today there are about 150 Islamic banking institutions throughout the world. Yet despite the ever increasing importance of the Islamic sector, the basic principles of the system remain a mystery to many experienced financiers and investors. In this special feature financial writer MOIN A. SIDDIQI provides a guide to the principles of the Islamic system and its instruments.

The value system of Islam provides guidelines for all aspects of human behaviour, including economic activities, legal affairs, and personal morality. Contained in the Sharia, the Islamic canon law, is an entire body of legal and ethical rules derived from the Holy Koran, and the sayings and practices of the Prophet Mohammed. In essence, pure Islamic banking is shaped by the Koran's prohibition of riba (interest or usury) and gharar (speculation). Usury, of course, has been condemned in other religions. The Koran contains no condemnation of wealth, and encourages private enterprise, but opposes "abnormal profit" based on unfair competitive advantages. The underlying principle dictates that profit is not morally acceptable unless an asset yields economic and social "added value". Hence direct correlation between investment and profit remains the fundamental difference between Islamic and conventional banks.

The essence of Islamic finance is that capital should be utilised for productive purposes only and investment activities should take the form of a partnership, in which the provider of capital and the entrepreneur share in the risks and rewards of the venture, ie the concept of profit and loss sharing (PLS). As Professor J. Presley of Loughborough University puts it: "Islamic banking is all about taking risks and sharing that risk with the client."

Islamic doctrine forbids the storing of money, and hence holding classic stores of value such as gold is not allowed (although, paradoxically, gold and jewellery dealings are common in most Muslim countries). Investments in companies and businesses which generate profits from proscribed activities are forbidden as, of course, are conventional banking and insurance. Fixed income assets such as Treasury Bonds and Gilts which pay predetermined interest rates, and trading in derivatives are also unacceptable under Sharia, as there are no physical goods involved. Development bonds, where the rate of return is compatible with underlying performance of development projects, mostly infrastructure related, are allowed in place of conventional bonds. Malaysia is reportedly in the process of launching the first Islamic asset-backed bond, where investors would receive a portion of the lease rental stream.

Thus while conventional banks exploit market imperfections - surplus, deficits, transaction costs, financial claims etc - to reap maximum profits, islamic banks maintain a greater balance between the interests of investors, shareholders, users, and society. Islamic banking operates within two sets of objectives: safeguarding investors' interests through undertaking prudent investment activities on the basis of fair and legitimate profits, and conformity to the Sharia, which opposes the concept of making money from money without any physical trade.

The perceived main difference between Western and Islamic banking is the concentration on human resources and their businesses, rather than on the profitability of their accounts. The spread of Islamic banking since the 1970s, even without full support of coherent legislation and sophisticated infrastructure has been impressive. Today, there are about 150 Islamic institutions throughout the globe, from Europe through the Middle East and Africa, to Asia. It is not entirely clear how much money is in the Islamic system worldwide. The funds under management were estimated at between $79$106 billion in 1996. Over the past decade, growth in Islamic banking - averaging 15 per cent per annum - has outpaced growth in the Arab banking system.

Modes of financing

Islamic financial instruments that have evolved over the past two decades, are ineffectual, little different from more conventional techniques. Below are some of the standard structures and components of modern Islamic finance:

Bai-Mujal/Murabaha is a resale contract, in which a bank purchases equipment or goods on the client's behalf, and then sells them on to the client at an agreed profit margin. The mark-up is for services rendered and not for deferred payments, and is justified since the financier accepts the risks of possible default or damage to goods between the time of purchase and selling on to the buyer. In practice the mark-up reflects prevailing London interbank offered rate (LIBOR), and the extent of the bank's mark-up depends on factors including the size of the overall transaction, the creditworthiness of the client - the same criteria which determines the pricing of a conventional trade deal. But mark-up expressed as a fixed price cannot be altered during contract's duration.

Murabaha deals usually cover short-term trade finance, though a few have extended over the medium term. Murabaha remains the most common Islamic instrument and confers considerable tax advantages.

Al-Bai Bithaman Ajil is a variant on the concept of Murabaha, where deferred payments are allowed by a bank within a specified period.

Ijara is similar to conventional leasing but with no option of ownership for the lessee.

Ijara Wa-Iktina is finance leasing with the option of eventual ownership, whereby a bank will purchase equipment such as buildings, or even an entire project. The client agrees a rent to be paid into an Islamic investment account, which will eventually lead, as stipulated, to the lessee's purchase from the lessor. Under the Sharia, conditions governing the use of both types of lease are:-

* Leased assets must have an active and physical use, a long and secure productive life, and must not be used in an unacceptable way, for example, for the purchase of arms or gambling equipment. The rent must be defined and pre-agreed to avoid speculation, and leases must not be based on riba.

* Maintenance and insurance of the leased asset are the responsibility of the lessor.

Mudaraba (Trust Financing) is a contractual arrangement whereby an investor, Rab Al-Maal (beneficial owner), entrusts capital to an agent, Mudarib, for investment and trading purposes. Profits are divided in a ratio specified in the original agreement. Losses are borne by Rab Al-Maal, but losses sustained due to the negligence of the Mudarib are borne by the latter.

Mudaraba cover usually short-term facilities (maximum of one year), extended as a working capital, or for expansion of business activities. A common variation now is the Two-Tier Mudaraba, in which a bank organises investors money into a mutual or unit trust fund, and channels it into a Mudaraba contract with a fund manager. Most operate as either closed or open-ended investment funds, with tradeable units.

Musharakah is the same as a joint-venture or equity partnership, whereby both parties (the bank and client) contract to provide capital, and either one or both may manage the business. The profits are shared in pre-agreed ratios but the losses are borne in proportion to equity participation. Musharakah is suitable for long-term project financing, and is regarded as the purest form of Islamic instrument, as it conforms to principle of PLS. But it is used on a relatively infrequent basis as it entails unlimited liability over the long term.

Takafol is a mutual insurance fund, in which various participants pay installments into a fund managed by the bank. The bank acts as managing trustee.

Istisna is a pre-delivery financing and leasing structure instrument and is used to finance the manufacturer of plant and equipment. Istisna forms an important component of large-scale project financing. Commodity futures trading has been developed on the basis of future contracts or swaps. Innovations include Bai-Salam, a trade deal in which a buyer pays an agreed price in advance for a commodity that is delivered at a future date.

Bai-Muajjal, whereby a seller allows a buyer to pay for a commodity at an agreed future price in either a lump sum or installments.

Qarz Hasana is a benevolent loan, and hence no interest or Al-Air (service charge) is levied. Repayment is made over a stipulated period as and when the borrower is able to repay. The government of Pakistan has resorted to borrowing on the Qarz Hasana principle in an effort to rebuild foreign exchange reserves.

Ordinary Loans are granted on an interest free basis but Al-Air is levied. Service charge represents an amount calculated on working out actual costs in providing a loan rather than a fixed percentage. An Islamic bank in an agrarian economy, for example in Pakistan or Sudan, may promote and accelerate development of a society by providing finance and other services on Mozara'ah basis, whereby money is offered for buying seeds and equipment, and the bank also undertakes functions for storage and marketing of the produce. The farmer contributes land and labour to the venture. Musaqat also relates to agricultural financing, but transactions pertain only to cultivation of land and irrigation.