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Commercial Question

When Religion and Finance Intersect

updated on 07 April 2009


What is Islamic finance?


It is widely recognised that Islamic banking and finance techniques have not only developed in recent years, but have also grown in importance. In short, Islamic finance is a general term, given to the investment of money in accordance with Islamic law, sharia. There are a number of features that distinguish Islamic finance from traditional banking methods, some of them more commonly recognised than others.

The most common principle is that both the payment and receipt of interest, riba, is prohibited. This means that instead of interest, any returns on funds provided by the Islamic bank are usually earned by way of profit, derived from a commercial risk taken by the bank. As a result, when an Islamic bank releases monies to a customer, it does so on the understanding that it shares some of the risks and rewards undertaken by the customer.

Another important principle is the fact that Islamic finance can only be made available for investments, or projects, that do not contradict general Islamic (or sharia) principles. For example, Islamic financing is unlikely to be available for investments involving alcohol or gambling, or for projects where part of the income for the project is to be derived from alcohol or gambling related activities.

There is some debate as to the extent to which the area of futures trading can operate alongside Islamic principles. As its definition suggests, futures trading usually involves trading in commodities that may or may not exist at the time that a contract is entered into. If the commodity exists on the date of sale, but is not to be delivered until a future date, then the transaction will generally be considered to be in line with Islamic principles. On the other hand, the idea that something does not exist on the date of sale, but can still be lawfully sold, is not consistent with Islamic principles.

Although currency futures or forward trading are likely to be prevented, currency swaps are generally considered to be consistent with Islamic principles. Currency swaps are likely to be considered sharia compliant so long as there is no element of an interest rate swap alongside a currency swap, and provided that transactions involve the simple exchange of one currency for another at an agreed spot exchange rate.

So how do Islamic banks continue to offer finance and operate in today’s markets? To ensure compliance with underlying Islamic principles, the majority of Islamic banks (or the Islamic branch of Western banks) maintain a so-called religious board, largely comprised of respected Islamic academics and scholars. This board will scrutinise proposed transactions and review the bank's overall financing methods.

As a consequence of the above, what techniques are used in Islamic finance? Although definitions vary, and certain institutions and established clients have their own standard mechanisms that incorporate Islamic principles, a few of the more common structures are outlined below.

This financing structure is frequently used in trade financing and project financing arrangements, either on secured or unsecured terms. The Islamic financing institution will, at the request of the customer, buy goods from a supplier. They will then sell the goods to the customer at an agreed, marked-up price, the payment of the purchase price to the bank being deferred. The bank may only hold title to the goods for a few seconds, but the profit generated by the bank on the marked-up price is still a profit derived from a sale transaction – the bank having taken a commercial risk in purchasing the original goods – and is therefore not prohibited as interest (riba).

This financing structure has been used to form the basis for Islamic investment funds. Customers subscribe to the mudaraba fund that the bank, in its professional investment capacity, invests in appropriate ventures (as described above). A fixed percentage of any profits, established at the outset, will be given to the investing customers and the bank will deduct charges/fees for managing the investment funds.

In essence, there are few differences between a Western lease and the ijara, Islamic financing's equivalent. With ijara, the bank purchases the asset in question and leases it to the customer for an agreed rent. The rent will take into consideration an agreed profit element, made in favour of the bank. Although commercial interest and insurance considerations will be relevant in setting the agreed profit, there must be no direct correlation between the ijara lease rental and interest rates.

As a result of the above, how widespread is Islamic finance? During an international conference on Islamic finance in June 2006, the now Prime Minister Gordon Brown (then chancellor of the exchequer) declared his desire to see London as the international global centre for Islamic financial activity. To this end, in March 2007 the British government announced plans to introduce equivalent tax relief incentives for Islamic debt securities as for conventional debt securities. In addition, the Financial Services Authority has also taken a keen interest in the area of Islamic finance and has dedicated resources to help develop the requisite regulatory framework.

As mentioned, Islamic finance is increasingly being offered by both Islamic departments of Western banks and specific Islamic financing institutions. The value of both the Islamic asset and debt markets are increasing rapidly and the geographical reach of Islamic finance is also widening. At the same time, Islamic compliant methods of finance (i) rely on concessions by financial institutions in order for them to work alongside a modern day, interest based economy, and (ii) present many challenges, albeit exciting and demanding, for the legal, regulatory and accounting sectors. Thus, although the area of Islamic finance is not without its problems or its critics, it certainly seems to be an area to watch closely, and one which is expected only to grow stronger.

Amy Kennedy is an associate from the London office of Skadden Arps Slate Meagher & Flom (UK) LLP.