Benefits of Islamic Finance as an investment vehicle

With Islamic finance being an emerging sector of the overall economic system, it is rapidly expanding and is now considered to be worth over $1 trillion globally, growing at a rapid rate of 12 to 15% per annum.  With £18 billion of the UK’s annual income generated through Islamic finance.(1)  Its growth is not only limited to the Gulf States as investors across the globe are now implementing its methods.

So, what is Islamic finance and what are its benefits?  The following article aims to highlight the investment principles of Islamic finance.

In essence, Islamic Finance can be described as finance under Islamic Law (or Sharia).  The Sharia is derived from the Quran (2), and also the Sunnah (3), with the consensus of the Jurists and Scholars of Islamic Law.

A contract is deemed Sharia compliant if it:

Prohibits the payment and receipt of interest (Riba)

Rules out uncertainty (or Gharur) about the subject matter and terms of the contract

Prohibits investments in undesirable businesses and unethical causes

Excludes speculative and gambling transactions

Encourages earnings through profit sharing investments

Deploys asset backing principles

Generally, the investment system for businesses that are in widespread use today focuses primarily on loans that are repaid with interest and the system usually favours the lenders.  Money is deemed as an asset in itself and more money can be made through interest.  The Islamic model uses money as a measuring tool for value and not as an asset in itself, so income is not received from money as this is seen as exploitative and usurious.

Investment vehicles through the Islamic finance structure are based on shared business risk. So for example the Islamic model could be loosely compared to the popular BBC show named Dragons Den, whereby investors lend money but also become partners in the business so any loss made will be shared as well as any profits, based on contractual agreements.  Losses being restricted to initial sums invested however gains made continue for the duration of the success of the business venture.  So investors will therefore naturally scrutinise proposed investment vehicles for greater return and those which are most likely to succeed, promoting good entrepreneurship, which in turn promotes a more stable economy.

There are two primary forms of investment vehicles that will be addressed;
 
Musharakah is a joint venture where all partners must contribute capital to the partnership and profits or losses are shared between investors and businesses at pre-agreed ratios, subject to the contribution share of each investor.  This is distinct from fixed income investing i.e. (loans) because of the shared risk and gain.

Partnerships can be agreed for a set period of time (diminishing) or be indefinite (permanent), the type is agreed beforehand.  Where new capital is required from other sources then permission is required from existing partners.  Any fixed wages or salaries can also be negotiated at the start of the contract.  During the process all partners must be regularly updated with information about the businesses.  Any termination of the deal must be done with mutual approval of all partners.

The other form of investment is the Mudarabah system where one partner inputs all the capital, the entrepreneur manages the business entirely by themselves and the management input itself is seen as a type of capital, the investor is seen as a non executive partner.

There is a pre agreed profit sharing ratio and ownership of invested assets remains with the investor at all times.  The losses are shared according to the contributions made by each financier.  So the investor’s maximum loss is limited to the amount contributed and the entrepreneur is not to bear any loss attributable to invested capital unless it is pre agreed that liability extends to the entrepreneur also.

It must be made clear if the entrepreneur wishes to contribute their own capital and permission is required if additional available funds are to be used.  Entrepreneurs make their money from the profitability of the business only, unless it is pre agreed that a wage shall be received.

The agreement may be single-tier where investors deal directly with the entrepreneur or known as two-tier where an intermediary deals with any entrepreneurs on the investors behalf.  Restrictions may also apply to the type of activities the entrepreneur is allowed to undertake, again being pre agreed.

With Islamic investment vehicles sitting on billions of pounds of money worldwide, mainly from sources such as oil and gas, it’s an option that businesses would do well to think about.  It is one of the fastest growing sectors of the finance industry and many new businesses are now venturing to the Middle East to secure investment for business ideas.  It’s important to note however that the ethical nature of Islamic finance would mean that businesses should provide some sort of positive benefit to society and so investments are not made to businesses promoting alcohol, tobacco, gambling, pornography or arms dealing etc.  Overall it is a lower risk system than the mainstream one in practice today and so is more stable for prospective businesses.  This ethical side of finance would give the whole banking industry a better image which is especially needed when booms turn to busts as modern times dictate.

Examples of structures in use today can be seen in London where it’s flourishing as one of the hubs for Islamic finance.  Major Banks like Britain’s HSBC and Citi of the US have set up their own Islamic banking subsidiaries.  The Vatican has put forward the idea that “the principles of Islamic finance may represent a possible cure for ailing markets”. (4)

Even though Islamic banking investment vehicles have been around for about 40 years, they still remain a fairly new and up and coming area in finance globally. It may be seen as a complimentary system rather than an alternative, as it is being used within the framework of the existing monetary system.  With certain aspects of Islamic banking still controversial as they may not be fully adhering to Sharia compliancy there remains many areas of the system that may need improving but it is an area that shows great potential for the future.

The majority of Islamic banks are still to be found in developed countries and the Gulf States, Islamic banking or banking in general is of little benefit to the general population of poorer countries.  However the principles of Musharakah and Mudarabah can be implemented into micro financing which can help poorer communities address the potential issue of Islamic banks not lending to smaller or more risky businesses.

In conclusion, Islamic finance is not simply just an interest free system but it offers much more such as the promotion of entrepreneurship, the safeguarding of property rights, transparent transactions and the honouring of contractual obligations.  It is a universal system that can operate in developed and undeveloped countries and takes into account cultural and regional differences.  It appeals to those who have a moral approach to money and is an ethical form of banking.  It is not about promoting the interest of one group of people at the cost of others.  So no bank will rule everything, risk and benefit is shared between banks and borrowers.  There is an emphasis on keeping the financial sector in sync with the other sectors as it deals with the markets for actual goods and services ruling out gambling and speculation, and contrary to some myths it is not just for Muslims.

(1) http://issuu.com/gifmagazine/docs/gif_media_pack_2011.
(2) The Quran - the last testament abrogating the old and new testaments which were revealed by God, the Lord of Noah, Moses, Abraham, Jesus and Muhammad peace be upon all of them.
(3) The Sunnah - is defined as the traditions of the last Prophet of Monotheism, Muhammad, through his sayings, actions and affirmations.
(4) Lorenzo Toturo (2009-03-04) Bloomberg