The Islamic Finance Model
The Islamic economic model has been developed over time, based on the rulings of Sharia on commercial and financial transactions. The Islamic financial framework, as seen today, stems from the principles developed within this model, some of which are outlined below:
• The Islamic economic model emphasises fairness. This is reflected in the
requirement that everyone involved in a transaction makes informed decisions and is not misled or cheated. On a macro-economic level, the Islamic model aims at social justice and the economic prosperity of the whole community; for example, specific Sharia rulings seek to reduce concentration of wealth in a few hands, which may be detrimental to society.
• Islam encourages and promotes the right of individuals to pursue personal
economic wellbeing, but makes a clear distinction between what commercial
activities are allowed and what are forbidden. For example, transactions involving alcohol, pork related products, armaments, gambling and other socially
• One key Sharia ruling on economic activities of Muslims is the strict and explicit prohibition of Riba, most usually described as usury or interest. Sharia scholars consider exchanging interest payments within the conventional banking system as Riba. Modern Islamic banking has developed mechanisms to allow interest income to be replaced with cash flows from productive sources, such as returns from wealth generating investment activities and operations. These include profits from trading in (real) assets and cash flows from the transfer of usufruct(the right to use an asset), for example, rental income.
ARE ISLAMIC BANKS MORE RISKY?
One of the prominent features of Islamic finance is that in conforming to Shariah law, any financing necessarily involves banks trading in and holding tangible assets, such as commodities and immovable property, or sharing risks with their customers through the use of partnerships or equity participation4. Some commentators have suggested that these elements of trading and ownership of assets, and sharing of business risks may expose an Islamic bank to additional risks that are not typical of a conventional commercial bank that has as its main activity the provision of loans. However, in practice, Islamic banks generally make extensive use of risk mitigation. These include the use of service agency contracts with customers to assign certain responsibilities5, agency contracts with customers for the procurement of assets, third party insurance to limit the risks of asset ownership, and special purpose vehicles to hold assets. There is also the structuring of transfer of ownership of the asset to the customer progressively through a diminishing musharaka (partnership), or at the end of a period as in ijara muntahia bittamleek (leasing with sale; henceforth referred to as “IMB”). Banks also commonly take collateral and/or ensure that they have recourse to customers. These risk mitigants reduce or limit the risks of asset ownership to the banks and have the effect of leaving the Islamic bank primarily exposed to the credit risk of the customer being financed
A simple illustration of how Islamic banks are not necessarily exposed to greater or different risks is the murabaha-based (mark-up) asset financing, commonly used in home financing and car financing internationally.
In such a transaction, the bank generally purchases the asset to be financed, and then sells it to the customer at a mark-up, to be paid on a deferred basis. The mark-up represents the profit to the bank for the transaction. As the purchase of the asset by the bank and the sale to the customer generally happen within a short period of time, the bank effectively takes on little additional risk6 from that short-term ownership of the asset. The main risk the bank takes on is the credit risk of the customer. Such a risk is not dissimilar
rom the risks taken by a conventional bank making a loan. The bank can choose to take security over the underlying asset in a murabaha to enforce the repayment of the amount owed, which is again similar to the taking of collateral in a conventional loan. In this way, Islamic banks make use of structuring and other risk mitigants to lower the risks that they take on, and ensure that they primarily take on credit risk. A second example is that of the IMB, which is commonly used in home financing and in project finance. A typical way of structuring an IMB is to have the bank purchase the asset, such as the house in the case of home financing, and then enter into a lease agreement with the customer, where the cumulative value of the lease payments generally exceeds the purchase price paid by the bank. To mitigate the risks of owning the asset, the bank will generally appoint the customer as its service agent for the purpose of maintaining the asset, obtaining appropriate insurance and paying taxes on the asset. The bank will also structure the transfer of ownership of the asset
to the customer by agreeing to pass the asset to the customer at the end of the lease, either as a gift or through a sale. As such, the bank is able to mitigate most of the risks of ownership of the asset. Through the techniques
of risk mitigation, the bank is able to ensure that it primarily takes on the credit risk of the customer.