Islamic finance: Leaning on Equity

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Islamic finance albeit more popular in recent times, has been around for 1400 years. The essence of Islamic finance revolves around the simple notion that wealth must be preserved, invested and circulated. It is rather different from the conventional financial model in form and substance. The cornerstones are set on grounds of social justice.

So what is the first thing that one must know about Islamic finance? This financial model, unlike its conventional counterpart, is not based on debt and interest. Instead, Islamic finance is an equity based model where the concept of wealth multiplication through Riba (interest) does not exist. Under Islamic finance, interest is forbidden. One cannot simply multiply their wealth without its constructive use and the return cannot be guaranteed with a pre-calculated sum. Rather the wealth must be invested under the umbrella of “equity” and risk must be shared. This model effectively places a lender into the shoes of a stakeholder. There are multifold ramifications to this form of investment:

  1. Social justice: This does not impose undue burden on the borrower. If their project fails, they would not be burdened by the otherwise enforceable interest under the conventional model.
  2. Higher reward: Provided the project turns into a successful one, the lender can be rewarded with a return on their investment. The more successful the project, the higher the profit and thus higher the return on the initial investment.
  3. Protection from loss: The risk in a project is usually borne by numerous lenders through portfolio management, ensuring that the loss is never too great for one individual lender.
  4. Higher accountability: The Islamic finance places a higher standard of accountability on the borrower in terms of investment of funds. Under some portfolios the lenders are even given the option to advise on investments without getting too involved. This automatically encourages and prompts the project to be more constructive and in turn, more successful.

There are numerous forms of financial arrangements that can take place under Islamic finance. The most widely used forms can broadly be categorized as follows:

  1. Mudarabah: This model encompasses the notion of profit and loss sharing contracts. The financial institution pools in the depositors’ money and invests into projects held under a diverse group of portfolios. The projects are carefully screened and depositors are rewarded by profits made through investments (as opposed to fixed interest). This model is based on the financial institution handling the funds and the deposits are not consulted on the projects.
  2. Musharakah: This refers to a joint enterprise and very similar to the concept of Mudarabah i.e. profit and loss sharing. Musharakah is different in that funds from two or more investors are pooled in together to invest in a given project, similar to a partnership or co-ownership. Again, there is no concept of fixed earning or interest under this model. Instead the profitability is determined on the success of the project on a pre-determined ratio. One risk that the investors undertake is that liability is undertaken in ratio of the capital invested. Given the underlying risk factor and direct investment, the investors all get a say in the management of the project. The entities formed through Musharakah are called Sharikats. There are two principal types of Sharikats:
    1. Shairkat al-mulk: partnership formed through inheritance or wills.
    2. Sharikat al-aqd: partnership formed through contract. This form of partnership or business entity can be further classified into three categories:
      • Sharikat al-inan (Limited Liability Partnership): This functions very much like a limited liability corporation where shareholders contribute capital and participate in management.
      • Shairkat al wojooh (Liability Partnership or Receivables Partnership): The capital of this partnership is reputation whereby partners buy goods on credit backed by reputation and sell the goods for immediate payment.
      • Sharikat al-mufawadhah (Full Authority and Obligation): A partnership that involves both partners contributing capital and participating in management. Nobody is a silent partner and everything is done on an equal basis.
      • Sharikat al-a’maal (Occupation Partnership): This involves partnership between two or more persons combining their professional expertise with a view to making profit.
    3. Ijarah: In simple terms, it refers to sale of the right use an object for a specific period of time i.e. leasing. The lessor must own the object for the entire duration of the lease. Under this model the lessor may provide the option of purchasing the object to the lessee.
    4. Sukuk: Sharia compliant bonds are referred to as Sukuks. Since interest is forbidden in Islamic finance, this type of bonds yield return in a different manner. As with all forms of Islamic models, this has to be backed by an asset. The borrower creates a SPV, which purchases the assets of the borrower and converts the values of assets into securities. These securities are Sukuk that are purchased by investors and the price is paid to the borrower against the assets. The SPV leases the assets back to the borrower with the option to buy back the assets at the end of the lease. In the meantime, the profit earned by the borrower is paid to the investors on the Sukuk.

It is no surprise that equity principle of Islamic finance is gaining popularity with the passage of time. The system works and provides an alternative to the conventional financial model for the risk-minimizers. On a spiritual note, the notion of risk sharing, social fairness and distribution of wealth is appeasing and is therefore becoming increasingly attractive to a lot of investors from around the globe. Global financial institutions have picked on this and are running the conventional and Islamic models concurrently.  Thailand has been working towards a framework to develop Islamic finance, but it has been a slow process.  Will this lead to a growth of the hybrid models in the future within Thailand? Only time will tell.



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