Islamic Finance: The Contracts, Instruments and Practices

Islamic Finance is based on interpretations from the Qua ran. It has two central themes. That is that no interest can be earned on loans and socially responsible investing is a requirement.

The start of modern Islamic Finance can traced back to the 1970's when the need for this type of finance was satisfied through a small-scale business involving people who did business in compliance with principles of Islamic law, or Shari'a. Shari'a is the Arabic term for Islamic law as a way of life. Another relevant term to understand is Fiqh that is generally translated as the philosophy of law and is the interpretation of Shari`a for specific circumstances by specialized fuqha, or legal experts.

As a result of the complex nature of Islamic Shari`a law, the operators in the Islamic financial market will usually appoint a Shariah board in order to scrutinize and approve planned financial transactions for suitability.

The Islamic Contract

Islamic Finance was originally primarily for the use of people of the Muslim faith. Notwithstanding several differences of understanding the different forms of commercial Islamic contracts that is in general use can be divided into three primary categories. These are:

1) Contracts of exchange

2) Contracts of rental

3) Contracts of investment partnerships

Contracts of Exchange

The contract of exchange is basically a contract where the one party (with the money) buys the item and then sells it back to another party (the one who is in need of financing) at an arrangement upon mark-up. This mark-up is normally closely linked to the prevailing interest rate. This type of contract is given the classical Arabic name murabaha.

Contracts of Rental

Contracts of rental are also called diminishing partnership agreements. This type of contract is known under the Arabic names Ijara or Musharaka Mutanaqisa.

In terms of this type of contract the owner of the funds buys the item and then leases the property to the customer for monthly payments. The monthly payments are calculated to be part rent and part capital amount.

Contracts of Investment Partnerships

This type of contract is generally used for consumer finance through a three-party contract known by the Arabic name Tawarruq. The basic principle of this type of contract is that the holder of the money will buy a certain amount's worth of a commodity and then sell this to the customer on credit at an agreed upon mark-up. The customer than sells the commodity to a third party, thus collecting the desired cash with the ability to repay the loan over time. The loan will be equal to the capital sum of the loan plus the markup that is often equal to the interest rate. The party buying back the commodity is frequently the same party that sold it to the owner of the money.

Interest Charges in Islamic Finance

The Shari'a law forbids riba/usury and result in the fact that Islamic finance is "asset-based". This implies that one cannot pay or charge interest on money, as is the practice in non Islamic Finance contracts.

Acceptable Practices in Islamic Finance

In Islamic financial contract dealings it is commonly accepted that commercial dealings must be compliant with certain acceptable practices. These practices can be summarized as follows:

1) The contract price of the item financed must be at a price that is mutually agreeable to all the parties to the contract.

2) The agreement to the price must not be made under duress.

3) The contract must be between parties that are mentally healthy and able to make rational decisions.

4) The parties to the agreement must be old enough to understand the implications and consequences of entering into the said contract or agreement. (in other words they are mumayiz)

5) The presentation of the fact relevant to the contacted item/s should be without ambiguity or deception (gharar). This often refers to the quality of the goods or the seller's capability to deliver the items.

6) No contract under Islamic Finance may be contradicting or opposing a value that is prohibited under Islamic law.

Conclusion to Islamic Finance

In an article published 0n 4 March 2009 by Lorenzo Totaro on Bloomberg.com he reported that "The Vatican said banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis." This type of article brings Islamic finance more and more under the attention of the main stream financial institutions.

Islamic financial institutions are growing at a rate of between 10 and 15% per year with signs of expanded growth in the future. Moderate estimation indicates that assets in excess of US$ 500 billion are managed in keeping with Islamic financial principles.

With the explosion in the need for Islamic Finance over the world it is important for all users and owners of money to get to grips with the principles that drive this very important and growing financial market.

© 2009 Carl Marx