Islamic finance refers to how businesses and individuals raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. Islamic finance can be seen as a unique form of socially responsible investment. This subbranch of finance is a burgeoning field. In this article, we offer an overview to provide elementary information and serve as the basis for further study.

The Big Picture of Islamic Banking

Although Islamic finance began in the seventh century, it has been formalized gradually since the late 1960s. This process was driven by the tremendous oil wealth that fueled renewed interest in and demand for Sharia-compliant products and practice.

The early Islamic caliphates had better-developed market economies than the nations of Western Europe during the Middle Ages.

The concept of risk sharing is central to Islamic banking and finance. It is essential to understand the role of risk-sharing in raising capital. At the same time, Islamic finance demands the avoidance of riba (usury) and gharar (ambiguity or deception).

Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the borrower's expense. Islamic law considers money as a measuring tool for value and not an asset in itself. Therefore, it requires that one should not be able to receive income from money alone. Interest is deemed riba, and such practice is proscribed under Islamic law. It is haram, which means prohibited, as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of an Islamic community.

Accordingly, Sharia-compliant finance (halal, which means permitted) consists of banking in which the financial institution shares in the profit and loss of the enterprise it underwrites. Of equal importance is the concept of gharar. In a financial context, gharar refers to the ambiguity and deception that come from the sale of items whose existence is uncertain. Examples of gharar would be forms of insurance. That could include the purchase of premiums to insure against something that may or may not occur. Derivatives used to hedge against possible outcomes are another type of gharar.

The equity financing of companies is permissible, as long as those companies are not engaged in restricted businesses. Prohibited activities include producing alcohol, gambling, and making pornography.

Basic Financing Arrangements

A brief overview of permissible financing arrangements often encountered in Islamic finance is given below.

Profit and Loss Sharing Contracts (Mudarabah)

The Islamic bank pools investors' money and assumes a share of the profits and losses. This process is agreed upon with the depositors. What does the bank invest in? A group of mutual funds screened for Sharia compliance has arisen. The filter parses company balance sheets to determine whether any sources of income to the corporation are prohibited. Companies holding too much debt or engaged in forbidden lines of business are excluded. In addition to actively managed mutual funds, passive funds exist as well. They are based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.

Declining Balance Shared Equity

Declining balance shared equity calls for the bank and the investor to purchase the home jointly. It is commonly used to finance a home purchase. The bank gradually transfers its equity in the house to the individual homeowner, whose payments constitute the homeowner's equity.

Lease to Own

This arrangement is similar to the declining balance one described above, except the financial institution puts up most, if not all, of the money for the house and agrees to sell the house to the eventual homeowner at the end of a fixed term. A portion of every payment goes toward the lease and the balance toward the home's purchase price.

Installment Sale (Murabaha)

An installment sale starts with an intermediary buying the home with a free and clear title to it. The intermediary investor then agrees on a sale price with the prospective buyer; this price includes some profit. The purchase may be made outright (lump sum) or through a series of deferred (installment) payments. This credit sale is an acceptable form of finance and is not to be confused with an interest-bearing loan.

Leasing (Ijarah)

Leasing, or Ijarah, involves selling the right to use an object (usufruct) for a specific time. One condition is that the lessor must own the leased object for the duration of the lease. A variation on the lease, 'ijarah wa 'iqtina, provides for a lease to be written where the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. This promise binds only the lessor. The lessee is not obligated to purchase the item.

Islamic Forwards (Salam and Istisna)

These are rare forms of financing, used for certain types of business. These are an exception to gharar. The price for the item is prepaid, and the item is delivered at a definite point in the future. Because there is a host of conditions to be met to render such contracts valid, the help of an Islamic legal advisor is usually required.

Basic Investment Vehicles

Some permissible Islamic investments are listed below.

Equities

Sharia law allows investment in company shares (common stock) as long as those companies do not engage in forbidden activities. Investment in companies may be in shares or by direct investment (private equity).

Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). One set of filters excludes companies that hold interest-bearing debt, receive interest or other impure income, or trade debts for more than their face values. Further distillation of the screens above would exclude companies whose debt/total asset ratio equals or exceeds 33%. Companies with "impure plus nonoperating interest income" revenue equal to or greater than 5% would also be screened out. Finally, Islamic scholars would exclude firms whose accounts receivable/total assets equal or exceed 45%.

Fixed-Income

Retirees who want their investments to comply with the tenets of Islam face a dilemma in that fixed-income investments include riba, which is forbidden. Therefore, specific types of investment in real estate could provide steady retirement income while not running afoul of Sharia law. These investments can be direct or securitized, such as a diversified real estate fund.

In a typical ijarah sukuk (leasing bond-equivalent), the issuer will sell the financial certificates to an investor group. The group will own the certificates before renting them back to the issuer in exchange for a predetermined rental return. As with the interest rate on a conventional bond, the rental return may be a fixed or floating rate pegged to a benchmark, such as LIBOR. The issuer makes a binding promise to buy back the bonds at a future date at par value. Special purpose vehicles (SPV) are often set up to act as intermediaries in the transaction.

A sukuk may be a new borrowing, or it may be the Sharia-compliant replacement of a conventional bond issue. The issue may even enjoy liquidity through listing on local, regional, or global exchanges, according to an article in CFA Magazine titled, "Islamic Finance: How New Practitioners of Islamic Finance are Mixing Theology and Modern Investment Theory" (2005).

Basic Insurance Vehicles

Traditional insurance is not permitted as a means of risk management in Islamic law. That is because it constitutes the purchase of something with an uncertain outcome (a form of gharar). Insurers also use fixed income—a type of riba—as part of their portfolio management process to satisfy liabilities.

A possible Sharia-compliant alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policyholders. Such a structure exists infrequently, so Muslims may avail themselves of existing insurance vehicles if needed.

The Bottom Line

Islamic finance is a centuries-old practice that is gaining recognition throughout the world. The ethical and economic principles of Islamic finance are even drawing interest outside the Muslim community. Given the increasing development of Muslim nations, expect this field to undergo even more rapid evolution. Islamic finance will continue to address the challenges of reconciling Islamic investment policy and modern portfolio theory.